7-i 7-7 7-8 7-8 7-9

7-5 7-6 7-9 7-10 CHAPTER 7. MARKUPS FOR EQUI PMENT PRICE DETERMINATION

TABLE OF CONTENTS

7.1 INTRODUCTION ........................................................................................................... 7-1 7.1.1 Distribution Channels .......................................................................................... 7-1 7.1.2 Markup Calculation Procedure ............................................................................ 7-2 7.2 DISTRIBUTOR AND RETAIL MARKUPS .................................................................. 7-2 7.3 ORIGINAL EQUIPMENT MANUFACTURER MARKUP

.......................................... 7.4 CONTRACTOR OR INSTALLER MARKUP

............................................................... 7.5 SALES TAXES

............................................................................................................... 7.6 OVERALL MARKUP

.....................................................................................................

LIST OF TABLES

Table 7.2.1 Data Used to Calculate Wholesale Markups

....................................................... Table 7.2.2 Data Used to Calculate Retail Markups

............................................................... Table 7.5.1 Average Sales Tax Rates by Cens us Division and Large State

........................... Table 7.6.1 Summary of Markups for Small Motors

............................................................

LIST OF FIGURES
Figure 7.1.1 Distribution Channels fo r Small Electric Motors ................................................ 7-1CHAPTER 7. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

7.1 INTRODUCTION To carry out the engineering and life-cy cle cost (LCC) analyses, DOE needed to determine the cost to the customer of a baseline product and the co st of more-efficient units. By applying multipliers called “markups” to the manuf acturers’ selling prices estimated in the engineering analysis, DOE estimated the end user prices for baseline models and more-efficient equipment.

7.1.1 Distribution Channels The appropriate markups for determining the end user equipment price depend on the type of distribution channels through which products move from manufacturers to purchasers. At each point in the distribution channel, compan ies mark up the price of the equipment to cover their business costs and profit margin.

Because most small electric motors are used as components in larger pieces of equipment, much of the market passes through original equipment manu facturers (OEMs) who design, assemble and brand products that may c ontain small electric motors. OEMs in turn obtain their motors either dire ctly from the motor manufacturer s or from manufacturers via distributors.
Based on market research, DOE defined thre e distribution channels for small electric motors, and estimated their respective shares of shipments. Two channels exist for motors installed in new equipment: (1 ) from manufacturers to OEMs and then to end-users through equipment distributors or retailers—40 percent of shipments; and (2) from manufacturers to wholesale motor distributors to OEMs and then to end-users through equipment distributors or retailers—25 percent of shipments. The third ch annel refers to replacement or spare motors: (3) from manufacturers to wholesale motor distri butors to end-users th rough distributors or retailers—35 percent of shipments.

Figure 7.1.1 Distribution Channels for Small Electric Motors

7-17-2 In its determination analysis for small electric motors, DOE estimated that there was no markup on incremental costs between the OEM and final installation. In this analysis, DOE estimates markup factors.

7.1.2 Markup Calculation Procedure As just discussed, at each point in the di stribution channel, companies mark up the price of the equipment to cover their business costs a nd profit margin. In fina ncial statements, gross margin is the difference between the company reve nue and the company cost of sales or cost of goods sold ( CGS ). Inputs for calculating the gross ma rgin are all corporate costs—including overhead costs (sales, general, and administ ration); research and development (R&D) and interest expenses; depreciation, and taxes—and profits. In order for sales of a product to contribute positively to company cash flow, th e product’s markup must be greater than the corporate gross margin. Individual pr oducts may command a lower or higher markup, depending on their perceived added value and the competition they face from similar products in the market.
In developing markups for OEMs, distributo rs and retailers, DOE obt ained data about the revenue, CGS , and expenses of firms that produce and sell the products of interest. DOE’s approach categorizes the expenses into two categories: labor-scaling costs ( LSC ), which are fixed labor and occupancy expenses that increase in proportion to the amount of labor required to produce or sell the product, and non-labor-scaling costs ( NLSC ), which are variable operating costs that do not scale with la bor and vary in proportion to CGS . Together, LSC and NLSC represent the gross margin.
For each step in equipment distribution, DOE estimated both a baseline markup and an incremental markup. For small electric motors, DOE understands that no in crease in distribution labor is necessary for the dist ribution of more efficient equi pment, while the non-labor-scaling cost does increase with increasing equipment costs. This allowed DOE to estimate the incremental markup given a breakdown of distri bution and manufacturing business expenses for a particular industry.
In the case of OEM manufacturing costs, DOE did not have detailed industry component costs, but it did have time series of total sales payroll and material costs for a variety of related industries. In this case, DOE performed a regr ession analysis to estimate incremental markups on material input costs.

