CHAPTER 6. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

TABLE OF CONTENTS

6.1 INTRODUCTION .............................................................................................................. 6-1 6.1.1 Baseline Markups.................................................................................................6-3 6.1.2 Incremental Markups ........................................................................................... 6-3 6.1.3 Overall Markups .................................................................................................. 6-4 6.2 BASIC ASSUMPTIONS USED TO ESTI MATE WHOLESALER/DISTRIBUTOR MARKUPS ........................................................................................................................ . 6-5 6.3 ESTIMATION OF DISTRIBUTOR- WHOLESALER MARKUPS.................................. 6-6 6.4 SALES TAX ...................................................................................................................... . 6-7 6.5 OVERALL MARKUPS...................................................................................................... 6-8 6.6 RESULTS ........................................................................................................................ ... 6-9 REFERENCES ..................................................................................................................... ..... 6-10

LIST OF TABLES

Table 6.3.1 Wholesaler/Distributor Expenses and Markups ................................................... 6-6

Table 6.4.1 State Sales Tax Rates ........................................................................................... 6-8

Table 6.5.1 Baseline Average Markups by Distribution Channel and Overall Average Markup, Including the Sales Tax Multiplier ........................................................ 6-8

Table 6.5.2 Incremental Average Markups by Di stribution Channel and Overall Average Markup, Including the Sales Tax Multiplier ......................................... 6-8

LIST OF FIGURES

Figure 6.1.1 Distribution Channels and Shares for Refrigerated Beverage Vending Machines .............................................................................................................. 6-2

6-iCHAPTER 6. MARKUPS FOR EQUI PMENT PRICE DETERMINATION

6.1 INTRODUCTION

To carry out the life-cycle cost (LCC) calculations described in chapter 8, the U.S. Department of Energy (DOE) needs to dete rmine the cost to the customer of baseline refrigerated beverage vending machines (BVMs) . This cost is determined for both baseline equipment and more efficient equipment that the customer would purchase following the promulgation of new energy cons ervation standards. However, the customer price of such equipment is not known because it depends on how the equipment is purchased. The manufacturer selling price (MSP) for both baseline equipment and the more efficient equipment is determined in the engineering analysis (cha pter 5). By applying a multiplier called a “markup” to the MSP, DOE was able to estimate the cu stomer price of equi pment purchased through various distribution channels. This chapte r describes how DOE derived these markups.

DOE determines customer prices for BV Ms from MSP and equipment price markups using industry balance sheet data and U.S. Cens us Bureau data. To determine price markups, DOE identifies distribution channels for equipm ent sales and determines the existence and amounts of markups within each distribution ch annel. For each distribution channel, DOE distinguishes between “baseline markups” appl ied to the MSP for baseline equipment and “incremental markups” applied to the incremen tal increase in MSP for higher efficiency equipment. Overall baseline and overall incremental markups are calculated separately based on the product of all baseline markups at each step within a distribut ion channel or the product of all incremental markups at each step within a distri bution channel, respectively. The combination of the overall baseline markup applied to the baselin e MSP and the incremental markups applied to the incremental increase in MSP for higher efficiency equipment, including sales tax, determines the final customer price.

The cost to the customer depends on how th e customer purchases the equipment. As shown in Figure 6.1.1 , DOE defined three distribution channe ls to describe how the equipment passes from the manufacturer to the customer. In the first distribution channel, the manufacturer sells the equipment to the bottler/distributor, w ho in turn installs, operates, and maintains the equipment on site at the user’s location. In the second and th ird distribution channels, the manufacturer sells the equipment to a wholesaler/d istributor, who in turn sells it directly to the customer (vending machine operator or site owne r). The site owner purch ases outright a small percentage of the machines from the distri butor and stocks and maintains them on site. Figure 6.1.1 also gives the distribution channel shares (in percentage of total sales) through each of the three distribution cha nnels. The distribution channel shares are based on industry comments from the public m eeting on the advance notice of proposed rulemaking. 1

6-1BVM Manufacturer

Bottler/Distributor Vending Machine Operator Site Owner Wholesaler/Distributor

85 % 10 % 5%
Figure 6.1.1 Distribution Channels and Shares for Refrigerated Beverage Vending Machines

The following equation describes how DOE determined the equipment price if a customer (in this case, the bottler/distributo r) purchases directly from the manufacturer:

EQP CUST = MSP BASE x (1+ ST) Eq. 6.1

Where: EQP CUST = equipment price to the customer ($), MSP BASE = MSP of baseline equipment ($), and ST = sales tax rate.

