Economic Effects Of State Bans On Direct Manufacturer Sales To Car Buyers

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ECONOMIC ANALYSIS GROUP

COMPETITION ADVOCACY PAPER

Economic Effects of State Bans on Direct

Manufacturer Sales to Car Buyers

EAG 09-1 CA May 2009

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* Economist, Antitrust Division, U.S. Department of Justice, Washington, DC. I am grateful to Oliver Richard and Carl Shapiro for insightful comments and to Terry Zeng for research assistance. Any errors are my own.

The Antitrust Division encourages independent research by its economists. The views voiced herein are entirely those of the author and are not purported to reflect those of the United States Department of Justice.

State franchise laws prohibit auto manufacturers from making sales directly to consumers. This paper advocates eliminating state bans on direct manufacturer sales in order to provide automakers with an chance to reduce inventories and distribution costs by better matching production with consumer preferences.

Automakers General Motors Corporation (GM) and Chrysler LLC have received $17.Four billion in loans under the Troubled Asset Ease Program (TARP) and have indicated that they may need up to an extra $21.6 billion in federal assistance to restructure their operations. (1) As a condition of the loans, the companies are required to develop plans to achieve profitability. Much attention in the plans has centered on getting labor costs under control. Among other measures addressed are ways to cut distribution costs. As part of its cost-cutting effort, GM has announced that it will reduce its dealership network from over 6,200 dealers today to Four,100. The cost of the auto distribution system in the United States has been estimated as averaging up to thirty percent of vehicle price. (Two)

With dealer networks being rationalized as part of cost-cutting initiatives, direct manufacturer sales to car buyers may present an extra chance to lower distribution costs. Such sales might range from consumers’ simply ordering assembled vehicles of their choice directly from automakers to a script along the lines of the “Dell Direct” build-to-order model that revolutionized the individual computer production and sale process. GM initiated a build-to-order sales model in Brazil for its Chevrolet Celta economy car over eight years ago. In 2008, the Celta was among the sales leaders in Brazil. (Three) At the time of the Celta’s introduction, an auto analyst said that build-to-order could result in “spectacular improvements in the company’s competitiveness and profitability.” (Four)

In the United States, however, direct manufacturer auto sales are prohibited in almost every state by franchise laws requiring that fresh cars be sold only by dealers. These bans on direct manufacturer sales are part of a broad array of state laws that bar manufacturer ownership of dealers and regulate entry and exit of dealers through territorial confinements and provisions on dealer termination. Analysis of the economic effects of these laws has led some to conclude that they harm consumers and should be eliminated. (Five) The concentrate here is more narrow – state laws banning direct manufacturer sales, since they may be curtailing development of a more cost-effective method of auto distribution. (6)

The next section offers a brief overview of the auto dealer franchise system. Then the essential features of the direct manufacturer distribution model are described and compared with the traditional method of selling autos. Discussion of the benefits of a direct distribution model to auto consumers and manufacturers goes after, along with economic analysis of some of the concerns of dealers. A conclusion addresses the question of federal involvement in this issue.

II. The Auto Dealer Franchise System

Early in the evolution of the auto industry direct manufacturer sales to consumers were not uncommon. At that time, production processes had not yet been standardized and industry sales volumes were low. Introduction by Ford of the assembly line mechanism early in the twentieth century enabled high-volume production and ushered in the era of mass-market sales in the United States. Ever since then manufacturers have sold cars through franchised dealerships.

Selling through dealerships has suggested several benefits to manufacturers historically. Auto production is a capital-intensive business and a franchise system permitted manufacturers to concentrate their resources upstream while accessing capital through franchise fees from independent entrepreneurs at the retail level. Economies of scale in auto production also required having relatively few, large manufacturing operations located near essential supplies like steel. This contrasted with the nationwide distribution network needed to reach consumers, who could be more effectively served through local dealerships in a better position to assess request in particular markets and to provide service and repairs.

