6

- i CHAPTER 6

. MARKUPS ANALYSIS

TABLE OF CONTENTS

6.1 INTRODUCTION

................................ ................................ ................................ ........... 6

- 1

6.1.1 Distribution Channels

................................ ................................ ................................ ...... 6

- 1

6.1.2 Markup Calculation Methodology

................................ ................................ ................... 6

- 1

6.2 MANUFACTURER MARKUPS

................................ ................................ .................... 6

- 2

6.3 RETAILER MARKUP

................................ ................................ ................................ .... 6

- 3

6.3.1 Approach for Calculating Retailer Markups

................................ ................................ .... 6

- 3

6.3.1.1 Baseline Retailer Markup

................................ ................................ .............. 6

- 3

6.3.1.2 Incremental Retailer Markup

................................ ................................ ......... 6

- 4

6.4 SALES TAXES

................................ ................................ ................................ ............... 6

- 8

6.5 SUMMARY OF M ARKUPS

................................ ................................ .......................... 6

- 9

LIST OF TABLES

Table 6.2.1 Major Appliance Manufacturer Gross Margins and Markups

............................. 6

- 2

Table 6.3.1 Data for Baseline Markup Calculation: Electronics and Appliance Stores (2002)

................................ ................................ ................................ ................... 6

- 4

Table 6.3.2 Data for Incremental Markup Calculation: Electronics and Appliance Stores (2002)

................................ ................................ ................................ ........ 6

- 6

Table 6.3.3 Electronics and Appliance Stores, Concentration by Four Firms

........................ 6

- 7

Table 6.4.1 Average Sales Tax Rates by Censes Division and Large State

........................... 6

- 8

Table 6.4.2 Average Sales Tax Rates by Product

................................ ................................ ... 6

- 8

Table 6.5.1 Summary of Markup

................................ ................................ ............................ 6

- 96-1 CHAPTER 6. MARKUPS ANALYSIS

6.1 INTRODUCTION

To carry out its analyses, DOE needed to determi ne the cost to the consumer of baseline product s and the cost of more

- efficient units. As discussed in chapter 8 , DOE developed retail prices for baseline products using proprietary retail price data collected by The NPD Group . For products with higher

- than

- baseline efficiency, DOE est imated the consumer prices b y applying appropriate markup s to the incremental manufacturing costs estimated in the engineering analys is.

6.1.1 Distribution Channels

The appropriate markups for determining consumer equipment price s depen d on the type of distribution channels through which products move from manufacturers to purchasers

. At each point in the distribution channel, companies mark up the price of the equipment to cover their business costs and profit mar gin.

D ata from the Association of Home Appliance Manufacturers (AHAM) 1

6.1.2 Markup Calculation Methodology indicate that an overwhelming majority of residential appliances are sold through retail outlets. Because DOE is not aware of any other distribution channel that plays a significan t role for room air conditioners and clothes dryers , DOE assumed that all of the products are purchased by consumers from retail outlets. DOE did not include a separate distribution channel for room air conditioners and clothes dryers included as part of a new home, as it did not have information on the extent to which these products are “pre

- installed” by builders in new homes.

As just discussed, at each point in the distribution channel, companies mark up the price

of the equipment to cover their business costs and profit margin. In financial statements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold ( CGS ). T he gross margin includes the expenses of companies in the distribution

channel

— including overhead costs (sales, general, and administration); research and development (R&D) and interest expenses; depreciation, and taxes

— and company profits

. T o cover costs and to contribute positively to company cash flow

, the price of product s must include

a mark up. P roducts command lower or higher markup s , depending on company expenses associated with the prod u ct and the degree of market competition. In develo ping markups for

manufacturers and retailers , DOE obtained da ta about the revenue, CGS , and expenses of firms that produce and sell the products of interest.6-2 6.2 MANUFACTURER MARKUPS

DOE uses manufacturer markups to transform a manufacturer’s production costs into a manufacturer sales price. Using the CGS and gross margin , DOE calculated the manufacturer markup ( MU MFG ) with the following equation:

MFG MFG MFG

MFG CGS GM CGS MU +

=

where:

MU MFG = Manufacturer markup,

CGS MFG = Manufacturer’s cost of goods sold or Manufacturer Production Cost ( MPC ), and

GM MFG = Manufacturer’s gross margin.

The manufacturer’s CGS (or MPC ) plus its GM equals the manufacturer selling price ( MSP ).

