61

EXHIBIT 10:

UNIT SALES WEIGHTED MARKUP FACTORS

1984 1984
10-Year 10-Year 1984 Heavy-Duty Heavy-Duty
Overhead Profit Light-Duty Gasoline Diesel
Company Markup Markup Market Share Market Share Market Share
General Motors 167 +058 .57 -65 +19
Ford 136 017 29 +25 —_
Chrysler .136 o° 14 £10 -—-
International Harvester! +330 0° —_ — 31
Caterpillar 267 047 -— -— 28
Cummins .338 -050 --- -— 08
Mack 129 -001 _ -— 14
Light-Duty Markup? 154 -038
Heavy-Duty Gasoline Markup? 1156 042
Heavy-Duty Diesel Markup? 1254 .028

linterna tional Harvester markups are based on five years of data (1984-1980).

Negative average profit markups for Chrysler and International Harvester are assumed to equal 0 for the calculation of the
average markups for the market segments since the firms cannot operate indefinitely losing money.

3

detailed market share data in Exhibit 11 (e.g., LDT, LHDGE, HHDGE or LHDDE, vs M/HHDDE).

Other markup factors for more detailed class or subclass breakdowns than given above can be determined using the more


IV. DATA ANALYSIS

The performance of the automobile industry has varied widely in recent years, and as a
result the overhead and profit margins show considerable variation over time. Previous
RPE analyses utilized by EPA were based on a three-to-five-year timeframe}, which EPA
believes may not be long enough to encompass cyclical swings in the economy. Thus,
this analysis covers a ten-year timeframe in order to average out cyclical effects upon
the markup factors. This section presents analysis of trends shown by the margins and
offers suggestions of items that may warrant consideration in evaluating and using the
RPE data.

IV.A. Corporate Overhead

Exhibit 8 presents a graph of the overhead margins for the three groups of manu-
facturers (automobile, HDE, and all manufacturers). The graph illustrates a number of
significant trends shown by the margins over the past 10 years. First, truck
manufacturers’ overhead expense is a much higher percentage of cost of sales than auto
manufacturers' overhead. While the overhead margins of the two groups have moved in
similar directions over the ten-year period, truck manufacturers' overhead margins have
been between 7-18 percent higher. The second noticeable trend is that overhead tends
to move inversely with general auto industry performance. The overhead margins
declined slightly from 1975-1978, which were generally good years for the auto and
truck industries. From 1979-1982, however, overhead as a percentage of cost of sales
rose steadily while industry performance declined. This is probably attributable to the
fact that manufacturers were slow to trim overhead costs in the face of declining sales.
In the last two years, auto and truck sales have rebounded, and the overhead margins
have declined somewhat. However, they are still at a relatively high level, and the
general trend over the past 10 years appears to be a slight rise in overhead as a
percentage of cost of sales. This observation is also supported by the three-year and
five-year moving averages shown in Exhibits 5 and 6.

1

"Summary and Analysis of Comments to the NPRM: 1983 and Later Model Year Heavy-
Duty Engines Proposed Gaseous Emission Regulations." December, 1979, U.S. EPA,
Office of Mobile Sources, pp. 328-332.

13


estimates shown in Exhibit 12 are also GM average markups. For heavy-duty diesel
manufacturers, the industry average markups are shown for the EPA and JFA studies.
Since PHB did not differentiate between groups of manufacturers, they do not have a
distinct heavy-duty-diesel markup at the manufacturer level (although they do calculate
different dealer markups at the heavy-duty level).

The EPA markups, which are based on data from 1976-1978, differ significantly from
the ten-year markups. The years 1976-1978 were all relatively good years in the auto
industry, while the ten-year period included several "down" years. Furthermore, the
EPA methodology left several items out of overhead costs, and did not delete non-
operating income from profits. Thus, at the manufacturer level the ten-year average
profit markups are lower and the overhead markups are higher than the corresponding
three-year EPA calculated markups. At the auto dealer level, the EPA profit markup is
higher (.030) than the ten-year average markup (.020). EPA did not calculate interest
expense or sales commission markups at the dealer level, and determined that no profit
margin should be added for truck dealers. Thus, further comparison at the dealer level
cannot be made.

