2 proposals for managing used-car inventory

The following is excerpted from Like I See It: Obstacles and Opportunities Shaping the Future of Retail Automotive by Dale Pollak.

If I needed investment advice, I probably wouldn't go to a car dealer or a used vehicle manager. To be sure, I've come to respect dealers and used vehicle managers for their savvy and skills in retailing used vehicles. But I've found their actions and instincts as managers of investments in used vehicles leave a lot to be desired.

I say this due to the persistence and prevalence of aged used vehicle inventory on dealer lots across the country. By and large, these aged units are the cumulative result of bad investment decisions that, too often, could have been avoided.

The answer to this persistent problem lies, I believe, in two new best practices I'd like to propose for the industry.

Managing inventory age [by focusing on how many days a car has sat on the lot] leads to less-than-optimal outcomes — a fallback reliance on the hope that you'll get lucky with profit-troubled vehicles and the persistent press of aged inventory on your used vehicle performance and profitability.

But the real problem is that age is the wrong metric to manage — it's the money, or the quality of your investment in each used vehicle, that really matters.

Think about it: A vehicle that, for whatever reason, isn't blessed with the ability to deliver a satisfactory or sufficient margin contribution from day one usually doesn't get any better by days five, 10, 15 or 20.

Dealers and used vehicle managers generally understand that a distressed used vehicle will only get worse.

But their retail instincts and traditional training get in the way of making decisions from an investment perspective.

Unlike investment managers, dealers and used vehicle managers find it difficult to view the early signs of a poor investment in a used vehicle as an opportunity — a cue or curtain call to redeploy their capital into another car that offers greater potential to make a satisfactory and sufficient return.

The key, of course, is knowing how to assess a vehicle's investment health right away to avoid making a bad or questionable investment, which will only get worse over time.

The assessment should cover these elements:

• An eyes-on assessment of a vehicle;
• The vehicle's cost-to-market ratio; and
• The vehicle's market days supply.

On a day-to-day basis, here's how this assessment plays out.

Let's say you have two vehicles you're considering to acquire. The first looks very sharp. After your pack and reconditioning, you own it at an 84 percent cost-to-market ratio, which gives you a respectable 16 percent spread between your investment and its prevailing retail price.

The market days supply is 60 days, which suggests a relatively high level of demand in relation to supply.

The second vehicle is more plain, with less likely shopper appeal. After your pack and reconditioning, you own it for an amount very close to its average retail asking price. The market days supply is 93 days, which suggests it'll take some time to retail.

The investment quality of the two vehicles should be readily apparent. The first vehicle represents a decent risk and offers the prospect of a sufficient return on investment. The second car has all the markings of a soon-to-be-aged unit.

You'll notice that, in this exercise, the age of the vehicle isn't even mentioned. That's because age is irrelevant when you focus on the quality of your investment in each used vehicle.

I propose that every dealer institute a hard cap or limit on their used vehicle inventory investment. Managers have X dollars to spend and manage in a given year, and that's it.

In effect, the hard cap or limit on your inventory investment would function like a household budget.

You only have X dollars at your disposal, which requires that you make the best possible use of the money.

If you ask dealers and used vehicle managers for their total used vehicle investment, you'll typically get ballpark figures that range between $500,000 and $1.5 million.

For the most part, dealers don't really track their total inventory investment. They have a general sense of how much money they've got tied up in inventory.

They may also know that the total investment amount tends to fluctuate — shifts they often attribute to changes in market conditions.

But I don't think market conditions cause the fluctuations as much as dealers think. I would bet that much, if not all, of the investment flux owes to the aged cars and losses that result from an over-reliance on hope on the part of managers.

It's almost like used vehicle managers are trust fund babies. If they make a bad financial decision, they just tap the trust for more money.

They don't face real consequences for their less-than-astute decisions. Their access to additional funds effectively covers up their transgressions.

That's why I've begun advocating for a hard cap or limit on each dealer's inventory investment.

Without this gate, used vehicle managers have an open checkbook.

There's no structural impediment that forces them to become more disciplined, investment minded, and market smart as they acquire, merchandise, price, and retail their used vehicles.