18

- i CHAPTER 18. REGIONAL STANDARDS I MPACTS ON MARKET PAR TICIPANTS

TABLE OF CONTENTS

18.1 Introduction

................................ ................................ ................................ ..................... 18

- 1 18.1.1 Regional Standards Overview

................................ ................................ ............. 18

- 1 18.1.1.1 Regional Standards vs. National Standard

................................ ............. 18

- 4 18.1.2 Discussion of Non Enforcement vs. Enforcement Issues

................................ .... 18

- 6 18.2 Market Participants

................................ ................................ ................................ ......... 18

- 7 18.2.1 Definition of Terms

................................ ................................ ............................. 18

- 7 18.2.1.1 Distributors

................................ ................................ ............................ 18

- 7 18.2.1.2 Contractors

................................ ................................ ............................. 18

- 7 18 .2.1.3 Dealers

................................ ................................ ................................ ... 18

- 7 18.2.1.4 Installers

................................ ................................ ................................ . 18

- 8 18.2.1.5 Builders

................................ ................................ ................................ .. 18

- 8 18.2.1.6 Market Participant Nomenclature

................................ .......................... 18

- 8 18.3 Distribution Chain

................................ ................................ ................................ ........... 18

- 8 18.3.1 Overview

................................ ................................ ................................ ............. 18

- 8 18.3.2 Vertical Integration

................................ ................................ .............................. 18

- 9 18.3.3 Distributors

................................ ................................ ................................ ........ 18

- 10 18.3.3.1 M arket Overview

................................ ................................ ................. 18

- 10 18.3.3.2 Distributor Business Model

................................ ................................ . 18

- 10 18.3.4 Contractors

................................ ................................ ................................ ........ 18

- 13 18.3.4.1 M arket Overview

................................ ................................ ................. 18

- 13 18.3.4.2 Business Model

................................ ................................ .................... 18

- 13 18.3.5 General Contractor

................................ ................................ ............................ 18

- 14 18.3.5.1 Market Overview

................................ ................................ ................. 18

- 14 18.3 .5.2 Business Model

................................ ................................ .................... 18

- 14 18.3.6 Retailers

................................ ................................ ................................ ............. 18

- 15 18.4 Discussion of Regional Standard Impacts

................................ ................................ .... 18

- 16 18.4.1 Distributor Impacts

................................ ................................ ............................ 18

- 16 No n

- enforcement Issues for Distributors

................................ .......................... 18

- 16 Enforcement Issues for Distributors

................................ ................................ .. 18

- 17 18.4.2 Contractor Impacts

................................ ................................ ............................ 18

- 17 Non

- enforcement Issues for Contractors

................................ ........................... 18

- 17 Enforcement Issues for Contractors

................................ ................................ .. 18

- 17 18.4.3 General Contractor Impacts

................................ ................................ ............... 18

- 18 Non

- enforcement Issues for General Contractors

................................ ............. 18

- 18 Enforcement Issues for General Contractors

................................ ..................... 18

- 18 18.5 Analysis of Regional Standard Impacts

................................ ................................ ........ 18

- 18 18.5.1.1 Data Sources

................................ ................................ ........................ 18

- 19 18.5.1.2 Sample Inventory Calculation for Southeastern Border CACHP Wholesaler

................................ ................................ ................................ ......... 18

- 22 18.5.2 Profitability Analysis of Regional Standard Impacts

................................ ........ 18

- 24 18.6 Conclusions

................................ ................................ ................................ ................... 18

- 2618

- ii LIST OF TABLES

Table 18.1.1 Regions for DFR Analysis of Furnace Standards

................................ ................. 18

- 2 Table 18.1.2 Regions for DFR Analysis of Central Air Conditioner and Heat Pump Standards 18

- 3 Table 18.1.3: Border States by Region for the Central Air Conditioners and Heat Pumps Rulemaking

................................ ................................ ................................ ................................ 18

- 5 Table 18.1.4: Border States by Region for the Furnaces Rulemaking

................................ ....... 18

- 5 Table 18.5.1 Typical Southeastern Wholesaler Assets, Liabilities, and Profitability