The Putnam, Hayes, and Bartlett (PHB) markups are based on data from 1979-1983.
The PHB dealer markups are nearly identical to the revised markups, both for
automobile and truck dealers. At the manufacturer level, the PHB profit and overhead
markups are significantly lower than the ten-year average markups. The profit markup
is lower due to the fact that the years from 1979-1983 were down years in the auto
industry. The overhead markup is lower because PHB did not include depreciation or
pension expense in its calculation of overhead; both the EPA and the revised ten-year
markups include these expenses as part of overhead, therefore increasing overhead as a
percentage of cost of sales.

In summary, the following markup factors are recommended for calculating EPA retail
price equivalents, based on this analysis and EPA's need to incorporate information on

each firm in a market segment into regulatory anslyes:

1. Light-duty market (LDVs and LDTs)

e Manufacturer overhead, .154
e Manufacturer profit, .038
e Manufacturer net, .192

23


e automobile and light truck manufacturers (GM, Ford, Chrysler)

e medium and heavy-duty vehicle/engine manufacturers only (Caterpillar,
Cummins, Mack, International Harvester)

e all seven manufacturers combined.

profit margins were calculated as pretax profit percentages of the cost of sales. Only
income from sales was used in calculating the markups; interest income and other
sources of income not stemming directly from operations previously included in income
by EPA were not included since they do not reflect income from manufacturing
operations. Exhibit 2 shows the calculated annual profit margin over the ten-year
timeframe for each company and for the 3 groups of manufacturers previously listed.

Exhibit 3 presents overhead and profit margins calculated for these firms by EPA in a
previous study for the period from 1976 through 1978.! Comparison of the data in
Exhibit 3 with that in Exhibit 2 and Exhibit 1 indicates that the modifications made to
the calculation of the overhead and profit markups (identified above) lead to higher
overhead margins and lower profit margins for each firm.

Exhibit 4 presents average overhead and profit margin for each company and for the
three groups of manufacturers. Averages were calculated over three different
timeframes: the entire ten-year period, the most recent 5 years, and the most recent 3
years. The averages were calculated by summing the overhead, profit, and cost of sales
values for each firm and/or for each market segment over the appropriate timeframe to
arrive at total overhead, total profit, and total cost of sales for the period, and then
calculating the percentage margins. This technique, as opposed to averaging the annual
margins, takes into account differing levels of cost, profit, and overhead over time.

As noted above, the firms were divided into industry groups based on the primary motor
vehicle business of each firm. Thus, General Motors, Ford, and Chrysler were not
included in the heavy-duty engine segment of the market, since their motor vehicle
business, and financial data, are dominated by their light-duty vehicle (auto) and light-
duty truck operations. However, as is discussed later, it will be necessary to include
General Motors, Ford and Chrysler overhead and profit figures in calculating the overall
HDGE markups, and General Motors figures will also have to be included with those of
the other HDDE manufacturers.

lus, Environmental Protection Agency, Office of Mobile Sources. "Summary and
Analysis of Comments to the NPRM: 1983 and Later Model Year Heavy-Duty Engines,
Proposed Gaseous Emission Regulations." December 1979, pp. 328-332.

4


EXHIBIT 11;
1984 MARKET FRACTIONS!

Market GM Ford Chrysler TH Cummins Cat Mack

LDV 60 26 “oo - = _
LDT 46 38 1 - 8 _
LHDGE? 65 23 woo - oe _
HHDGE 88 42 - + - - _
LHDDE? 32 - — 68 - = _
M/HHDDE® 13 - - 16 4000 13

‘Normalized to 100 Percent.
2 primarily Class 2b.

Spata were not available at this time to break these market shares into their
respective MHDDE and HHDDE portions.

1H had very limited sales in HHDGEs in 1984 and left the market in 1985, so their
sales are not considered in these figures.

