CHAPTER 7. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

TABLE OF CONTENTS

7.1 INTRODUCTION

........................................................................................................... 7-1

7.1.1 Distribution Channels

...................................................................................................... 7-1

7.1.1.1 Residential Products

....................................................................................... 7-1

7.1.1.2 Commercial Clothes Washers

........................................................................ 7-1

7.1.2 Markup Calculation Procedure

........................................................................................ 7-2

7.1.2.1 Approach for Manufacturer Markups

............................................................ 7-3

7.1.2.2 Approach for Retailer and Distributor Markups

............................................ 7-3

7.1.2.3 Overall Markup

.............................................................................................. 7-5

7.2 MANUFACTURER MARKUPS

.................................................................................... 7-6

7.3 RETAILER MARKUP FOR RESIDENTIAL COOKING PRODUCTS

....................... 7-7

7.4 DISTRIBUTOR MARKUPS FOR COMMERCIAL CLOTHES WASHERS

............... 7-8

7.5 SALES TAXES

............................................................................................................. 7-10

7.6 SUMMARY OF MARKUPS

........................................................................................ 7-11

LIST OF TABLES

Table 7.2.1 Major Appliance Manufacturer Gross Margins and Markups

............................. 7-7

Table 7.3.1 Data Used to Calculate Retailer Markups for Residential Cooking

Products

................................................................................................................ 7-8

Table 7.4.1 Data Used to Calculate Distributor Markups for Commercial Clothes

Washers

................................................................................................................ 7-9

Table 7.4.2 Distributor (Mac-Gray) Baseline Markup for Commercial Clothes

Washers

.............................................................................................................. 7-10

Table 7.5.1 Average Sales Tax Rates by Census Division and Large State

......................... 7-11

Table 7.5.2 Average Sales Tax Rates by Product

................................................................. 7-11

Table 7.6.1 Summary of Markups

........................................................................................ 7-12

LIST OF FIGURES

Figure 7.1.1 Distribution Channel for Commercial Clothes Washers

..................................... 7-2

7-iCHAPTER 7. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

7.1 INTRODUCTION

To carry out the engineering and life-cycle cost (LCC) analyses, DOE needed to determine the cost to the customer of a baseline product and the cost of more-efficient units. By applying a multiplier called a “markup” to the manufacturers’ equipment costs estimated in the engineering analysis, DOE estimated the consumer prices for baseline models and more-efficient equipment.

DOE developed one set of markups for residential cooking products and another set for

commercial clothes washers.

7.1.1 Distribution Channels

The appropriate markups for determining the consumer equipment price depend 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 margin.

7.1.1.1 Residential Products

For residential products, DOE based the distribution channels on data from the Association of Home Appliance Manufacturers (AHAM). 1 AHAM estimates that 93 percent of residential cooking products are sold through retail outlets. Because an overwhelming majority of products are sold through retail outlets, DOE assumed that all of the residential products are purchased by consumers from retail outlets.

7.1.1.2 Commercial Clothes Washers

For commercial clothes washers, DOE based the distribution channels (see Figure 7.1.1) on data developed by the Consortium for Energy Efficiency (CEE). 2 The CEE states that the relevant portions of the commercial, family-sized clothes washer market can be divided into three areas: laundromats; private multi-family housing; and large institutions. Included as part of large institutions are military barracks, universities, housing authorities, lodging establishments, and health care facilities. For these three market areas, the CEE data indicate that an overwhelming majority of commercial clothes washers are sold through either distributors or route operators. Laundromats generally purchase their equipment through distributors while multi-family housing and large institutions generally lease their equipment from route operators. For purposes of developing the markups for commercial clothes washers, DOE based its calculations on the distribution channel that involves only distributors. DOE assumed that the markups and the resulting consumer equipment prices determined for the distribution channel

7-1involving distributors would be representative of the prices paid by consumers acquiring their equipment from route operators.

Source: CEE , 1998

Figure 7.1.1 Distribution Channel for Commercial Clothes Washers

7.1.2 Markup Calculation Procedure

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 ). Inputs for calculating the gross margin are all corporate costs—including overhead costs (sales, general, and administration); 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, the product’s markup must be greater than the corporate gross margin. Individual products may command a lower or higher markup, depending on their perceived added value and the competition they face from similar products in

the market.

