CHAPTER 5. MARKUPS FOR PRODUCT PRICE DETERMINATION

TABLE OF CONTENTS

5.1 INTRODUCTION ........................................................................................................... 5-1

5.1.1 Distribution Channels .......................................................................................... 5-2

5.2 MARKUP CALCULATION METHODOLOGY ........................................................... 5-3

5.3 APPROACH FOR CALCULATING OVERALL MARKUP ........................................ 5-4

5.3.1 Baseline Markup .................................................................................................. 5-4

5.3.2 Incremental Markups ........................................................................................... 5-5
5.4 APPROACH FOR CALUCLATING MANUFACTURER MARKUP .......................... 5-6

5.5 APPROACH FOR CALCULATING WHOLESALER AND CONTRACTOR
MARKUPS ...................................................................................................................... 5-6

5.5.1 Key Data and Assumptions of the Markups Methodology .................................. 5-7

5.5.2 Approach for Wholesaler Markup ....................................................................... 5-8

5.5.3 Approach for Mechanical and General Contractor Markup ................................ 5-9

5.6 DERIVATION OF MARKUP S .................................................................................... 5-10

5.6.1 Manufacturer Markups....................................................................................... 5-10

5.6.2 Wholesaler Markups .......................................................................................... 5-10

5.6.3 Mechanical Contractor Markups........................................................................ 5-12

5.6.3.1 Aggregate Baseline Markups for Mechanical Contractors ...................... 5-12

5.6.3.2 Baseline Markups for Mechanical Contractors in the Replacement
and New Construction Markets ................................................................ 5-13

5.6.3.3 Baseline Markups for Small and Large Mechanical Contractors ............. 5-13

5.6.3.4 Baseline Markups by Disaggregated Mechanical Contractor Type ......... 5-14

5.6.3.5 Incremental Markups by Mechanical Contractor Type ............................ 5-15

5.6.4 Estimation of General Contractor Markups ....................................................... 5-16

5.7 SALES TAX .................................................................................................................. 5-18

5.8 OVERALL MARKUPS

................................ ................................ ................................. 5-18
REFERENCES .......................................................................................................................... 5-20

LIST OF TABLES

T able 5.1.1 Shares of Market by Distribution Channel .................................................... 5-3

Ta ble 5.6.1 Wholesaler Expenses and Markups ............................................................. 5-11
Table 5.6.2 Baseline Markup, All Mechanical Contractors ............................................ 5-12
Table 5.6.3 Baseline Markups for the Replacement and New Construction Markets, All Mechanical Contractors .......................................................... 5-13
Table 5.6.4 Baseline Markups for Small and Large Mechanical Contractors ................ 5-14
Table 5.6.5 Baseline Markups by Mechanical Contractor Type ..................................... 5-15
Table 5.6.6 Mechanical Contractor Disaggregated Expenses and Markups Based

on 2007 U.S. Census Bureau Data ............................................................... 5-15
Table 5.6.7 Incremental Markups by Mechanical Contractor Type ............................... 5-16

5-iTable 5.6.8 General Contractor Expenses and Markups ................................................. 5-17
Table 5.7.1 Average Sales Tax Rates by Census Division and Large State ................... 5-18
Table 5.8.1 Summary of Overall Markups (3-phase, air cooled, air conditioning and heat pumps <65,000 Btu/h and water source heat pumps) ................... 5-19

LIST OF FIGURES

Figure 5.1.1 Distribution Channels for New Construction Applications ........................... 5-2 Figure 5.1.2 Distribution Channels for Replacement Applications ................................... 5-3

5- iiCH APTER 5. MARKUPS FOR PRODUCT PRICE DETERMINATION

5.1 INTRODUCTION

To carry out the life- cycle cost (LCC) calculations described in Chapter 6 , DOE needed
to determine the cost to the commercial consumer of baseline air

- cooled, air -conditioners and heat pumps, and water source heat pumps, along with the cost of the more- efficient unit s the consumer would purchase under potential standards. Howe ver, the commercial consumer price of such units is not generally known. By applying a multiplier called a “markup” to the known manufacturer’s price, DOE was able to estimate the commercial consumer ’s price. DOE based the markups for small commercial air

- cooled air -conditioning and heating equipment and watersource heat pumps on the analysis conducted for commercial unitary air conditioners and heat

pumps (CUAC/CUHP)

. This chapter describes how DOE derived those markups and the
modifications made for toda y's NOPR.

