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

........................................................................................ 7-1 7.1.2.1 Approach for Manufacturer Markups

............................................................ 7-2 7.1.2.2 Approach for Retailer Markups

..................................................................... 7-2 7.1.2.3 Overall Markup

.............................................................................................. 7-4 7.2 MANUFACTURER MARKUPS

.................................................................................... 7-5 7.3 RETAILER MARKUP FOR RESIDE NTIAL COOKING PRODUCTS

....................... 7-6 7.4 SALES TAXES

............................................................................................................... 7 -7 7.5 SUMMARY OF MARKUPS

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

LIST OF TABLES Table 7.2.1 Major Appliance Manufactur er Gross Margins and Markups

............................. 7-6 Table 7.3.1 Data Used to Calculate Reta iler Markups for Residential Cooking Products

................................................................................................................ 7-7 Table 7.4.1 Average Sales Tax Rates by Ce nsus Division and Large State

........................... 7-8 Table 7.4.2 Average Sales Tax Rates by Product

................................................................... 7-8 Table 7.5.1 Summary of Markups

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

7-iCHAPTER 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 a multiplier called a “markup” to the ma nufacturers’ equipment costs estimated in the engineering analysis, DOE estimated the consumer prices for baseline m odels and more-efficient equipment. DOE developed one set of markups for all residential cooking products. The technical support document (TSD) for DOE’s notice of proposed rulemaking (NOPR) covered conventional cooking products (i .e., cooktops and ovens), microwave ovens, and commercial clothes washers (CCW). 1 This chapter presents information and results pertaining solely to conventional cooking product s and microwave ovens. The impact of moreefficient equipment on CCW markups and consumer prices will be addressed in a subsequent TSD.

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, compan ies mark up the price of the equipment to cover their business costs and profit margin.

DOE based the distribution channels on data from the Association of Home Appliance Manufacturers (AHAM). 2 AHAM estimates that 93 percent of residential cooking products are sold through retail outlets. Because an overw helming majority of products are sold through retail outlets, DOE assumed that all of the residential products are purchased by consumers from retail outlets.

7.1.2 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.

7-1In developing markups for manufacturers and retailers, 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 la bor 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 transfor m 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 MFG + GM 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 Markups DOE based the retailer markups for resident ial cooking products on financial data from the U.S. Census Business Expenditure Survey. DOE organized the financial data into balance sheets that break down cost components in curred by firms that sell the products. a The key assumptions that DOE used to estimate the reta iler markups using these financial data were:

1. The balance sheets faithfully represent the various average costs incurred by firms selling home appliances.

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 sales prices vary in proportion to retailer 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

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

7-2costs and profit. Although retailers tend to handle multiple commodity lines, the data provide the most accurate available indicat ion of home appliance expenses.

Information obtained from the trade literatu re pertaining to the h eating, ventilation, and air-conditioning (HVAC) contracti ng industry tends to support the second assumption. This information indicates that retailer markups shoul d vary according to the quantity of labor and materials used to sell or dist ribute the equipment, with mar kups 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 sugge sts that labor inputs vary more with sales volume than with appliance cost or efficiency. In the discu ssion that follows in s ection 7.3, DOE assumes a division of costs between those th at do not scale with the manufac turer 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 markups described below in section 7.3. In support of the third assumption, the retailer industries are relatively competitive, and consumer demand for residential home appliances is relatively inelastic, i.e. the demand is not expected to decrease significantl y with a relatively small increase in price. The large number of household appliance stores 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 ove r 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 costs (i.e., both LSC and NLSC ), to determine the sales price of baseline models. The baseline markup rela tes the manufacturer sales price to the retailer sales price. DOE considers baseline models to be equipm ent sold under existing market conditions (i.e., without new ener gy efficiency standards). DOE calculated the baseline markup ( MU BASE ) for retailers using the following equation:

MU = CGS RTL / DIST + GM RTL / DIST = CGS RTL / DIST + ( LSC RTL / DIST + NLSC RTL / DIST )
BASE CGS RTL / DIST CGS RTL / DIST
where:

MU BASE = Baseline retailer markup, CGS RTL/DIST = Retailer’s cost of goods sold, GM RTL/DIST = Retailer’s gross margin,

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

.
7-3LSC RTL/DIST = Retailer’s labor-scaling costs, and NLSC RTL/DIST = Retailer’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 sale s price of higher-efficiency models to the change in the retailer 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 using the following equation:

CGS RTL / DIST + NLSC RTL / DIST MU INCR = CGS RTL / DIST where:

MU INCR = Incremental retailer markup, CGS RTL/DIST = Retailer’s cost of goods sold, and NLSC RTL/DIST = Retailer’s non-labor-scaling costs.