7.2 DISTRIBUTOR AND RETAIL MARKUPS DOE based its distributor and retail markups on financial data from the U.S. Census Business Expenses Survey (BES). DOE organized the financial data into balance sheets that break down cost components incurred by firms that sell equipment with small motors orreplacement motors. a The key assumptions that DOE used to estimate the retailer and distributor markups using these financial data were:

1. The balance sheets faithfully represent th e various average costs incurred by firms distributing motors and e quipment containing motors.

2. These costs can be divided into two categories:

a. Costs that vary in proportion to the manu facturer sales price (variable costs); and b. Costs that do not vary with the manu facturer sales price (fixed costs).

3. Retailer and distributor sales pr ices vary in proportion to reta iler and distributor costs that are included in the balance sheets.
In support of the first assumption, the balanc e sheets itemize firm costs into a number of expense categories, including CGS , operating labor and occupancy costs, and other operating costs and profit. Although retailers and distribu tors tend to handle multiple commodity lines, the data provide the most accurate available indication of distributor expenses.
In the discussion that follows, DOE uses a division of costs between those that do not scale with the manufacturer sale s price (fixed costs—labor and occupancy expenses referred to above as LSC ), and those that do scale (variable costs —operating expenses and profit referred to above as NLSC ).
In support of the third assumption, the retail er and distributor indus tries are relatively competitive, and end user demand for motors and equipment with motors is relatively inelastic— i.e., the demand is not expected to decrease signifi cantly with a relatively small increase in price. Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or qu ickly go out of business. i

Using the above assumptions, DOE developed baseline and incremental markups and applied them in calculating end user equipment prices from manufactur er sales prices. DOE used the baseline markups, which cover all of a retailer’s or distribut or’s costs (i.e., both LSC and NLSC ), to determine the sales price of baselin e models. The baseline markup relates the manufacturer sales price to the retailer sales pr ice or distributo r sales price. DOE considers baseline models to be equipment sold under ex isting market conditions (i.e., without new energy efficiency standards). DOE calculated the baseline markup ( MU BASE ) for retailers and distributors using the following equation:

DISTRTL DISTRTL DISTRTL DISTRTL

DISTRTL DISTRTL DISTRTL BASE CGS NLSC LSC CGS CGS GM CGS MU

/ / / /

/ / / ) ( + +

= +

=

7-3 a The distributors to whom these financial data refer handle multiple commodity lines.Where:

MU BASE = baseline retailer or distributor markup, CGS RTL/DIST = retailer’s or distribut or’s cost of goods sold, GM RTL/DIST = retailer’s or distri butor’s gross margin, LSC RTL/DIST = retailer’s or distributo r’s labor-scaling costs, and NLSC RTL/DIST = retailer’s or distributor’s non-labor-scaling costs.
Incremental markups cover only those co sts that scale with a change in the manufacturer’s sales price (i.e., NLSC ). Incremental markups are co efficients that relate the change in the manufacturer sales price of higher-efficiency models to the change in the retailer or distributor sales price. DOE considers higher-efficiency models to be equipment sold under market conditions with new efficiency standard s. It calculated the incremental markup ( MU INCR ) for retailers and distributors using the following equation:

DISTRTL DISTRTL DISTRTL INCR CGS NLSC CGS MU

/ / / +

=
Where:

MU INCR = incremental retailer or distributor markup, CGS RTL/DIST = retailer’s or distributo r’s cost of goods sold, and NLSC RTL/DIST = retailer’s or distributor’s non-labor-scaling costs.

DOE used financial data from the BES fo r the categories “Electrical Goods Merchant Wholesalers” and “Machinery, Equipment, and S upplies Merchant Wholesalers” to calculate markups used by wholesale distributors of moto rs to OEMs and by distributors of equipment containing small motors or replacement motors, respectively. Table 7.2.1 shows the data from the BES and the markups DOE estimated using the procedures described above.
DOE used financial data from the BES, in the “Building materials, hardware, garden supply and mobile home dealers” category to calculate markups us ed by retail outle ts that sell equipment containing motors or replacement motors. ii Table 7.2.2 shows the BES data that DOE used and the markups that DOE estimated following the procedures described above.

