Auto manufacturers in Europe and the United States, the world's two biggest car markets, have a distribution headache: their retailing systems, built up in an incremental and uncoordinated way over several decades, are relics of the past. Given the wafer-thin profits that manufacturers in both markets currently realize on car sales, these companies are in sore need of the extra margins that a more efficient distribution system could deliver. Indeed, there is plenty of room for consolidation as well as other efficiency-enhancing improvements, but both markets have been highly regulated in ways that stifled change. There the similarities end.

European manufacturers haven't been inclined to undertake the performance improvements they need, because the regulatory environment so far has made them feel relatively comfortable. Exemption from various EU competition rules has given these companies a degree of control over their retailing systems that can only be dreamed of in Detroit. As a result, their high margins on spare parts and services have more than compensated for inefficiencies (the average European dealer, for example, is only a fraction of the size of the average US one).

But now the kind of regulation that favored European manufacturers over retailers—and, some would say, consumers—is being swept away. In its place comes the "revised block exemption," which is designed to erode the manufacturers' control over car retailing. Largely due to come into force by October 2003, the new regulations confront auto manufacturers with an alarming prospect: sharply reduced control over their distribution networks, the potential for lower margins on new cars, and a smaller share of the highly profitable after-sales market.

By contrast, the US regulatory system has been built up to favor dealers rather than manufacturers, which have therefore done their best to tune up the economic performance of their existing networks, since regulation prevents more significant structural change. Some consolidation has been possible. But more often than not, legal and regulatory constraints have prevented manufacturers from taking the measures, such as direct intervention in dealership operations, that might be needed to make their networks still more efficient. The very strong political lobby of the dealers means that change will be hard to achieve.

US automotive manufacturers rely almost entirely on dealers to distribute their wares. In 2001, dealerships had sales of more than $800 billion—close to 100 percent of the manufacturers' total vehicle sales. The manufacturers also depend on their dealer networks to provide the after-sales parts and services that are fundamental to their success.¹

Yet the structure of these networks is inefficient. Most were built in an ad hoc fashion over many years, with manufacturers awarding franchises to thousands of independent owner-operators ranging from sleepy family businesses to efficiently managed national chains such as AutoNation. Once a dealership opens for business, the manufacturer can't exert much direct control over it and must be content, essentially, with the role of product and financing supplier. Multibrand² manufacturers face the additional complication of dealing with several overlapping networks that work against one another. When Fiat, for example, acquired the commercial-vehicle makers Case and New Holland, it left both of their dealer networks intact to maximize unit sales. While this increased coverage of the market, the fact that two separate dealer networks remained within it clearly created the potential for interbrand competition.

If the manufacturers had a free hand, they would have restructured these dealer networks long ago, consolidating their presence in some markets and expanding it in others. But state franchise laws and other regulations protect dealers from such intrusive moves. In some states, direct ownership of dealers by manufacturers is prohibited outright; in others, manufacturers can't close or relocate poorly performing dealerships and must settle for isolated and relatively superficial store-level improvements, such as remodeling showrooms or providing additional sales and service training.

In a few cases, where direct or joint ownership is allowed, manufacturers have tried to reshape local markets by purchasing underperforming dealers. But these efforts have often foundered: manufacturers tend to lack the entrepreneurial skills and local market knowledge needed to run showrooms profitably, so manufacturer-owned outlets usually do worse than independent ones.³ Furthermore, given the patchwork of federal and state regulations, the manufacturers have found no easy way to coordinate their efforts across their US networks.

This isn't to say that change is impossible within the current constraints. It would certainly be worthwhile. One manufacturer that did find a way to reshape its dealer networks netted a 50 percent increase in the market share of a key brand in one of its largest markets and, it estimates, could ultimately increase its revenue by as much as 10 percent. It is now extending the effort to more than 300 local markets, with nearly 1,000 dealerships.