The equipment price to the commercial consumer depends on how the consumer purchases the equipment. DOE defines two primary types of distribution channels to describe
how air -conditioners and heat pumps generally pass from the manufacturer to the consumer : (1) in the first 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 turn
sells it to the consumer; (2) in the second distribution channel, the manufacturer sells the equipment directly to the consumer through a national account. DOE has further subdivided the first distribution channel by mechanical contractor size (as measured in annual revenues).

DO E did not use the national accounts distribution channel in this rulemaking. National accounts are used by large commercial consumers of HVAC equipment, such as national retail chains. Due to the large volume of equipment purchased, the large commercial co nsumer s can buy directly from the manufacturer at lower prices than would be obtained in the typical distribution chain. Small, air -cooled, 3- phase air -conditioning and heat pump equipment less than 65,000 Btu/h and water source heat pumps with cooling capacities less than 135,000 Btu/h do not fit the profile of equipment which would be used by a large, national chain. Therefore,
DOE assumed all equipment uses a small or large mechanical contractor distribution channel to determine the markups in this rulemaking.

For wholesalers and contractors, DOE estimated a baseline markup and an incremental markup. DOE defines a baseline markup as a multiplier that converts the manufacturing selling price of equipment with baseline efficiency to the consumer purchase p rice for the equipment at the same baseline efficiency 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 e quipment. Because companies mark up the price to cover business cost and profit margin at each step in the distribution channel, both baseline and incremental markups are dependent on the particular distribution channel, as described in s ection

5.1.1

.

5-15.1.1 Distribution Channels

The appropriate markups for determining consumer equipment prices depend on the type of distribution channels through which products move from manufacturers to purchasers. At each point in the distribution channel, companies mark up the price of the equipment to cover their business costs and profit margin. In this analysis, DOE considered a primary distribution
channel involving distributors and contractors. Within this primary channel, DOE distinguishes between new and replacement applications, as only new construction applications are expected to include a general contractor. DOE also distinguishes between small and large mechanical

contractors.

The d istribution channel for new construction applications is shown in Figure 5.1.1 . In the new construction distribution channel, the manufacturer sells the equipment to a wholesaler, who in turn sells it to either a small or large mechanical contractor, who in turn sells it to a general contractor, who in turns sells it to the consumer and performs the installation.

Figure 5.1.1 Distribution Channels for New Construction Applications

Distribution channels for replacement applications are shown in Figure 5.1.2 . In the replacement distribution channel, the manufacturer sells the equipment to a wholesaler, who in turn sells it to either a small or large mechanical contractor, who in turns sells it to the consumer and performs the installation. Wholesaler Small
Mechanical

Contractor General

Contractor Consumer

Manufacturer

Large
Mechanical

Contractor General

Contractor Consumer

5-2Figure 5.1.2 Distribution Channels for Replacement Applications

Based on information that equipment manufacturers provided in the commercial unitary air conditioner and heat pump rulemaking , end

- use commercial consumers purchase 50 percent of equipment through small mechanical contractors, 32.5 percent through large mechanical contractors, and the remaining 17.5 percent through national accounts. DOE excluded national accounts from this analysis, therefore of the contractor distribution channel, small contractors represent 61 percent of sales and large contractors represent 39 percent of sales. In addition, 20 percent of commercial air -conditioning equipment is purchased for the new construction market while the remaining 80 percent is assumed to serve the replacement market. DOE used this same distribution for the equipment in today's NOPR. Table 5.1.1 lists each distribution channel’s
share of the full commercial air conditioner market for the original CUAC/CUHP analysis and today's analysis.

Table 5.1.1 Shares of Market by Distribution Channel

Distribution Channel CUAC/CUHP
Share of

Market Small 3

- Phase
AC/HP and
WSHP Share of

Market

New Construction, Small Mechanical Contractor 10.0 % 12.2 %

New Construction, Large Mechanical Contractor 6.5 % 7.8 %

New Construction, National Account 3.5 % N/A

Replacement, Small Mechanical Contractor 40.0 % 48.8 %

Replacement, Large Mechanical Contractor 26.0 % 3 1.2 %

Replacement, National Account 14.0 % N/A

5.2 MARKUP CALCULATION METHODOLOGY

At each point in the distribution channel, companies mark up the price of the equipment to cover their business costs and profit margin. In financial statements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold Wholesaler Small
Mechanical

Contractor Consumer

Manufacturer

Large
Mechanical

Contractor Consumer

5-3( CGS ). The gross margin 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. In orde r for sales of a product to contribute positively to company cash flow, the product’s markup must be greater than the corporate gross margin. 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 wholesalers. Wholesalers sell to contractors at the wholesale price. Wholesalers absorb short

- term imbalances in supply and demand, allowing manufacturers to operate more efficiently and satisfying consumer needs for fast deliveries. In addition, wholesalers are important sources for parts. Most contractors compete at the local level. Many carry more than one brand of air conditioner, and most install the products th ey sell.