.............. 18

- 2 1 Table 18.5.2 Border Wholesaler Required Inventory

................................ .............................. 18

- 24 Table 18.5.3 Profitability Impacts of Inventory Cost Increases

................................ .............. 18

- 25 Table 18.5.4 Return on Net Worth Impacts of Inventory Cost Increases

................................ 18

- 25

LIST OF FIGURES

Figure 18.1.1 Map of the Regions for the DFR Analysis of Furnace Standards

...................... 18

- 4 Figure 18.1.2 Map of Preliminary Analysis Proposed Regions for Central Air Conditioner and Heat Pump Standards

................................ ................................ ................................ ................. 18

- 4 Figure 18.3.1 Distribution Chain in Replacement Market

................................ ......................... 18

- 9 Figure 18.3.2 Distribution Chain in New Construction Market

................................ ................ 18

- 918

- 1 CHAPTER 18. REGIONAL STANDARDS I MPACTS ON MARKET PAR TICIPANTS

18.1 I NTRODUCTION

The Energy Policy and Conservation Act (EPCA), as amended by the Energy Independence and Security Act of 2007 (EISA; Pub. L. 110

- 140) , directs the U.S. Department of Energy (DOE) to “consider the impact of additional regional standards on consumers, manufa cturers, and other market participants, including distributors, dealers, contractors, and installers,” before establishing additional regional standards. ( 42 U.S.C. 6295(o)(6)(D)(ii)) Specifically, the language of EPCA affects the current energy conservati on standards rulemakings for residential furnaces and central air conditioners and heat pumps.

This technical support document (TSD) chapter establish es a framework for understanding the HVAC distribution chain and market dynamics

. Based on the establish ed framework, DOE provides analysis of the impacts of regional standards on market participants.

Th e chapter is structured as follows: First, DOE provides an overview of the adopted regional standards as they relate to the market participants specified in EPCA. Second, DOE defines the market participants and the interaction of those participants in the distribution chain. Third , DOE investigates how regional standards could affect those market participants based on industry research, discussions with ma nufacturers, distributors and contractors, and the comments received during the rulemaking process for residential furnace and central air conditioner and heat pump products

. Fourth , when possible given data availability, DOE quantitatively assesses the im pacts of regional standards on the analyzed market participant s. Two quantitative analyses are the result of this effort: (1) an investigation of the impact of regional standards on distributor inventory holdings and (2) a modeling of changes in distributo r profitability due to changes in inventory.

Additionally, c hapter 6 of the TSD presents information on the impacts of regional standards on market participant markups. The chapter includes an analysis of regional standards’ impact on markups for the dis tribution chain, including distributors, contractors and general contractors.

18.1.1 Regional Standards Overview

DOE is establishing regional standards for residential furnaces, air conditioners and heat

pumps

. EPCA, as amended by EISA, enables DOE to define one additional standard region for furnaces and one or two additional standard regions for central air conditioners and heat pumps. ( 42 U.S.C. 6295(o)(6)(B)(ii)) By statute, the regions must include whole, c ontiguous states. ( 42 U.S.C. 6295(o)(6)(C))

For residential furnace products, DOE establishes one multi

- state region in addition to a base national standard that would prevail in states throughout the rest of the country. For the

purpose s of analysis, the geographic region and the rest of country are treated as two analysis regions referred to as the “North” and the “South” . The regions are generally based on the population

- weighted number of heating degree days (HDD) of each State. States with 5,000 HDD or more are mostly considered as part of the n o rthern region, while States with less than18

- 2 5,000 HDD are mostly considered part of the sou thern region. A complete list of States in each region is show in Table 18.1

. 1

.