The following equation describes how DOE determined the equipment price if a distributor sells the equipment to the cu stomer through the wholesaler/distributor:

EQP CUST = MSP BASE x MU DIST x (1+ ST ) Eq. 6.2

Where: MU DIST = wholesaler/distributor markup.

The markup multiplier to the equipment price is thus lessened for shorter distribution channels.

For each of the wholesaler/distributor markups presented above, DOE further differentiated between a baseline markup and an incremental markup, as described below. The overall markup describes the product of all the markups plus sales tax within a distribution channel.

6-26.1.1 Baseline Markups

DOE defined baseline markups as co st multiplie rs that relate the purchase cost to the MSP for each step in the distribution channel.

If sold to a customer by the manufacturer, the following equation defines the equipment price:

EQP MFGR BASE = MSP BASE x (1+ST) Eq. 6.3

Where: EQP MFGR BASE = bottler/distributor price to the cust omer of baseline equipment ($).

If sold to a customer by a wholesaler/distributor:

EQP DIST BASE = MSP BASE x MU DIST BASE x (1+ST) Eq. 6.4

Where: EQP DIST BASE = distributor price to the customer of baseline equipment ($), MU DIST BASE = distributor markup on baseline equipment, and ST = sales tax rate.

The use of the markups results in the wholesaler/distributor ( EQP DIST BASE ) prices of baseline BVM equipment.

6.1.2 Incremental Markups

For the purpo se of this analysis, incrementa l markups are cost mu ltipliers that relate incremental changes in the MSP of higher effici ency equipment (from efficiency improvements) to changes in the distributor sales price.

If sold to a bottler/distributor directly by the manufacturer, the following equation defines the equipment price:

EQP MFGR INCR = MSP INCR x (1+ST) Eq. 6.5

Where: EQP MFGR INCR = incremental equipment price to the customer ($), MSP INCR = change in the MSP of higher effi ciency equipment brought about by an increase in efficiency due to new standards ($), and ST = sales tax rate.

6-3If sold by a wholesaler/distri butor directly to a customer:

EQP DIST INCR = MFG INCR x MU DIST INCR x (1+ ST) Eq. 6.6

Where: EQP DIST INCR = incremental wholesaler/distributor price to the customer ($), and MU DIST INCR = incremental wholesaler/distributor markup ST = sales tax rate.

In equation 6.6, the MU DIST INCR term refers to the incremental wholesaler/distributor markup that is applied to the incremental MSP. The use of the incremental markup results in the incremental wholesaler/distributor ( EQP DIST ) price.

6.1.3 Overall Markups

Overall ma rkups, including both overall base line and overall incremental markups, relate the MSP to the customer price as indicated by the following equations:

EQP CUST BASE = MSP BASE x (WT MFGR BASE + WT DIST BASE x MU DIST BASE ) x (1+ST)

= MSP BASE x (1+ MU OVERALL BASE ) Eq. 6.7

EQP CUST INCR = MSP INCR x (WT MFGR INCR + WT DIST INCR x MU DIST INCR ) x (1+ST)

= MFG INCR x MU OVERALL INCR Eq. 6.8

EQP CUST = EQP CUST BASE + EQP CUST INCR Eq. 6.9

Where: MU OVERALL BASE = overall weighted baseline markup that is the product of all the weights and baseline markups for each step of the distribution channel, MU OVERALL INCR = overall weighted incremental markup th at is the product of all the weights and incremental markups for each step of the distribution channel, EQP CUST BASE = baseline customer price ($), EQP CUST INCR = incremental customer price ($), EQP CUST = total customer price ($), WT MFGR BASE = weight (percent) of baseline equi pment sales direct to customers, WT DIST BASE = weight (percent) of baseline equipment sales through wholesalers, WT MFGR INCR = weight (percent) of higher efficiency equipment sales direct to customers, and WT DIST INCR = weight (percent) of higher efficiency equipment sales through wholesalers, and ST = sales tax rate.

The use of the overall baseline and overall incremental markups results in the baseline customer price ( EQP CUST BASE ) and the incremental customer price ( EQP CUST INCR ). For a particular higher efficiency level that increa ses the MSP of equipment, the total price of equipment to the customer ( EQP CUST ) is the sum of the baseline customer price ( EQP CUST BASE ) and the incremental customer price ( EQP CUST INCR ).

