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Cutting the link between list price and residual value

Last month I promised to explode a few myths which plague the world of future residual values. And what better way to start than with the simple and dangerous way of setting residual values as percentages of list price.

There are many reasons why this method is fundamentally flawed. The list price is rarely the real cost of the car, especially when special offers and discounts are taken into consideration.

In addition, the used car market takes little notice of the original list price. Prospective buyers don't ask how much the car was new.

However, the most important fact is that no-one pays for a car in percentages. Pounds matter - whether they are parted with weekly, monthly, or all at once.

Residual values are not set by the manufacturer, the trade or the dealer. They are dictated by what customers deem the car to be worth. By establishing a retail price, the dealer is setting a margin. And that establishes the trade value.

We can illustrate the dangers of restricting residuals to percentages with the following hypothetical example. Take a Ford Mondeo 2.0LX 5dr with a list price, including delivery, of £15,505. This car has a three-year/60,000 residual of 34%. On the other hand, a Honda Accord 1.8S, at £15,120, has a residual at the same point of 41% - seemingly the runaway winner. That is, if you use the percentage-only method.

However, say you got a £1,000 discount on the Ford and nothing off the Honda. The Ford's residual stands at £5,300 - a reduction in value of £9,205, compared to the undiscounted Honda at £6,225 - a reduction of £8,895.

Therefore the real difference in terms of cash lost would be £310.

Turn this back into percentages and the Ford residual moves closer to 37% - still not the winner, but a significantly better performance, which would have gone undetected under the percentage of list price method.

Another danger of setting residuals in percentage terms is that you are left at the mercy of manufacturer price fluctuations. For the percentage method to work, you have to assume that when the new price rises, so does the future residual value of the car. Conversely, with a price cut comes a lower value in the future for the used car.

Customers would then be aware three years down the line what the new price had been - and what list price movements had taken place.

In a small number of instances the list price does play a more significant role in the car's used value, but only in exotic cases, such as Porsche Boxster, where rarity means the first used examples can fetch list or even above.

So the golden principle in forecasting future residual values is a simple motto: The pound in your pocket is king.

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