Table 18.1

. 1 Regions for DFR Analysis of Furnace Standards

Northern Region States (Rest of Country) Southern Region States
Alaska Pennsylvania Alabama Colorado Rhode Island Arizona Connecticut South Dakota Arkansas Idaho Utah California Illinois Vermont Delaware Indiana Washington Dist. of Columbia
Iowa West Virginia Florida
Kansas Wisconsin Georgia Maine Wyoming Hawaii
Massachusetts Kentucky Michigan Louisiana
Minnesota Maryland
Missouri Mississippi
Montana Nevada
Nebraska New Mexico New Hampshire North Carolina New Jersey Oklahoma
New York South Carolina
North Dakota Tennessee
Ohio Texas Oregon Virginia

For central air conditioner and heat pump products, DOE establishes two multi

- state regions in addition to a base national standard that would prevail in states throughout the rest of the country. The two regional and the rest of country are treated as three analysis regions, referred to as Hot

- Humid (Southeast)

, Hot

- Dry region (Southwestern), and North (Rest of Country). A complete list of States in each region is show in Table 18.1

. 2

.18

- 3 Table 18.1

. 2 Regions for DFR Analysis of Central Air Conditioner and Heat Pump Standards Northern Region States Hot

- Humid States Hot

- Dry States (Rest of Country) (Southeast Region) (Southwest Region)
Alaska New York Alabama Arizona

Colorado North Dakota Arkansas California

Connecticut Ohio Delaware Nevada

Idaho Oregon District of Columbia New Mexico

Illinois Pennsylvania Florida

Indiana Rhode Island Georgia

Iowa South Dakota Hawaii

Kansas Utah Kentucky

Maine Vermont Louisiana

Massachusetts Washington Maryland Michigan West Virginia Mississippi

Minnesota Wisconsin North Carolina

Missouri Wyoming Oklahoma

Montana South Carolina

Nebraska Tennessee New Hampshire Texas New Jersey Virginia

Figure 18.1

. 1 and Figure 18.1

. 2 illustrate the regional boundaries in the DFR

.18

- 4 Figure 18.1

. 1 Map of the Regions for the DFR Analysis of Furnace Standards

Figure 18.1

. 2 Map of Regions for DFR Analysis of Central Air Conditioner and Heat Pump Standards

18.1.1.1 Regional Standards vs. National Standard

It is important to differentiate between the impacts of an amended national standard and the impact of introducing regional standards. The following sections do not assess the impact on market participants of more s tringent energy conservation standards

. The impact s of higher standards are evaluated in DOE’s standard analysis, as summarized in the Direct Final Rule

n otice. For example, the impacts of physically larger HVAC units on distributors (due to a more stringe nt standard) are not discussed in this chapter because such an impact would occur under an increase in a single national standard as well. Rather, t his chapter considers the impacts of additional

For firms located farther from the borders of the standard region s and serving only small areas, the impact of regional standards is expected to be very similar to the impact of a national energy conservation standard. However, firms located near the border between regions and

serv ing more than one region are expected to be most strongly impacted because they may have to respond to different efficiency requirements for each region in which they operate. For example, distributors located near regional border s may carry more inventory or manage their inventory differently to meet the separate needs of customers in each region. regional standards on these market participants , including p roduct distributors, dealers, contractors, and installers. For example, the impact on a distributor of having to alter inventory systems to serve regions with differential efficiency levels is an impact that would be considered.

Table 18.1

. 3 and Table 18.1

. 4 display the states on the borders of the CACHP and f urnaces regions, respectively.18

- 5 Table 18.1

. 3 : Border States for the Central Ai r Conditioners and Heat Pumps Regions

Northern Region States (Rest of Country) Hot

- Humid States (Southeast Region) Hot

- Dry States (Southwest Region)

Colorado Arkansas Arizona

Idaho Delaware California

Indiana Kentucky Nevada

Illinois Maryland New Mexico

Kansas Oklahoma

Missouri Tennessee
New Jersey Texas
Pennsylvania Virginia

Ohio
Oregon

Utah
West Virginia

Table 18.1

. 4 : Border States for the Furnaces Regions

Northern Region States Southern Region States Colorado Arizona

Idaho Arkansas

Illinois California

Indiana Delaware

Kansas Kentucky

Missouri Maryland

New Jersey Nevada

Ohio New Mexico
Oregon Oklahoma
Pennsylvania Tennessee

Utah Virginia
West Virginia18

- 6 18.1.2 Discussion of Non Enforcement vs. Enforcement Issues

For the purposes of this chapter, DOE groups potential impacts of regional standards on market participants into two categories: (1) non

- enforcement related issues and (2) enforcement

re lated issues. Non

- enforcement issues are those that arise from regional standards regardless of the enforcement plan eventually established by DOE. Enforcement

- related issues are those impacts that would vary depending on the enforcement path proposed by DOE ( e.g.

