6

- i CHAPTER 6. MARKUPS FOR PRODUCT PRICE DETERMINATION

TABLE OF CONTENTS

6.1 INTRODUCTION

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

- 1

6.1.1 Distribution Channels

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

- 2

6.2 MARKUP CALCULATION M ETHODOLOGY

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

- 3

6.3 MANUFACTURER MARKUP

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

- 4

6.4 APPROACH FOR CALCULA TING WHOLESALER AND CONTRACTOR

MARKUPS

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

- 4

6.4.1 Assumptions

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

- 5

6.4.2 Approach for Wholesaler Markup

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

- 7

6.4.3 Approach for Mechanical and General Contractor Markup

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

- 8

6.5 DERIVATION OF NATION AL WHOLESALER AND CO NTRACTOR

MARKUPS

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

- 9

6.5.1 Wholesaler Markups

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

- 9

6.5.2 Mechanical Contractor Markups

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

- 10

6.5.2.1 Markups for Mechanical Contractors in the Replacement and New

Construction Markets

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

- 11

6.5.3 Estimation of General Contractor Markups

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

- 13

6.6 DERIVATION OF REGIONAL MARKUPS

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

- 14

6.6.1 Regions Being Analyzed

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

- 14

6.6.1.1 Estimation of Regional Wholesaler Markup

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

- 14

6.6.1.2 Estimation of Regional Mechanical Contractor Markup

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

- 15

6.6.1.3 Estimation of Regional General Contractor Markup

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

- 16

6.7 MARKUP FOR MOBILE HO ME GAS FURNACES

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

- 17

6.8 SALES TAX

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

- 18

6.9 OVERALL MARKUPS

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

- 18

LIST OF TABLES

Table 6.5.1 Wholesaler Expenses and Markups

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

- 9

Table 6.5.2 Baseline Markup, All Mechanical Contractors

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

- 10

Table 6.5.3 Baseline Markups for the Replacement and New Construction Markets,

All Mechanical Contractors

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

- 11

Table 6.5.4 Mechanical Contractor Expenses and Baseline Markup, Residential and Light Commercial

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

- 12

Table 6.5.5 Mechanical Contractor Expenses and Markups Based on Census Bureau

Data

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

- 12

Table 6.5.6 General Contractor Expenses and Markups

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

- 13

Table 6.6.1 Regional Wholesaler Markups for Furnaces

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

- 15

Table 6.6.2 Regional Wholesaler Markups for CACs and HPs

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

- 156

- ii Table 6.6.3 Population

- Weighted Regional Mechanical Contractor Markups for

Furnaces

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

- 16

Table 6.6.4 Population

- Weighted Regional Mechanical Co ntractor Markups for CACs

and HPs

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

- 16

Table 6.6.5 Regional General Contractor Markups for Furnaces

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

- 17

Table 6.6.6 Regional General Contractor Markups for CACs and HPs

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

- 17

Table 6.8.1 Average Sales Tax Rates by Census Division and Large State

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

- 18

Table 6.9.1 Summary of National Average Markups on CACs, HPs, and Residential

Furnaces and Boilers

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

- 20

Table 6.9.2 Summary of Markups on Different Types of Residential Furnaces and

Boilers

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

- 20

LIST OF FIGURES

Figure 6.1.1 Distribution Channels for Residential Furnaces, Central Air Conditioners and Heat Pumps

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

- 3 Figure 6.1.2 Distribution Channel for Mobile Home Gas Furnaces

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

- 36

- 1 CHAPTER 6. MARKUPS FOR PRODUCT PRICE DETERMINATION

6.1 INTRODUCTION

To carry out its analyses, DOE needed to determine the cost to the consumer of baseline products and the cost of more efficient units the consumer would purchase following the promulgation of new energy conservation standards

. However, the consumer price of baseline or

hi gher efficiency equipment is not generally known. For this analysis the price w ould be determined based on engineering estimates of manufacturing costs plus appropriate markups based on how the equipment is purchased.

For wholesalers and contractors , DOE estimated a baseline markup and an incremental markup. DOE defined a baseline markup as a multiplier that convert s the manufacturing selling price of equipment with baseline efficiency to the consumer purchase price for the equipment at

the same baseline e fficiency level. An incremental markup is defined as the multiplier to convert

the incremental increase in manufacturing selling price of higher efficiency equipment to the

consumer purchase price for the same equipment. Because companies mark up the price to cover business cost and profit margin at each step in the distribution channel, b oth baseline and incremental markups are dependent on the particular distribution channe l, as described in Section

6.1.1

.

In this chapter , DOE first address es the differences between distribution channels and the methodology used to derive baseline and incremental markups

. DOE then summarizes the results in two sections: (1) national markups estimation and (2) regional markups estimation. The reason that DOE differentiated markups between national and regional estimations is that additional regional standards for all market participants are proposed for furnaces and central ai r conditioners and heat pumps in The Energy Policy and Conservation Act (EPCA), as amended by the Energy Independence and Security Act of 2007. Hence, DOE is considering regional

standards for central air conditioners and heat pumps for two regions (Hot

- Hu mid and Hot

- Dry ), in addition to a base national standard that would prevail in states throughout the rest of the country. DOE is also considering regional standards for residential furnaces and boilers that would have two regions (North and South). Since the region al division for furnaces is different

from the division for central air conditioners and heat pumps , regional markup estimations for

each of these market participants are presented in separate tables as shown in Section 6 .6

.6

- 2 6.1.1 Distribution Channels

The appropriate markups for determining consumer equipment prices depend on the type of distribution channels through which products move from manufactur ers 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.