20


aS

EXHIBIT 12:

COMPARISON OF RPE MARKUPS

EPA PHB JFA
(1976-1978) (1978-1983) (1975-1984)

LDV HDG HDD LDV HDG HDD LDV HDG HDD

Manufacturer!’
Overhead «114.224 +167 -068 .068 - 068 +167) «1670254
Profit 138 2138 119 - 039 -039 039 058 058 028
Sum +252 +252 +286 -107 107 107 2225 2225 -282

Dealer2/

Interest -000 . .000 -000 022 -028 6.028 017 024 = ,024
Profit -030 = .030 -000 -013° .014 .014 -020 «.018 += .018
Sales Commission -000 .000 .000 022 022 -022 -020 .020 .020
Sum -030 =©.030 =. 000 +057 064 .064 -057 062 062

eas used the GM everage markup for light-duty and heavy-duty gasoline manufacturers, and the
industry average for HDD manufacturers. PHB did not differentiate between manufacturers, and their
markup is the GM average markup. The JF A markups shown here are the 10-year average GM markup
for LD and HDG manufacturers and the industry average for HDD manufacturers. The ten-year JFA
average markups for all LD manufacturers are .154 for overhead and .038 for profit, totaling .192; and
for all HDG manufacturers, .156 for overhead and .042 for profit, totaling .198.

2EpA did not estimate interest and sales commission markups at the dealer level, and determined that no
profit markup should be added for heavy-duty vehicle dealers.


these losses have occurred in recent years, the five and three year averages are
probably even less representative. The problem is particularly acute for heavy-duty
truck and engine manufacturers, who in aggregate have sustained losses in each of the
past five years, and for whom the last ten years do not constitute a full business cycle.
{total net profit is still negative in 1984.)

An alternative approach to using industry average figures would be to use individual
company averages. Both GM and Cummins have maintained profit levels above their
respective industry averages, and their average profit margins may represent a truer
indication of profit margins which manufacturers actually seek. However, the financial
performance of these single firms may not be representative for the industry as a
whole, and therefore the application of their profit markup factors is probably not
appropriate. Another alternative for the HDE segment would be to consider the ten-
year average excluding International Harvester: in this case,the profit margin would be
039.

IV.C.. Dealer Markups

Auto and truck dealers (heavy-duty gasoline or diesel) operate on relatively thin
margins, and thus the variations in dealer profit margins are relatively small in
comparison to variations in manufacturer profit margins. Automobile dealer profit
margins have ranged between .007 and .025 since 1976. Generally, they have moved in
the same direction as auto manufacturer profits, declining during the late 1970's and
then rising somewhat in 1983 and 1984. Truck dealer profit margins dropped sharply
from 1977 to 1980, and have remained low since. The truck dealer margins have ranged
from .027 in 1976 to .010 in 1981. Because the cyclical movements of dealer profit
margins appear to be closely related to manufacturer cyclical movements, adopting
similar timeframes for calculating the-RPE markups appears appropriate.

Interest expense margins at the dealer leve] have also been cyclical in nature, generally
moving inversely with auto industry performance. Automobile dealer interest margins
moved from .012 in 1976 to .030 in 1980, and have since declined to .011 in 1984. The
average interest expense over the period is .018. Truck dealer interest expense as a
percentage of cost of sales has historically been slightly higher than auto dealer
interest expense, while changes in truck and auto dealer interest margins have been in

17


EXHIBIT 5:

THREE YEAR MOVING AVERGE MARKUPS

OVERHEAD PROFIT

Mid- Auto HDE All Auto HDE All

Year Manuf. Manuf. Manuf. Manuf. Manuf. Manuf.
1983 173 324 187 040 (.099) 027
1982 182 328 198 -004 (.089) (.006)
1981 180 298 195 (.039) (.050) (.041)
1980 161 261 172 (.018) 015 (.014)
1979 144 -236 153 021 051 024
1978 128 213 134 072 +101 2075
1977 122 2212 129 -092 -106 -093
1976 +128 216 134 -079 +097 -080

(_ ) indicate negative numbers (i.e., losses)


EXHIBIT 3:
PREVIOUS MARKUPS CALCULATED BY EPA

1976 1977 1978

Overhead Profit Overhead Profit Overhead Profit
GM IT +145 .109 141 «117 +129
Ford +113 -080 -099 -100 -103 -081
Chrysler -102 049 067 023 .193 -0
Caterpiller 121 165 -113 «172 -109 0172
Cummins -308 -169 -335 +150 336 115
Mack -123 055 -096 067 085 .099

International Harvester +172 075 -169 074 -193 +056


Company
GM

Ford
Chrysler

All Auto Manufacturers

Caterpiller

Cummins

Mack

International Harvester

All HDE Manufacturers

All Manufacturers

(_ ) indieate negative numbers (i.e., losses)