7-2In developing markups for manufacturers, retailers, and distributors, DOE obtained 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 labor and vary in proportion to CGS . Together, LSC and

NLSC represent the gross margin.

7.1.2.1 Approach for Manufacturer Markups

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

CGS + GM MFG MFG MU = MFG CGS MFG where:

MU MFG = Manufacturer markup,

CGS MFG = Manufacturer’s cost of goods sold, and

GM MFG = Manufacturer’s gross margin.

7.1.2.2 Approach for Retailer and Distributor Markups

DOE based the retailer markups (for residential products) and distributor markups (for commercial clothes washers) on financial data from the U.S. Census Business Expenditure Survey. DOE organized the financial data into balance sheets that break down cost components incurred by firms that sell the products. 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 the various average costs incurred by firms selling home appliances and commercial clothes washers.

2. These costs can be divided into two categories:

a. Costs that vary in proportion to the manufacturer sales price (variable costs); and

b. Costs that do not vary with the manufacturer sales price (fixed costs).

3. Retailer and distributor sales prices vary in proportion to retailer and distributor costs that

are included in the balance sheets.

In support of the first assumption, the balance sheets itemize firm costs into a number of expense categories, including CGS , operating labor and occupancy costs, and other operating

a The retailers and distributors to whom these financial data refer handle multiple commodity lines.

7-3costs and profit. Although retailers and distributors tend to handle multiple commodity lines, the data provide the most accurate available indication of home appliance and commercial clothes washer expenses.

Information obtained from the trade literature pertaining to the heating, ventilation, and air-conditioning (HVAC) contracting industry tends to support the second assumption. This information indicates that retailer and distributor markups should vary according to the quantity of labor and materials used to sell or distribute the equipment, with markups on labor tending to be much larger than markups on materials. 3 This information also describes markups as varying much more in relation to sales volume than in relation to other factors, including appliance efficiency. This last finding strongly suggests that labor inputs vary more with sales volume than with appliance cost or efficiency. In the discussion that follows in sections 7.3 and 7.4, DOE assumes a division of costs between those that do not scale with the manufacturer sales price (fixed costs—labor and occupancy expenses referred to above as LSC ), and those that do (variable costs—operating expenses and profit referred to above as NLSC ). This division of costs led to the estimate of retailer and distributor markups described below in sections 7.3 and

7.4.

In support of the third assumption, the retailer and distributor industries are relatively competitive, and consumer demand for residential home appliances and commercial clothes washers is relatively inelastic, i.e. the demand is not expected to decrease significantly with a relatively small increase in price. The large number of household appliance stores and merchant wholesalers of service equipment (i.e., distributors of products including commercial clothes washers) listed by the U.S. Census Bureau in its Statistics of U.S. Businesses indicates the competitive nature of the market. 4 For example, there are more than 10,000 household appliance store establishments and over 5000 merchant wholesaler establishments of service equipment in

the U.S. b Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or quickly go out of business. 5

Using the above assumptions, DOE developed baseline and incremental markups to transform the manufacturer sales price into a consumer equipment price. DOE used the baseline markups, which cover all of a retailer’s or distributor’s costs (i.e., both LSC and NLSC ), to determine the sales price of baseline models. The baseline markup relates the manufacturer sales price to the retailer sales price (in the case of residential products) or distributor sales price (in the case of commercial clothes washers). DOE considers baseline models to be equipment sold under existing market conditions (i.e., without new energy efficiency standards). DOE calculated the baseline markup ( MU BASE ) for retailers and distributors using the following equation:

b DOE determined the number of establishments for household appliance stores based on the following North American Industry Classification System (NAICS) code and description: 443111, Household Appliance Stores

. DOE determined the number of establishments for distributors of commercial clothes washers based on the following NAICS code and description: 42385, Service Establishment Equipment and Supplies Merchant

Wholesalers

.

7-4CGS + GM CGS + ( LSC + NLSC ) RTL / DIST RTL / DIST RTL / DIST RTL / DIST RTL / DIST

= MU BASE = CGS CGS RTL / DIST RTL / DIST

where:

MU BASE = Baseline retailer or distributor markup,

CGS RTL/DIST = Retailer’s or distributor’s cost of goods sold,

GM RTL/DIST = Retailer’s or distributor’s gross margin,

LSC RTL/DIST = Retailer’s or distributor’s labor-scaling costs, and

NLSC RTL/DIST = Retailer’s or distributor’s non-labor-scaling costs.