6-46.2 BASIC ASSUMPTIONS USED TO ES TIMATE WHOLESALER/DISTRIBUTOR MARKUPS

DOE based the wholesaler/distributor m ar kups on U.S. Census Bureau data for the “Other commercial equipment merchant wholes aler” segment of durable goods and merchant wholesalers category of Wholesale Trade. Three key assumptions used to estimate markups for the BVM wholesaler/distributor industry were:

1. The data accurately represent the various costs incurred by firms distributing and installing BVM equipment.

2. The costs can be divided into two categories: (1) costs that vary in proportion to the MSP of BVM equipment (variable costs), and (2) co sts that do not vary with the MSP of BVM equipment (fixed costs).

3. Wholesaler/Distributor pr ices vary in proportion to the stat ed wholesaler/distributor costs.

In support of the first two assumptions, the cost data are categorized correctly to reflect the direct costs to purc hase or install the equipment, opera ting labor and occupancy costs, and other operating costs and profit.

Although the BVM wholesaler /distributors may handle multiple commodity lines (including non-refrigerated vendi ng machines and other equipment) , the data provide the most accurate available indication of BVM equipment costs.

DOE searched for but did not find data on two to pics that relate to the price determined by the markup analysis. The first is the division a nd application of fixed and variable costs, and the second is the level of competition.

In the case of the division and application of fixed and variable costs to determine baseline and incremental markups, DOE relied on prior analysis of the heating, ventilation, and air conditioning wholesalers, contractors, and consultants, including information obtained from the trade literature. 2

, 3 This analysis indicates that whol esaler and contractor markups vary according to the quantity of labor and materials us ed to distribute and install appliances, with markups on labor tending to be much larger than markups on materials. The analysis implies that these distribution channel markups vary more w ith sales volume than with other factors, including appliance efficiency. Distribution chan nel labor inputs also vary more with sales volume than with appliance cost or efficiency. DOE assumed a division of costs between those that do not scale with the MSP (labor and occ upancy costs) and those that do (operating costs and profit). This division of costs led to the estimation of wholesaler/distributor markups, as described below.

In the case of the BVM industry, the le vel of competition among the wholesaler/ distributors of BVM equipment and customer de mand for BVM equipment is relatively inelastic (i.e., the demand is not expected to decrease si gnificantly with an increase in price of the equipment). The large number of wholesaler firm s listed in the U.S. Census Bureau data (2002) indicates that the market is relatively compe titive in nature, as there are about 450 wholesaler/

6-5distributors of BVM equipment. 4 Following standard economic theory, competitive firms facing elastic demand either set prices in line with costs or quickly go out of business. 5

6.3 ESTIMATION OF DISTRIBUTOR-WHOLESALER MARKUPS

DOE derived ma rkups for wholes aler/distributors from U.S. Census Bureau data (2002) for Other Commercial Equipment Merchant Wholesalers (North American Industry Classification System [NAICS] 423440). This sector includes establishments primarily engaged in distributing and wholesaling refrigerated BVMs and other equipment to restaurants and hotels (NAICS 4234401) and stores (NAICS 4234402). The U.S. Census Bureau data for this sector include revenue and expense data in total dollars rather than in t ypical values for an average or representative business. Because of this, DOE assumed that once converted to a percentage basis, the total dollar values that the U.S. Census Bureau reported represented revenues and expenses for an average or typical contracting business. Table 6.3.1 summarizes the expenses for wholesaler/distributors as expenses per dollar sales revenue in the first data column (appendix C contains dollar values from the survey). The direct cost of sales represents about $0.69 per dollar sales revenue to the wholesal er/distributor. Labor expenses account for $0.13 per dollar sales revenue, occupancy expenses and other ope rating expenses account for $0.10, and profit accounts for $0.09 per dollar sales revenue.

Table 6.3.1 Wholesaler/Distribut or Expenses and Markups Wholesale Firm Expenses or Revenue