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

cost.

5.3 APPROACH FOR CALCULATING OVERALL MARKUP

5.3.1 Baseline Markup

DOE used the overall baseline markup to estimate the consumer product price of baseline models, given the manufacturer cost of the baseline models. DOE considers baseline 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 in the first new construction distribution
channel.

CC CCCC BBBBBBBB = CCCCCCCC MMMMMM

× � MMMM MMMMMM × MMMM WWWWWWWW

_ BB BBBBBB × MMMM MMMM MM MMMM MM MM

_ BBBBBBBB × MMMM

_ BB BBBBBB �

= CCCCCCCC MMMMMM × MMMM OO

_ BB BBBBBB

W here:

CPP BASE = Consumer product price for baseline models,

COST MFG = Manufacturer cost for baseline models,

MU MFG = Manufacturer markup,

MU WHOLE_BASE = Baseline wholesaler markup,

MUM CONTRACT_BASE = Baseline mechanical contractor markup,

MUM GENERAL_BASE = Baseline general contractor markup, and

MU OVERALL_BASE = Baseline overall markup.

The following equation shows how DOE used the overall baseline markup to determine the product price for baseline models in the first replacement distribution channel.

5-4CCCCCC BBBBBBBB = CCCCCCCC MMMMMM × � MMMM MMMMMM × MMMM WWWWWWWW

_ BB BBBBBB × MMMM MMMM MM MMMM MM MM

_ BBBBBBBB × TTTT �

= CCCCCCCC MMMMMM × MMMM OO

_ BB BBBBBB

W here:

CPP BASE = Consumer product price for baseline models,

COST MFG = Manufacturer cost for baseline models,

MU MFG = Manufacturer markup,

MU WHOLE_BASE = Baseline wholesaler markup,

MUM CONTRACT_BASE = Base line mechanical contractor markup,

TAX SALES = Sales tax, and

MU OVERALL_BASE = Baseline overall markup.

5.3.2 Incremental Markups

Similarly, DOE used the overall incremental markup to estimate changes in the consumer product price, given changes in the manufa cturer cost from the baseline model cost resulting from an energy conservation 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 with 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 product price for more energy -efficient models in the first new construction distribution channel.

CCCCCC = CCCCCC BBBBBBBB + CCCCCCCC MMMM

_ II

_ × � MMMM MMMMMM × MMMM WWWWWWWW

_ II × MMMM MMMM MM MMMM MMMM

_ II × MMMM

_ II �

= CCCCCC BBBBBBBB + CCCCCCCC MMMMMM

_ II × MMMM OO

_ II

W here:

CPP EFF = Consumer product price for more

- efficient models

, CPP BASE = Consumer equipmen t price for baseline models,

COST MFG

_ INCR = Incremental manufacturer cost

, MU MF G = Manufacturer markup,

MU WHOLE_INCR = Incremental wholesaler markup,

MU M CONTRACT_INCR = Incremental mechanical contractor markup,

MU M GENERAL_INCR = Incremental general contractor markup, and

MU OVERALL_INCR = Incremental overall markup.

The following equation shows how DOE used the overall incremental markup to determine the product price for more energy

- efficient models in the first replacement distribution
channel.

5-5CCCCCC = CCCCCC BBBBBBBB + CCCCCCCC MMMMMM

_ II

× � MMMM MMMMMM × MMMM WW

_ II × MMMM MMMM MM MMMM MM MM

_ II × TTTT �

= CC CCCC BBBBBBBB + CCCCCCCC MMMMMM

_ II × MMMM OO

_ II

W here:

CPP EFF = Consumer product price for more- efficient models

, CPP BASE = Consumer equipmen t price for baseline models,

COST MFG

_ INCR = Incremental manufacturer cost

, MU MFG = Manufacturer markup,

MU WHOLE_INCR = Incremental wholesaler markup,

MU M CONTRACT_INCR = Incremental mechanical contractor markup,

TAX SALES = Sales tax, and

MU OVERALL_INCR = Incremental overall markup.

5.4 APPROACH FOR CALUCLATING MANUFACTURER 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:

MMMM MMMM = CCCCCC MMMMMM + MMMMMM

CCCCCC MMMMMM Where:

MU MFG = Manufacturer markup,

CGS MFG = Manufacturer cost of goods sold, and

GM MFG = Manufacturer gross margin.