Incremental markups cover only those costs that scale with a change in the manufacturer’s sales price (i.e., NLSC ). Incremental markups are coefficients 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 standards. It calculated the incremental markup ( MU INCR ) for retailers and distributors using the following equation:

CGS + NLSC RTL / DIST RTL / DIST

= MU INCR CGS RTL / DIST where:

MU INCR = Incremental retailer or distributor markup,

CGS RTL/DIST = Retailer’s or distributor’s cost of goods sold, and

NLSC RTL/DIST = Retailer’s or distributor’s non-labor-scaling costs.

7.1.2.3 Overall Markup

The overall markup is the product of the manufacturer, retailer, and distributor markups,

as well as sales taxes.

DOE used the overall baseline markup to estimate the consumer equipment price of baseline models, given the manufacturer cost of the baseline models. As stated above, DOE considers baseline models to be equipment sold under existing market conditions (i.e., without new energy efficiency standards). The following equation shows how DOE used the overall baseline markup to determine the equipment price for baseline models.

EQP BASE = COST MFG × 

## ( MU MFG × MU BASE × Tax SALES 

## )

= COST MFG × MU OVERALL

_ BASE

where:

EQP BASE = Consumer equipment price for baseline models,

COST MFG = Manufacturer cost for baseline models,

7-5MU MFG = Manufacturer markup,

MU BASE = Baseline retailer or distributor markup,

Tax SALES = Sales tax, and

MU OVERALL_BASE = Baseline overall markup (product of manufacturer markup, baseline retailer or distributor markup, and sales tax).

Similarly, DOE used the overall incremental markup to estimate changes in the consumer equipment price, given changes in the manufacturer cost above the baseline model cost resultingfrom a standard to raise equipment efficiency. The total consumer equipment price for higherefficiency models is composed of two components: the consumer equipment price of the baseline model and the change in consumer equipment price associated with the increase in manufacturer cost to meet the new efficiency standard. The following equation shows how DOE used the overall incremental markup to determine the consumer equipment price for higher-efficiency models (i.e., models meeting new efficiency standards).

EQP = COST × MU + Δ COST × 

## ( MU × MU × Tax 

## )

STD MFG OVERALL

_ BASE MFG MFG INCR SALES

= EQP + Δ COST × MU BASE MFG OVERALL

_ INCR

where:

EQP STD = Consumer equipment price for models meeting new efficiency standards, EQP BASE = Consumer equipment price for baseline models,

COST MFG = Manufacturer cost for baseline models,

Δ COST MFG = Change in manufacturer cost for higher-efficiency models,

MU MFG = Manufacturer markup,

MU INCR = Incremental retailer or distributor markup,

Tax SALES = Sales tax,

MU OVERALL_BASE = Baseline overall markup (product of manufacturer markup, baseline retailer or distributor markup, and sales tax), and

MU OVERALL_INCR = Incremental overall markup (product of manufacturer markup, incremental retailer or distributor markup, and sales tax).

7.2 MANUFACTURER MARKUPS

DOE developed an average manufacturer markup by examining the annual Securities and Exchange Commission (SEC) 10-K reports filed by four publicly-traded manufacturers primarily engaged in appliance manufacturing and whose combined product range includes residential cooking products and commercial clothes washers. 6 The four manufacturers represent a nearly 50 percent market share fore core appliances. Because these companies are typically diversified, producing a range of different appliances, an industry average markup was assumed by DOE to

7-6be representative for the manufacture of each type of appliance. DOE evaluated markups for the years between 2002 and 2005, inclusive.

Table 7.2.1 lists the average corporate gross margin during the years from 2002 to 2005, and corresponding markups, for each of the four manufacturers.

Table 7.2.1 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)

The average markup value based on these four companies is 1.26.

7.3 RETAILER MARKUP FOR RESIDENTIAL COOKING PRODUCTS

DOE used financial data from the U.S. Census Business Expenditure Survey (BES), in the “Household Appliance Stores” category, to calculate markups used by retailers that apply to residential cooking products. c 7 Table 7.3.1 shows the BES data that DOE used and the retail markups for these appliances that DOE estimated following the procedures described above.

c DOE used the 1997 BES because the 2002 BES did not contain sufficient data for the calculation of gross margin or cost of goods sold.

