CHAPTER 6

. MARKUPS FOR PRODUCT PRICE DETERMINATION

TABLE OF CONTENTS

6.1 INTRODUCTION

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

- 1

6.1.1 Distribution Channels

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

- 1

6.1.2 Markup Calculation Procedure

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

- 1

6.2 MANUFACTURER MARKUP

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

- 2

6.3 RETAILER MARKUP

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

- 3

6.3.1 Approach for Retailer Markups

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

- 3

6.3.1.1 Baseline Retailer Markup

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

- 3

6.3.1.2 Incremental R etailer Markup

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

- 4

6.4 SALES TAXES

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

- 7

6.5 SUMMARY OF MARKUPS

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

- 8

LIST OF TABLES

Table 6.2

- 1 Manufacturer Markups by Product Class

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

- 2

Ta ble 6.3

- 1 Data for Baseline Markup Calculation: Electronics and Appliance Stores (2007)

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

- 4

Table 6.3

- 2 Data for Incremental Markup Calculation: Electronics and Appliance Stores (2007)

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

- 5

Table 6.3

- 3 Electronics and Appliance Stores, Concentration by Four Large Firms

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

- 7

Table 6.4

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

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

- 7

Table 6.5

- 1 Summary of Markups for Cooled Cabinets

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

- 8

Table 6.5

- 2 Summary of Markups for Non

- Compressor Refrigerators

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

- 8

Table 6.5

- 3 Summary of Markups for Ice Makers

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

- 8

Table 6.5

- 4 Summary of Markups for Hybrid Products

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

- 9

6

- iCHAPTER 6. MARKUPS FOR PRODUCT PRICE DETERMINATION

6.1 INTRODUCTION

To carry out its analyses, the U.S. Department of Energy ( DOE ) needed to determi ne the

cost to the consumer of baseline product s and the cost of more

- efficient units . As discussed in chapter 8, DOE developed retail prices for baseline products mainly using online survey data

. For products with higher

- than

- baseline efficiency, DOE estimated the consumer prices b y applying appropriate markup s to the incremental manufacturing costs estimated in the engineering analys is.

6.1.1 Distribution Channels

The appropriate markups for determining consumer equipment price s depend on the type of distribution channels through which products move from manufac turers 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.

D ata from the Association of Home Appliance Manufacturers (AHAM) 1 indica te that an overwhelming majority of residential appliances are sold through retail outlets. Because DOE is not aware of any other distribution channel that plays a significant role for refrigeration products

, DOE assumed that all of the miscellaneous refri geration products are purchased by consumers from retail outlets.

6.1.2 Markup Calculation Procedure

As just discussed, at each point in the distribution channel, companies mark up the price of the equipment to cover their business costs and profit margin. In financial statements, gross margin (GM) is the difference between the company revenue and the company cost of sales or cost of goods sold ( CGS ). T he GM includes the expenses of companies in the distribution

channel

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

— and company profits

. T o cover costs and to contribute positively to company cash flow, the price of product s must include

a mark up. The markup commanded by a particular product depend s on company expenses associated with the prod u ct and the degree of market competition. In develo ping markups for

manufacturers and retailers , DOE obtained data about the revenue, CGS , and expenses of firms that produce and sell the products of interest.

6-16.2 MANUFACTURER MARKUP

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

manufacturer selling price (MSP)

. DOE used CGS and GM to calculate the manufacturer markup ( MU MFG ) with the following equati on:

MFG MFG MFG

MFG CGS GM CGS MU +

=

where:

MU MFG = m anufacturer markup,

CGS MFG = m anufacturer’s cost of goods sold or m anufacturer p roduction c ost ( MPC ),

and

GM MFG = m anufacturer’s gross margin.

DOE developed the average manufacturer markup for each product class by examining the annual U.S. Security and Exchange Commission (SEC) 10

- K reports from publicly owned manufacturing companies primarily engaged in producing miscellaneous refrigeration products

. Because these companies are typically diversified, producing a range of different appliances, DOE assumed that an industry average markup was representative for the

manufacture r s of miscellaneous refrigeration products. Table 6.2

- 1 presents manufacturer markups for all product classes considered in this analysis.