5.5 APPROACH FOR CALCULATING WHOLESALER AND CONTRACTOR

MARKUPS

DOE examined the manner in which ma rkups change by efficiency level and other factors for wholesalers 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 measurable differences between incremental markups on direct equipment costs and the

average aggregate markup on direct business costs. Additionally, DOE discovered significan t differences between average and incremental markups for heating, ventilation, air -conditioning and refrigeration (HVACR) wholesalers and for HVAC contractors.

5-6The main reason that the selling price of a product may not be strictly proportional to the

pu rchase 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 relativel y constant. Certain business expenses are uncorrelated with the cost of equipment or cost of goods. For example, if the unit price of an air conditioner increases by 30 percent, it is unlikely that the cost of secretarial support in an administrative offic e will increase by 30 percent also.

5.5.1 Key Data and Assumptions of the Markups Methodology

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 b ased 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 statements from the Heating, Air

conditioning & Refrigeration Distributors International (HARDI) 2010 Profit Planning Report and from the Air Conditioning Contractors of America (ACCA). 1 2 HARDI and ACCA are trade associations representing wholesalers and mechanical contractors, respectively. DOE used the financial data from the 2007 US Census of Business to develop general contractor markups in
the same form as the income statement data for wholesalers and mechanical contractors. 3 4 These income statements break down the components of all costs incurred by firms that supply and install air conditioning equipment. a

The key assumptions used to estimate markups using these financial data are:

• The firm income statements faithfully represent the various average costs incurred by firms distributing and installing HVAC products including commercial air conditioners.

• These costs can be divided into two categories: 1) costs that vary in proportion to the manufacturer selling price (MSP) of commercial air conditioners (varian t costs); and 2) costs that do not vary with the MSP commercial air conditioners (invariant costs).

• Overall , commercial air -conditioner wholesaler and contractor prices vary in proportion
to commercial air -conditioner wholesaler and contractor costs 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 wholesalers and contractors tend to handle multiple commodity 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 commercial air conditioners.

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

residential and commercial air

- conditioners.

5-7Information obtained from the trade literature, and from selected heating, ventilating, and
air

- conditioning (HVAC) wholesalers, contractors, and consultants, tends to support the second assumption; this information indicates that wholesale and contractor markups vary according to the quantity of labor and materials used to distribute and install appliances In its analysis, 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 is 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 2007 Census indicates the competitive nature of the market. For example, there are more than 700 HVAC manufacturers, 5 ,300 wholesalers of heat pumps and air-conditioning equipment, 6 more than 170,000 general residential contractors, 36,000 commercial and institutional building contractors, 7

, 8 and 91,000 HVAC contractors
listed in the 2007 Census. 9 Additionally, the 2007 Census estimated that the four firm concentration ratio (FFCR) for the HVAC wholesale sector is 29.7%. 10 The F FCR is the market share of the four largest firms in the industry; FFCR under 40% represents a competitive industry. 11

, 12 Following standard economic theory, competitive firms facing inelastic demand either set prices i n line with costs or quickly go out of business. 13

5.5.2 Approach for Wholesaler Markup

Using the above assumptions, DOE developed baseline and incremental markups for wholesalers using the firm income statement from the Heating, Air -conditioning & Refrigeration Distributors International (HARDI) 2010 Profit Report (Appendix 5A.1). DOE used the baseline 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 wholesalers using the following equation:

MMMM WWWWWWWW

_ BB BBBBBB = CCCCCC WWWWWWWW + WWWWWWWW CCCCCC WWWWWWWW = CCCCCC WWWWWWWW + ( IIII WWWWWWWW + WWWWWWWW )

CCCCCC WWWWWWWW

Where:

MU WHOLE_BASE = Baseline wholesaler markup,

CGS WHOLE = Wholesaler cost of goods sold,

GM WHOLE = Wholesaler gross margin,

IVC WHOLE = Wholesaler invariant costs, and

VC WHOLE = Wholesaler va riant costs.

5-8Incremental 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 s ales price. Incremental markups cover only those costs that scale with a change in the manufacturer’s sales price (i.e., variant
costs, VC ). DOE calculated the incremental markup for wholesalers using the following equation:

MMMM WWWWWWWW

_ II = CCCCCC WWWWWWWW + WWWWWWWW CCCCCC WWWWWWWW

Where:

MU WHOLE_INCR = Incremental wholesaler markup,

CGS WHOLE = Wholesaler cost of goods sold, and

VC WHOLE = Wholesaler variant costs.