At this stage, while DOE is considering various enforcement plans, no mechanisms or requirements are adopted here. As such, DOE does not attempt to quantify enforcement

- related impacts in this chapter. EPCA requires DOE to begin an enforcement rulemaking not later than 90 days after the issuance of a final rule establishing regional standards and complete the rulemaking not later than 15 months following the issuance of the rule. (42 U.S.C. 6295 (o)(6)(G)(ii)). DOE recognizes the challenges of regional standards enforcement and continues to investigate the most effective means of meeting those challenges. DOE will incorporate all feedback from this standards rulemaking process into the enforcement rulemaking. , certification, verification, and labeling costs).1 8

- 7 18.2 MARKET PARTICIPANTS

18.2.1 Definition of Terms

As discussed previously, EPCA directs DOE to consider the impacts of additional regional standards on market participants, including “distributors, dealers, contractors, and installers.” ( 42 U.S.C. 629 5(o)(6)(D)(ii)) Based on DOE’s research and comments from stakeholders, some of the market participants enumerated in EPCA have overlapping or identical functions in the HVAC marketplace. Industry often uses the various terms interchangeably to describe th e same market participant. Therefore, it is important to clarify what market roles are associated with each term for the purposes of this analysis. Below is a brief description of DOE’s understanding of each player in the distribution chain

.

18.2.1.1 Distributors

Also known as ‘wholesalers,’ distributors purchase HVAC equipment directly from the original equipment manufacturers (OEMs). Distributors absorb short

- term imbalances in supply and demand and sell equipment to contractors at a markup to cover operating exp enses and profit.

18.2.1.2 Contractors

There are two basic types of contractors of relevance to the HVAC market: (1) general contractors and (2) mechanical contractors.

In the new construction market, general contractors manage and oversee residential and

commerc ial construction projects. General contractors often lack the necessary technical expertise to install and inspect HVAC systems. As a result, they hire HVAC trade specialists, or mechanical contractors, to install equipment. General contractors usually hav e no significant role in the residential replacement market, except for cases of major retrofits.

Mechanical contractors are specialized contractors that install and maintain HVAC systems, plumbing, wiring, etc. Mechanical contractors purchase HVAC systems from distributors and install them for their customers. Contractors often service existing HVAC systems as well. Again, in the new construction market, they are usually hired by general contractors. In the replacement market, they are hired by homeowners and are considered synonymous with dealers (below).

18.2.1.3 Dealers

Much like mechanical contractors, HVAC dealers purchase systems from distributors. Often they may have a more formal relationship with a manufacturer. Dealers resell the equipment to the end

- user at a mark

- up, nearly always installing the HVAC system as well. Dealers also inspect, maintain, and repair existing systems.18

- 8 18.2.1.4 Installers

The industry uses installers interchangeably with mechanical contractors and dealers. Because the HVAC market is very rarely a do

- it

- yourself market, DOE includes homeowners who install their own systems in this category. In general, the impact of regional standards on homeowners is assessed in the LCC analysis.

18.2.1.5 Builders

For the purposes of this chapter, builders serve the same function in the HVAC marketplace as general contractors.