7-7Table 7.3.1 Data Used to Calculate Retailer Markups for Residential Cooking Products

Item Million Dollars

Sales (revenue) 10343

Cost of Goods Sold (CGS) 7151

Gross Margin (GM) 3193

Labor-Scaling Costs (LSC)

Payroll 1366

Fringe Benefits 208

Contract Labor 69

Taxes and License Fees 53

Lease and Rental Payments 238

Telephone and Communications 58

Utilities 70

Repair and Maintenance 36

LCS Subtotal: 2098

Non-Labor-Scaling Costs (NLSC)

Depreciation and Amortization 94

Office Supplies 37

Packaging and Other Materials 0

Advertising Services 274

Legal Services 8

Accounting, Auditing, and Bookkeeping 19

Computer Related Services 10

Other Operating Expenses 389

Net Profit Before Taxes 263

NLCS Subtotal: 1094

Baseline Markup (MU BASE ) = (CGS+GM)/CGS 1.45

Incremental Markup (MU INCR ) = (CGS+NLSC)/CGS 1.15

7.4 DISTRIBUTOR MARKUPS FOR COMMERCIAL CLOTHES WASHERS

DOE used financial data from the BES for the category “Machinery, Equipment, and Supplies Merchant Wholesalers” to calculate markups used by distributors for commercial

7-8clothes washers. d 8 Table 7.4.1 shows the data from the BES and the distributor markups DOE estimated using the procedures described above.

Table 7.4.1	 Data Used to Calculate Distributor Markups for Commercial Clothes

Washers

Item Million Dollars

Sales (revenue) 225425

Cost of Goods Sold (CGS) 158097
Gross Margin 67328

Labor-Scaling Costs (LCS):

Payroll 25904
Fringe Benefits 3233

Contract Labor 954

Taxes and License Fees 823
Lease and Rental Payments 2932
Telephone and Communications 1185

Utilities 705

Commissions Paid 963

Contract Work 958
Repair and Maintenance 826

LCS Subtotal: 38483

Non-Labor-Scaling Costs (NLCS):

Depreciation and Amortization 2650
Office Supplies 885
Packaging and Other Materials 346
Advertising Services 959
Legal Services 277
Accounting, Auditing, and Bookkeeping 346
Computer Related Services 403
Other Operating Expenses 8149

Net Profit Before Taxes 14830

NCLS Subtotal: 28845

Baseline Markup (MU BASE ) = (CGS+GM)/CGS 1.43
Incremental Markup (MU INCR ) = (CGS+NLSC)/CGS 1.18

d DOE used the 1997 BES was used because the 2002 BES did not contain sufficient data for the calculation of gross margin or cost of goods sold. Also, because complete financial data were not available for the category Service Establishment Equipment and Supplies Merchant Wholesalers , DOE used data from the classification of Machinery, Equipment, and Supplies Merchant Wholesalers which encompasses a broader set of merchant wholesalers.

7-9As a check on the above markup values for distributors, DOE calculated markups based on the annual report of one distributor company (Mac-Gray) within this sector. e 9 The report includes data regarding revenue and CGS for this company, but not a breakdown of other expenses. As a result, it was only possible to estimate a baseline markup. Table 7.4.2 below shows the data for the commercial clothes washer distributor from the annual report as well as the baseline distributor markup DOE estimated for the sector as a whole using the procedures described above. The average value of 1.27 over the 2000–2004 time period for one company is lower than the value of 1.43 developed from the Census data. Although this one company has a lower baseline markup than that determined with the Census data, DOE decided to base its distributor markups on the Census data because this data is supposed to be representative of all

distributors of commercial clothes washers.

Table 7.4.2 Distributor (Mac-Gray) Baseline Markup for Commercial Clothes Washers

Firm Year Revenue Cost of goods sold Baseline Markup

Mac-Gray Services

Inc. 2000 154268 119120 1.30

2001 152069 121127 1.26

2002 150368 117956 1.27

2003 149656 118349 1.26

2004 182694 145080 1.26

Average Baseline Markup 1.27

Source: Mac-Gray Services Inc. 2004 annual report.

7.5 SALES TAXES

The sales tax represents state and local sales taxes that are applied to the consumer equipment price of the equipment. 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 Clearinghouse. 10
These data represent weighted averages that include county and city rates. DOE then derived population-weighted average tax values for each Census division and large state, as shown in

Table 7.5.1 below.

e Mac-Gray also serves the multi-family sector and can also be considered a route operator.