5.5.3 Approach for Mechanical and General Contractor Markup

Similar financial data to that used to estimate wholesaler markups are also available for mechanical contractors and general contractors from ACCA and the 2007 Economic Census. 2

, 9

T o 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. To estimate general

con tractor markups, DOE collected data from the Commercial and Institutional Building Construction series from the 2007 Economic Census (NAICS 236220).

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

MMMM MMMM MM MMMM MM MM

_ BBBBBBBB = SSSS (%)

SS SS ( % )

− (% )

The 2007 Economic Census data include the number of establishments, payroll for construction workers, value of construction, cost of materials, and cost of subcontracted work at both state and national level. DOE calculated another estimate of the baseline markup for mechanical contractors and general contractors using the following equation:

MMMM BBBBBBBB = CC
PP + MM + SS

Where:

MU BASE = Baseline mechanical contractor or general contractor markup,

V CONSTRUCT = Value of construction,

5-9PAY = 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 considering those costs that scale with a change in the manufacturer’s sales price (variant cost s, VC ) for higher energy efficiency products. As stated in
Section 5.5.1 , DOE assumes a division of costs between those that do not scale with the manufacturer pric e (labor and occupancy expenses), and those that do (other operating expenses and profit). Hence, DOE categorized the 2007 Economic Census cost data in each major cost category and estimated incremental contractor markups using the following equation:

MM

_ II = CCCCCC +

CCCCCC
Where:

MU CONTRACT_INCR = Incremental contractor markup,

CGS CONTRACT = Contractor cost of goods sold, and

VC CONTRACT = Contractor variant costs.

5.6 DERIVATION OF MARKUPS

5.6.1 Manufacturer Markups

For this rulemaking, DOE relied on the manufacturer markups developed for central air conditioners and heat pumps, which is a markup of 1.30. b DOE applied this markup to all equipment classes.

5.6.2 Wholesaler Markups

Wholesalers re ported median data in a confidential survey that HARDI conducted across its members. In the survey, HARDI itemized revenues and costs into categories, including direct equipment expenses (cost of goods sold), labor expenses, occupancy expenses, other opera ting expenses, and profit. DOE presents these data in full in appendix 5A.1, Detailed Data for Equipment Price Markups. Table 5.6.1 s ummarizes them in terms of cost

- per

- dollar sales
revenue in the first data column and in terms of cost- per -dollar of cost of goods sold in the
second column.

b http://www1.eere.energy.gov/buildings/appliance_standards/pdfs/cacfurn_dfr.pdf

5-10Table 5.6.1 Wholesaler Expenses and Markups

Descriptions Per Dollar
Sales Revenue
$ Per Dollar Cost
of Goods
$ Direct Cost of Equipment Sales: Cost of goods sold 0.737 1.000 Labor Expenses: Salaries and benefits 0.151 0.205 Occupancy Expense: Rent, maintenance, and utilities 0.036 0.049 Other Operating Expenses: Depreciation, advertising, and
insurance. 0.055 0.075

Operating Profit 0.020 0.027 Baseline Revenue: Baseline revenue earned per dollar cost of goods sold 1.357
Wholesaler Baseline Markup (MU WHOLE BASE ) 1.357 Incremental Revenue: Increased revenue per dollar increase cost of goods
sold 1.103

Incremental Markup (MU WHOLE INCR ) 1.103 Source: Heating, Air Conditioning & Refrigeration Distributors International. 2012. 2012 Pro fit Report (2010 Data).

In this case, direct equipment expenses (cost of goods sold) represent about $0.74 per dollar sales revenue, so for every $1 wholesalers take in as sales revenue, $0.74 is used to pay the direct equipment costs. Labor expenses repr esent $0.15 per dollar sales revenue, occupancy expenses represent $0.04, other operating expenses represent $0.06, and profit accounts for $0.02 per dollar sales revenue.

DOE converted the expenses per dollar sales into expenses per dollar cost of goods sold, by dividing each figure in the first data column by $0.74 (i.e., cost of goods sold per dollar of sales revenue). For every $1.00 the wholesaler spends on equipment costs, the wholesaler spends $0.205 to cover labor costs, $0.049 to cover occupancy expenses, $0.075 for other operating expenses, and $0.027 in profits. This totals to $1.357 in sales revenue earned for every $1.00 spent on equipment costs. Therefore, the wholesaler baseline markup ( MU WHOLE BASE ) is 1.357 ($1.357 ÷ $1.00).

DOE also used t he data in column two to estimate the incremental markups. The incremental markup depends on which of the costs in Table 5.6.1 are variant or invariant with respect to 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 wholesale price will be $1.357, implying that the incremental markup is 1.357, or the same as the baseline markup. At the other extreme, if no other costs are 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.

