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How Do Dealers Set Car Prices?

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How Do Dealers Set Car Prices?

It seems like a simple question: What’s the true price of a car?

But as anyone who’s bought a car or truck knows, setting car prices is a complicated game. Even experienced buyers might not fully understand all the rules.

Cars are among the few goods Americans purchase that don’t have fixed prices. When you buy a box of cereal, bike or book, you simply pay the list price. But buying a car is more like buying a house — you have to negotiate. And the way that manufacturers and car dealers calculate their costs and make money complicates things.

Simply put, car dealers are middlemen. They buy their inventory from automakers, then mark up the prices and sell to consumers. Dealers also get bonuses, awards and incentives from automakers that help cover the costs of selling the cars and add to dealerships’ profit. Dealerships also make money — a lot of money — from selling used cars that were trade-ins, arranging auto loans through financial partners, and charging for service and parts.

Knowing all the factors at play prepares you to negotiate a good price. We’ll walk you through the key elements, including:

  • What is the sticker price, or MSRP?
  • What is the dealer invoice price, or “dealer cost”?
  • How much did other consumers pay for this model?

What is the sticker price, or MSRP?

That dollar figure you see in large print in ads or on the window sticker of a new car is the manufacturer’s suggested retail price. It’s also known as the sticker price, because every new car leaves the factory with a federally mandated window sticker listing the MSRP for the car, as well as for each option or accessory on that car.

Sticker price is an important number, but most cars sell for less. It’s set by the manufacturer, and includes some room for the dealer to make a profit. Roughly speaking, it may be around 20% higher than the dealer’s invoice cost (more on that below). Treat this higher price as exactly what it is: a suggestion by the manufacturer that’s meant to influence you to pay a higher price.

With the sticker price, automakers are trying to “anchor” negotiations at a high starting point. Anchoring is a psychological effect that occurs in negotiations when the parties involved cluster near the first number that’s on the table. To counter the anchoring effect, some consumer advocates suggest you do your negotiating far away from the car and its window sticker, so you won’t be as likely to be swayed by suggestion.

There are rare instances when cars do sell at the sticker price: when a hot new model hits the market to great demand, for instance. However, there are also scams in which dealerships claim that customers must pay a higher price because the car is in high demand or because they have poor credit.

You’re free to ignore the sticker price and start your negotiations from a lower point. Just remember that your goal should be to reach a fair price: one that allows the dealership to make a reasonable profit over the wholesale price it paid, without gouging you.

What is the dealer invoice price, or ‘dealer cost’?

So, what’s the dealer’s cost on the car? The best guideline consumers can use is the dealer invoice price, sometimes referred to as “dealer’s cost.” This is the price on the manufacturer’s invoice when the factory delivers a car to a dealer. You can look up the invoice price of a particular model online.

But like so much in car sales, this is not as it seems. Dealer invoice price is typically higher than what the dealer ends up paying. The invoice comes with the understanding that the manufacturer will pay a percentage back to the dealer through discounts and incentives.

“The dealer has many costs associated with each car. A given dealership likely has to finance their inventory and might have to pay interest on the cars they have, or they may have to buy 10 other less-popular cars just to get the one car you really want. Therefore, they may have to offer the unpopular models at a steep discount just to sell them,” says Brian Moody, executive editor of Autotrader.

Manufacturer-to-dealer payments take many forms:

Holdbacks: Payments to cover dealers’ costs and supplement their profits. They don’t appear on any window sticker and are typically not revealed to consumers, but they may amount to about 2% to 3% of either invoice price or MSRP, according to Edmunds.com.

Dealer cash incentive: This is a cash rebate offered to the dealer by the manufacturer. The dealer is not obligated to pass this on to the customer.

Sales target incentives: These are sometimes called “stair-step incentives.” The manufacturer agrees to pay the dealer more if the dealer hits a specific sales target. These payments can be high enough that the dealer might not care if she loses money on your specific sale.

These incentives make it possible for dealers to advertise attractive sales. If you hear of cars being sold “at invoice price” or “just $1 over invoice price,” understand that this marketing-speak doesn’t really mean the dealer is making no profit.

How much did other consumers pay for this model?

With MSRP and invoice price as benchmarks, and keeping in mind the incentives listed above, you’ll have a good sense of how to arrive at a fair price.

You can add a third price benchmark to your research: market price, or what others in your area are paying for the same model. Car prices fluctuate because of factors including supply and demand, seasonality and geography. A specific model might cost more in a wealthier ZIP code, for instance, according to a J.D. Power spokesman.

Many auto websites list estimated market prices, each using its own formulas and methodology, so it’s a good idea to check several. Kelley Blue Book has a tool called “Fair Purchase Price” that gives a range based on purchase data collected across the country and is updated each week, according to Allan. Other sites offer similar information.

“Always have a good handle on what others are paying before visiting the dealer, as market price is typically hundreds or thousands below MSRP,” says Jason Allan, managing editor for Kelley Blue Book’s KBB.com.

The bottom line

To negotiate a fair deal for your car, you need to know how the dealer set its price. When you’re getting ready to buy, be sure to look at all the factors that go into manufacturer’s suggested retail price, invoice price and market price. And, when you’re negotiating, be sure you refer to all your collected price research. That way, the dealer will know he’s dealing with an informed and prepared buyer.

Jeanne Lee is a staff writer at NerdWallet, a personal finance website. Email: jlee@nerdwallet.com.


Image via iStock.