The Case AGAINST Internal Discounts for Parts and Service Sales

By Walter J. McDonald

Why not discount parts and service sales to internal operations? (Rental fleet repairs, used equipment reconditioning and new equipment “pre-delivery” work). The three most frequently heard reasons given for discounting internal work include:

1. We can’t take profits on internal work.
2. It’s just moving money from one pocket to another anyway.
3. Internal parts and service discounts help us become more competitive.

Unfortunately, all three of these reasons are misleading. Here are the true facts.

1. The most profitable dealers, those in the top quartile of industry cost-of-doing business surveys, do not discount parts and service for internal repairs. They charge no less than what an external customer of equal size pays.
2. There are no IRS regulations regarding internal pricing or profits from internal sales.
3. Internal discounts severely distort profit contribution efforts of parts and service managers. This makes fair and equitable performance bonuses difficult to manage.
4. Internal discounts understate true costs and give a false sense of security. This is especially risky when financial decisions on rental fleet investments must be made.
5. Internal discounts are rarely recovered through better pricing to retail customers. For example, since most sales managers price used equipment from cost up, the internal parts/service discounts on reconditioning are never a consideration in setting retail price. This causes the entire gross profit margin of the dealership to deteriorate.

Here is an actual dealer illustration from a student in my recent Sales Management workshop:

On the surface, this is a fairly strong product support operation. This dealer’s external labor rate is $55.00 with an average technician wage and benefit cost of $22.00. His Service Gross Margin is 60%. (GM%= Sell – Cost Sell)

External customer parts pricing is also fairly aggressive at 30% Gross Margin. And, this is how his business would look if he were to carry these margins across all of his internal and external business transactions:

Potential Product Support Gross Profit (GP) based on Gross Margin Opportunity

Unfortunately, this Dealer Principal had imposed the following internal pricing. 1) Parts would be sold at cost to the rental fleet and for used equipment reconditioning. Therefore, all internal parts sales had zero gross profit. 2) In addition, the internal labor rate was established at $20.00 for rental repairs, used equipment reconditioning and new equipment “pre-delivery.” (Remember his average labor cost with benefits is $22.00/hr.) Here is the actual Gross Profit spreadsheet based on actual 1997 activity. Please note that at the $20.00 internal labor rate, the new Service Gross Margin is now minus 10%:

Actual Product Support Gross Profit (GP) based on Actual Gross Margins Earned

In this case, the dealer earned about $606,000 less Gross Profit in 1997 because of his internal discounts (1,248,000 – 642,000 = 606,000).

This unfortunate situation resulted not from one big transaction, but from many small ones that should not have been a problem. For example, the shop charges the sales department 2 hours to pre-deliver a machine. At regular external rates, this would add about $110.00 to the cost of a $44,000.00 new unit. However, at the highly discounted internal rate of $20.00, the pre-delivery cost is only $40.00. My question: how much salesmanship is really needed to recover that additional $70.00 ($110 – $40)?

This dealer continues to experience significant profitability problems. And, he refuses to recognize that he has an internal pricing structure that is causing a slow death by a thousand cuts. The reality is that the profitability of his entire dealership has been diminished by the amount of these internal discounts. At $8 million, his overall pre-tax profit on sales has been reduced by 6.9 percentage points (606,000¸8,000,000=7.6).  

Internal discounts can be an appealing, easy answer to pressure from your sales department. However, they are extremely dangerous to your financial health. Your product support operations should generate the revenue you need to fund aggressive sales and marketing programs. And, GP$ from parts & service should cover your fixed expenses with a 100% absorption rate. But, neither is happening in this operation.

For this dealer, the case against internal discounts for parts and service sales should be clear. The most profitable dealers charge internal rates equal to prices given to equal size external customers. Once this policy is established, a more rational, equitable and more effective margin improvement program can be established across the entire enterprise. An equitable approach to recognizing contributions from each revenue center is also an important step to fostering better relationships and team play in the entire business. And, one fork lift dealer in my last AGM Workshop gained 5 profit percentage points overall the first year he discontinued internal discounts, at no loss of sales in any direction. From our perspective the overwhelming evidence is surely against internal discounts for parts and service sales.

If you would like to discuss any aspect of this article or to learn more about our machinery dealer development resources and capabilities, I’d welcomed hearing from you.

Walt McDonald Walt@McDonaldGroupInc.com  www.McDonaldGroupInc.com