As stated in section 5.5 DOE believes that the labor and occupancy costs are invariant with respect to MSP, while other operating costs and profit are variant. In this case, for a $1.00 increase in the MSP, the wholesale price will increase in line with changes in the categories “other operating costs” and “operating profit”; these are approximately of $0.067, which when divided by $0.737 cents in cost of goods sold yields an increase of $0.103, giving a wholesaler incremental markup ( MU WHOLE INCR ) of 1. 103. See appendix 5.A for cost details.

5-115.6.3 Mechanical Contractor Markups

5.6.3.1 Aggregate Baseline Markups for Mechanical Contractors

The HVAC contractors, represented here as mechanical contractors, reported median cost data in an ACCA financial analysis of the HVAC industry. These data are shown in Table 5.6.2

Table 5.6.2 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 those provided by HARDI and the U.S. Census, containing only cost of goods sold and gross margin. Since the gross margin is the sum of labor, occupancy expenses, operating expenses, and profit, the data are sufficient to estimate the baseline markup. The first data column in Table 5.6.2 provides the cost of goods sold and gross margin, expressed as dollars 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.

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 t he equipment cost, and $0.37 in sales revenue 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 1.37 for mechanical contractors. This is the beginning point for the determination of mechanical contractor markups.

The baseline markup derived above for mechanical contractors is the average value for all contractors, including large and small contractors serving the replacement an d new construction markets. The following sections describe how DOE further derived the baseline and incremental markups for four distinct categories of mechanical contractors: (1) small contractors in the replacement market; (2) small contractors in the new construction market; (3) large contractors in the replacement market; and (4) large contractors in the new construction market.

5-125.6.3.2 Baseline Markups for Mechanical Contractors in the Replacement and

New Construction Markets

As presented above for all mechanical contractors in aggregate , the ACCA financial data provided only gross margin data, which allows for the determination of only the baseline markup for the four types of contractor, since the gross margin is the sum of all contractor labor and operating expenses plus profit.

Table 5.6.3 summarizes the gross margin and resulting baseline markup data for all mechanical contractors that serve the replacement and new construction markets. Note t hat while this data is disaggregated by the market served, it aggregates mechanical contractors of all sizes.

Table 5.6.3 Baseline Markups 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 0.703 1.000 0.745 1.000

Gross Margin: Labor, occupancy, operating expenses, and profit 0.297 0.422 0.255 0.342

Baseline Markup (MU MECH CONT

BASE ): Revenue per dollar cost of goods NA 1.42 NA 1.34

% Difference from Aggregate
Mechanical Contractor Baseline

MU NA 3.6% NA -2.2%

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

Using the baseline markup data for replacement and new construction contractors from
Table 5.6.3 , DOE calculated that the baseline markups for the replacement and new markets are 3.6 percent higher and 2.2 percent lower, respectively, t han that for all mechanical contractors serving all markets shown in Table 5.6.2 . These percentage differences are later used, along
with those defined in section 5.6.3.3 to estimate separate markups for the four categories of
mechanical contractor of interest.

5.6.3.3 Baseline Markups for Small and Lar ge Mechanical Contractors

ACCA provides data for contracting businesses earning annual revenues in each of the four following categories: (1) below one million dollars; (2) from one to two million dollars; (3) from two to five million dollars; and (4) over five million dollars. DOE aggregated the data into two categories: contractors earning annual revenue below two million dollars and contractors

5-13earning annual revenue above two million dollars. The values reported for small contractors are the average of the categories: (1) below one million dollars, and (2) from one to two million dollars. The values reported for large contractors are the average of the categories: (3) from two to five million dollars, and (4) over five million dollars.

Table 5.6.4 Baseline Markups for Small and Large Mechanical Contractors

Description Contractor Expenses or Revenue by Market Type Small ( < $2 million) Large ( > $2 million)

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 0.653 1.000 0.753 1.000

Gross Margin: Labor, occupancy, operating expenses, and profit 0.347 0.532 0.247 0.328

Baseline Markup (MU MECH CONT

BASE ): Revenue per dollar cost of goods NA 1.53 NA 1.33

% Difference from Aggregate
Mechanical Contractor Baseline

MU NA 11.6% NA -3.2%

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

Using the baseline markup data for small and large contractors from Table 5.6.4

, DOE calculated that the baseline markups for small and large are 11.6 percent higher and 3.2 percent lower, respectively, than that for all mechanical contractors serving all markets shown in Table

5.6.2

.