Table 6.2

- 1 Manufacturer Markups by Product Class

Product class Product description Baseline Markup

Cooled cabinets

CC

- 1 Vapor compression cooled cabinet 1.26

CC

- 2 Thermoelectric cooled cabinet 1.22 Cooled cabinet average (weighted by market share) 1.23

Non

- Compressor Refrigerators

NCR

- 1 Thermoelectric refrigerator 1.22

NCR

- 2 Absorption refrigerator

I

ce makers

IM

- P Portable ice maker 1.23

IM

- C Non

- portable ice maker , c ooled

- storage

IM

- U Non

- portable ice maker

, u ncooled

- storage Hybrid products

H

- 3A

- BI Standard

- size, built

- in hybrid all

- refrigerators with automatic

defrost 1.26

H

- 9I

- BI Standard

- size, built

- in upright hybrid freezers with automatic

ice maker

H

- 11A Compact hybrid all

- refrigerators with manual defrost

H

- 13A Compact hybrid all

- refrigerators with automatic defrost

6-26.3 RETAILER MARKUP

6.3.1 Approach for Retailer Markups

DOE based the retailer markups for miscellaneous refrigeration products on financial

data for electronics and appliance stores from the 200 7 U.S. Census Annual Retail Trade Survey ( ARTS ), which is the most recent survey available with detailed operating expenses for this particular sector

. 2 DOE organized the financial data into s tatements that break down cost components incurred by firms in this category

. DOE assumes that the income statements faithfully represent the various average costs incurred by firms selling home appliances. Although electronics and appliance stores handle multiple commodity lines, the data provide the most accurate available indication of expenses for selling home appliances.

The 2007 ARTS data provided for electronics and appliance stores contain total sales and

de tailed operating expenses. In order to construct a complete data set to estimate markups, DOE

needed to estimate CGS and GM

. The most recent 2011 ARTS publishes a separate historical

sales and GM of Household Appliance Stores from 1993 to 2011

. DOE then to ok the GM as percent of sale reported for 2007 and combined this with 2007 ARTS data to construct a complete income statement for electronics and appliance stores to estimate both baseline and incremental markups.

6.3.1.1 Baseline Retailer Markup a

The baseline m arkup relates the manufacturer sales price of baseline products to the retailer sales price. DOE considers baseline models to be equipment sold under existing market conditions ( i.e., without new energy efficiency standards). DOE calculated the baseline ma rkup ( MU BASE ) for retailers as an average markup using the following equation:

RTL RTL RTL

BASE CGS GM CGS MU +

=

where:

MU BASE = b aseline retailer markup,

CGS RTL = r etailer’s cost of goods sold,

GM RTL = r etailer’s gross margin,

Table 6.3

- 1 shows the calculation of the baseline retailer markup.

a As described in section 6.1, the baseline retail markup was not used in the analysis for refrigeration products. DOE presents the derivation of this markup so it can be contrasted with the incremental retail markup.

6-3Table 6.3

- 1 Data for Baseline Markup Calculation: Electr onics and Appliance Stores (2007 )

Kind of business item Amount ($1,000 ,000 )

Sales $ 110.673 Cost of Goods Sold (CGS) $ 81.234 Gross Margin (GM) $ 29.439
Baseline Markup = (CGS+GM)/CGS 1. 36

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

6.3.1.2 Incremental Retailer Markup

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

- efficiency models to the chang e in the retailer sales price. DOE considers higher

efficiency models to be equipment sold und er market conditions with new efficiency standards. The incremental markup reflects a situation in which the retailer faces an increase in CGS for a particular product due to new or amended standards.

Unfortunately, DOE was able to find limited empirical evidence regarding appliance retailer markup practices associated with increases in a product’s cost (due to increased efficiency or other factors). DOE understands that real

- world markup practices will vary depending on the market conditions faced by ret ailers

, on the magnitude of the change in CGS associated with an efficiency increase

, and on any associated changes in retail costs. Pricing in

retail stores may also involve rules of thumb that are difficult to know and to incorporate into DOE’s analysis.

Given the uncertainty about actual markup practices in appliance retailing, DOE uses an approach that reflects the following k ey concepts:

1. Changes in the efficiency of the goods sold are not expected to increase economic profits. Thus, DOE calculates m arkups/gross margins to allow cost recovery for retail companies

i n the distribution chain (including changes in the cost of capital) without changes in company profits.