18.2.1.6 Market Participant Nomenclature

Given the above similarities and overlapping roles in the distribution chain, DOE believes that EPCA’s requirement to analyze the impacts on product distrib utors, dealers, contractors, and installers is satisfied by an analysis of the impact s of regional standards on three categories of market participants:

**•** Distributors

**•** Mechanical contractors

**•** General contractors

The category of “mechanical contractors” includes dealers, mechanical contractors, and installers. The category of “general contractors” comprises builders and general contractors. In accordance with comments received and consistent with the markups analysis, DOE believes such a grouping is appro priate for this analysis and allows DOE to consider the economic impact of regional standards on the relevant market participants as required by EPCA. Impacts on manufacturers are assessed in the manufacturer impact analysis (chapter 12 of the TSD) , while impacts on consumers are assessed in the life

- cycle cost analysis (chapter 8 of the TSD)

.

18.3 DISTRIBUTION CHAIN

18.3.1 Overview

A single distribution channel represents the vast majority of the HVAC market. Simply, the OEM assembles the system and sells it to a distributor; the distributor warehouses and sells the unit to a contractor; and the contractor sells the unit to the final consumer and performs the installation. The final consumer varies in the replacement and in the new construction market. In the repl acement market, the final consumer is usually the home or business owner, as illustrated in Figure 18.1

. 1

. In the new construction market, a builder or general contractor is effectively the final end

- user, as shown in Figure 18.3

. 2

.18

- 9 Figure 18.3

. 1 Distribution Chain in Replacement Market

Figure 18.3

. 2 Distribution Chain in New Construction Market

After installation, mechanical contractors typically perform additional lifecycle service on the system, including inspection, maintenance, and repair.

18.3.2 Vertical Integrat ion

In some cases, a single entity can perform one or more of the basic steps along the HVAC distribution channel. For example, most manufacturers own at least some distribution centers, which operate much like the independent distribution companies. In fa ct, all major manufacturers maintain at least some distribution capability in

- house. In this distribution model, the OEM ships units to its own subsidiaries, which operate distribution centers and sell product to contractor s

. Manufacturers usually employ t his strategy in areas where they have limited relationships with distributors for a given product line.

Historically, the degree of vertical integration has ebbed and flowed with the economic well

- being of the industry. In good times, OEMs have historicall y been more likely to acquire a distribution presence. Conversely, in bad times, they have been more likely to seek to shed the costs and risks associated with the distribution function. According to the U.S. Census Bureau, in 2002, 74 percent of HVAC sale s went through independent distributors. 1

Lennox International Inc. (LII), a large equipment manufacturer, has on e of the largest distribution presences in the industry. It owns several subsidiaries which operate as distributors and even as contractors, as is the case with LII subsidiary, Service Experts. While Service Experts is a wholly owned subsidiary, it operate s independently from LII’s manufacturing operations. Service Experts carries heating and cooling equipment inventory and offers service for HVAC equipment from various manufacturers. Currently, the percentage of the dollar value of HVACR products that go through independent distributors is estimated to be around 80 percent.

218

- 10 Importantly, w hile some entities may have a controlling interest over multiple steps in the distribution chain, the costs, markups, and business processes in the distribution chain ultimately remain relatively equivalent. That is, the distributor and contractor markups (and the resulting pricing) for the manufacturer

- owned d istributor and contractor businesses are roughly equivalent to the markups that occur where those businesses operate independently.

The business models of distributors, contractors, and general contractors are described in greater detail below.

18.3.3 Distributor s

18.3.3.1 Market Overview

The HVAC distribution market is a well

- established yet fragmented industry consisting of approximately 1,300 distribution companies. Independent distributors are responsible for the majority of the business in the industry, but all majo r manufacturers have some type of factory

owned distribution. The vast majority of independent distributors are small, private companies. In 2002, there were 5,468 total distribution branches, 5,156 of which were independent distribution branches and 312 o f which were owned by manufacturers. 3

18.3.3.2 Distributor Business Model

Distributors link the handful of furnace and central air conditioning and heat pump manufacturers to the tens of thousands of contractors. Distributors receive shipments from manufacturers and resell the equipment to contractors at a markup that covers distributor operating expenses and profit. Manufacturers rely on distributors to consolidate and forecast product demand at the regional and local levels. Contractors rely on distributors to h old enough inventory and parts to meet their day