7.1.2.3 Overall Markup The overall markup is the product of the ma nufacturer and retailer markups, as well as sales taxes. DOE used the overall baseline markup to es timate 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 followi ng 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, MU MFG = Manufacturer markup, MU BASE = Baseline retailer markup, Tax SALES = Sales tax, and MU OVERALL_BASE = Baseline overall markup (product of manufacturer markup, baseline retailer 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 resulting from a standard to raise equipment efficiency. The total consumer equipment price for higher7-4efficiency models is composed of two components: the consumer equipment price of the baseline model and the change in consumer equipment pri ce 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 STD = COST MFG × MU OVERALL

_ BASE + Δ COST MFG × 

## ( MU MFG × MU INCR × Tax SALES 

## )

= EQP BASE + Δ COST MFG × MU 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 markup, Tax SALES = Sales tax, MU OVERALL_BASE = Baseline overall markup (product of manufacturer markup, baseline retailer markup, and sales tax), and MU OVERALL_INCR = Incremental overall markup (product of manufacturer markup, incremental retailer markup, and sales tax).

7.2 MANUFACTURER MARKUPS DOE developed an average manufacturer ma rkup by examining the annual Securities and Exchange Commission (SEC) 10-K reports filed by four publicly-t raded manufacturers primarily engaged in appliance manufacturing and whose combined product range includes residential cooking products. 6 The four manufacturers represent a ne arly 50 percent market share fore core appliances. Because these companies are typica lly diversified, produci ng a range of different appliances, an industry average markup was as sumed by DOE to be 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 gr oss margin during the years from 2002 to 2005, and corresponding markups, for each of the four manufacturers.

7-5Table 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 th ese 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” ca tegory, 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 estimat ed 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.

7-6Table 7.3.1 Data Used to Calculate Retailer Mark ups 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 SALES TAXES The sales tax represents state and local sa les 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 da ta provided by the Sales Tax Clearinghouse. 8 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 7.4.1 below.

7-7Table 7.4.1 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 7.4.2 below) based on the product’s sa turation within each Census di vision and large state. It determined the saturations from the DOE En ergy Information Administration (EIA)’s 2001 Residential Energy Consumption Survey. 9 Note that the range of tax rates is relatively narrow— ranging from a low of 6.83 percent for microwav e ovens to a high of 7.07 percent for gas nonself-cleaning ovens.

Table 7.4.2 Average Sales Tax Rates by Product Product Tax Rate

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%

7.5 SUMMARY OF MARKUPS Table 7.5.1 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.

7-8Table 7.5.1 Summary of Markups Markup Baseline Incremental Manufacturer 1.26 Retailer 1.45 1.15 Sales Tax 1.069* Overall 1.95 1.55

* Represents average of all seven product classes of cooking products. The example for microwave ovens, provide d 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 resul ting baseline consumer equipment price ( EQP BASE ) and higher-efficiency equipment price ( EQP STD ) are:
EQP BASE = COST MFG × 

## ( MU MFG × MU BASE × Tax SALES 

## )

= $120 × 1.26 × 1.45 × 1.069 = $234

EQP STD = EQP BASE + Δ COST MFG × 

## ( MU MFG × MU INCR × Tax SALES 

## )

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

7-9REFERENCES

1 U.S. Department of Energy-Office of Energy Efficiency and Renewable Energy. Technical Support Document: Energy Efficiency Program for Consumer Products and Commercial and Industrial Equipment: Residential Dishwa shers, Dehumidifiers, Cooking Products, and Commercial Clothes Washers , September, 2008. Washington, DC.
< http://www1.eere.energy.gov/buildings/appliance_ standards/residential/home_appl_tsd.html >

2 Association of Home App liance Manufacturers. AHAM 2003 Fact Book , 2003. Washington, DC. p. 25.

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

9 U.S. Department of Energy-En ergy 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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