Since running a dealership can require making a substantial investment in real estate and assets like showrooms and service facilities, the franchise system also had to suggest terms that would make it attractive to dealers. This was accomplished voluntarily by contract, through franchise agreements, even prior to enactment of state franchise laws. Typically such franchise agreements give a dealer special rights to a particular geographic sales territory of a manufacturer. This type of arrangement permits dealers to realize a come back on their investment while providing them incentives to undertake advertising and promotional activities and to provide services, like showroom displays, test drives and other types of consumer information, valuable to manufacturers in marketing their vehicles.

With the advent of the internet, some of the mutually beneficial nature of the franchise system for manufacturers and dealers has diminished, as information and access to services historically provided primarily by dealers has become more readily available. Online buying services are an visible example. In addition, a multiplicity of auto information, including pricing data and reviews, can be found online from sites like Edmunds and Consumer Reports. This raises the prospect of disintermediation, broadly defined as direct-to-consumer sales through reduction or elimination of the role of retailers. With respect to autos, unlike the situation with books and CDs, most customers most likely will proceed to want some hands-on contact with the product before purchasing, likely implying a continuing, tho’ possibly switched, role for dealers. Since the internet can potentially provide manufacturers with better information on consumer preferences than the traditional local franchised dealer, direct manufacturer sales may be one way through which that switched dynamic occurs.

III. Comparison of Direct Manufacturer Sales with Traditional Auto Distribution

There are substantial differences inbetween the auto industry and the private computer (PC) industry in which Dell pioneered the direct manufacturer distribution model. (7) These differences have implications for the extent to which a direct manufacturer sales model is adaptable to the auto industry. Auto production is presently characterized by integral and closed product architecture where product design is critical. There is much more product diversity in autos than in PCs and the myriad auto components tend to be non-standardized without a common interface across models or companies. By contrast, the manufacture of PCs involves a modular structure with a smaller number of standardized components or modules having a common interface. Build-to-order private computer products can be readily assembled using the common interface by matching modules to customer preferences.

Despite the differences in the design and production processes of PCs and autos, the computer industry’s Dell Direct model can provide some insight into potential cost reductions, particularly with respect to inventories, from direct manufacturer sales of autos. The defining characteristic of the Dell Direct model is the virtual elimination of inventories. Albeit Dell modified its distribution system a few years ago, historically Dell had sold only directly to final consumers based on customized orders shipped to end users. (8) In the process Dell avoided the cost of carrying finished inventories. Unlike the build-to-order PC model, auto distribution is “make-to-stock,” with cars sold through extensive franchised dealer networks. Dealer inventories can range from sixty to ninety days, a consequence of which are substantial carrying costs and negotiation of prices with consumers in order to keep inventory stocks manageable.

Direct manufacturer car sales may have the potential to reduce inventory costs. The salient point is that whether or not direct manufacturer sale of autos is to evolve as a distribution channel in the United States should be determined by the preferences of consumers and the capability of auto producers to meet those preferences, rather than being precluded by fiat. If state laws prohibiting direct manufacturer auto sales remain in effect, automakers may be frustrated from making one type of long-run adjustment to reduce costs that could play a role in their efforts to restructure.

IV. Benefits of Direct Manufacturer Auto Sales

Perhaps the most evident benefit from direct manufacturer sales would be greater customer satisfaction, as auto producers better match production with consumer preferences ranging from basic attributes on standard models to meeting individual specifications for customized cars. With better information about consumer request, optimal inventory levels should fall, even brief of utter build-to-order capability by auto manufacturers. To the extent that there are cost savings from leaner inventories, a portion could be passed on to consumers as lower prices. The total value of fresh car inventory held by the 20,700 franchised fresh car dealerships in the United States near the end of two thousand eight was about $100 billion and the annual carrying cost of that inventory was estimated as $890 million. (9) These figures may provide an order-of-magnitude perspective of the savings potential from a reduction in inventories that might derive from direct manufacturer sales of autos.