Two types of distribution channels describe how most equipment passes from the

manufacturer to the consumer , as shown in Figure 6.1.1 . The first distribution channel applies to

furnaces

, central air conditioners

, and heat pumps installed in the replacement markets . In this replacement distribution channel, the manufacturer sells the equipment to a wholesaler , who in

turn sells it to a mechanical contractor, who in turns sells it to the consumer . The second distribution channel applies to furnaces and centra l air conditioners and heat pumps that are installed in new construction, and thus includes an additional link in the chain

— the general

contractor . In this new construction distribution channel, the manufacturer sells the equipment to

a wholesaler , who in turn sells it to a mechanical contractor, who in turn sells it to a general

contractor , who in turns sells it to the consumer

. a

Figure 6.1.1 illustrates the two main distribution channels for furnaces and central air conditioners and heat pumps . These t wo channels also apply to all of the central air conditioner ( CAC ) and central heat pump ( CHP ) product classes and five of the six furnace product classes (all but mobile home gas furnaces ) . DOE calculated the markups for non

- weatherized gas

furnaces and used these markups to develop the markups for weatherized gas furnaces, oil

- fired furnaces, gas boilers, and oil

- fired boilers.

a One manufacturer uses a one

- step distribution chain (manufacturer to contractor) and is the only known exception. Several large retailers are trying to step between wholesaler s and contractors, but most experts do not expect the trend to change the distribution chain significantly in the near term

.6

- 3 Replacement:

New Construction:

Figure 6.1.1 Distribution Channel s for Residential Furnaces

, Central Air Conditioners and Heat Pumps

Mobile home gas furnaces are sold as part of mobile homes, so these furnaces have a speci fic distribution chain (Figure 6 .1.2). The heating

- equipment manufacturer sells to the maker of the mobile home, who installs the equipment in the home. The mobile home maker sells the home to a reseller, who in turns sells it to a homebuyer. The equipment manufacturer markup for mobile home gas furnaces is identical to the manufacturer markup for other fur naces, as described in Section 6.3 below. The markup derivation for mobile home gas fu rnaces is

described in Section 6.7

.

Figure 6.1.2 Distribution Channel for Mobile Home Gas

Furnaces

6.2 MARKUP CALCULATION METHODOLOGY

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 sta tements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold ( CGS ). The gross margin includes the expenses of companies in the distribution

channel

— including overhead costs (sales, general, and ad ministration); research and development (R&D) and interest expenses; depreciation and taxes

— and company profits. In Manufacturer Wholesaler Mechanical

Contractor Consumer

Wholesaler Mechanical

Contractor General

Contractor Consumer

Manufacturer Mobile Home

Manufacturer Mobile Home

Reseller Consumer Manufacturer6

- 4 order for sales of a product to contribute positively to company cash flow, the product’s markup must be greater than the corporate gross ma rgin . Products command lower or higher markups, depending on company expenses associated with the product and the degree of market competition.

Equipment manufacturers sell most of their products directly to wholesaler s. Wholesaler s sell to contractor s at the wholesale price. Wholesaler s absorb short

- term imbalances in supply and demand, allowing manufacturers to operate more efficiently and satisfying consumer needs for fast deliveries. In addition, wholesaler s are important sources for parts.

Most c ontractors compete at the local level. Many carry more than one brand of furnaces and central air conditioners and heat pumps , and most install the products they sell. The trend is for contractors to consolidate into larger companies, following similar tre nds set by wholesaler s and

manufacturers.

In addition to the wholesale r and mechanical contractor markups, in new construction the general contractor adds a markup. In retrofit installations, sales tax applies to the final consumer

cost.

6.3 MAN UFACTURER MARKUP

DOE uses manufacturer markups to transform a manufacturer’s product cost into a manufacturer sales price. Using the CGS and gross margin, the manufacturer markup can be

calculated as follows:

MFG MFG MFG

MFG CGS GM CGS MU **+**

**=**

Where:

MU MFG = Manufacturer markup,

CGS MFG = Manufacturer cost of goods sold, and

GM MFG = Manufacturer gross margin.

6.4 APPROACH FOR CALCULA TING WHOLESALER AND CONTRACTOR

MARKUPS

F or the final rule , DOE examined the manner in which markups change by efficiency

level and other factors for wholesaler s and contractors

. DOE determined that markups are neither

fixed

- dollar, nor proportional to all direct costs, which means that the selling price of a product may not be strictly proportional to the purchase price of the equipment . Using the available data,

DOE has found measura ble differences between incremental markups on direct equipment costs

and the average aggregate markup on direct business costs. Additionally, DOE discovered6

- 5 significant differences between average and incremental markups for heating, ventilation, air

cond itioning and refrigeration (HVACR) wholesaler s and for HVAC contractors. Section 6.4.2

and Section 6.4.3 further discusses the differences between average and incremental markups.

The main reason that the selling price of a product may not be strictly proportional to the purchase price of the equipment is that businesses incur a wide variety of costs. When the purchase price of equipment and materials increases, only a fraction of the business expenses increase, while the remainder of the businesses’ expenses stays relatively constant. For example

, if the unit p rice of an air conditioner increases by 30 percent, it is unlikely that the cost of secretarial support in an administrative office will increase by 30 percent also. Certain business expenses are uncorrelated with the cost of equipment or cost of goods.

6.4.1 As sumptions

DOE derived the wholesaler and contractor markups from three key assumptions about

the costs associated with furnaces and central air conditioners and heat pumps . DOE based the

wholesaler and mechanical contractor markups on firm

- level income statement data, while it based the general contractor markups on U.S. Census Bureau data for the residential building construction industry. DOE obtained the firm income stat ements from the Heating, Air

conditioning & Refrigeration Distributors International (HARDI) 20 1 0 Profit Planning Report

and from the Air Conditioning Contractors of America (ACCA)

. (1; 2) HARDI and ACCA are

trade associati ons representing wholesaler s and mechanical contractors, respectively. DOE used the financial data from the 2007 US Census of Business for developing general contractor markups in the same form as the income statement data for wholesaler s and mechanical

co ntractors. (3; 4) These income statements break down the components of all costs incurred by firms that supply and install air conditioning equipment. b The key assumptions used to estimate markups using these financial d ata are:

1. The firm income statement s faithfully represent the various average costs incurred by firms distributing and installing residential furnaces, central air conditioners and heat

pumps , and light

- commercial furnaces

.

