6

- i

CHAPTER 6

. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

TABLE OF CONTENTS

6.1 INTRODUCTION

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

- 1

6.1.1 Distribution Channels

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

- 1

6.1.2 Procedure for Calculating Markups

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

- 1

6.2 MANUFACTURER MARKUPS

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

- 2

6.3 RETAILER MARKUPS

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

- 2

6.3.1 Approach to Calculating Retailer Markups

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

- 2

6.3.2 Derivation of Retailer Markups

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

- 5

6.4 SALES TAXES

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

- 6

6.5 SUMMARY OF MARKUPS

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

- 7

LIST OF TABLES

Table 6.3.1 Four

- Firm Concentration Ratio for Major Appliance Sales in Three Retail

Channels

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

- 5

Table 6.3.2 Data for Calculating Baseline Markup: Electronics and Appliance Stores

......... 6

- 5

Table 6.3.3 Data for Calculating Incremental Markup: Electronics and Appliance

Stores

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

- 6

Table 6.4.1 Average Sales Tax Rates by RECS Region

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

- 7

Table 6.4.2 Average Sales Tax Rates by CBECS Region

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

- 7

Table 6.5.1 Summary of Markups

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

- 86-1

CHAPTER 6. MARKUPS FOR EQUIPMEN T PRICE DETERMINATIO N

6.1 INTRODUCTION

To carry out the life

- cycle cost (LCC) calculations described in chapter 8 of th is technical support document (TSD), the U.S. Department of Energy (DOE) had to determine t he cost

consumers will pay for portable air conditioners (ACs) . Th e cost is determined for both baseline product s and more efficient product s that consumer s would purchase following the promulgation

of any new or amended energy conservation standards for p ortable ACs . The manufacturer selling price (MSP) for both baseline and more efficient product s is determined in the engineering analysis (chapter 5 of th is TSD). By applying a multiplier called a markup to the
MSP, DOE can estimate the purchase price of the product after it travels through its distribution

channel to the retailer . This chapter describes how DOE derived markups f or both manufacturers

and retailers

.

6.1.1 Distribution Channels

The appropriate markups for determining consumer product prices depend on the type of

distribution channel (s) through which the product move s from manufacturer to consumer

. At each point in the distribution channel, companies mark up the price of the product to cover their business costs and profit margin. Almost all p ortable ACs are purchased for residential use, although DOE estimates that perhaps one percent are used in a commercial setting

.

Data from the Association of Home Appliance Manufacturers (AHAM) 1 indicate that an overwhelming majority of residential appliances are sold through retail outlets. Because DOE is

un aware of any other distribution channel that plays a significant role for portable ACs , DOE

assumed that consumers purchase all portable AC s , whether destined for residential or commercial application, from retail outlets. DOE considered portable ACs purchased for the replacement market and by first

- time owner s or owners who purchase an additional unit

, but did

not consider the new constructio n market, because DOE found no information to indicate the extent, if any, to which builders install the products in new construction

.

6.1.2 Procedure for Calculating Markup s

As not ed above

, companies at each point in the distribution channel mark up the price of

a product to cover their bu siness costs and profit margin. In financial statements, gross margin (GM) is the difference between a company 's revenue and its cost of sales

, or cost of goods sold ( CGS ). The GM of companies throughout the distribution channel includes expenses such as overhead (sales, general, and administration); research and development (R&D) and interest expenses; depreciation ; taxes

— and company prof its. To cover costs and to contribute positi vely to company cash flow, the price of a p roduct must include a markup. Products command lower or higher markups depending on company expenses associated with the product and the degree6-2

of market competition. In developing markups for manufacturers and re tailers, DOE obtained data about the revenue, CGS , and expenses of firms that produce and sell portable ACs

.

6.2 MANUFACTURER MARKUPS

DOE uses manufacturer markups to transform a manufacturer’s production costs into a n MSP

. Applying the CGS and GM , DOE calcu lated the manufacturer markup using the following equation

.