- to

- day business needs. As the only player along the distribution chain that holds significant inventory, distributors add value by absorbing short

- term imbalances in supply and demand while still satisfying the needs of the homeowner (and, by extension, the contractor) for fast deliveries. 4

The distributor’s warehouse is usually the only stop for HVAC equipment on the way to the final installation site; however, in some markets distributors utilize regional distribution centers that supply secondary distribution warehouses. In either case, shipments are warehoused as distributor inventory until sold to contractors

. Although it can vary widely, typically 60 to 70 percent of revenue comes from unitary equipment , with the remainder coming from parts and other supplies.

Distribution is a highly competitive and low

- margin business. The critical driver of profitability is the ability to manage inventory efficiently. Traditionally, distributors tended to receive larg e

- volume pre

- season shipments from original equipment manufacturers (OEMs). However, the market has migrated away from that model as industry lead times (the time it takes to receive an order from the OEM) have fallen. Most distributors now operate in some what of a blend between just

- in

- time supply and the traditional model. To streamline inventory management, distributors often conduct extensive demand forecasting to estimate the timing and quantity of their orders. Key factors include historical demand, n ew construction, OEM lead times, new products and lines, and weather patterns. The typical lead time of an average18

- 11 residential HVAC system is 2

- 3 weeks, although different parts or components, as well as more intricate HVAC systems, may have different lead times. Some of the more advanced coils, for example, can have lead times of 6

- 8 weeks.

Financing and credit, closely related to inventory, play a critical role in the distribution business model. With the high working capital requirements due to inventor y needs, short

- term credit availability is the lifeblood of many small wholesalers. Distributors typically purchase equipment from manufacturers on credit, with the balance being paid within 30 days, often with discounts for early payment. Historically, OE Ms have offered financing to their distributor clients, but have generally exited that business. Instead, most distributors now are financed through local banks. In turn, distributors often extend lines of credit to certain contractors based on the amount of business volume, profitability of the relationship, and previous experience with the contractor. As a result, distributors incur the carrying costs associated with the difference between the financing terms that they receive from their creditors and the terms they extend to their contractor customers. Effectively, the distributor incurs as a cost the difference between these two rates over the period of time after the distributor pays the OEM for the unit and before it receives payment from the contracto r.

Because of this dynamic, a key financial metric driving profitability is days sales outstanding (DSOs), a measure of the number of days it takes a company to collect revenue after a sale has been made. DSOs in the industry average between 40

- 45 days; i f they grow higher, the increased carrying costs can threaten the thin margins under which distributors operate. In extending credit to their customers, distributors also assume the risks involved with floating the receivables (i.e., the contractor goes out of business or otherwise fails to pay).

Changes in market dynamics, which can lead to changes in the quantity and type of product demanded, may cause distributors to incur one

- time costs associated with temporary increases in inventory, inventory obsolescence, or the opportunity costs represented by the failure to meet customer needs. Increased market uncertainty forces distributors to hold greater

than

- usual inventory to reduce the risk of not meeting customer needs. 5 Failure to do so could mean l osing customers to competition. 6 However, if certain products do not sell, distributors absorb the costs of unsold inventory. 7 Typically, following an initial learning curve associated with these market changes, distributors adjust to their customers’ dema nds and are able to adjust inventory levels accordingly. 8

The increasing use of information technology in distribution has helped wholesalers adapt to market transitions. Sales and orders are usually made electronically at each step along the distribution chain. IT systems exist that allow distributors to forecast demand, source and purchase supplies, manage and track inventory, streamline the supply chain, and manage various sales channels. 9 Many distributors give contractors the ability to place orders o nline after

- hours so that the orders are ready for pickup the following morning, while others give some customers a direct link into a computer system for automatic inventory replenishment. 10

At the distribution center, inventory is generally organized by model and SEER/HSPF/AFUE rating. Units are stacked vertically and, depending on their size, may be transported with forklifts. The layout of warehouse s and placement of product s affect order processing and inventory efficiency. 11 It is important for distrib utors to organize inventory in a18

- 12 manner that minimizes the order cost and minimizes mistakes that lead to costly reprocessing. The average cost of processing an order, from receipt of the order until payment is received, is $35

- $45. 12

For distributors, the largest cost considerations aside from the costs of goods sold are those that impact inventory and transportation costs. The size of an HVAC system impacts both. Larger, more efficient units require more warehouse space to inventory. The switch from 10 SEER to 13 SEER in 2006, for example, required 35

- 40% more floor space for every condensing unit. Cycle counts are perf ormed frequently to minimize and document inventory shrinkage.