The lesson for other vehicle manufacturers is that they must play the role of orchestrator, conceiving and then encouraging—since they don't have the power to demand—a series of ownership changes in each market in order to improve the network's overall performance. Any realistic strategy must accommodate the complex regulatory environment of dealer ownership in the United States, for the dealers, whose goodwill is vital to the manufacturers, must acquiesce in any changes to the system. An aggrieved dealer has substantial power to put a manufacturer's top and bottom lines at risk—for example, by cutting back its investment in facilities, pushing the brands of competitors, or pursuing fewer but higher-margin sales at the expense of the manufacturer's volume goals—thereby optimizing its own profits and undermining those of the OEM.

Elements of success

An automotive company must understand the factors that affect the performance of a network to restructure it effectively. Four are critical. The first is geographic distribution: outlets must be close to customers but not too close to one another. In reality, neither condition is met. The once robust networks of the Big Three—GM, Ford, and DaimlerChrysler—were built largely in the 1920s, 1930s, and 1950s, for example, and haven't been adapted to demographic shifts: these networks are too tightly clustered in urban areas and too sparse in the suburbs.

Dealers in the top quartile sell up to four times as many vehicles as the dealers in the bottom quartile

The second factor is the skill of the dealers, for some are much better at running their businesses than others are. Indeed, the experience of one major manufacturer suggests that, adjusting for market size and location, dealers in the top quartile sell three to four times as many vehicles as dealers in the bottom quartile.

Brand mix is the third factor: some dealers sell a number of brands, others just one. There is a debate about whether different brands should be sold at the same location. While there is no single right answer, manufacturers generally want dealers to sell only one brand at a given showroom to create a strong loyalty to that brand, to sharpen its identity, and to minimize competition within the network. But the dealers usually want to hedge their bets, selling two or more brands—sometimes from competing manufacturers. Single-brand dealerships are most viable in growing markets or for strong products that can make it on their own (think Lexus). Multiple-brand dealerships make sense in markets or for brands that can't give a dealer sustainable volumes, which we estimate at 100 cars a year. Some US brands, such as Ford's Mercury, probably couldn't survive without sharing showrooms with a stronger complementary brand such as Lincoln.

The fourth factor to be considered when a company tries to recast its dealerships is their business format, for it is vital that they capture downstream revenues in full. Service and parts sales are essential to the health of dealerships and manufacturers alike; some dealers cover 100 percent of their fixed (and even other) costs through parts and service, thus cushioning themselves against downturns in the sales cycle.

Most, however, fall well short of that mark, and this hurts the manufacturers, which sell fewer parts when dealers provide less service. The problem is that traditional business formats require authorized dealers to provide service only at or near their showrooms. If a local market can't support the customary full sales and service operation, dealers have no way of providing service by itself,⁴ and the network forfeits tens of billions of dollars to independent repair shops and third-party parts makers. Some automakers estimate that they control no more than 20 percent of the total service business for their cars—a painful state of affairs, since margins on spare parts are several times higher than those on new cars.

Building a better network

Any restructuring of dealer networks must ensure that all four factors have been considered, for halfhearted measures, such as improved sales training, don't produce lasting results. Fortunately, an integrated approach to automotive retailing is perfectly possible. Saturn, for example, has built a remarkable retail arm despite its limited product line—until recently, it didn't offer a midsize sedan or a sports utility vehicle, and it still has no minivan.

Rebuilding a dealer network is a three-step process. The first requirement is to determine the network's ideal shape. Manufacturers should map the best locations for their showrooms and service centers in every local market by analyzing historic and projected sales data, demographics, and market trends. One automotive OEM, for instance, found that it had too few sales locations for the size of the market in the Atlanta area—just four outlets, to seven for its key competitor—and had no sales points whatever in the fast-growing suburb Cobb County. Detailed knowledge is vital for developing a blueprint to expand (or, in some cases, to contract) a network.

The next step is to undertake a thorough review of the sales history and financial health of each dealership, as well as its appetite for growth and long-term strategies, including its plans for succession. In this way, a manufacturer can identify dealers that have both the skills and the resources to add brands to their franchises or to succeed in new locations. In addition, the manufacturer must rank the relative importance of the obstacles in each market—such as the burden of local regulations and the receptivity of dealers to change, for restructuring will succeed only if enough of them support and benefit from it. A manufacturer would be well-advised to move first in its largest markets, where quick results can be achieved most easily.