2. These costs can be divided into two categories: 1 ) costs that vary in proportion to the

manufacturer selling price (MSP) of furnaces, central air conditioners and heat pumps

, and boilers ( variant costs ) ; and 2 ) costs that do not vary with the MSP of furnac es, and central air conditioners and heat pumps ( invariant costs).

3. Overall

, wholesale and contractor prices for r esidential furnaces and central air conditioners and heat pumps vary in proportion to wholesale and contractor costs for

b Wholesaler s and mechanical contractors to which these reports refer handle multiple commodity lines, including

resident ial and commercial air

- conditioners and warm

- air furnaces.6

- 6 residential furnaces and central air conditioners and heat pumps included in the income

statements

.

In support of the first assumption, the income statements itemize firm costs into a number of expense categories, including direct costs to purchase or install the equipment, operating labor and occupancy costs, and other operating costs and profit. Although wholesaler s and contractors tend to handle multiple c ommodity lines, including room air conditioners, furnaces, central air conditioners and heat pumps , and boilers, the data provide the most accurate

available indication of the expenses associated with residential furnaces, central air conditioners

and heat pumps , and boiler s

.

Information obtained from the trade literature, and from selected heating, ventilating, and

air

- conditioning (HVAC) wholesaler s, contractors, and consultants, tends to support the second assumption ; t his information indicates that wh olesale and contractor markups vary according to the quantity of labor and materials used to distribute and install appliances In the following discussion, DOE assumes a division of costs between those that do not scale with the manufacturer price (labor and occupancy expenses), and those that do (operating expenses and profit). This division of costs led to the estimate of wholesale and contractor markups described

below.

In support of the third assumption, the HVAC wholesaler and contractor industry i s competitive

, and consumer demand for commercial heating and air conditioning is inelastic, i.e., the demand is not expected to decrease significantly with an increase in price of equipment

. The large number of HVAC firms listed in the 200 7 Census indicat es the competitive nature of the

market

. For example, there are more than 700 HVAC manufacturers, (5) 5,300 wholesaler s of heat pumps and air

- conditioning equipment, (6) more than 170 ,000 general residential contractors

, 36,000 commercial and institutional building contractors, (7) and 91,000 HVAC contractors (8)

listed in the 200 7 Census

. Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or quickly go out of business. (9)6

- 7 6.4.2 Approach for Wholesaler Markup

Using the above assumptions, DOE developed baseline and incremental markups for

wholesaler s using the firm income statement from the Heating, Air

- conditioning & Refrigeration

Distributors International (HARDI) 20 1 0 Profit Report ( App endix 6A.2 ) . DOE used the baselin e markups, which cover all of the wholesaler ’s costs ( both invariant costs and variant costs ), to determine the sales price of baseline models. Here variant costs were defined as costs that vary in proportion to the change in MSP induced by increased efficiency standards; in contrast , invariant costs were defined as costs that do not vary in proportion to the change in MSP due to increased efficiency standards. The baseline markup relates the manufacturer sales price to the wholesaler sales price. DOE calculated the baseline markup for wholesaler s using the following equation:

WHOLE WHOLE WHOLE WHOLE

WHOLE WHOLE WHOLE

BASE CGS VC IVC CGS

CGS GM CGS MU ) ( **+ +** 

**= +** 

**=**

Where:

MU BASE = Baseline wholesaler markup,

CGS WHOLE = Wholesaler cost of goods sold,

GM WHOLE = Wholesaler gross margin,

IV C WHOLE = Wholesaler invariant costs, and

V

C WHOLE = Wholesaler variant costs.

Incremental markups are coefficients that relate the change in the manufacturer sales price of more energy

- efficient models , or those products that meet the requirements of new energy conservation standards

, to the change in the wholesaler sales price. Incremental markups cover only those costs that scale with a change in the manufacturer’s sales price ( variant costs,

V

C

). It calculated the incremental markup ( MU INCR ) for wholesaler s using the following equation:

WHOLE WHOLE WHOLE

INCR CGS VC CGS MU **+**

**=**

Where:

MU INCR = Incremental wholesaler markup,

CGS WHOLE = Wholesaler cost of goods sold, and

V

C WHOLE = Wholesaler variant costs.6

- 8 6.4.3 Approach for Mechanical and General Contractor Markup

The type of financial data used to estimat e markups for wholesaler s is also available for

mechanical contractors and general c ontractors from ACCA and the 2007 Economic Census

. To

estimate mechanical contractor markups for furnaces and central air conditioners and heat

pumps , DOE collected financial data from ACCA and from the Plumbing and HVAC

Contractors (NAICS 23822) series from the 2007 Economic Census. T o estimate general contractor markups, DOE collected data from the Residential Building Construction series from

the 2007 Economic Census , which is the aggregation of New Single

- Family General Contractors (NAICS 236115)

, New M ultifamily H ousing C onstruction (NAICS 236116), New H ousing

O

perative B uilders (NAICS 236117), and Residential R emodelers (NAICS 236118 )

. ACCA financial data provides gross margin (GM) as percent of sales for the mechanical contractor industry; therefore, baseline markup can be derived with the following equation:

(%) (%) (%)

GM Sales Sales MU BASE

**− =** 

The census data include the number of establishments, payroll for construction workers

, value of construction, cost of materials, and cost of subcontracted wor k at both state and national

level . DOE calculated the baseline markup for mechanical contractors and general contractors using the following equation:

SubCost MatCost Pay V MU CONSTRUCT

BASE **+ +**  **=**

Where:

BASE MU = Baseline mechanical contractor or general contr actor markup,

CONSTRUCT V = Value of construction,

Pay = Payroll for construction workers

, MatCost = Cost of materials, and

SubCost = Cost of subcontracted work.