Description Per Dollar Sales Revenue Per Dollar Cost of Goods Sold Direct Cost of Equipment Sales: Cost of goods sold $0.69 $1.00 Labor Expenses: Salaries and benefits $0.13 $0.19 Occupancy Expense: Rent, maintenance, and utilities $0.07* Other Operating Expenses: Depreciation, advertising, and insurance $0.10 $0.07* Profit $0.09 $0.13 Baseline Markup ( MU WHOLE BASE ): Revenue per dollar cost of goods sold 1.46 Incremental Markup ( MU WHOLE INCR ): Increased revenue per dollar increase cost of goods sold 1.20 Source: U.S. Census Bureau. Decem ber 2005. Wholesale Trade, Miscella neous Subjects: 2002. EC02-42SX-SB Table 4. Detailed Type of Oper ation for the United States: 2002 U.S. Census Bureau. December 2 005. Wholesale Trade, Miscellane ous Subjects: 2002. EC02-42SX-SB Table 6. Gross Margin and Its Components for Merchant Wholesalers for the United States: 2002 U.S. Census Bureau. December 2 005. Wholesale Trade, Miscellane ous Subjects: 2002. EC02-42SX-SB Table 7. Gross Profit and Its Components for Me rchant Wholesalers for the United States: 2002 *Because data were not available to calculate the individual values for Occupancy and Other Operating Expenses in the “Per Dollar Cost of Goods Sold” column, the values were calculated from the “Per Dollar Sales Revenue” value by arbitrarily dividing the total in half. Evidence from other rulema kings indicates that the Occu pancy Expense value in the “P er Dollar Cost of Goods Sold” column is often slightly lower than the value for Other Op erating Expenses. If this were th e case in this category, then the effect would be to understate the incr emental by 1 or 2 points (i.e., it may be 1.21 or 1.22 instead of 1.20).
DOE converted these expenses per dollar sales into revenue per dolla r cost of goods sold by dividing each figure in the first data column by $0.69. The data in the last column show that for every $1.00 the wholesaler/distr ibutor spends on equipment cost s, the wholesaler/distributor earns $1.00 in sales revenue to cover the equipment cost, $0.19 to cover labor costs, $0.07 to cover occupancy expenses, $0.07 for other operating expenses, and $0.13 in profits. This totals $1.46 in sales revenue earned for every $1.00 sp ent on equipment costs and results in a wholesaler/distributor baseline markup ( MU DIST BASE ) of 1.46 ($1.46 ÷ $1.00).

6-6DOE was also able to use the data in the last column in Table 6.3.1 to estimate the incremental m arkups by separating the fixed and vari able costs. For example, if all of the other costs scale with the equipment price (i.e., all co sts are variable), the increase in wholesaler/ distributor price will be $1.46, impl ying that the incremental markup is 1.46 or the same as the baseline markup. However, if none of the other costs are variable, then a $1.00 increase in the equipment price will lead to a $1.00 increase in the wholesaler/distri butor price, for an incremental markup of 1.0. DOE assumes the labor and occupancy costs to be fixed and the other operating costs and profit to scale with the equipmen t price (i.e., be variable). In this case, for a $1.00 increase in the equipment price, the whol esaler/distributor pr ice will increase by $1.20, giving a wholesaler/distri butor incremental markup ( MU DIST INCR ) of 1.20 ($1.20 ÷ $1.00).

DOE recognizes that there is a possibility of case-to-case devia tion in the markups developed from the above financial data. Based on the analysis of U.S. Census Bureau data for wholesalers, DOE calculated a standard deviation from the mean of 12.1 percent (see appendix C for further details). DOE assumed that the vari ation determined for the baseline markup applied to the incremental markup as well. For the ba seline markup of 1.46, a standard deviation of 12.1 percent translates into an absolute value of approximately 0.06. For the incremental markup of 1.20, a standard deviation of 12.1 percent tr anslates into an absolute value of 0.024.

The national level census data on distribution of BVM units suggest that over 95 percent of new units sold pass through bottl er/distributors or wholesaler/dis tributors. Uncertainty in the quantitative value of markups is introduced into the LCC analysis through the use of the Excelspreadsheet based Crystal Ball program. DOE app lied the same baseline and incremental markup to all sales of BVM units passing through wholesaler/d istributors.

6.4 SALES TAX

The sales tax represents State and lo cal sales taxes that are applied to the customer price of BVM units. The sales tax is a multiplier that increases the customer equipment price. DOE derived sales taxes representative of the combined State and local sales ta x rates from the Sales Tax Clearinghouse, 6 shown in Table 6.4.1 . The State level combined ta x rates can be applied to the estim ated value of State level BVM equipment shipments to obtain the total purchase cost to the customer located in any State.