DOE developed an average manufacturer markup by examining the annual Securities and Exchange Commission (SEC) 10

- K reports filed by fo ur publicly

- traded manufacturers primarily engaged in appliance manufacturing and whose combined product range includes residential refrigeration products. 2 The four manufacturers represent a nearly 50 percent market share for major appliances. Because th ese companies are typically diversified, producing a range of different appliances, an industry average markup was assumed by DOE to be representative for the manufacture of refrigeration products. DOE evaluated m arkups for the years 2002 ─2005

.

Table 6.2

. 1 lists the average corporate gross margin during the years 2002 ─2005 , and corresponding markups, for each of the four manufacturers. The average markup value based on these four companies is 1.26, which is the value that DOE used.

Table 6.2

. 1 Major Appliance Manufacturer Gross Margins and Markups

Mfr A Mfr B Mfr C Mfr D

Average Net Revenues (Million) $372 $280 $4770 $12,682

Corporate Gross Margin 15% 28% 16% 22%

Markup 1.18 1.39 1.19 1.28

Source: SEC 10

- K reports (2002

- 2005)6-3 6.3 RETAILER MARKUP

6.3.1 Approach for Calculating Retailer Markups

DOE based the retailer markups for room air conditioners and clothes dryers on financial

data for Electronics and Appliance Stores from the 2002 U.S. Census Business Expenses Survey (BES), whi ch is the most recent available survey

. 3 DOE organized the financial data into

s tatements that break down cost components incurred by firms in this category

. DOE assumes

that the income statements faithfully represent the various average costs incurred by firms selling home appliances. Although Electronics and Appliance Stores handle multiple commodity lines, the data provide the most accurate available indication of expenses for selling home appli ances.

The BES data provided for Electronics and Appliance Stores only contain total sales and detailed operating expenses. In order to construct a complete data set to estimate markups, DOE needed to estimate CGS and gross margin. The 1997 Business Expe nses Survey provides total sales, gross margin and detailed operating expenses of Household Appliance Stores. The CGS and gross margin account for around 70% and 30% of the total sales

, respectively. DOE found that gross margin as percent of sales has been roughly constant in this category from 1993 to

2007

. a

6.3.1.1 Baseline Retailer Markup Therefore, DOE assum ed that the fractions of CGS and gross margin as percent of sales

in 2002 are the same as in 1997. Following this assumption, DOE calculate d the CGS

, gross margin and net profit fo r Electronics and Appliance Stores in the 2002 BES

.

The baseline markup relates the manufacturer sales price of baseline products to the retailer sales price. DOE considers baseline models to be equipment sold under existing mark et conditions (i.e., without new energy efficiency standards). DOE calculated the baseline markup ( MU BASE ) for retailers as an average markup using the following equation:

RTL RTL RTL

BASE CGS GM CGS MU **+**

**=**

where:

MU BASE = Baseline retailer markup,

CGS RTL = Retailer’s cost of goods sold,

GM RTL = Retailer’s gross margin,

Table 6.3

. 1 shows the calculation of the baseline retailer markup.

a U

. S

. Census, 2007 Annual Retail Trade Report: Electronics and Appliance Stores Sales and Gross Margin6-4 Table 6.3

. 1 Data for Baseline Markup Calculation: Electronics and Appliance Stores (2002)

Kind of business item Amount ($1,000)

Sales $83,896,811 Cost of Goods Sold (CGS) $57,888,800
Gross Margin (GM) $26,008,011
Baseline Markup = (CGS+GM)/CGS 1.45

Source: U.S. Census, 2002 Business Expenses Survey (for Sales) and 1997 Business Expenses Survey (for CGS and GM shares)

6.3.1.2 Incremental Retailer Markup

Incremental markups are coefficients that relate the change in the manufacturer sales price of higher

- efficiency models to the chang e in the retailer sales price. DOE considers higher

efficiency models to be equipment sold under market conditions with new efficiency standards. The incremental markup reflects a situati on in which the retailer faces an increase in CGS for a particular product due to new or amended standards.

Unfortunately, empirical evidence regarding appliance retailer markup practices when a product increases in cost (due to increased efficiency or o ther factors) is lacking. DOE

understands that real

- world markup practices will vary depending on the market conditions faced by retailers

, on the magnitude of the change in CGS associated with an efficiency increase and on any associated changes in retail costs. Pricing in retail stores may also involve rules of thumb that are difficult to know and to incorporate into DOE’s analysis.

