A New Way To Think About “Water” In Your Inventory

November 10, 2017

Dealers have long understood that having water in their inventory is a bad thing.

The conventional view holds that you determine the level of water in your inventory by comparing your costs to own the vehicle against the amount you could get if you wholesaled it right away.

Hence, if you own a used vehicle for $10,500, and current valuations suggest you’d only get $9,500 for the car on the wholesale market, you’ve got $1,000 in water for the unit. The same math holds for a dealer’s entire inventory.

Dealers pay varying degrees of attention to their inventory water. For some, it doesn’t really matter at all. If the vehicle’s a fairly fresh piece, dealers will hold out hope that a retail sale will make any water a moot point. Others reckon with water when they’ve given up on the vehicle as a retail unit, and take their lumps as they wholesale the car.

But I’ve begun to believe that this traditional view of inventory water isn’t as useful for dealers as it has been in the past.

For starters, the wholesale market, despite a headwind of high supplies of late-model vehicles, has remained relatively strong. Both demand and valuations are surprisingly resilient. On a day to day basis, dealers may still take baths as they wholesale vehicles, but the water’s not as deep or as cold as it could have been.

Second, the traditional view of water doesn’t really measure the most significant challenge dealers face in today’s used vehicle market—the continuing grind-down of front-end gross profits.

In our current margin-compressed environment, even a vehicle that isn’t weighed down by water often doesn’t produce a sufficient level of return on the dealer’s investment.

This condition shows up every day in my work with dealers. More and more, it’s increasingly common for dealers to have a large number of vehicles with Cost to Market ratios at 90 percent or higher. The ratio suggests the dealers might make a 10 percent front-end gross profit, given the spread between the vehicle’s costs and retail asking prices. But, in reality, the vehicles will likely transact at less than their asking prices—which means the front-end margin for dealers will be significantly less than 10 percent.

I often tell dealers that “30 is the new 45 or 60 in used vehicles”—a saying that captures how margin compression has shortened the viable retail shelf-life of most vehicles.

I also share an analogy: Suppose your inventory was like a block of ice, sitting in the middle of a room that’s 100 degrees and getting hotter. The longer the ice sits, the more it turns to water, runs down the block, spreads across the floor and loses its original purpose.

This is the water that dealers should really be worrying about. Here are two best practices that I recommend dealers follow to mitigate the water’s ongoing erosion of their front-end gross profits in used vehicles:

  • Maintain at least a minimum of 55 percent of your used vehicle inventory under 30 days of age. If you want to keep a block of ice from melting, you need to insulate or protect it from heat. For dealers, your best protection is a faster pace of retail sales. If the cars sell faster, you minimize the profit loss that occurs as vehicles age in inventory. I tell dealers, “30 is the new 45 or 60 in used vehicles” to underscore how inventory age has a direct bearing on a used vehicle’s investment quality—the longer it sits, the less you get.
  • Mind your Cost to Market metrics. The Cost to Market metric is useful to dealers in two ways. First, the metric tells you, from the moment you acquire a vehicle, what your likely retail gross profit margin will be. Second, it helps you monitor, on an individual vehicle basis, how much potential profit resides in a vehicle. I recommend that dealers strive to maintain an overall inventory Cost to Market average of 85 percent. This benchmark allows for the realities of today’s market. Some vehicles, with a low Market Days Supply and other unique characteristics, may be perfectly fine to acquire at a Cost to Market ratio higher than 85 percent. They may cost more, but they’ll sell fast. Meanwhile, other vehicles, such as rental car purchases, should have Cost to Market ratios considerably lower than 85 percent, even below 80 percent, given they are less special, and more abundant, in the market.

I’m not suggesting that dealers ditch the conventional view of inventory water. But I do think dealers will need to more vigilant about managing their inventory investments in an era of margin compression.

As the old song goes, “you don’t miss your water, ‘til your well runs dry.”