6-7Table 6.4.1 State Sales Tax Rates

State Combined State and Local

Tax Rate [%] State Combined State and Local

Tax Rate [%] State Combined State and Local

Tax Rate [%] Alabama 8.15 Kentucky 6.00 North Dakota 5.75 Alaska 1.45 Louisiana 8.70 Ohio 6.80 Arizona 7.15 Maine 5.00 Oklahoma 8.10 Arkansas 8.20 Maryland 6.00 Oregon 0.00 California 8.00 Massachusetts 5.00 Pennsylvania 6.25 Colorado 6.35 Michigan 6.00 Rhode Island 7.00 Connecticut 6.00 Minnesota 6.85 South Carolina 6.90 Delaware 0.00 Mississippi 7.00 South Dakota 5.50 Dist. of Columbia 5.75 Missouri 7.05 Tennessee 9.40 Florida 6.75 Montana 0.00 Texas 8.00 Georgia 6.95 Nebraska 6.00 Utah 6.70 Hawaii 4.40 Nevada 7.50 Vermont 6.05 Idaho 6.05 New Hampshire 0.00 Virginia 5.00 Illinois 8.40 New Jersey 6.95 Washington 8.50 Indiana 7.00 New Mexico 6.40 West Virginia 6.00 Iowa 6.75 New York 8.25 Wisconsin 5.40 Kansas 6.90 North Carolina 6.80 Wyoming 5.35

The distribution of sale s tax rates ranges from a minimu m of 0 percent to a maximum of 9.4 percent with a mean value of 6.8 percent. DOE applied the aver age sales tax to the customer equipment price irrespective of th e distribution channel and the market in which the customer is located.

6.5 OVERALL MARKUPS

DOE multiplied the direct and wholesaler/dis trib utor markups described above by the average sales tax multiplier to obtain the overa ll baseline and incremental markups shown in Table 6.5.1 and Table 6.5.2 . DOE based overall markups on one of two distribution channels according to how the equipment is purchased: either directly or through a wholesaler/distributor and the State into which the BVM unit is delivered. Table 6.5.1 presents two markups for the overall baseline ma rkup and the overall weighted average baseline markup, and Table 6.5.2 presents the same information for overall incremental markups.

Table 6.5.1 Baseline Average Markups by Distribution Channel and Overall Average Markup, Including the Sales Tax Multiplier
Manufacturer Direct Wholesaler/Distri butor Overall Weighted Average Markup 1.0 1.46 1.069 Sales Tax Multiplier 1.070 1.070 1.070 Overall Markup 1.070 1.562 1.144
Table 6.5.2 Incremental Average Markups by Di stribution Channel and Overall Average Markup, Including the Sales Tax Multiplier
Manufacturer Direct Wholesaler/Distri butor Overall Weighted Average Markup 1.0 1.20 1.030 Sales Tax Multiplier 1.070 1.070 1.070 Overall Markup 1.070 1.284 1.102

6-8DOE used the overall markups to estimate th e customer price of baseline equipment, given the manufacturer cost of ba seline equipment. For example, if the MSP of a baseline BVM unit is $1,000, DOE can multiply this by the averag e overall baseline markup to estimate that the baseline customer price of the BVM unit so ld is $1,144. Similarly, DOE used the overall incremental markup to estimate ch anges in the customer price, given changes in the MSP above the baseline due to increases in equipment effici ency. For example, if a new standard increases the BVM MSP by $100, DOE can multiply this pri ce ($100) by the average overall incremental markup (1.102) to estimate a cu stomer price increase of $102.

6.6 RESULTS

The overall baseline and ove rall incremental m arkups are presented in section 6.5 . These

ma rkups will be used with the MSPs to genera te customer prices for refrigerated BVMs. Supporting data for the calculation of baseline and incremental markups are provided in appendix C.

6-96-10 REFERENCES

1. Comm ents by Royal Vendors, No. 29 at p. 39 and Dixie-Narco, No. 29 at p. 40.

2. Dale L., D. Millstein, K. Coughlin, R. Van Buskirk, G. Rosenquist, A. Lekov, and S. Bhuyan. An Analysis of Price Determination and Markups in the A ir-Conditioning and Heating Equipment Industry . 2004. Lawrence Berkeley National Laboratory: Berkeley, CA. Report No. LBNL-52791.

3. M. Metoyer as reported in M. Skaer. What Should You Charge? Try These Tested Formulas. Air Conditioning, Heating and Refrigerator News . March 26, 2001.

4. U.S. Census Bureau. 2002 Economic Census Release Date: 12/3/2004 Sector 42: Wholesale Trade: Industry Series: Product Lines by Kind of Bu siness for the United States: 2002 < http://factfinder.census.gov /servl et/IBQTable?_bm=y&- MFG=10971:42&-ds_name=EC0242I3&-_lang=en >. 2002. (Accessed on April 16, 2007.)

5. Pindyck R. and D. Rubinfield. Microeconomics . 2000. Prentice-Hall.

6. The Sales Tax Clearinghouse. < https://thestc.com/STRates.stm > (Accessed on January 20, 2009.)