7-47-5 Table 7.2.1 Data Used to Calculate Wholesale Markups

Item Equipment Wholesale (Million Dollars) Motors Wholesale (Million Dollars) Sales (revenue) 225425 205688 Cost of Goods Sold (CGS) 158097 160435 Gross Margin (GM) 67328 45253 Operating Expenses 52498 42110 Labor-Scaling Costs (LSC): Annual Payroll 25804 19402 Fringe benefits 4343 3233
Contract labor 750 954
Taxes and license fees 823 450 Lease and rental payments 2932 1980 Telephone and other communications 1185 958
Purchased Utilities 706 478
Contract work 151 269 Purchased repair and maintenance services 826 436 Commissions paid 963 1309
LCS Subtotal: 38483 29469 Non-Labor-Scaling Costs (NLSC): Depreciation and Amortization 2650 1947 Office Supplies 885 663 Packaging and Other Materials 346 425 Advertising Services 959 1842 Legal Services 277 292 Accounting, Auditing, and Bookkeeping 346 215 Computer Related Services 403 498 Other Operating Expenses 8149 6759
Net Profit Before Taxes 14830 3143
NLSC Subtotal: 28845 15784 Baseline Markup (MU BASE ) = (CGS+GM)/CGS 1.43 1.28 Incremental Markup (MU INCR ) = (CGS+NLSC)/CGS 1.18 1.107-6 Table 7.2.2 Data Used to Calculate Retail Markups Item Million Dollars Sales (revenue) 148397 Cost of Goods Sold (CGS) 102922 Gross Margin (GM) 45475 Operating Expenses 3664 Labor-Scaling Costs (LSC) Annual Payroll 17740 Fringe benefits 3212 Contract labor 941 Taxes and license fees 728 Lease and rental payments 2474 Telephone and other communications 601 Purchased Utilities 918 Contract work 0 Purchased repair and maintenance services 840 Commissions paid 0 LCS Subtotal: 27454 Non-Labor-Scaling Costs (NLSC) Depreciation and Amortization 1783 Office Supplies 488 Packaging and Other Materials 264 Advertising Services 1321 Legal Services 159 Accounting, Auditing, and Bookkeeping 196 Computer Related Services 179 Other Operating Expenses 4820 Net Profit Before Taxes 8811 NLSC Subtotal: 18021 Baseline Markup (MU BASE ) = (CGS+GM)/CGS 1.44 Incremental Markup (MU INCR ) = (CGS+NLSC)/CGS 1.187.3 ORIGINAL EQUIPMENT MANUFACTURER MARKUP DOE calculated the OEM markup as follows:

BASE MU CAPMATPAY SALES

= + + .

Where:

SALES = value of shipments, PAY = payroll expenses, MAT = material input expenses, CAP = capital expenses, MU BASE = baseline markup.

The 2002 Economic Census Manufacturing Industry Series reports the payroll (production and total), cost of materials, capital expend itures, and total valu e of shipments for manufacturers of various types of machinery. Six years of data are reported for each manufacturer type. DOE collected this data for 11 types of OEMs:

• Air-conditioning and warm air heating equipment and commercial and industrial refrigeration equipment manufacturing

• All other industrial machinery manufacturing

• Farm machinery and equipment manufacturing

• Food product machinery manufacturing

• Heating equipment (except warm air furnaces) manufacturing

• Industrial and commercial fan and blower manufacturing

• Machine tool (metal cutting types) manufacturing

• Machine tool (metal form ing types) manufacturing

• Other metalworking machinery manufacturing

• Sawmill and woodworking machinery manufacturing

• Textile machinery manufacturing
The markups range between 1.20 (Industrial machinery, Machine tools) and 1.56 (Heating equipment), w ith an average of 1.37.
DOE estimated incremental markups using a least squares regression of the value of shipments on payroll and cost of materials. Beca use there is a large range in the size of the OEM types, companies with value of sales greater th an $10 billion were separated from those with value of sales less than $10 b illion. The incremental markup for larger companies was 1.27 and the incremental markup for smaller companies was 1.33. DOE used the former value for the

7-77-8 ce

all cases. channel in which OEMs purchase motors directly from motor manufacturers, and the latter value for the channel in which OEMs purchase motors from a motor distributo r. This approach assumes that larger companies would be more likely to purchase motors directly from motor manufacturers.

7.4 CONTRACTOR OR INSTALLER MARKUP
DOE used information from RSMeans Electrical Cost Data iii to estimate markups used by contractors in the installati on of equipment with small motors or replacement motors. RSMeans electrical cost data estimates material expense markups for electrical contractors as 10%, leading to a markup factor of 1.10. DOE rec ognizes that contractors are not used in all installations, since some firms have in-house technicians who would install equipment or repla a motor. However, DOE has no information on the extent to which this occurs, so it applied a markup of 1.10 in

7.5 SALES TAXES The sales tax represents state and local sa les taxes that are applied to the end user equipment price of the equipment. The sales tax is a multiplicative factor that increases the end user equipment price.