Analogously, DOE estimated the incremental mechanical contractor and general

contractor markups by only marking up those costs that scale with a change in the

manufacturer’s sales price ( variant costs

, V C

) for higher energy efficiency products. As stated in

Section 6.4 .1, DOE assumes a division of costs between those that do not scale with the manufacturer price (labor and occupancy expenses), and those that do ( other operating expenses and profit). Hence, DOE categorized the Census cost data in each major cost category and

estimated markup s using the following equation :

CONT CONT CONT

INCR CGS VC CGS MU **+**

**=**

Where:6

- 9 MU INCR = Incremental contractor markup,

CGS CONT = Contractor cost of goods sold, and

VC CONT = Contractor variant costs.

6.5 DERIVATION OF NATIONAL WHOLESALER AND CONTR ACTOR

MARKUPS

6.5.1 Wholesaler Markups

Wholesaler s reported median data in a confidential survey that HARDI conducted of

member firms. 2 In the sur vey, HARDI itemized revenues and costs into cost categories, including direct equipment expenses (cost of goods sold), labor expenses, occupancy expenses, other operating expenses, and profi t. DOE p resents these data in full in Appendix 6A .1

, Detailed

Data for Equipment Price Markups

. Table 6.5

. 1 summarizes them as cost

- per

- dollar sales

revenue in the first data column.

Table 6.5

. 1 Wholesaler Expenses and Markups

Descriptions Per Dollar

Sales Revenue
$ Per Dollar Cost

of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.73 4 1.000 Labor Expenses: Salaries and benefits 0.1 61 0.21 9 Occupancy Expense: Rent, maintenance, and utilities 0.03 8 0.0 5 2 Other Operating Expenses: Depreciation, advertising, and insurance. 0.05 4 0.07 4 Operating Profit 0.0 13 0.0 18

Baseline Revenue: Baseline revenue earned per dollar cost of goods sold 1.3 62

Wholesaler Baseline Markup ( MU WHOLE BASE ) 1.3 62

Incremental Revenue : Increased revenue per dollar increase cost of goods sold 1. 091 Incremental Markup ( MU WHO LE INCR ) 1. 091

Source: Heating, Air Conditioning & Refrigeration Distributors International

. 20 1 0. 20 10 Prof it Report (200 9 D ata).

In this case , direct equipment exp enses (cost of goods sold) represent about $0.73 per dollar sales revenue, so for every $1 wholesaler s take in as sales revenue, $0.73 i s used to pay the direct equipment costs. Labor expenses r epresent $0.1 6 per dollar sales revenue, occupancy

expenses represent $0.0 4

, other operating expenses represent $0.05, and profit accounts for $0.0 1 per dollar sales revenue.

DOE converted the expenses per dollar sales into expenses per dollar cost of good s sold, by dividing each figure in the first data column by $0.73 (i.e.

, cos t of goods sold per dollar of sales revenue). The data in column two show that, for every $1.00 the wholesaler spends on equipment costs, the wholesaler spends $0.21 9 to cover labo r costs, $0.0 52 to cover occupancy

expenses, $0.07 4 f or other operating expenses, and $0.0 18 in profits. This totals to $1.3 62 in sales revenue earned for every $1.00 spent on equipment costs. Therefore, the wholesaler baseline markup ( MU WHOLE BASE ) is 1.3 62 ($1.3 62 ÷ $1.00).6

- 10 DOE also used the data in column two to estimate the incremental markups. The incremental markup depends on which of the costs in Table 6.5.1 are variant and which are

invariant with MSP . For example, for a $1.00 increase in the MSP, if all of the other costs scale with the MSP (i.e., all costs are variant ), the increase in wholesa le price will be $1.362, implying that the incremental markup is 1.362, or the same as the baseline markup. At the other extreme,

if none of the other costs is variant , then a $1.00 increase in the MSP will lead to a $1.00

increase in the wholesale price, for an incremental markup of 1.0. Actually, DOE believes that the labor and occupancy costs will be invariant and that the other operating costs and profit will scale with the MSP (i.e., be variant ). In this case, for a $1.00 increase in the MSP, the whole sale price will increase to match changes in ”other” operating costs and operating profit of $0.067, which when divided by 73.4 cents in cost of goods sold yields an increase of $0.091, giving a

wholesaler incremental markup ( MU WHOLE INCR ) of 1.091. See ap pendix 6.A for cost details.

6.5.2 Mechanical Contractor Markups

The HVAC contractors, defined here as mechanical contractors, reported median cost data in an ACCA financial analysis of the HVAC industry. These data are shown in Table 6.5

. 2

.

Table 6.5

. 2 Baseline Markup , All Mechanical Contractors

Description Contractor Expenses or Revenue

Per Dollar

Sales Revenue
$ Per Dollar

Cost of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.73 1.00 Gross Margin: Labor, occupancy, operating expenses, and profit 0.27 0.37

Revenue: Baseline revenue earned per dollar cost of goods 1.37 Baseline Markup ( MU MECH CONT BASE ) 1.37 Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry.

Data reported in this analysis are not as detailed as that provided by the other sources, containing only cost of goods sold and gross margin. S ince the gross margin is the sum of labor, occupancy expenses, operating expenses, and profit, the gross margin allows for the determination of the baseline markup. The first data column in Table 6.5

. 2 provides the cost of goods sold and gross margin as expenses per dollar of sales revenue. The only important difference is that the direct cost of equipment sales in this table includes installation costs as well as the cost of goods sold. As shown in the table, the direct cost of sales represents about $0.73 per dollar sales revenue to the contractor and the gross margin is $0.27 per dollar sales revenue. The mechanical contractor expenditures per dollar s ales revenue in Table 6.5

. 2 are quite similar

to the wholesaler expenditures per dollar sales revenue reported in Table 6.5

. 1

.