2. E fficiency improvements impact some distribution costs but not others . DOE sets markups and retail prices to cover only the distribution costs that are expected to change with efficiency and does not adjust them for distribution costs that are not expected to change with efficiency.

The incremental markup approach is described in m ore detail in Dale et al. (2004). 3

T o estimate incremental retailer markups

, DOE divides retailers’ operating expenses into two categories: (1) t hose that do not change when CGS increases due to amended efficiency standards (“fixed”), and (2) t hose that i ncrease proportionately with CGS (“variable”). DOE

6-4define s labor and occupancy expenses as fixed costs

, because these costs are not likely to increase as a result of a rise in CGS due to amended efficiency standards. All other expenses, as

well as the net profit, are assumed to vary in proportion to CGS. Although it is possible that some of the other expenses may not scale with CGS, DOE is inclined to take a more conservative position and include these as variable costs. (Note: Under DOE’s approach, a high fixed cost component yields a low incremental markup.)

DOE calculated the incremental markup ( MU INCR ) for retailers using the following equation:

RTL RTL RTL

INCR CGS VC CGS MU +

=

where:

MU INCR = i ncremental retailer markup,

CGS RTL = r etailer’s cost of goods sold, and

VC RTL = r etailer’s variable costs.

Table 6.3

- 2 shows the breakdown of operating expenses using the 2007 ARTS data. T he incremental markup is calculated as 1.1 1

.

Table 6.3

- 2 Data for Incremental Markup Calculation: Electronics and Appliance Stores (200 7 )

Amount ($1,000,000)

Sales $110,673
Cost of Goods Sold (CGS) $81,234

Gross Margin (GM) $29,439

Labor & Occupancy Expenses (“Fixed”)
Annual payroll $11,714
employer costs for fringe benefit $1,829
Contract labor costs including temporary help $154

Purchased utilities, total $623
Cost of purchased repair and maintenance services $369

Cost of purchased professional and technical services $1,164

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

Subtotal: $20,444

Other Operating Expenses & Profit (“Variable”)
Expensed equipment $114
Cost of purchased packaging and containers $68
Other materials and supplies not for resale $502
Cost of purchased transportation, shipping and warehousing services $606
Cost of purchased advertising and promotional services $2,625

6-5Cost of purchased software $159 Cost of data processing and other purchased computer services, except communications + Commissions paid $368
Depreciation and amortization charges $1,525
Other operating expenses $2,070
Net profit before tax (Operating profit) $958

Subtotal: $8,995

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

Source: U.S. Census, 200 7 Annual Retail Trade Survey (Sales)

, and 2011 Annual Retail Trade Survey (GM and CGS)

By dividing expenses into fixed and variable components, the incremental markup approach envisions that retailers cover costs without changing profits. Although retailers may be able to reap higher profits for a time, DOE’s approach assumes that competition i n the appliance retail market, combined with relatively inelastic demand ( i.e., the demand is not expected to decrease significantly with a relatively small increase in price ), will tend to pressure retail margins back down.

To measure the degree of com petition in appliance retailing, DOE estimated the four firm concentration ratio (FFCR) of major appliance sales in three retail channels: Electronics and Appliance Stores, Building and Material and Supplies Dealers, and General Merchandise Stores.

The FFC R represents the market share of the four largest firms in the relevant sector

. G enerally,

an FFCR of less than 40% indicates that the sector is not concentrated and an FFCR of more than

70% indicates that a sector is highly concentrated. b

, c

The FFCR of sub

- sector appliance sales within each channel is equal to the sector FFCR times the percent of total sales within each channel accounted for by major appliances. As shown

in Table 6.3

- 3 , t he results indi cate that appliance sales in Electronics and Appliance Stores, Household Appliance Stores, Building Material Supplies Dealers

, and General Merchandise

Stores have a FFCR well under the 40% threshold. Moreover, the Electronics and Appliance Stores sector includes “Household Appliance Stores” as a subsector. Because there are many stores in this subsector, it has a FFCR of only 21.3 %.