The most comprehensive estimate of the savings in the vehicle order-to-delivery cycle from build-to-order, direct manufacturer sales is set out in a two thousand report by a Goldman Sachs analyst. (Ten) Based on an average vehicle price of $26,000, total cost savings in the order-to-delivery cycle were estimated as $Two,225 or about 8.6%. (11) The components of those savings were as goes after: $832 from improvement in matching supply with consumer request; $575 from lower inventory; $387 from fewer dealerships; $381 from lower sales commissions and $50 from lower overall shipping costs, since fewer dealerships would reduce the number of distribution points. The Goldman Sachs report identified other possible build-to-order savings of about $1,000 per vehicle in product development, manufacturing plasticity and procurement and supply but the lion’s share of the benefits were attributed to improvements in the order-to-delivery cycle. In a nutshell, the current auto industry make-to-stock sales model takes a lot of money, much of it tied up in inventories and dedicated to discounting to clear lots of less popular vehicles, to attempt to sell cars that can come up brief of what customers would truly choose.

While the Goldman Sachs report provides estimates of potential cost savings, a real-world example of the benefits of a build-to-order, direct manufacturer sales model is GM do Brasil’s practice with production and sale of the Chevrolet Celta economy car at its modern Blue Macaw plant in Gravatai. (12) Since 2000, customers in Brazil can order the Celta over the internet from a site that links them with GM’s assembly plant and four hundred seventy dealers nationwide. By 2006, 700,000 Celtas had been produced and the car resumes to be one of Brazil’s best sellers. (13) Consumers have twenty “build-combinations” from which to configure a model of their choice, including colors and accessories, and can view each switch as it is being made. GM built five distribution centers via Brazil to reduce transportation time from its assembly plant and buyers can track location of their car online on its way to delivery at a dealer of their choice. The time from configuration at the factory to delivery is only about a week, in contrast to the several week wait that can be common in ordering a car in the United States.

The Celta was designed by GM in collaboration with suppliers who produce just-in-time pre-assembled modules to the factory. GM estimates that collaboration in design and manufacturing enabled it to use sixty percent fewer suppliers and fifty percent fewer parts than in a traditional assembly operation. According to Mark Hogan, president of e-GM at the time of the Celta’s introduction, GM can sell Celtas twenty four hours a day and likes a competitive advantage from diminished production time, lower inventory levels and an overall more efficient distribution and sales model where dealers need to stock only two models, one for the demonstrate room and one for test drives. Consumers benefit from Celta’s online no-haggle pricing structure, where prices are about six percent lower than for sales made through conventional distribution channels. The price is lower because GM passes on to consumers some of the tax benefits it gets from the Brazilian government as a result of the diminished inventory and real estate associated with online sales.

Since direct manufacturer auto sales are presently prohibited by the state franchise laws in the United States, no direct comparison with GM’s Celta practice in Brazil is possible. However, surveys do demonstrate that many fresh car buyers in America would be interested in buying directly from manufacturers, particularly to avoid costs associated with the dealer/customer bargaining process. In one survey, almost half of respondents said that they would opt to buy cars direct from the manufacturer even if it didn’t save any money. (14)

Some indication of the value that consumers place on an alternative that minimizes the auto purchase bargaining process is the popularity of auto referral services like Autobytel.com. Such internet services provide auto pricing information and refer prospective buyers to traditional dealers for auto purchases. One investigate of the effect of Autobytel on dealer pricing in California found that customers using its online referral service paid an average of $450 (about two percent) less than non-online consumers. (15) Of the savings, about twenty five percent came from buying at a lower-priced dealer affiliated with Autobytel and the rest were from bargaining by the service on behalf of the consumers, provision of information online and cost efficiencies.

While Autobytel reduces the bargaining costs of the “dealership practice” for consumers and may increase inventory turnover somewhat, inventory on dealer lots remains an integral part of the process. (16) Manufacturers, with greater visibility into and more direct control over their own inventory, should be better placed both to implement quicker order fulfillment and to manage inventories efficiently if they were permitted to make direct sales to consumers. (17) Moreover, only a manufacturer, as GM has done in Brazil, can realize extra savings up the value chain, from build-to-order improvements in design, production and supply chain management made possible by advances in networked communications over the internet.