DOE converted these expenses per dollar sales into revenue per dollar cost of goods sold by dividing each figure in the first data column by $0.73. For every $1.00 the mechanical

contractor spends on equipment costs, the mechanical contractor earns $1.00 in sales revenue to cover the equipment cost, and $0.37 to cover the other costs. This totals $1.37 in sales revenue earned for every $1.00 spent on equipment costs, for a baseline markup ( MU MECH CONT BASE ) of 1.376

- 11 for mechanical contractors, since the contractor earns $1.37 in sales revenue for every $1.00 spent to purchase the equipment. This is the beginning point for the determination of mechanical contractor markups.

6.5.2.1 Markups for Mechanic al Contractors in the Replacement and New

Construction Markets

The baseline markup derived above for mechanical contractors is the average value for all contractors including the replacement and new construction markets. This section describes

how DOE furt her derived the baseline and incremental markups for these two markets. As above, the ACCA financial data provided gross margin data, which allows for the determination of only the baseline markup for the two markets, since the gross margin is the sum of a ll contractor labor and operating expenses plus profit. Calculation of the incremental markup uses Census Bureau data, because this was not possible with the ACCA data as the variant costs are not provided separately.

Table 6.5

. 3 summarizes the gross margin and resulting baseline markup data for all mechanical contractors that serve the replacement and new construction markets

.

Table 6.5

. 3 Baseline Markup s for the Replacement and New Construction Markets, All

Mechanical Contractors

Description Contractor Expenses or Revenue by Market Type Replacement New Construction

Per Dollar

Sales Revenue
$ Per Dollar

Cost of Goods
$ Per Dollar

Sales Revenue
$ Per Dollar

Cost of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.70 1.00 0.75 1.00

Gross Margin: Labor, occupancy, operating expenses, and profit 0.30 0.43 0.25 0.33

Baseline Markup ( MU MECH CONT BASE ): Revenue per dollar cost of goods NA 1.43 NA 1.33

Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry.

Using the baseline markup data from Table 6.5.3 and results of a financial analysis , DOE calculated that the baseline markups for the replacement and new markets are 4.4 percent higher and 2.9 percent lower, respectively, than that for all mechanical contractors serving all markets

shown in Table 6.5.2

.

DOE then used the ACCA data to calculate the baseline markup of 1.32 specifically for the residential and light commercial building construction sectors only as shown in Table 6.5

. 4

.6

- 12 Table 6.5

. 4 Mechanical Contractor Expenses and Baseline Markup , Residential and
Light Commercial

Description Contractor Expenses or Revenue

Per Dollar

Sales Revenue
$ Per Dollar Cost of

Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.76 1.00 Gross Margin: Labor, occupancy, operating expenses, and profit 0.24 0.32 Baseline Markup ( MU MECH CONT BASE ): Revenue per dollar cost of goods 1.32 Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry.

The markup deviations derived above (i.e., 4.4 percent higher and 2.9 percent lower for the replacement and new construction markets, respectively ) derived for all mechanical contractors were then applied to the baseline markup of 1.32 for the more specific residential and light commercial building construction sector. This resulted in baseline markups of 1.38 and 1.28, respectively, for the replace ment and new construction markets served by mechanical contractors for the residential and light commercial building construction sectors

.

Calculation of the incremental markups for each market type required separation of the

invariant and variant costs. Since this was not possible using the ACCA data, DOE used more

detailed 200 7 Census Bureau data for all plumbing, heating, and air

- c onditioning contractors.

The Census Bureau data were used to calculate the baseline and incremental markups as shown

in Table 6.5

. 5

. (Appendix 6A.2 contains the full set of data.)

Table 6.5

. 5 Mechanical Contractor Expenses and Markups B ased on Census Bureau Data

Description Contractor E xpenses or Revenue

Per Dollar

Sales Revenue
$ Per Dollar

Cost of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.6 8 1.00 Labor Expenses: Salaries (indirect) and benefits 0.1 7 0.26 Occupancy Expense: Rent, maintenance, and utilities 0.02 0.03 Other Operating Expenses: Depreciation, advertising, and insurance. 0.0 4 0.0 6

Net Profit Before Taxes 0. 09 0.1 3 Baseline Markup ( MU MECH BASE ): Revenue per dollar cost of goods 1. 47 Incremental Markup ( MU MECH INCR ): Increased revenue per dollar increase cost of goods sold 1. 18

Source: U.S. Census Bureau

. 200 7. Plumbing, Heating, and Air

- Conditioning Contractors. Sector 23: 238220. Construction: Industry Series

, Preliminary Detailed Statistics for Establishments

, 2007.

Using the data in Table 6.5

. 5 , the incremental markup is 20 percent lower than the baseline markup. DOE assumed that this deviation applies equally to the baseline markups

calculated for the replacement ( 1.38 ) and new con struction markets ( 1.28 ) . This yields incremental markups of 1.104 and 1.024, respectively, for the replacement and new construction markets served by mechanical contractors.6

- 13 6.5.3 Estimation of General Contractor Markups

DOE derived markups for general contractors from U.S. Census Bureau data for the residential building construction sector. The residential construction sector includes establishments primarily engaged in construction work, including new construction work, additions, alterations, and repairs. The U.S. Census Bureau data for the construction sector include detailed statistics for establishments with payrolls, similar to the data reported by

HARDI for wholesaler s. The primary difference is that the U.S. Census Bureau reports itemized revenues and expenses for the construction industry as a whole in total dollars rather than in typical values for an average or representative business. Because of this, DOE assumed that the

total dollar values that the U.S. Census Bureau reported, once converted to a percentage basis, represented revenues and expenses for an average or typical contracting business. Similar to the

data for wholesaler s, Table 6.5

. 6 summarizes the expenses for general contractors as expenses per dollar sales revenue in the first data column ( A ppendix 6A .3 contains the full set of data)

.