b University of Maryland University College http://info.umuc.edu/mba/public/AMBA607/IndustryStructure.html

c Horizontal Merger Guidelines by U.S. Department of Justice and Federal Trade Commission

http://www.justice.gov/a tr/hmerger/11247.pdf

6-6Table 6.3

- 3 Electronics and Appliance Stores, Concentration by Four Large Firms

Sector Four Firm

Concentration Ratio (Percent of Sector Sales) Percent of Sales Accounted for by Major Appliance s Four Firm

Concentration Ratio

(Percent of Major Appliance Sales)

Electronics and Appliance

Stores 46.3 42.1 19.5

Household Appliance

Stores subsector 21.3 37.1 7.9

Building Material and Supplies Dealers 45.9 17.0 7.8

General Merchandise

Stores 73.2 31.6 23. 1

Source: U.S. Economic Census, Establishment and Firm Size: (Including Legal Form of Organization), 2007

. *Note: The assumption used here is that major appliance sales are uniformly distributed within all firms in each sector.

6.4 SALES TAXES

The sales tax re presents state and local sales taxes that are applied to the consumer

equ ipment price. The sales tax is a multiplicative factor that increase s the consumer equipment price. DOE derived state and local taxes from data provided by the Sales Tax Clearinghouse

. 4
DOE derived population

- weighted average tax values for each Census division and la rge state, as
shown in Table 6.4

- 1

.

Table 6.4

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

Census

Division/State Population Tax Rate (2013)

% New England 14,492,360 5.64

Middle Atlantic 21,564,041 6.62

East North Central 46,519,084 6.84

West North Central 20,639,751 7.02

South Atlantic 41,167,090 6.44

East South Central 18,553,961 8.01

West South Central 11,304,323 8.67

Mountain 22,373,411 6.46

Pacific 12,799,425 5.30

New York 19,465,197 8.40

California 37,691,912 8.45

Texas 25,674,681 7.95

Florida 19,057,542 6.65
Population weighted av erage 7.146

6-76.5 SUMMARY OF MARKUPS

Table 6.5

- 1 to Table 6.5

- 4 summarize the national average markups at each stage in the

distribution channel and th e average sales tax for each product class

.

Table 6.5

- 1 Summary of Markups for Cooled Cabinets

Markup Baseline Markup Incremental Markup

Manufacturer Vapor compression cooled cabinet (CC

- 1) 1.26

Thermoelectric cooled cabinet (CC

- 2) 1.22

Retailer 1. 36 1.1 1

Sales Tax 1.0 7 1

Table 6.5

- 2 Summary of Markups for Non

- Compressor Refrigerators

Markup Baseline Markup Incremental Markup

Manufacturer Thermoelectric refrigerator (NCR

- 1) 1.22

Absorption refrigerator (NCR

- 2) 1.22

Retailer 1.36 1.11

Sales Tax 1.071

Table 6.5

- 3 Summary of Markups for Ice Makers

Markup Baseline Markup Incremental Markup

Manufacturer Portable ice maker (IM

- P) 1.23

Non

- portable ice maker , c ooled

- storage (IM

- C) 1.23

Non

- portable ice maker , u ncooled

- storage (IM

- U) 1.23

Retailer 1.36 1.11

Sales Tax 1.071

6-8Table 6.5

- 4 Summary of Markups for Hybrid Products

Markup Baseline Markup Incremental Markup

Manufacturer Standard

- size d , built

- in hybrid all

refrigerators with automatic defrost (H

- 3A

BI) 1.26

Standard

- size d , built

- in upright hybrid

freezers with automatic ice maker (H

- 9I

- BI) 1.26

Compact hybrid all

- refrigerators with

manual defrost (H

- 11A) 1.26

Compact hybrid all

- refrigerators with

automatic defrost (H

- 13A) 1.26

Retailer 1.36 1.11

Sales Tax 1.071

6-9REFERENCES

1 Association of Home Appliance Manufacturers. AHAM 2003 Fact Book

, 2003. Washington,

DC. p. 25.

2 U.S. Census Bureau. 2007 Annual Retail Trade Survey

, Electronics and Appliance Stores

, 200 7

. Washington, DC. < http://www.census.gov/retail/arts/historic_releases.html >

3 Dale, Larry et al., “An Analysis of Price Determination and Markups in the Air

- Conditioning and Heating Equipment Industr y”, LBNL

- 52791, January 2004.

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

county rates . Last access in July 2013 < http://thestc.com/STrates.stm >

6-10