W here:

MU MFG = m anufacturer markup,

CGS MFG = manufacturer’s cost of goods sold or manufacturer production cost ( MPC ),

and

GM MFG = m anufacturer’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 publicly available

financial information

, including Securities and Exchange Commission (SEC) 2 10

- K reports for manufacturers of major household appliances having product offerings that in clude portable

AC s

. DOE determined the weighted

- average manufacturer markup for portable ACs to be 1. 42

. The method for deriving manufacturer markups is described in more detail in the engineering analysis (chapter 5).

6.3 RETAILER MARKUP S

This section presents the approach and equations DOE used to calculate retailers' markups on portable ACs (both markups on baseline products and incremental markups on higher

- efficiency products)

. The section also presents the retailer markups DOE calculated.

6.3.1 Approach to Calculating Retailer Markups

DOE based retailer markups for portable AC s on financial data for electronics and appliance stores from the 2007 U.S. Census Annual Retail Trade Survey (ARTS)

, 3 which is the most recent survey that includes detailed industry

- wide operating expenses for that economic

sector. DOE organized the financial data into statements that break down cost components incurred by firms with in the sector containing electronics and appliance stores . DOE assumes

that the income statements faithfully represent the various average costs incurred by firms selling6-3

home appliances. Although electronics and appliance stores handle multiple commodity lines, the data provide t he best available indication of expenses associated with selli ng portable AC s

.

The baseline markup convert s the MSP of baseline products to the retailer 's sales price. DOE considers baseline products to be those sold under current market conditions ( i.e. , without new energy conservation standards). DOE used the following equation to calculate an average baseline markup for retailers.

MU BASE = CGS

RTL + GM

RTL
CGS RTL Where:

MU BASE = retailer’s baseline markup,

CGS RTL = retaile r’s cost of goods sold (CGS), and

GM RTL = retailer’s gross margin (GM).

Incremental markups are coefficients that relate the change in the MSP of higher

efficiency models to the change in retailer sales price. DOE considers higher

- efficiency models to be products sold under potential new efficiency standards. The incremental markup reflects

the retailer ’ s increase in a product ’ s CGS because of new standards.

There are few empirical data describing appliance retailer practices rega rding markup s taken in response to a product’s cost increase ( whether due to increased efficiency or other factors). DOE understands that real

- world markup practices vary depending on the market conditions that retailers face and on the magnitude of the ch ange in CGS. Pricing in retail stores also may involve rules of thumb that are difficult to quantify and to incorporate into DOE’s analysis. Given the uncertainty about markup practices in appliance retailing, DOE’s approach reflects the following key assu mptions

.

1. Changes in the efficiency of goods sold are not expected to increase retailer profits. Thus, DOE calculates markups/gross margins to allow cost recovery for retail companies in the distribution channel (including changes in the cost of capital) but

not changes in company profits.

2. Efficiency improvements affect some distribution costs but not others. DOE sets markups and retail prices to incorporate th os e distribution costs expected to change with efficiency, but not th os e that are not expected t o change with efficiency.

The approach to calculating incremental markup s is described in more detail in Dale and Fujita , 2004

. 4 To estimate incremental retailer markups, DOE divided retailers’ operating expenses into two categories: (1) those that do not change when CGS increases because of new efficiency standards (invariant), and (2) those that increase proportionately with CGS (variant).

DOE defines invariant costs as labor and occ upancy expenses, because those costs likely will not

increase because of a rise in CGS. All other expenses, as well as net profit, are assumed to vary in proportion to CGS. Although some other expenses may not scale with CGS, DOE takes a6-4

conservative posit ion that considers other expenses to be variant costs. Note that, under DOE’s approach, a high fixed cost component yields a low incremental markup.

DOE used the following equation to calculate the incremental markup retailers might apply to higher

- efficiency products

.

MU INCR = CGS

RTL + VC

RTL
CGS RTL Where:

MU INCR = retailer’s incremental markup,

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

VC RTL = retailer’s variant costs.

In dev e loping incremental markups, DOE 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 competition in the retail appliance market, combined with relatively

inelastic demand ( i.e., the demand is not expected to decrease significantly in response to 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

concentra tion ratio (FFCR) of major appliance sales for three retail channels: electronics and appliance stores, building materials and supplies dealers, and general merchandise stores.