13 Fewer units can fit on trucks and forklifts, requiring more time per unit for transportation and handling, absent new and upgraded equipment. 14 The larger units can require two people to offload them instead of one. 15

Manufacturer

- to

- Distributor Interactions

The relationships between manufacturers and distributors are generally w ell

- established, long

- term relationships. In most markets, distributors are the exclusive carrier of a given manufacturer ’s product. Distributors will often carry a second brand from the same manufacturer, which has a different price point targeting a seco nd market segment.

Most manufacturers will not allow distributors to carry products from a competitor, unless the manufacturer does not offer a product applicable to the market. In that case, distributors may partner with a second manufacturer. T he terms of agreements can vary significantly depending on a wide range of factors, including sales volume, the extent of contractor relationships, strength of the brand in the area, and projected market growth. If a distributor carries a product line, it also has the parts business associated with that line.

Manufacturers are generally responsible for getting the equipment to distributors’ warehouses and incur the associated costs, which they embed in their prices. Manufacturers usually hire a shipping company to transport the equipment and pass on these costs to the distributors in the sales price. Almost all inbound freight shipped to distributors is shipped FOB Origin Freight Prepaid, which means that once the manufacturer ships the freight, the distributor

owns it. 16 This can lead to problems when items are damaged or broken upon arrival, representing another risk in the distributor business model

. 17

Distributor

- to

- Contractor Interactions

Because there is relatively low manufacturer brand loyalty among consumer en d

- users, distributors compete actively over contractor customers. While OEMs focus on general brand awareness and product demand, distributors are frequently involved in providing multi

functional support to their contractors. To increase competitiveness and revenues, distributors are increasingly offering value

- added services, such as business planning help, financial management classes, and support for advertising, to their contractor customers beyond their supply function. This is also a strategy for in creasing profitability

— a contractor that is unprofitable cannot pay the distributor in a timely fashion, if at all. Thus, successful distributors are heavily invested in their contractors’ success. 1818

- 13 In the vast majority of cases, contractors purchase the u nit over the counter at the distributor’s warehouse. Because most contractors do not carry much or any inventory, the transaction will include a specific unit needed for a single job. The contractor can generally call

in, order online, or fax in an order a nd go pick up the needed unit on the same day. At the warehouse, the distributor loads the unit onto the contractor’s truck (some distributors have “drive through” warehouses) and contractor can be on the way to the job site in minutes. While business is p rimarily done in this over

- the

- counter model, distributors also make onsite deliveries for their customers.

18.3.4 Contractors

18.3.4.1 Market Overview

The HVAC contractor market is even more fragmented than the distribution industry. There are 36,345 HVAC branches that specialize 51 percent or more in HVAC, 25,496 of which specialize entirely in the industry. 19

The large majority of contractors operate as small businesses, as defined by the U.S. Small Business Association. The SBA size limit for residential construction (NACIS codes 236115 through 236118) is $33.5 million in sales and the limit for heating and air conditioning contractors is $14 million in sales (NAICS code 238220). The 2002 Census Bureau figures break out general contractors that focus on residential co nstruction. Only 3,648 out of the total of 171,652, or 2.1%, of residential construction general contractors had more than $10 million in sales. Residential builders are overwhelmingly small businesses. Of mechanical contractors in 2002, only 1,832 out of 87,501, or 2.1%, of mechanical contractors had sales of at least $10 million. As with general contractors, it is clear from the national

- level data that the mechanical contractor sector is overwhelming ly composed of small businesses.