EXHIBIT 2:
PROFIT/COST OF SALES

1984 1983 1982 1981 1980 1979 1978 1977 1976 1975
+056 070 (.009) -009 +034 -082 +126 +136 +132 -073
-066 +033 (038) (.056) (.078) 018 +067 084 059 +006
135 +063 (.024) (.069) (.201) (.100) (.030) 012 -039 (017)
-069 057 (.021) (.031) (.066) 038 084 -100 -091 034

(.071) (.146) (.115) +101 +102 +107 2121 «120 +112 -110
+159 (.071) (.048) 058 (.012) 051 -094 105 147 -010
+023 (.079) (.079) (.026) (.050) -051 -076 -048 +010 -001

(.050) (.177) (262) (.157) (.152) - _ - - -

(.022) (.138) (.154) (.008) (.007) -089 -109 -108 -099 -081
-061 +041 (.035) (.028) (.058) 042 -086 -101 -092 -038

Source: Corporate Annual Reports


the same direction. The average truck dealer interest expense margin is .024 (Exhibit
1). Because of the cyclical nature of the interest margins, average markups calculated
using the longest timeframe possible appear to be the most suitable figures.

IV.D. Unit Sales Weighted Markups

As was mentioned previously, a deficiency with the methodology used above to
calculate the average overhead and profit markups for each market segment is that a
firm is assigned to a market segment based on its primary motor vehicle related
business. Thus, General Motors, Ford and Chrysler are assigned only to the light-duty
segment of the market, although all three firms also operate in the heavy-duty gasoline
vehicle market, and General Motors operates in the heavy-duty diesel market. This
approach was used above because manufacturing costs and operating profits related to
heavy-duty operations cannot be separated from total motor vehicle operations, which
are dominated by the light-duty vehicle (auto) and light-duty truck operations of each
firm. However, the role of these manufacturers in the HDE market (gas and diesel)
must be considered in calculating the overall markups.

An alternative approach which would permit incorporation of financial data from these
firms into the respective heavy-duty market segments would be to weight the ten-year
average markup factors for each firm in a market segment by its unit sales merket
share. Exhibit 10 presents the market share for each firm and the resultant overhead
and profit markup factors using this approach for three market segments, as follows:

e the light-duty market (General Motors, Ford, and Chrysler);
e the heavy-duty gasoline market (General Motors, Ford, and Chrysler); and

e the heavy-duty diesel market (General Motors, International Harvester,
Cummins, Mack, and Ceterpillar).

This methodology assumes that the overall corporate markup factor for each firm is
appropriate for each market segment in which that firm operates. Although this may
not be the case (j.e., the proportion of overhead costs and income to cost of sales can
vary among different market segments for a single firm), the approach does permit
incorporation of data from all firms in a market segment into the calculation of
overhead and profit markups for that market segment. In the prior instance, this

18


Exhibits 5 and 6 show the margins obtained when the data is smoothed by the use of
three-and five-year moving averages. Moving averages are commonly used in time-
series analysis in order to reduce the effects of cyclical variations in data. The moving
averages maintain the overall trend while minimizing year-to-year variations. In these
exhibits overhead and profit moving average margins are presented for the three

aggregate groups of manufacturers.

Il. DEALER MARKUP

At the dealer level, three cost elements were identified as being part of the dealer
markup factors: profit margin, interest expense, and sales commissions. In developing
markup factors, these costs were quantified as percentages of dealer costs, with
differentiation between truck and auto dealer markups. Because the addition to
vehicles of emission control equipment does not change dealer overhead expense, an
overhead markup is not included at the dealer level. Following is a summary of the
data sources and techniques used to quantify the costs of each element in the dealer
markup factor.

The best public data source for information on automobile and light-duty truck dealers
is the National Automobile Dealers Association (NADA). NADA publishes an annual
report entitled NADA Data: Economic Impact of America's New Car and Truck Dealers

which contains data on total dealership sales, gross sales, pretax profit, and new vehicle
sales as a percentage of total dealer sales. Unfortunately, no data was available to
enable determination of the contribution to total dealer profits of new vehicle sales.
Thus, the dealer profit margins were calculated under the assumption that new vehicle
contribution to total dealer profits is identical to new vehicle contribution to total
dealer sales. Using this assumption, the profit margins were calculated by subtracting
total dealer gross sales from total dealer sales in order to obtain dealer cost of sales.
Total dealer’ pre-tax profits were then divided by cost of sales to give the markup
factors, which are presented in Exhibit 7.