T he FFCR represents the market share of the four largest firms in a given secto r

. G enerally, an

FFCR of less than 40 percent indicates that a sector is not concentrated ; an FFCR of more than

70 percent indicates that the sector is highly concentrated. a
, b

The FFCR of appliance sales for each retail channel is equal to the sector FF CR times the percent of total sales within that channel accounted for by major appliances. As shown in Table

6.3

. 1 , appliance sales in electronics and appliance stores, building materials and supplies dealers, and general merchandise stores have a FFCR less than the 40

- percent threshold. The electronics and appliance stores sector includes a subsector titled “household app liance stores.” Because that subsector includes numerous stores, it has a FFCR of 21.3 percent

.

a University of Maryland University College. (Last accessed September 7, 2014.)

< http://info.umuc.edu/mba/public/AMBA607/IndustryStructure.html >

.

b Quick MBA. (Last accessed September 7, 2014.) < http://www.quickmba.com/econ/micro/indcon.shtml >

.6-5

Table 6.3

. 1 Four

- Firm Concentration Ratio for Major Appliance Sales in Three Retail

Channels

Sector FFCR % of

Sector Sales Percent of Sales

Accounted for by Major Appliances % FFCR % of Major Appliance Sales

Electronics and appliance

stores 46.3 42.1 19.5

Subsector : household appliance stores 21.3 37.1 7.9

Building material s and supplies dealers 45.9 17.0 7.8

General merchandise stores 73.2 31.6 23.1

Source: U.S. Economic Cens us. Establishment and Firm Size ( Including Legal Form of Organization )

. 2007.

*Note: It is assumed that major appliance sales are uniformly distributed within all firms in each sector.

6.3.2 Derivation of Retailer Markup s

The 2007 ARTS data for electronics and appliance stores include total sales data and detailed operating expenses. 3 To construct a complete data set for estimating markups, DOE

needed to estimate CGS and GM for the stores . The most recent ( 2011 ) ARTS publishes a separate document containing historical sales and gross margin from 1993 to 2011 for electronics

and appliance stores. DOE took the GM as a percent of sales reported for 2007 and combined that percent with 2007 ARTS data to construct a complete income statement for electronics and appliance stores to estimate both baseline and incremental markups. Table 6.3

. 2 shows DOE's

calculation of the baseline retailer markup.

Table 6.3

. 2 Data for Calculati ng Baselin e Markup: Electronics and Appliance Stores

Business Item Amount $1,000,000

Sales 110.673 Cost of goods sold (CGS) 81.234 Gross margin (GM) 29.439

Baseline m arkup = (CGS+GM)/CGS 1.36

Source: U.S. Census Bureau. 2007 Annual Retail Trade Survey

.

Table 6.3

. 3 shows the breakdown of operating expenses for electronics and appliance

stores based on the 2007 ARTS data. The incremental markup is calcu lated as 1.11.6-6

Table 6.3

. 3 Data for Calculating Incremental Markup: Electronics and Appliance Stores

Business Item Amount $1,000,000

Sales 110,673 Cost of goods sold 81,234 Gross margin 29,439

Labor & Occupancy Expenses ( invariant) Annual payroll 11,714 Employer costs for fringe benefit 1,829 Contract labor costs, including temporary help 154 Purchased utilities, total 623 Cost of purchased repair and maintenance services 369 Cost of purchased professional and technical services 1,164

Purchased communication services 396 Lease and rental payments 3,576 Taxes and license fees (mostly income taxes) 619

Subtotal 20,444 Other Operating Expenses & Profit ( variant) Expensed equipment 114

Cost of purchased packaging and containers 68 Other materials and supplies not for resale 502 Cost of purchased transportation, shipping, and warehousing services 606 Cost of purchased advertising and promotional services 2,625 Cost of purchased software 159 Cost of data processing and other purchased computer services, except communications + commissions paid 368

Depreciation and amortization charges 1,525 Other operating expenses 2,070 Net profit before tax (operating profit) 958

Subtotal 8,995

Incremental M arkup = (CGS + Total Other Operating Expenses and Profit)/CGS 1.11

Source: U.S. Census Bureau

. 2007 Annual Retail Trade Survey ( for sales), and 2011 Annual Retail Trade Survey

.