Third, to have an optimally configured network, the manufacturer must put the best dealers in control of it—for example, by using negotiators to facilitate the transfer of ownership among dealers in each market. Typically, the negotiators might be retired employees of the manufacturer's dealer operations or financing arm, who have worked with dealers in the past. Although retained by the manufacturer, these people should have no financial stake in the sale of dealerships.

After studying the performance and aspirations of the dealers, as well as the geographic coverage the manufacturer hopes to achieve, the negotiator meets with dealer principals in each market, connects willing buyers and sellers, and then helps to structure a deal. (Although some dealers can and do pursue such transactions entirely on their own, many lack the market intelligence, the financing, or the confidence to do so successfully.) A manufacturer can help its negotiators by offering the buyers incentives such as a preferential allocation of new products or factory support, attractive loans through its finance arm, or, occasionally, its own direct financial participation in the deal.

In one case, the negotiator employed by a manufacturer arranged for a successful dealer in a Southwestern US city to buy a faltering dealership there. The manufacturer assumed a $100,000 liability, which was only a small part of the projected benefit of the deal. In return, the dealer agreed to a set of aggressive targets, including a 20 percent sales increase over a three-year period. In fact, the dealer met its year-two targets in year one, is on track to double its sales in year two, and expects to contribute more than $300,000 in revenue to the manufacturer by year three.

Furthermore, a change in the ownership of a dealer is one of the few opportunities that manufacturers have to adjust the brand mix of their networks, for it is at this point that the dealer can be induced to separate or consolidate its brand offerings or to drop competing brands. In the case of the Southwestern dealership, the manufacturer not only facilitated the takeover of a failing location but also awarded the successful dealer an additional franchise for a desirable brand. The dealer had wanted to combine all of its operations and to use one sales force in a single location, but the manufacturer could insist that it create separate locations to give each brand a higher profile as well as sales support dedicated to that brand alone.

Manufacturers should also revisit their dealers' business formats. Novel solutions can be found even without a change of ownership. One manufacturer of commercial vehicles, for example, increased its sales of parts and tripled the size of its service area by linking its dealers with independent repair shops, which were already active in underserved areas and could make a profit where an authorized dealer couldn't, because independents generally have lower cost structures. These affiliated shops realize revenue from their labor while the manufacturer and its local "master" dealer, from which they purchase the parts, reap higher revenues from parts sales—another example of the way changes in the structure of dealer networks can help manufacturers alter long-standing but ineffective practices.

Letting the market work

Historically, manufacturers have lacked the will, or perhaps the imagination, to push such initiatives. The legal constraints, the potential for a dealer backlash, and the sheer size and expense of the undertaking have inhibited wholesale restructuring of dealer networks. But manufacturers have tried just about everything else, including buying out and operating showrooms themselves where that is allowed. Although such efforts failed, they suggest a better way: working with dealers, case by case, to encourage and coordinate (rather than demand) grassroots change.

Of course, a manufacturer can't impose its proposals on the dealers. In our experience, about 40 percent of those who are asked to sell decline the offer at first. Even such a rejection gives the manufacturer leverage, however; the dealers know that the company will approach others, who might be more amenable. As the restructuring unfolds and successful dealers become stronger, the economic pressures to dispose of a languishing business often increase. Ultimately, about half of the dealers who initially resisted an overture choose to accept it.

The trick is to collaborate with dealers to forge a consensus that benefits them and the producer

The trick is to work through dealers to forge a consensus that benefits both them and the manufacturer, so that it can not only overcome the regulatory impediments to change but also apply the four elements of network success. The manufacturer can then expand or contract its network in each market as needed and cherry-pick its best dealers, rewarding the stars while easing out the less capable. Furthermore, the sale or transfer of dealerships allows a manufacturer to renegotiate the franchise agreements that govern their mix of brands, thereby providing the impetus to change business formats in each market.

Restructuring networks remains a massive job. Among the Big Three, Ford and DaimlerChrysler each has more than 4,000 dealer locations in the United States; GM, more than 7,500. Assessing the performance of each dealership, setting its goals for the future, and overseeing the necessary changes is a rigorous three- to five-year process. But the rewards are significant. Dealers and manufacturers, acting together in their own self-interest, can create networks that will sustain long-term improvements for both.