1

These moving averages are centered on the year identified in the exhibits. Thus, the 3
year moving average for 1983 includes data for 1984, 1983, and 1982; the 5 year moving
average for 1982 includes data for 1984, 1983, 1982, 1981, and 1980.

Dealer data were available only back to 1976.


Dealer interest expense, .017
Dealer profit, .020

Dealer sales commission, .020
Dealer net, .057

2. Heavy-duty gasoline market

Manufacturer overhead, .156
Manufacturer profit, .042
Manufacturer net, .198
Dealer interest expense, .024
Dealer profit, .018

Dealer sales commission, .020
Dealer net, .062

3. Heavy-duty diesel market

Manufacturer overhead, .254
Manufacturer profit, .028
Manufacturer net, ,282
Dealer interest expense, .024
Dealer profit, .018

Dealer sales commission, .020
Dealer net, .062

eoeeensk ee

The resultant total markup factors are the following for each market segment:

° Light-duty market — 1.26

e Heavy-duty gasoline market — 1.27

e Heavy-duty diesel market — 1.36

24


SJACKF AU-85-322-3

UPDATE OF EPA's MOTOR VEHICLE EMISSION CONTROL EQUIPMENT
RETAIL PRICE EQUIVALENT (RPE) CALCULATION FORMULA

Final Report
Work Assignment 3
Contract No. 68-03-3244

Submitted to:
U.S. ENVIRONMENTAL PROTECTION AGENCY
Office of Mobile Sources
Ann Arbor, Michigan 48105

September 4, 1985

JACK FAUCETT ASSOCIATES

5454 WISCONSIN AVENUE - SUITE 1155.
CHEVY CHASE. MARYLAND 20815
(301 657-8223


EXHIBIT 7:
DEALER MARKUPS

Automobile Dealers Truck Dealers
Year Interest Profit Interest Profit
1984 .011 025 nal NA
1983 +008 025 NA NA
1982 +018 +015 022 011
1981 +028 -014 -049 -010
1980 030 +007 032 -010
1979 +025 -015 -020 -018
1978 016 +023 -017 -025
1977 +012 +023 -013 025
1976 12,024 016,027
Average -018 -020 024 -018
3 Year Average 012 +022 034 010
5 Year Average .019 -017 +028 -015
'NA = Not Available
Sourees: National Automobile Dealers Association, NADA DATA,

annual issues. Robert. Morris Associates, Annual State-
ment Studies.

11


ot

EXHIBIT 6:

THREE YEAR MOVING AVERGE MARKUPS

OVERHEAD PROFIT

Mid- Auto HDE All Auto HDE All
Year Manuf. Manuf. Manuf. Manuf. Manuf. Manuf.
1982 173 301 187 007 (.057) +001
1981 172 297 185 (.002) (.044) (.007)
1980 160 272 172 (.002) (.002) {.003)
1979 145 246 155 025 041 +026
1978 +137 231 145 047. 066 049
1977 130 214 136 -070 -098 072

(_ ) indicate negative numbers (i.e., losses)


EXHIBIT 4:

AVERAGE MARKUP FACTORS

OVERHEAD PROFIT

COMPANY 10 YR 5 YR 3YR 10 YR 5 YR 3 YR
GM 167 «185 -189 058 -019 043
FORD +136 156 +157 -017 (.010) 026
CHRYSLER +136 166 152 (.007) 004 074
AUTO MANUF. 152 +173 +173 036 -007 040
CATERPILLAR 267 311 -370 047 (.009) (.108)
CUMMINS 338 - 339 +345 050 026 026
MACK +129 135 130 2001 (035) 033
IH = 330 329 _ (158) (.160)

v V/

HDE MANUF. 271 301 324 (003) (.057) (.099)
ALL MANUF. 164 187 .187 032 001 027

Source: Corporate Annual Reports.

( ) indicate negative numbers (i.e., losses)

Lineludes data for International Harvester from 1980 through 1984. Without International Harvester, averages for
Caterpillar, Cummins, and Mack are .254 for overhead and .039 for profit.


approach is better than one which excludes data from the large, multi-market producers
(e.g. General Motors, Ford and Chrysler) in the calculation of RPE markup over cost for
individual market segments, as it reflects the experience of each individual firm.