DOE applied the same baseline and incremental retail markup s for both residential and commercial application s because the portable ACs for both go through the same distribution

channel.

6.4 SALES TAXES

The sales tax represents state and local taxes that are applied to the price a consumer pays for a product

. The sales tax is a multiplicative factor that increases the consumer product price. DOE derived state and local taxes from data provided by the Sales Tax Clearinghouse

. 5 DOE6-7

then derived population

- weighted average tax values for each region identified for the Residential Energy Consumption Survey (RECS) 6 and the Commercial Buildings Energy Consumption Survey (CBECS)

. 7 DOE applied those population

- weighted average tax values to residential and commercial application s , respectively , as shown in Table 6.4

. 1 and Table 6.4

. 2

.

Table 6.4

. 1 Average Sales Tax Rates by RECS Region

Census Division/State Population (201 9 ) Tax Rate (2014)

% New England 15,309,528 5.69

Middle Atlantic 22,248,989 6.6 0

East North Central 48,208,733 6.9 0

West North Central 21,246,442 7.0 8

South Atlantic 45,035,501 6.0 6

East South Central 18,978,828 8.02

West South Central 11,515,069 8.6 9

Mountain 25,557,049 6.4 5

Pacific 13,879,323 5.30

New York 19,576,920 8.4 5

California 42,206,743 8.4 0

Texas 28,634,896 7.9 5

Florida 23,406,525 6.65
Population

- Weighted Average 7.10

Table 6.4

. 2 Average Sales Tax Rates by CBECS Region

Census Division/State Population (201 9 ) Tax Rate (2014)

% New England 15,309,528 5.63

Middle Atlantic 41,825,909 7.47

East North Central 48,208,733 6.88

West North Central 21,246,442 7.10

South Atlantic 68,442,026 6.26

East South Central 18,978,828 8.04

West South Central 40,149,965 8.16

Mountain 25,557,049 6.54

Pacific 56,086,066 7.63
Population

- Weighted Average 7.10

6.5 SUMMARY OF MARKUPS

Table 6.5

. 1 summarizes the markups at each stage in the distribution channel for portable

ACs , starting with the manufacturer, and then applies the average sales tax to arrive at overall markup s

.6-8

Table 6.5

. 1 Summary of Markups

Residential Application Commercial Application Markup Baseline Incremental Baseline Incremental

Manufacturer 1. 42 1. 42

Retailer 1. 36 1.1 1 1. 36 1.1 1

Sales Tax 1.071 1.071

Overall 2.07 1.69 2.07 1.696-9

REFERENCES

1

. Association of Home Appliance Manufacturers. AHAM 2003 Fact Book . 2003. AHAM, Washington, D.C.

2

. U.S. Security and Exchange Commission (SEC)

. SEC 10

- K Reports . 2008

– 2012. U.S. Security and Exchange Commission

, Washington, D.C.

3

. U.S. Census Bureau. 200 7 Annual Retail Trade Survey, Electronics and Appliance

Stores. 2007. U.S. Census Bureau

, Washington, D.C.

4

. Dale, L., and K. Fujita. An Analysis of Price Determination and Markups in the Air

Conditioning and Heating Equipment Industry . January 2004.

5

. Sales Tax Clearinghouse, I. State Sales Tax Rates Along with Combined Average City and County Rates . [cited 2014 July 18.] Available from: http://thestc.com/STrates.stm

.

6

. U.S. Department of Energy

– Energy In formation Administration. Residential Energy Consumption Survey . 2009. [cited 2011 May.] Available from: http://www.eia.gov/consumption/residential/data/2009/

.

7

. U.S. Department of Ene rgy

– Energy Information Administration. Commercial Building Energy Consumption Survey (CBECS) . 2003. (Last accessed September 8, 214.)

< http://www.eia.gov/consumption/commercial/data/2003/ >

.