5.6.3.4 Baseline Markups by Disaggregated Mechanical Contractor Type

Using the percentage difference from the aggregate mechanical contractor baseline markup ( Table 5.6.2 ), D OE then estimated the baseline markup for each of the four mechanical contractor types: (1) small contractors in the replacement market; (2) small contractors in the new construction market; (3) large contractors in the replacement market; and (4) large contractors in the new construction market. The baseline markup for each mechanical contractor type is estimated using the following equation:

MMMM MMMM MM MMMM MM MM

_ BBBBBBBB = MMMM + MMMM × μμ SS + MMMM × μμ MM MM MM MM

W here:

MU AGGREGATE = Baseline markup for aggregate of all mechanical contractors,

μ SIZE = Size modifier (small or large contractor percentage difference from aggregate of all contractors’ markup),

5-14μ MARKET = Market modifier (replacement or new construction contractor percentage difference from aggregate of all contractors’ markup), and,

MUM CONTRACT_BASE = Baseline markup for specific mechanical contractor type.

Table 5.6.5 Baseline Markups b y Mechanical Contractor Type
Mechanical Contractor Type Size
Modifier Market
Modifier Baseline Markup Size Market

Small Replacement 11.6% 3.6% 1.58

New Construction 11.6%

- 2.2% 1.50

Large Replacement

- 3.2% 3.6% 1.38

New Construction

- 3.2%

- 2.2% 1.30

5.6.3.5 Incremental Markups by Mechanical Contractor Type

Calculation of the incremental markups for each mechanical contractor type required separation of the invariant and variant costs. Since this was not possible using the ACCA data,
DOE used more detai led 2007 U.S. Census Bureau data for all plumbing, heating, and airconditioning contractors. The U.S. Census Bureau data were used to calculate the baseline and incremental markups as shown in Table 5.6.6 . Appendix 5A.2 contains the full set of data used
in this calculation.

Table 5.6.6 Mechanical Contractor Disaggregated Expenses and Markups Based on 2007
U.S. Census Bureau Data

Description Contractor 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 0.17 0.26 Occupancy Expense: Rent, maintenance, and utilities 0.02 0.03 Other Operating Expenses: Depreciation, advertising, and
insurance. 0.04 0.06

Net Profit Before Taxes 0.09 0.13 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

Percent difference between Baseline and Incremental Markup 20.0% Source: U.S. Census Bureau. 2007. Plumbing, Heating, and Air-Conditioning Contractors.

Sec tor 23: 238220. Construction: Industry Series, Preliminary Detailed Statistics for Establishments, 2007.

5-15Using the data in Table 5.6.6 , the incremental markup is 20 percent lower than the baseline markup. By applying this 20 percent differential between baseline and incremental markup to the baseline markups estimated for th e four specific mechanical contractor types, DOE estimates the incremental markup for each type ( Table 5.6.7 ).

Table 5.6.7 Incremental Markups by Mechanical Contractor Type
Mechanical Contractor Type Incremental Markup Size Market

Small Replacement 1.26

New Construction 1.20

Large Replacement 1.10

New Construction 1.04

5.6.4 Estimation of General Contractor Markups

DOE derived markups for general contractors from U.S. Census Bureau data for the commercial building construction sector. The commercial construction sector includes establishments primarily engaged in construction work, including new construction work,
ad ditions, 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 wholesalers. The primary difference is that the U.S. Census Bureau reports itemized revenues and expenses in total dollars for the construction industry as a whole, 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 wholesalers,
Table 5.6.8 summarizes the expenses for general contractors as expenses per dollar sales revenue
in the first data column (Appendix 5A.3 contains the full set of data).

5-16Table 5.6.8 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 0.76 1 Labor Expenses: Salaries (indirect) and benefits 0.08 0.10 Occupancy Expense: Rent, maintenance, and utilities 0.01 0.01 Other Operating Expenses: Depreciation, advertising, and
insurance. 0.03 0.04

Net Profit Before Taxes 0.12 0.15 Baseline Markup (MU GEN CONT BASE ): Revenue per dollar cost of goods 1.31 Incremental Markup (MU GEN CONT INCR ): Increased revenue per dollar increase cost of goods sold 1.19

Source: U.S. Census Bureau. 2007. Sector 236220 (Commercial Building Construction). Construction: Industry Series: Preliminary Detailed Statistics for Est ablishments: 2007.

As shown in the first column , the direct cost of sales represents about $0.76 per dollar sales revenue to the general contractor. Labor expenses represent $0.0 8 per dollar sales revenue, occupancy expenses represent $0.01 per dollar sales revenue, other operating expenses represent $0.03, and profit makes up $0.12 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 by $0.76. 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, $0.10 to cover labor costs, $0.01 to cover occupancy expenses, $0.04 for other operating expenses, and $0.15 in profits. This totals to $1.31 in sales revenue earned for every $1.00 spent on equipment costs. Thus, the general contractor baseline markup ( MU GCONTRACT_ BASE ) is 1.31.