Dealers tend to view direct manufacturer sales with a skeptical eye, worried that they could be cut out of the sales process and have the investments in their dealerships eroded. Broadly speaking, dealer concerns fall into two categories: a need for protection from manhandle by presumably more powerful manufacturers and the prospect that local dealers will not be adequately compensated for services that only they can effectively provide, as consumers take advantage of dealer sales efforts like test drives before buying at a lower price from a manufacturer. (Legal) In economics, these concerns are referred to as the holdup problem and the free-rider problem. On both theoretical and empirical grounds, there are reasons why these concerns are misplaced or can be addressed without a need for state franchise laws.

The holdup problem occurs if manufacturers can adequate a portion of dealer-specific investments through opportunistic behavior. Generally this derives from dealer concern about a manufacturer’s installing a 2nd dealer within a dealer’s established territory, thereby eroding the very first dealer’s profitability. The same concern can apply to competition from manufacturer direct sales. As a matter of economic theory, holding up dealers is unlikely to be a viable long-run strategy for a manufacturer when, as in the auto industry, reputation is significant. Opportunistic behavior by a manufacturer would erode its reputation, making it difficult to attract fresh dealers and have existing dealers proceed to provide the promotion and service essential to attracting those customers not buying directly from the manufacturer.

The free-rider problem is similar to the holdup problem in that it involves dealers being inadequately compensated, in this example for services provided locally on sales made by the manufacturer. It bears reiterating that, as with the holdup concern, manufacturer self-interest provides a strong incentive to solve this problem. Given that, manufacturers and their dealers are likely to develop contractual arrangements to address free-rider issues should manufacturer direct sales emerge in the United States. A plain example might involve a manufacturer’s compensating dealers for services provided by granting a commission to a dealer on any direct manufacture sale made within the dealer’s territory. (Nineteen)

Because of reputational effects, even a manufacturer with market power has an incentive to address the holdup and free-rider problems, since the manufacturer derives no revenue from sales lost if disgruntled dealers sell fewer cars. In the case of today’s U.S. auto industry, inter-brand competition among manufacturers boundaries their market power and further undercuts the “dealer protection” argument empirically. (20) In brief, present-day dealers have a number of auto manufacturers contesting for their services, each of whom has a concern for its reputation, and that competition among manufacturers inures to dealers’ benefit.

Among the Big Three’s competitors with production facilities in the United States are Toyota, Honda, Nissan, Hyundai, BMW and Mercedes-Benz. As Table one shows, the Big Three’s share of fresh vehicle sales fell from almost seventy two percent in one thousand nine hundred ninety seven to around fifty two percent in 2007. Inter-brand rivalry among manufacturers fostered a competitive climate for dealers, where many dealers now have franchise agreements with numerous manufacturers and relatively fewer dealerships are dependent on a single manufacturer than in the past. Albeit the vast majority of dealers are privately wielded, the country’s largest dealer, AutoNation, has over two hundred dealerships and is publicly-held, with a current market capitalization greater than GM’s. Many other dealerships are substantial businesses in their own right. The average dealership had fresh vehicle sales of almost $20 million and a net worth of $Two.Trio million in 2007. (21)

As mentioned earlier, even under a direct manufacturer sales model, some dealer role likely will be maintained since most customers will proceed to want to see and test drive fresh vehicles before purchase. That was the case with GM’s direct sales of the Celta in Brazil. A Harvard Business Review article on implications of the internet for auto competition sums this up well: “Most buyers will value a combination of online services, private services and physical locations over stand-alone Web distribution. They will want a choice of channels, delivery options and ways of dealing with companies.” (22)

Ultimately, it also may be the case that dealers would get some benefits from ancillary activities like warranty and service work that are complements to direct manufacturer sales. As Figures one and two showcase, the average dealership actually lost money on fresh car sales in two thousand six and two thousand seven and, even in years of profitable fresh car sales, profits on service and parts tended to be higher. This may suggest that while direct manufacturer sales may reduce the ranks of dealers somewhat, those dealers that remain could turn out to be relatively more profitable than presently.

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