Given the uncertainty about actual markup practices in appliance retailing, DOE uses an approach that reflects the followi ng k ey concepts:

1. Changes in the efficiency of the goods sold are not expected to increase economic profits. Thus, DOE calculates m arkups/gross margins to allow cost recovery for retail companies

i n the distribution chain (including changes in the cost of capital) without changes in company profits.

2. E fficiency improvements impact some distribution costs but not others . DOE sets markups and retail prices to cover the distribution costs expected to change with efficiency but not the distribution costs t hat are not expected to change with efficiency.

The incremental markup approach is described in more detail in Dale et al. (2004). 4

T o estimate incremental retailer markups

, DOE divides retailers’ operating expenses into two categories: (1) Those that do not change when CGS increases due to amended efficiency standards (“fixed”), and (2) Those that increase proportionately with CGS (“variable”). DOE6-5 define s fixed costs to include labor and occupancy expenses because these costs are not likely to increase as a result of a rise in CGS due to amended efficiency standards. All other expenses, as well as the net profit, are assumed to vary in proportion to CGS. Although it is possible that some of the other expenses may not scale with CGS, DOE is inclined to take a more conservative position and include these as variable costs. (Note: Under DOE’s approach, a high fixed cost component yields a low incremental markup.)

DOE calculated the incremental markup ( MU INCR ) for retailers using the following equation:

RTL RTL RTL

INCR CGS VC CGS MU **+**

**=**

where:

MU INCR = Incremental retailer markup,

CGS RTL = Retailer’s cost of goods sold, and

V

C

RTL = Retailer’s variable costs.

Table 6.3

. 2 shows the breakdown of operating expenses using the 2002 BES data. T he incremental markup is calculated as 1.17.6-6 Table 6.3

. 2 Data for Increment al Markup Calculation: Electronics and Appliance Stores (2002)

Amount ($1,000)

Sales $83,896,811
Cost of Goods Sold (CGS) $57,888,800

Gross Margin (GM) $26,008,011

Labor & Occupancy Expenses (“Fixed”)
Annual payroll $10,267,605
Employer costs for fringe benefit $1,407,970
Contract labor costs including temporary help $160,094

Purchased utilities, total $427,809
Cost of purchased repair and maintenance services $308,789 Cost of purchased management consulting administrative services and other professional services $300,548

Purchased communication services $400,598
Lease and rental payments $2,655,286
Taxes and license fees (mostly income taxes) $385,538

Subtotal: $16,314,237

Other Operating Expenses & Profit (“Variable”)
Expensed computer related supplies $86,751
Cost of purchased packaging and containers $41,866
Other materials and supplies not for resale $611,361
Cost of purchased transportation, shipping and warehousing services $500,233
Cost of purchased printing services $285,012
Cost of purchased advertising and promotional services $1,840,898
Cost of purchased legal services $90,020
Cost of purchased accounting, auditing, and bookkeeping services $86,292 Cost of purchased custom coded original software (expensed) including adaption of

off

- the

- shelf software $18,944
Cost of system support design and services including web design $35,748

Cost of insurance $393,201 Cost of data processing and other purchased computer services, except

communications $41,056
Depreciation and amortization charges $1,229,110
Commissions paid $106,061
Other operating expenses $2,929,906

Cost of contract work $21,955
Net profit before taxes $1,375,360

Subtotal: $9,693,774

Incremental Markup = (CGS+Total Other Operating Expenses and Profit)/CGS 1.17

Source: U.S. Census, 2002 Business Expenses Survey

By dividing expenses into fixed and variable components, the incremental markup approach envisions that retailers cover costs without changing profits. Although retailers may be able to reap higher profits for a time, DOE’s approach assumes that competitio n in the appliance6-7 retail market, combined with relatively inelastic demand ( i.e., the demand is not expected to decrease significantly with a relatively small increase in price ), will tend to pressure retail margins back down.

To measure the degree of competition in appliance retailing, DOE estimated the four firm concentration ratio (FFCR) of major appliance sales in three retail channels: Electronics and Appliance Stores, Building and Material and Supplies Dealers, and General Merchandise Stores.

The FFCR represents the market share of the four largest firms in the relevant industry.