Vv. CONCLUSIONS

The overhead margins at the manufacturer level show significant cyclical swings, and
thus use of a ten-year timeframe to calculate the overhead markup factor appears to be
appropriate in order to average out the cyclical effects. The use of a ten-year average
margin for manufacturer profit markup, however, presents some difficulties. The losses
incurred by manufacturers (particularly truck manufacturers) in recent years have a
significant downward effect on the ten-year profit margins. Use of an alternative
approach such as an average based on the last 5 years or 3 years, however, does not
eliminate this problem, nor does use of the average for the period for the market leader
(i.e., GM or Cummins) yield a necessarily representative markup factor. Consequently,
it is reasonable to use a ten-year average profit markup for the light-duty manufac-
turing segment, since it does embrace a full business cycle; and for the heavy-duty
market segment, since losses predominate in recent years. Furthermore, given EPA's
need to address individual market segments in regulatory analyses, use of the ten-year
average sales-weighted markup factors calculated for the light-duty, heavy-duty
gasoline, and heavy-duty diesel market segments appears to be appropriate. Finally,
the profit, interest expense, and sales commission margins calculated for auto dealers
should be used for the respective markups in the light-duty market segment; and the
profit, interest expense, and sales commission margins calculated for truck dealers
should be used for the respective markups in the heavy-duty gasoline and diesel market
segments.

Exhibit 12 compares the markups calculated by JFA using a ten-year timeframe with
the markups calculated in two previous studies by EPA and Putnam, Hayes and Bartlett
(PHB).2 Both manufacturer and dealer markups are presented for each of the studies,
with separate estimates shown for light-duty, heavy-duty gasoline, and heavy-duty
diesel markups. At the manufacturer level, the light-duty and heavy-duty gasoline
estimates shown in Exhibit 12 are the GM average markups. Both EPA and PHB used
the GM estimates in their analyses, and thus to maintain comperability the JFA

luis. EPA, Office of Mobile Sources, op.cit.

Putnam, Hayes & Bartlett, Inc. "Report on EPA's Retail Price Equivalent Methodology."
September 28, 1984. Prepared for U.S. EPA, Economic Analysis Division, OPPE.

21


EXHIBIT 1:
OVERHEAD/COST OF SALES

Company 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975

GM 167 194 -210 177 «185 140 -140 +136 145 -162
Ford -139 -158 .180 -160 147 114 101 -101 -119 ~132
Chrysler 125 -156 194 -187 - 203 -132 107 -102 -101 -109
All Auto Manufacturers 152. 1TT 198 +172 +172 -142 121 +118 +128 142
Caterpillar 312 432 +380 . 260 232 220 204 -214 -220 213
Cummins -310 ~352 -385 -323 +339 .338 344 -337 321 333
Mack! 094 +152 164 141 «144 -099 105 118 151 144
International Harvester 2257 359 +381 +331 2332 _ - - - -
All HDE Manufacturers 262 365 358 -280 266 .219 +205 -213 ~ 222 214
All Manufacturers -162 .193 216 -186 .184 -147 127 -125 -135 .148

Source: Corporate Annual Reports

Irhe annual overhead/cost of sales ratio calculated for Mack trucks is much lower than those calculated for the other HDE
manufacturers over the period from 1975 to 1984.- This is because the ratio of cost of sales to sales is higher for Mack than for the
other firms throughout the period; and the ratio of overhead costs to sales is lower. Since profit levels have not been significantly
different for Mack than for the other HDE manufacturers, and since Mack's line of business is much the same, this difference may be
due to the use of different, yet still acceptable, cost accounting procedures by Mack.


OVERHEAD/COST OF SALES.

400

-1004

3007

2004.

EXHIBIT 8:
OVERHEAD MARKUPS

19ts 76 7 7 79 «+80 81 82 83 84
Key
ee —— All Manuf.
----  HDE Manuf.
«- +- Auto Manuf.

14


Sy

2007

100

EXHIBIT 9:

PROFIT MARKUPS

-1004

~200 |

Key

—— All Manuf.
----  HDE Manuf.
*-:- Auto Manuf.

16


Ford, Chrysler, Mack, Caterpillar, Cummins, and International Harvester!