Table 6.5

. 6 General Contractor Expenses and Markups

Description Wholesale Firm Expenses or Revenue

Per Dollar

Sales Revenue
$ Per Dollar

Cost of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.68 1.00 Labor Expenses: Salaries (indirect) and benefits 0.08 0.12 Occupancy Expense: Rent, maintenance, and utilities 0.01 0.01 Other Operating Expenses: Depreciation, advertising, and insurance. 0.03 0.05

Net Profit Before Taxes 0.20 0.30 Baseline Markup ( MU GEN CONT BASE ): Revenue per dollar cost of goods 1. 48 Incremental Markup ( MU GEN CONT INCR ): Increased revenue per dollar increase cost of goods sold 1. 35

Source: U.S. Census Bureau

. 200 7. Residential Building Construction. Sector 23: 236115

- 236118. Construction: Industry Series: Preliminary Detailed Statisti cs for Establishments: 2007

.

As shown in the first column , the direct cost of sales represents about $0.68 per dollar sales revenue to the general contractor. Labor expenses represent $0.08 per dollar sales revenue, occupancy expenses represent $0.01 per dollar sales revenue, other operating expenses represent $0.03, and profit makes up $0.20 per dollar sales revenue.

DOE converted these expenses per dollar sales into revenue per dollar cost of goods sold, by dividing each figure in the first data column b y $0.68. The data in column two show that, for every $1.00 the general contractor spends on equipment costs, the general contractor earns $1.00 in sales revenue to cover the equipment cost, $0.12 to cover labor costs, $0.01 to cover occupancy expenses, $0. 05 for other operating expenses, and $0.30 in profits. This totals to $1.48 in sales revenue earned for every $1.00 spent on equipment costs. Thus, the general contractor baseline markup ( MU GEN CONT BASE ) is 1.48.

DOE was also able to use the data in colum n two in the table above to estimate the incremental markups

, after classifying the costs as either invariant or variant . At one extreme, if all of the other costs scale with the equipment price (i.e., all costs are variant ), the increase in general contra ctor price will be $1.48, implying that the incremental markup is 1. 48, or the same6

- 14 as the baseline markup. At the other extreme, if none of the other costs are variant , then a $1.00 increase in the equipment price will lead to a $1.00 increase in the gene ral contractor price, for an incremental markup of 1.0. DOE believed the labor and occupancy costs to be invariant and the other operating costs and profit to scale with the equipment price (i.e., be variant ). In this case, for a $1.00 increase in the equi pment price, the general contractor price will increase by $1.35, giving a general contractor incremental markup ( MU GEN CONT INCR ) of 1. 35.

6.6 DERIVATION OF REGIONAL MARKUPS

6.6.1 Regions Being Analyzed

For furnaces

, DOE is analyzing r e g i onal stand ar ds for north ern a n d south ern States . The

n orthern r e g i on re p r esen t s t hose s t a t es w it h ave ra g e H D D g r eat e r or eq u a l to 5,000 and the

southern re g i on represents those states with a ver a g e HDD less than 5,000. To carry out the life

cycle cost calculation for different reg ions

, wholesalers , mechanical

, and general contractors in the

furnace indust r y are therefore divided into north and south sub g roups. A list of the states in each region is provided in A ppendix 6A. Furthermore, regional baseline and incremental markups are derived using the region/state level data from the 2010 HARDI Profit Report and

the 2007 Economic Census.

For CAC s and HP s , DOE is analyzing r e g i onal stand ar ds for Hot

- Humid, Hot

- Dry

, and Rest of Country regions. The states are grouped such that the popu lations of the two hot regions generally average fewer than 5

, 000 heating degree

- days (HDD) . T he Hot

- Humid region has high relative humidity while the Hot

- Dry region (California, Nevada, Arizona, and New Mexico) does not. The Rest of Country is the same as the n orthern region in the furnace analysis and includes those states that average 5

, 000 annual heating degree

- day s or more.

6.6.1.1 Estimation of Regional Wholesaler Markup

Based on the regional income statement from the 2010 HARDI Profit Report, DOE estimated baseline and incremental markups for the seven HARDI regions (Northeastern, Mid

Atlantic, Southwestern, Great Lakes, Central, Southwestern, and Western) with the methodology

shown in Table 6.5

. 1 . Next, each state in each region was assigned the HARDI regional baseline and incremental markups for the region to which it belong s . Third, population

- weighted baseline and incremental averages were calculated for the n orth ern and s outh ern regions as a whole

. R esults are summarized in Table 6.6

. 1

.6

- 15 Table 6.6

. 1 Regional Wholesaler Markups for Furnaces Markup Rate Detailed Relative Rate

North

Baseline 1.369 1.004

Incremental 1.081 1.004

South

Baseline 1.361 0.998

Incremental 1.102 0.998

In the CAC and HP analysis, each state was assigned to one of the seven HARDI regions. The assignments for the northern states were identical to the furnace analysis. The southern states were assigned to the HARDI regions corresponding either to Hot

- Humid or Hot

- Dry. A relative markup factor was estimated for the HARDI regions and population

- weighted average relative markup factors for the each of the three climate regions used in the analysis. These climate zone average relative markup factors were assigned to each state in each climate region and applied to individual households when they were sampled for the analysis

. The average relative markup factors and resulting regional markup rates are shown in Table 6.6

. 2

.