DOE was also able to use the data in column two of Table 5.6.8 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 contractor price will be $1.48, implying that the incremental markup is 1.48, or the same
as the baseline ma rkup. 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 general contractor price, for an incremental markup of 1.0. DOE believes the labor and occupancy costs are invariant, while the other operating costs and profit to scale with the equipment price (i.e., are variant). In this case, for a $1.00 increase in the equipment price, the general contractor price will increase by $1.19 , giving a general contractor increm ental markup ( MU GCONTRACT_INCR ) of 1. 19.

5-175.7 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 the consumer equipment price.

DOE der ived state and local taxes from data provided by the Sales Tax Clearinghouse. 14
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 5.7.1 below. The average sales tax presented in the bottom row of the table is the weighted average accounting for commercial building floor space with packaged cooling by Census division, calculated using CBECS 2003. Detailed sales tax data by each state can be found in Appendix 5A.4.

Table 5.7.1 Average Sales Tax Rates by Census Division and Large State

Census Division/State Tax Rate
New England 6.91%

Mid Atlantic 8.01%

East North Central 7.47%

West North Central 6.44%

South Atlantic 5.68%

East South Central 7.65%

West South Central 6.50%

Mountain 7.09%

Pacific 8.13%

New York 8.40%

California 8.45%

Texas 7.90%

Florida 6.65%
Average 7.16% Source: The Sales Tax Clearinghouse at https://thestc.com/STRates.stm (Accessed March, 2014)

5.8 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 . These values are provided
in Table 5.8.1

.

5-18Ta ble 5.8.1 Summary of Overall Markups (3-phase, air cooled, air conditioning and heat pumps <65,000 Btu/h and water source heat pumps)

Distribution Channel Segment Replacement New Construction

Baseline Markup Incremental Markup Baseline Markup Incremental Markup
Manufacturer 1. 30 1. 30 1. 30 1. 30

Wholesaler 1.36 1.10 1.36 1.10

Mechanical Contractor (large/small) 1.38 / 1.58 1.10 / 1.26 1.30 / 1.50 1.04 / 1.20

General Contractor (new construction only) -- -- 1.31 1.20

Sales tax (replacements only) 1.07 1.07

-- -- Overall Markup (large/small contractor) 2.60 / 2.99 1.70 / 1.94 3.00 / 3.47 1.78 / 2.06

5-19REFERENCES

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

2 Air Conditioning Contractors of America, 2005 Financial Analysis for the HVACR Contracting Industry, 2005.

3 U.S. Census Bureau, Data set for Sector 23, EC0723A1, Construction: Geographic Area Series, Detailed Statistics for Establishments, 2 007.

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

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

2007 . Air -Conditioning and Warm Air Heating Equipment and Commercial and Industrial Refrigeration Equipment Manufacturing. Data set for Sector 31: EC073111 2007.

6 U.S. Census Bureau, Wholesale Trade: Industry Series: Preliminary Summary Statistics for the
Uni ted States: 2007. HVAC Equipment Merchant Wholesaler. Data set for Sector 42: EC0742111, 2007.

7 U.S. Census Bureau, Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007. Commercial and Institutional Building Construction . , 2007.

8 U.S. Census Bureau, Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007. New Single- Family General Contractors, New Multifamily Housing Construction (Except Operative Builders), New Housing Operative Builders Residential.,

2007.

9 U.S. Census Bureau, Plumbing, Heating, and Air-Conditioning Contractors. Sector 23: 238220. Construction: Industry Series, Preliminary Detailed Statistics for Establishments, 2007., 2007.

10 U.S. Census Bureau, Wholesale Trade: Subje ct Series: Estab and Firm Size: Summary Statistics by Concentration of Largest Firms for the United States: 2007. Data set for Sector

42: EC074373. 2007.

11 University of Maryland University College, Note on Industry Structure, 2002. (Last accessed February, 2013.) < http://info.umuc.edu/mba/public/AMBA607/IndustryStructure.html

12 QuickMBA, Industry Concentration, 2010. (Last accessed February, 2013.)

< http://www.quickmba.com/econ/micro/indcon.shtml >

13 Pindyck, R. and D. Rubinfeld, Microeconomics. 2000. Prentice Hall.

14 The Sales Tax Clearinghouse, < https://thest c.com/STRates.stm >

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