For all of
the firms except International Harvester, annual levels were calculated for the
ten-year period from 1975 through 1984. However, International Harvester has
undergone @ major restructuring since 1982 and has discontinued many of its operations.
International Harvester has prepared financial statements for the years 1980 through
1984 which account for the effects of discontinued operations and restructuring. Thus,
International Harvester overhead and profit margins were determined only for the last
five years. The company's operations have changed so dramatically that overhead and

profit margins prior to 1980 do not reflect operating conditions at the company today.

Financial data used in calculating the markup factors were obtained from corporate
annual reports. Previous EPA estimates of markup factors were based primarily on
financial information contained in Moody's Industrial Manual, with some supplemental
data from corporate annual reports. However, the income statement information in
Moody's is not complete for all companies and varies over time for individual
companies.” Therefore, it was determined that corporate annual reports should be used
exclusively in order to develop a consistent set of markups across all companies over

the ten-year analytical timeframe.

Overhead margins were calculated as percentages of the cost of sales, where overhead
was defined as the sum of the following items taken from the financial statements of
each firm: selling, general, and administrative expense (S,G&A); pension expense;
depreciation and amortization; and interest expense. Generally, EPA had previously
included S,G&A, depreciation, and amortization in overhead; in some cases, however,
EPA included only S,G&A in overhead. Exhibit 1 presents the calculated annual
overhead margins over the ten-year timeframe for each of the seven companies. Also
included are aggregate factors for three groups of manufacturers:°

Nissan, Toyota, Volkswagen and other foreign competitors in the U.S. market were not
considered due to differences in the generally accepted accounting principles followed
by these foreign firms. American Motors was not considered due to its financial
relationship with Renault, a foreign firm.

2 Moody's often uses a standard format which requires the restatement of data contained
in the corporate annual reports. Restatement can lead to the suppression or
reassignment of financial data. Furthermore, Moody's does not include the notes to the
corporate financial statements in the summaries. The notes contain data and
information vital to conducting any financial analysis of a firm.

3 Groupings are based on the primary motor vehicle business of each firm. These factors
were calculated by summing the overhead, profit, and cost of sales values of the firms
together to arrive at total overhead, total profit, and total cost of sales for the industry
segment, and then calculating the margins for that segment.

2


1. INTRODUCTION

In assessing the cost to consumers of emission control equipment, EPA uses a "markup"
approach to estimate the retail price equivalent (RPE) for an emission control
component from an estimate of the component's direct manufacturing cost. Given this
methodology, the difference between the RPE and the direct manufacturing cost
includes allocated overhead costs, profit margins, and other indirect cost elements at
each of several stages in the production and marketing process.) EPA originally
developed this methodology in 1978 and modified it in 1980.2 An independent review of
the methodology in 1984 agreed with the overall methodology, suggested additional
costs to be considered, and offered alternative markup values.”

The purpose of this report is to review and update the margins at the vehicle
manufacturer and dealer levels which EPA uses to calculate retail price equivalents, in
light of the 1984 analysis. It consists of four major sections. In the first section, profit
and overhead margins at the vehicle manufacturer level are presented, along with a
discussion of the data development methodology employed in their calculation. The
second section presents estimated margins at the dealer level for profit, sales
commissions, and floor plan financing®, and describes the techniques and data used to
develop these markups. The third section examines the results, illustrates some general
trends evident in the data, and suggests several items to be considered when evaluating
the RPE markup data. Conclusions are drawn and recommendations are presented in
the final section.

H. CORPORATE OVERHEAD AND PROFIT

Corporate overhead and profit margins were calculated at the vehicle (engine)
manufacturer level for seven motor vehicle and engine manufacturers: General Motors,

Cost_Estimations for Emission Control Related Component/System and Cost _Method-
ology Description, Le Roy H. Lindgren (Rath & Strong, Inc.), EPA-460/3-78-002, March

US. Environmental Protection Agency, Office of Mobile Sources, "Summary and
Analysis of Comments to the NPRM: 1983 and Later Model. Year Heavy-Duty Engines,
Proposed Gaseous Emission Regulations.” December 1979, pp. 328-332.

Memo from Putnam, Hayes and Bartlett, Inc. to Willard Smith, U.S. EPA, Office of
policy Planning and Evaluation, Economic Analysis Division: "Report on EPA's Retail
4 rice Equivalent Methodology." September 28, 1984.