Table 6.6

. 2 Regional Wholesaler Markups for CAC s and HP s Markup Rate Detailed Relative Rate

Hot

- Humid

Baseline 1.343 0.986

Incremental 1.076 0.986

Hot

- Dry

Baseline 1.402 1.029

Incremental 1.123 1.029 Rest of Country (North)

Baseline 1.36 7 1.004

Incremental 1. 095 1.004

6.6.1.2 Estimation of Regional Mechanical Contractor Markup

The 2007 Economic Census prov ides Geographic Area Series for the Plumbing and

HVAC Contractors (NAICS 23822) sec tor , which contains state

- level sale and cost data including value of construction, cost of subcontract work, cost of materials, and payroll for construction workers. By usi ng the equation mentioned in Section 6.4.3 , DOE was able to

estimate baseline markups for each state. Since the Census does not provide more disaggregated

cost data , DOE was not able to differentiate between invariant and variant cost

.

As an alternative , DOE calculated a statewide relative baseline markup

, which equals the quotient of each state’s baseline markup and national average markup

. The relative values are multiplied times the mean markups for all four categories of mechanical contractor markup: both baseline and incremental markups for both new construction and replacements. The advantage of6

- 16 taking this approach is that DOE is able to estimate regional mar kups for both distribution channels by using ACCA financial data supplemented with the U.S. Census data. For example,

as shown in Table 6A. 4 .1, the relative mechanical contractor markup value for California is 1.043, which would be multiplied times the mean markup factor of 1.28 for new construction, yielding a mechanical contractor baseline markup of 1.335. If instead the incremental markup on a replacement unit was neede d , the 1.043 relative markup value would be multiplie d times the mean incremental markup factor for replacements of 1.104, yielding a mechanical contractor markup value of 1.151. Lastly, DOE divided all states into north ern and south ern regio n s and then population

- weighted baseline and incremental average markups were calculated for both regions , as shown in Table 6.6

. 3

.

Table 6.6

. 3 Population

- Weighted Regional Mechanical Contractor Markups for Furnaces
North Region South Region Replacement

Baseline 1.384 1.376

Incremental 1.107 1.101

New Construction

Baseline 1.284 1.276

Incremental 1.027 1.021

In the CAC and HP analysis, as was done in the furnace analysis, a relative mechanical contractor markup value was calculated for each state. The baseline and incremental markups

for individual household observation s depended on the state to which the hou sehold was assigned in the sampling process. However, DOE calculated the population

- weighted baseline and incremental average markups for each region. These values are shown in Table 6.6

. 4

.

Table 6.6

. 4 Population

- Weighted Regional Mechanical Contractor Markups for CAC s and

HP s

Hot

- Humid Hot

- Dry Rest of Country (North) Replacement

Baseline 1.354 1.429 1.384

Incremental 1.084 1.144 1.107

New Construction

Baseline 1.256 1.326 1.284

Incremental 1.005 1.061 1.027

6.6.1.3 Estimation of Regional General Contractor Markup

In order to derive regional general contractor markups for the residential building construction sector from the 2007 Economic Census, DOE combined four Geographic Area Series: (1) New Single

- Family General Contractors (NAICS 236115), (2) New M ultifamily

H

ousing C onstruction (NAICS 236116) , (3) New H ousing O perative B uilders (NAICS 236117),6

- 17 and (4) Residential R emodelers (NAICS 236118) . Each series consist s of statewide cost data required to calculate baseline markups for each state as illustrated in Section 6.4.3 . Although there is only a new construction (no replacement) channel for general contractors, the same technique shown for mechanical contractors can still be employed to estimate regional baseline and incremental markups. First, a state wide re lative markup can be derived by dividing each state’s baseline markup with the national average markup. Then, the relative markup can be applied to both baseline and incremental markups ; they are multiplied by different mean values (1.48 for baseline and 1.35 for incremental). The final results are summarized in Table 6.6

. 5

below.

Table 6.6

. 5 Regional General Contractor Markups for Fu r naces North Region South Region Baseline Markup 1.482 1.582 Incremental Markup 1.352 1.443

As with furnaces, for the CAC and CHP markets, there is only a new construction (no replacement) channel for general contractors . T he same technique shown for mechanical contractors can still be employed to estimate regional baseline and incremental markups. First, a

state wide relative markup can be derived by dividing each state’s baseline markup wi th the national average markup. Then, the relative markup can be applied to both baseline and incremental markups ; they are multiplied by different mean values (1.48 for baseline and 1.3 5 for incremental). The final weighted average results are summarized in Table 6.6

. 6 below.

Table 6.6

. 6 Regional General Contractor Markups for CAC s and HP s

Hot

- Humid Hot

- Dry Rest of Country (North) Baseline Markup 1.498 1.779 1.481 Incremental Markup 1.364 1.619 1.351

6.7 MARKUP FOR MOBILE HO ME GAS FURNACES

Based on the shipment forecast for the year 2016 (see Chapter 9), 50% of the mobile home gas furnaces go to new construction, and the other 50% go to replacement s

. In a comment to DOE, (10) the Manufactured Housing Institute (MHI) indicated that the total markup of the mobile home manufacturer and the mobile home retailer has traditionally been a factor of 2.22 in

the new construction channel

. Thus, DOE applied this number to the estimated M SP of a mobile home gas furnace for both the baseline and for incremental costs. As for those units purchased

for replacement , DOE used the same baseline and incremental markups estimated for non

weatherized gas furnaces , which are 2.65 and 1.70 respective ly

.6

- 18 6.8 SALES TAX

The sales tax represents state and local sales taxes that are applied to the consumer price of the equipment. The sales tax is a multiplicative factor that increases t he consumer equipment price.

DOE derived state and local taxes from data provided by the Sales Tax Clearinghouse. (11)
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 6.8

. 1 below. Detailed sales tax data by each state can be found in A ppendix 6A .5

.