DOE derived state and local taxes from da ta provided by the Sales Tax Clearinghouse. iv These data represent weighted averages that in clude county and city rates. DOE then derived population-weighted average tax values for each Ce nsus division and large state, as shown in Table 7.5.1 below. DOE then derived U.S. av erage tax values usi ng a populated-weighted average of the Census division and large State va lues. This provides a national average tax rate of 6.84 percent, which DOE used for each of the distribution channels.Table 7.5.1 Average Sales Tax Rates by Census Division and Large State
Census Division/State Tax Rate Population (July 1, 2007) v New England 4.98% 14,264,185
Mid Atlantic 6.07% 21,118,712
East North Central 6.56% 46,338,216
West North Central 6.65% 20,050,579
South Atlantic 5.95% 39,609,017
East South Central 7.85% 17,944,829
West South Central 8.30% 10,745,317
Mountain 6.46% 21,360,990
Pacific 4.97% 12,182,745
New York State 8.25% 19,297,729
California 7.95% 36,553,215

Texas 7.95% 23,904,380
Florida 6.70% 18,251,243

7.6 OVERALL MARKUP The overall markup for each distribution channe l is the product of the relevant markups, as well as the sales tax. DOE used the overa ll baseline markup to estimate the end user equipment price of baseline models, given the manuf acturer selling price of the baseline models. As stated above, DOE considers baseline models to be equipment sold under existing market conditions (i.e., without new ener gy efficiency standards).
DOE used the overall incremental markup to es timate changes in the end user equipment price, given changes in the manu facturer cost above the baseline model cost resulting from a standard to raise equipment efficiency. The tota l end user equipment price for higher-efficiency models is composed of two com ponents: the end user equipment pr ice of the baseline model and the change in end user equipment price associated with the increas e in manufacturer cost to meet the new efficiency standard. The followi ng equation shows how DOE used the overall incremental markup to determine the end user eq uipment price for higher-efficiency models (i.e., models meeting new efficiency standards). 

## ( )

INCR OVERALL MFG BASE SALES INCR MFG BASE OVERALL MFG STD MU COST EQP Tax MU COST MU MSP EQP

_ _ × Δ+= × × Δ + ×=

7-97-10 Where:

EQP STD = end user equipment price fo r models meeting new efficiency standards, EQP BASE = end user equipment price for baseline models, MSP MFG = manufacturer selling price for baseline models, Δ MSP MFG = change in manufacturer selling price for higher-efficiency models, MU INCR = incremental OEM or distributor markup, Tax SALES = sales tax, MU OVERALL_BASE = baseline overall markup (product of manufacturer markup, baseline OEM or distributor markup, and sales tax), and MU OVERALL_INCR = incremental overall markup (product of manufacturer markup, incremental OEM or distributor markup, and sales tax).
Table 7.6.1 summarizes the markups and the overall baseline and incremental markups for each of the three identified channels. Weigh ting the values by the respective shares of each channel yields an average overall baseline mar kup of 2.42 and an overall incremental markup of 1.75.

Table 7.6.1 Summary of Markups for Small Motors
Direct to OEMs (40%) Via Distributors to OEMs (25%) Via Distributors to EndUsers (35%)

Baseline Incremental Baseline Incremental Baseline Incremental

Motor Wholesale Distributor - - 1.28 1.10 1.28 1.10

Equipment Manufacturer (OEM) 1.37 1.27 1.37 1.33 - -

Equipment or Motor Distributor or Retailer 1.43 1.18 1.43 1.18 1.44 1.18

Contractor or Installer 1.10 1.10 1.10 1.10 1.10 1.10

Sales Tax 1.0684 1.0684 1.0684

Overall 2.30 1.76 2.95 2.03 2.17 1.53

The example provided below illustrates how DOE used the baseline and incremental markups to derive an end user equipment price. Assuming the baseline manufacturer selling price is $93.46 and the change in manufacturer price to meet a given energy efficiency standard is $10, the resulting baseline end user equipment price ( EQP BASE ) and higher-efficiency equipment price ( EQP STD ) are:63.219$35.246.93$ _ =×= × = BASE OVERALL MFG BASE MU MSP EQP


# ( ) 13.237$50.17$63.219$)75.110($63.219$ ) (

_ =+=×+= × Δ += INCR OVERALL MFG BASE STD MU MSP EQP EQP

7-117-12 REFERENCES

i Pindyck, R.S. and D.L. Rubinfeld, Microeconomics, 5 th ed. , 2000. New Jersey: Prentice Hall.

ii U.S. Census Bureau. 1997 Economic Census, Business Expenses Survey, Retail Trade, Household Appliance Stores , 1997. Washington, DC.
< http://www.census.gov/csd/bes/bes97.htm >

iii RSMeans Construction Publishers & Consultants, Electrical Cost Data, 31 st Annual Edition. 2008. ed. J.H. Chiang, Kingston, MA.

iv Sales Tax Clearinghouse, Inc. State sales tax rates along with combined average city and county rates , 2006. <http://thestc.com/STrates.stm>

v U.S. Census Bureau. Table 1: Annual Estimates of the Population for the United States, Regions, States, and Puerto Rico: April 1, 2000 to July 1, 2007 (NST-EST2007-01) , December 27, 2007, < http://www.census.gov/popes t/states/NST-ann-est.html >