Floor plan finanei

‘ ing costs are the interest expenses incurred by motor vehicle dealers
to finance their y

ehicle inventory.


while NADA does not publish any data on dealer interest expense, the NADA Industry
Analysis Department was able to provide estimates of floor plan interest expense per
new vehicle sold over the past 9 years. This data was used to calculate the interest
margins for automobile (LDV) and light-duty truck (LDT) dealers. Multiplying the
interest expense per vehicle figures by the average number of new vehicles sold at an
LDV/LDT dealer provided estimates of total dealer interest expense in each year.
Then, total dealer cost of sales was multiplied by new vehicle sales as a percentage of
total sales in order to obtain an estimate of new vehicle cost of sales. Dividing floor
plan interest expense in each year by the new vehicle dealer cost of sales yielded the
interest expense markup factor for each year. These markups are shown in Exhibit 7.

The most extensive data on truck dealers is found in Robert Morris Associates’ Annual
Statement Studies.! This publication contains key financial ratios and income state-
ment data on a percentage of sales basis. The data are presented by Standard Industrial
Classification and are composite data of all firms with total assets of $100 million or
Jess. Data for the category "Truck Retailers, New and Used" (SIC 5511) were used to
develop margins for truck dealers. Interest expense was derived using the EBIT
(earnings before interest and taxes) to interest ratio (multiplying the inverse of the
ratio by EBIT yields interest expense). Both interest expense and profit margins were
then expressed as percentages of cost of goods sold and are presented in Exhibit 7.

Neither the Robert Morris nor the NADA publications contained information on sales
commissions. However, a member of NADA's economic analysis staff estimated that
sales commissions were approximately 2 percent of the wholesale price of the vehicle.
This estimate is applicable to both cars and trucks.”

Also included in Exhibit 7 are average dealer margins. Average interest and profit
margins were calculated for automobile and truck dealers over three timeframes: all
years of data, the most recent three years, and the most recent five years.

'Data were available only through 1982.

2 National Automobile Dealers Association, Industry Analysis Group, personal communi-
cations.

12


The primary reason for using a ten-year timeframe is to encompass a complete periodic
economic cycle, and thus average out the effects of cyclical swings. A potential
problem with this approach is that manufacturers may have restructured their opera-
tions to such an extent that using 10 year data will not accurately reflect existing
conditions. Indeed, auto manufacturers have claimed that they have sharply cut
overhead in recent years. However, the data available through 1984 does not clearly
support this assertion; overhead as a percentage of cost of sales has dropped the past
two years, but the drop appears to be in response to increasing sales (and thus cost of
sales) rather than changing overhead structure. The 10-year average overhead markup
factor for auto manufacturers is .152, while the latest three- and five-year average
markups are both .173. From this data, there does not appear to be any compelling
reason to select a timeframe shorter than 10 years for developing an appropriate
overhead markup factor.

IV.B. Corporate Profit

Profit margins have varied widely over the last 10 years (Exhibit 9). Profits as a
percentage of cost of sales rose from 1975-1977, and then dropped sharply from
1978-1980, although still positive. From 1980-1982, the industry experienced large
losses, and all three groups of manufacturers earned no profits overall during the three-
year period. Since 1982 the auto industry has turned around, and profit margins are now
approaching the levels they reached in the mid-late 1970's. Heavy-duty truck and
heavy-duty engine sales and profits have remained depressed, however, and as a result,
firms manufacturing only heavy-duty engines or trucks as a group have not earned
profits for the past 5 years. Exhibit 9, which is a graph of the profit margins for the 3
groups of manufacturers, illustrates the highly cyclical nature of the profit margins
over the past 10 years.

The average profit margin for firms engaged primarily in the manufacture of auto-
mobiles is .036 over the last 10 years, .007 over the last 5 years, and .040 over the last
3 years. The average profit margin for firms engaged primarily in the manufacture of
HDT's or HDE's is (.003) over the last 10 years (.039 if International Harvester is
excluded), (.057) over the last 5 years, and (.099) over the last 3 years. One problem in
using a ten-year average for profit markup is that both auto and truck manufacturers
sustained heavy losses in several years during the period, and thus the industry average
for the period may understate profit margins the manufacturers actually seek. Since

15