G enerally, an FFCR of less than 40% indicates that the industry is not concentrated and an FFCR of more than 70% indicates that an industry is highly concentrated. b c

Th e FFCR of major appliance sales is equal to the sector FFCR times the percent of total

sales within each sector accounted for by major appliances. As sh own in Table 6.3

. 3 , t he results

indi cate that appliance sales in Electronics and Appliance Stores, Household Appliance Stores, Building Material Supplies Dealers and General Merchandise Stores have a FFCR well under the

40% threshold. Moreover, the Electronics and Appliance Stores sector includes “Household Appliance Stores” as a subsector. Because there are many stores in this subsector, it has a FFCR

of only 16.8%.

Table 6.3

. 3 Electronics and Appliance Stores, Concentration by Four Firms

Sector Four Firm

Concentration Ratio (Percent of Sector Sales) Percent of Sales Accounted for by Major Appliance s Four Firm

Concentration Ratio

(Percent of Major Appliance Sales)

Electronics and Appliance

Stores 43.9 39.4 17.3

Household Appliance

Stores subsector 16.8

- -

Building Material and Supplies Dealers 41.7 15.7 6.5

General Merchandise

Stores 65.1 35.4 23.0

Source: U.S. Economic Census, Establishment and Firm Size: (Including Legal Form of Organization), 1997, 2002. *Note: The assumption used here is that major appliance sales are uniformly distributed within all firms in each

sector.

b University of Maryland University College http://info.umuc.edu/mba/public/AMBA607/IndustryStructure.html

c Quick MBA http://www.quickmba.com/econ/micro/indcon.shtml6-8 6.4 SALES TAXES

The sales tax represents state and local sales taxes that are applied to the consumer

equ ipment price. The sales tax is a multiplicative factor that increases the consumer equipment price.

DOE derived state and local taxes from data provided by the Sales Tax Clearingh ouse

. 5

Table 6.4

. 1 DOE derived population

- weighted average tax values for each Census division and la rge state, as
shown in below.

Table 6.4

. 1 Average Sales Tax Rates by Censes Division and Large State

Census Division/State Tax Rate (2010 July )

New England 5.55 %

Mid Atlantic 6.62 %

East North Central 6.94 %

West North Central 6.86 %

South Atlantic 6.44 %

East South Central 7.90 %

West South Central 8.42 %

Mountain 6.50 %

Pacific 5.21 %

New York State 8.45 %

California 9.15 %

Texas 8.05 %

Florida 6.70 %

DOE then derived U.S. average tax values for each product (as shown in Table 6.4

. 2 below) based on the product’s saturation within each Census division and large state. It

determined the saturations from the DOE Energy Informa tion Administration (EIA)’s 2005

Residential En ergy Consumption Survey. 6

Table 6.4

. 2 Average Sales Tax Rates by Product

Product Tax Rate

Room air conditioners 7.18% d

Clothes dryers 7.15%

d This figure includes both residential room air conditioners which c over all Census division and large states and commercial room air conditioners which only cover Census division.6-9 6.5 SUMMARY OF MARKUPS

Table 6.5

. 1 summarizes the markups at each stage in the distribution channel and the

average sales tax.

Table 6.5

. 1 Summary of Markup

Room Air Conditioners Clothes Dryers

Markup Baseline Incremental Baseline Incremental

Manufacturer 1.26 1.26

Retailer 1.45 1.17 1.45 1.17

Sales Tax 1.0718 1.0715

Overall 1.96 1.58 1.96 1.586-10 REFERENCES

1 Association of Home Appliance Manufacturers. AHAM 2003 Fact Book

, 2003. Washington,

DC. p. 25.

2 Security Exchange Commission, SEC 1 0

- K Reports, Various dates, 2002

- 2005, Security Exchange Commission. < http://www.sec.gov/ >

3 U.S. Census Bureau. 2002 Economic Census, Business Expenses Survey, Retail Trade, Household Appliance Stores , 2002. Washington, DC.

< http://www.census.gov/csd/bes/bes97.htm >

4 Dale, Larry et al., “An Analysis of Price Determination and Markups in the Air

- Conditioning and Heating Equipment Industry”, LBNL

- 52791, J anuary 2004.

5 Sales Tax Clearinghouse, Inc. State sales tax rates along with combined average city and

county rates

. < http://thestc.com/STrates.stm >

6 U.S. Department of Energy

- Energy Information Administration. Residential Energy Consumption Survey , 2005Public Use Data Files . Washington, DC.

< http://www.eia.doe.gov/emeu/recs/recspubuse05/pubuse05.html >