This article originally appeared in the May 2013 issue of Canadian Auto World.

Stair step incentive programmes are causing dealers headaches and wreaking havoc on dealership networks—and factories can’t get enough of them.

Every now and then, an issue rears its head that negatively affects automobile dealer clients across multiple brands.  These are the types of issues that fundamentally change the way dealership networks work.  They threaten the dealer business model and challenge dealers’ ability to consistently earn a profit.

The latest such issue to hit my desk is stair step incentive programmes.  After briefly disappearing for a few years, stair steps are back with a vengeance, with nearly every factory running some type of stair step programme.

For the uninitiated: stair step programmes are incentive programmes where factories offer dealers cash bonuses if the dealers can achieve monthly vehicle volume targets.  The monthly volume targets are set by the factories and assigned to dealers on an individual basis.  If a dealer makes its target then it stands to receive a sizeable rebate from the factory.  If it doesn’t, it has to pay the rack rate for the inventory it sold in the preceding month.

By way of a simple example, a dealer might get a rebate of $200 for car each car sold in the previous month if it attains 90% of its volume target, $400 per car if it attains 100%, or $600 per vehicle if it attains 110% or more.  At each level of the incentive plan the potential rebates become bigger, hence the name “stair step” incentives.

Factories say they use stair step programmes because they incentivise dealers to be more aggressive in terms of vehicle pricing and encourage them to compete with each other in the same markets.  Lower retail prices means more units sold, and the factory wins. A dealer that beats its number for a month may also win.  So, what’s wrong with this picture?

Stair step programmes seem relatively benign on the surface.  Factories promote them as “free money” for dealers, and participation in the programmes is optional.  Yet, when you scratch beneath the surface it becomes clear that these types of programmes are undermining dealers on a massive scale.

From the dealer perspective (the urban dealer in particular), there are at least three big problems with stair step programmes:

1) They encourage dealers of the same factory to under-cut one another on price.  In urban centres, dealers will drop their prices dramatically towards the end of the month in an attempt to make their targets. This results in dealers from the same line competing with one another for the same customers.  Worst-off are the dealers who slash their prices and still get under-cut by a neigbouring dealer.  It’s a race to the bottom, and ultimately most (if not all) dealers will lose.

Vehicles being sold for below factory prices are not uncommon.  Some dealers will even buy new car inventory on their own account, go through the vehicle registration process, and convert the new cars into used inventory in a desperate attempt to make their numbers for a month.

2) The monthly volume targets are set by factories in an arbitrary way (although some programmes are more arbitrary than others). In all of the programmes I’ve seen there are no objective and independently verifiable criteria for how the volume targets are set.  In my experience, the targets are often set according to what the factory ideally wants to sell in a market and not what the market can realistically support.  Historical sales data and market data rarely figure into the targets; the economy and market conditions are not even considered.  Rural dealers tend to hate stair-step incentives just as much as urban dealers for this reason.  And, if a dealer does make its target for a month, the target for the following month will inevitably be higher.  If you’re not on the wrong side of your monthly volume targets now, just wait a few months and you may be.

3) Stair step programmes make it impossible for dealers to price their products rationally.  At the start of any given month, a dealer won’t know if it will receive a stair-step rebate or not.  Accordingly, it has no sure way of balancing discounts (in an attempt to make its target) and margin optimization according to sound business principles.

Looked at objectively, stair step programmes aren’t really incentive programmes at all.  Rather, factories incorporate the rebates they will have to pay out when they establish their factory prices.  Factories simply raise their prices to all dealers then subsidize high-volume dealers in the form of “bonuses”.  Low volume dealers, on the other hand, are left in the lurch since they in effect have to bear a higher cost of goods.

Most troubling is the fact that stair step programmes erode the traditional client development aspects of the car business.  Dealers have a difficult time building long-term customers under a stair step programme since there is always another dealer in town who is willing to under-cut them on price, even if that means selling a vehicle at a loss.  You simply cannot count on repeat customers and dealer loyalty in a system where the next dealership over can sell a customer the same vehicle for $1,000 less.

Many stair step programmes are coercive, subjective and arbitrary, creating a climate of constant insecurity among dealer networks.  They allow factories to manage their dealer networks much as a feudal lord would manage his subjects.

Depending on their vintage, dealers tend to view stair step programmes as either a recent headache or an unfortunate fact of life.  But the truth is that they are not part of the original deal that dealers struck with manufacturers when they first opened up their dealerships.  Dealers have a right to be told what the factory price for vehicles is, and to expect that the price will be the same for all of the other dealers in their network regardless of their sales volume.  Stair step programmes throw that principle right out the window since dealers are effectively being sold the same vehicles for different prices depending on arbitrary monthly volume targets.  In some cases stair step programmes appear to be contrary to dealer agreements; in others they are merely unfair.

Dealers in the United States have already started pushing back against stair step programmes.  The National Automobile Dealers Association launched a campaign last year against stair steps, calling them a “cancer in the industry.”  At least one dealer in Florida sued its manufacturer over a stair step programme, alleging in part that its unrealistically high volume targets caused it to go out of business.

How long will it be before Canadian dealers reach their breaking point?

Stair step programmes are like a Trojan virus waiting to destroy.  Automobile dealers tend to think of themselves as independent business people whose interests occasionally diverge from their factories.  Yet, what happens when the factories gain the power to discriminate amongst dealers arbitrarily? It creates a system of subservience, where dealers are constantly pressured into towing the company line for fear of reprisal in the form of a higher cost of goods.  If allowed to continue, dealers will eventually become nothing more than corporate managers.  Meanwhile, it will be their millions invested into their businesses that will evaporate.

In the long term, it is in the best interests of both dealers and factories to do away with the current version of stair step incentives for good.  Dealership networks will be healthier for it.  Rather than squeezing out dealers and encouraging destructive infighting within their dealership networks, factories should focus on providing superior products at competitive prices and allow dealers to do what they do best: sell vehicles.

At the very least, if the stair step programmes are to continue, the monthly targets should be calculated based on transparent, objective and predictable formulae.  As it stands, the volume targets are being calculated in an inconsistent and unfair manner.

John Sotos is a preeminent franchise lawyer in Canada. Together with having the largest franchise law practice in the country, John and his partners at Toronto-based firm Sotos LLP have been major contributors to the development of franchise law and franchising in Canada for over 30 years. John may be reached by telephone at (416) 977-0007 or by email at jsotos@sotosllp.com