Table 6.8

. 1 Average Sales Tax Rates by Census Division and Large State

Census Division/State Tax Rate (2010)

New England 5.55 %

Mid Atlantic 6.62%

East North Central 6.94%

West North Central 6.86%

South Atlantic 6. 44 %

East South Central 7.90%

West South Central 8.42%

Mountain 6. 50 %

Pacific 5.21 %

New York 8.45%

California 9.15%

Texas 8.05%

Florida 6.70%

6.9 OVERALL MARKUPS

The overall markup for each distribution channel is the product of the appropriate markups, as well as sales tax in the case of replacement applications ( Table 6.9

. 1 )

.

DOE used the overall baseline markup to estimate the consumer product price of baseline models, given the manufacturer cost of the baseline models. As stated above, DOE considers

baselin e models to be product sold under existing market conditions (i.e., without new energy conservation standards). The following equation shows how DOE used the overall baseline markup to determine the product price for baseline models.6

- 19 

## ( **)**

BASE OVERALL MFG SALES BASE MFG MFG BASE MU COST Tax MU MU COST CPP

_ **× =**  **× ×**  **× =** 

Where:

CPP BASE = Consumer product price for baseline models,

COST MFG = Manufacturer cost for baseline models,

MU MFG = Manufacturer markup,

MU BASE = Baseline replacement or new home channel markup

, Tax SALES = Sales tax (replacement application s only), and

MU OVERALL_BASE = Baseline overall markup.

Similarly, DOE used the overall incremental markup to estimate changes in the consumer product price, given changes in the manufacturer cost from the baseline model cost resulting from an energy con servation standard to raise product energy efficiency. The total consumer product price for more energy

- efficient models is composed of two components: the consumer product price of the baseline model and the change in consumer product price associated wit h the increase in manufacturer cost to meet the new energy conservation standard. The following equation shows how DOE used the overall incremental markup to determine the consumer product price for more energy

- efficient models (i.e., models meeting new en ergy conservation standards).



## ( **)**

INCR OVERALL MFG BASE SALES INCR MFG MFG BASE OVERALL MFG STD

MU COST CPP Tax MU MU COST MU COST CPP

_ _

**× ∆**  **+ =**  **× ×**  **× ∆**  **+ ×**  **=**

Where:

CPP STD = Consumer product price for models meeting new energy conservation standards,

CPP BASE = Consumer product price for baseline models,

COST MFG = Manufacturer cost for baseline models,

Δ COST MFG = Change in manufacturer cost for higher energy efficient models,

MU MFG = Manufacturer markup,

MU INCR = Incremental replacement or new home channel markup

, Tax SALES = Sales tax (replacement applications only),

MU OVERALL_BASE = Baseline overall markup (product of manufacturer markup, baseline replacement or new home channel markup, and sales tax),

and

MU OVERALL_INCR = Incremental overall markup.

National average baseline and incremental markups for each market participant are

summarized in Table 6.9

. 1 . Based on the ratio of housing starts and gas furnace shipment6

- 20 forecast s for the year 2016 (see Chapter 9), DOE estimated that 2 5 percent of gas furnaces

, 50 percent of mobile home gas furnaces

, and 10 percent of oil

- fired furnaces go to new
construction. On the other hand, 75 percent of gas furnaces, 50 percent of mobile home ga s furnaces

, and 90 percent of oil

- fired furnaces go to the replacement market

. By weighing the markups by market share s of different types of furnaces, final total markups for each type of

furnace are listed in Table 6.9.2

Table 6.9

. 1 Summary of National Average Markups on CAC s, HP s, and Residential

Furnaces and Boilers

Baseline Markup Incremental Markup

Manufacturer 1.26 1.26

Wholesaler 1.36 2 1.091

Mechanical Contractor

(new construction /replacement) 1.280/1.380 1.024/1.104

General Contractor

(new construction only) 1.48 1.35

Sales tax (replacements only) 1.07 0 1.07 0

Table 6.9

. 2 Summary of Markups on Different Types of Residential Furnaces and

Boilers

Total markup (on manufacturing cost) Baseline Markup Incremental Markup

Non

- weatherized gas furnace 2.94 1.83

Oil

- fired furnace

2.83 1.77 Hot

- water gas boiler

Hot

- water oil

- fired boiler

Mobile home gas furnace 2.77 2.296

- 21 REFERENCES

1. Heating, Air Conditioning & Refrigeration Distributors International 2010 Profit Report.

2. 2005 Financial Analysis for the HVACR Contracting Industry. s.l. : Air Conditioning

Contractor of America.

3. U.S. Census Bureau, Data set for Sector 23, EC0723A1, Construction: Geographic Area Series, Detailed Statistics for Establishments. 2007.

4. U.S. Census Bureau, 2007, Data set for Sector 23: EC0723I1, Construction: Industry Series, Preliminary Detailed Statistics for Establishments: 2007.

5. U.S. Census Bureau, 2007, Manufacturing Industry Series: Detailed Statistics for the United

States: 200 7. Air

- Conditioning and Warm Air Heating Equipment and Commercial and Industrial Refrigeration Equipment Mnufacturing. Data set for Sector 31: EC073111 .

6. U.S. Census Bureau, 2007, Wholesale Trade: Industry Series: Preliminary Summary Statistics for the United States: 2007. HVAC Equipment Merchant Wholesaler. Data set for Sector 42:

EC0742111.

7. U.S. Census Bureau. 2007. Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007. New Single

- Family General Contractors, New M ultifamily Housing Construction (Except Operative Builders), New Housing Operative Builders Resi.

8. U.S. Census Bureau. 2007. Plumbing, Heating, and Air

- Conditioning Contractors. Sector 23: 238220. Construction: Industry Series, Preliminary Detailed Stat istics for Establishments, 2007.

9. Pindyck, R. and Rubinfeld, D. Microecono mics. s.l. : Prentice Hall, 2000.

10. Manufactured Housing Institute, Comment #13, personal communication. Docket # EE

RM/STD

- 01

- 350. August/13/2001.

11. The Sales Tax Clearinghou se. [Online] https://thestc.com/STRates.stm.