7-10Table 7.5.1 Average Sales Tax Rates by Census Division and Large State

Census Division/State Tax Rate

New England 4.98%

Mid Atlantic 6.07%

East North Central 6.56%

West North Central 6.65%

South Atlantic 5.95%

East South Central 7.85%

West South Central 8.30%

Mountain 6.46%

Pacific 4.97%

New York State 8.25%

California 7.95%

Texas 7.95%

Florida 6.70%

DOE then derived U.S. average tax values for each product (as shown in Table 7.5.2 below) based on the product’s saturation within each Census division and large state. It determined the saturations from the DOE Energy Information Administration (EIA)’s 2001 Residential Energy Consumption Survey. 11 Note that the range of tax rates is relatively narrow—ranging from a low of 6.83 percent for microwave ovens to a high of 7.07 percent for gas non-self-cleaning ovens.

Table 7.5.2 Average Sales Tax Rates by Product

Product Tax Rate

Commercial clothes washers 6.84%

Cooking products

Electric cooktops 6.70%

Gas cooktops 7.06%

Electric non-self-cleaning ovens 6.74%

Electric self-cleaning ovens 6.64%

Gas non-self-cleaning ovens 7.07%

Gas self-cleaning ovens 6.98%

Microwave ovens 6.83%

7.6 SUMMARY OF MARKUPS

Table 7.6.1 summarizes the markups at each stage in the distribution channel and the overall baseline and incremental markups, as well as sales taxes, for each product.

7-11Table 7.6.1 Summary of Markups

Cooking Products Commercial Clothes Washers

Markup Baseline Incr. Baseline Incr.

Manufacturer 1.26 1.26

Retailer 1.45 1.15

- -
Distributor

- - 1.43 1.18

Sales Tax 1.069* 1.0684

Overall 1.95 1.55 1.93 1.59

* Represents average of all seven product classes of cooking products.

The example for microwave ovens, provided below, illustrates how DOE used the baseline and incremental markups to derive a consumer equipment price. Assuming the baseline manufacturer cost is $120 and the change in manufacturer cost to meet a given energy efficiency standard is $10, the resulting baseline consumer equipment price ( EQP BASE ) and higher-efficiency equipment price ( EQP STD ) are:

EQP = COST × 

## ( MU × MU × Tax 

## )

BASE MFG MFG BASE SALES

= $120 × 1.26 × 1.45 × 1.069 = $234

EQP = EQP + Δ COST × 

## ( MU × MU × Tax 

## )

STD BASE MFG MFG INCR SALES

= $234 + $10 × 1.26 × 1.15 × 1.069 = $234 + $15 = $249

7-12REFERENCES

1 Association of Home Appliance Manufacturers. AHAM 2003 Fact Book , 2003. Washington, DC. p. 25.

2 Consortium for Energy Efficiency, Commercial Family-Sized Washers: An Initiative Description of the Consortium for Energy Efficiency , 1998. Boston, MA.

< http://www.cee1.org/com/cwsh/cwsh-main.php3 >

3 Skaer, M. What should you charge? Try these Tested Formulas. The Air Conditioning, Heating, and Refrigeration News , 2001.

< http://www.achrnews.com/CDA/ArticleInformation/features/BNP_Features_Item/0,1338,23113,00.html >

4 U.S. Census Bureau. Statistics of U.S. Businesses , 2004. Washington, DC.

< http://www.census.gov/csd/susb/susb04.htm >

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

6 Security Exchange Commission, SEC 10-K Reports, Various dates, 2002-2005, Security Exchange Commission. < http://www.sec.gov/ >

7 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 >

8 U.S. Census Bureau. 1997 Economic Census, Business Expenses Survey Merchant

Wholesalers

, Machinery, Equipment, and Supplies , 1997. Washington, DC.

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

9 Mac-Gray Corporation. 2004 Annual Report , 2004. Waltham, MA.

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

county rates , 2006. <http://thestc.com/STrates.stm>

11 U.S. Department of Energy-Energy Information Administration. Residential Energy Consumption Survey, 2001 Public Use Data Files , 2001. Washington, DC.

< http://www.eia.doe.gov/emeu/recs/recs2001/publicuse2001.html >

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