The contactor industr y primarily consists of small businesses and is extremely fragmented. Approximately 60 percent of branches in the industry generate less than $500,000 in revenue annually and 76 percent generate less than $1,000,000 annually. 20 Comfort Systems USA is the la rger of two public HVAC contractor companies that DOE identified

. Its 2008 revenues ($1,328,465,000 21 ) accounted for approximately 3 percent of the $49,425,445,000 22 HVAC contractor industry (although the company does provide ancillary services). 23 Most indep endent contractors work with a variety of HVAC brands, although some specialize in one particular brand, or have a relationship as a licensed dealer of a specific manufacturer.

18.3.4.2 Business Model

HVAC contractors primarily install and service HVAC systems. Co ntractors are the interface with the end

- users, installing new HVAC systems to end user specifications as well as inspecting, servicing, or repairing existing systems. Contractors must balance two very different aspects of their business to be successful. First, contractors must fulfill the technical role of installing and servicing the HVAC systems. This requires a staff that is knowledgeable about HVAC principles in general and adept at installation and service on many different HVAC units. Second, contra ctors must also operate the commercial aspects of their business. Because of the18

- 14 high level of competition, advertising, customer service, and sales skills are integral aspects of the contractor’s business. Rarely do HVAC companies achieve sufficient scale to have staff specialize in a single business practice.

Contractors have the largest influence on which system a consumer will purchase. 24 For their part, contractors tend to gravitate toward the products with which they are familiar. 25
Contractors often em ploy a good

- better

- best selling philosophy to up

- sell consumers on premium products. 26 The minimum SEER model is a “good” system; there is a “better” system that is rated a few SEER points higher; and finally, there is a “best” system which has a very high SEER rating. 27 A sample good

- better

- best set of systems might be 13 SEER

- 16 SEER

- 20 SEER; however, this is dependent on minimum efficiency requirements. 28 Customers are more likely than they used to be to purchase energy

- efficient and environmentally friendl y products, in spite of the higher cost associated with them, because they have become more sensitive to the environment and the cost of energy. 29

While some contractors have exclusive relationships with manufacturers, most

contractors compete by offering a large variety of product offerings and by being trained to install, inspect, service, and repair those offerings. As with distributors, the size and w eight of HVAC systems affect the business of contractors. While the vast majority of inventory is held by distributors, some contractors do carry a small amount of inventory and could be likewise affected by larger units. Larger systems are also more diffi cult to transport from the distributor to the job site, possibly even requiring special precautions or equipment to load or unload the unit in extreme cases. Increasing tax credits and utility rebates can defray some of the higher incremental first cost as well.

A contractor’s labor costs related to the installation and service of HVAC systems remain relative ly constant regardless of the HVAC systems that the company installs and services. 30 Once the technicians are trained, the time spent installing an HVAC unit does not vary greatly from system to system. 31

18.3.5 General Contractor

18.3.5.1 Market Overview

As discussed ab ove, for the purposes of this chapter and consistent with comments received

, DOE considers general contractors and homebuilders to have essentially the same role in the distribution chain. Thus, DOE believes the two will have similar concerns and face simi lar potential impacts from regional standards. As with mechanical contractors, the general contractor and builder market is highly fragmented and localized. According to the U.S. Census, there were more than 200,000 general contractor establishments in 20 02. 32

18.3.5.2 Business Model

General contractors manage new construction and significant renovation projects. When supervising a project, the general contractor hires a mechanical contractor to perform the installation. In this situation, the general contractor functions as the final step in the distribution chain. The general contractor may purchase the HVAC system from the distributor and hire the mechanical contractor or purchase the system from the installing mechanical contractor. When18

- 15 projects are larger

— a townhouse development, for example

— a distributor may seek to establish a supplying relationship with the general contractor and deliver the units in bulk. The general contractor would then hire a mechanical contractor to perform the installation. For a cu stom

built home or renovation, the mechanical contractor may purchase the unit to the specifications requested by the general contractor.

18.3.6 Retailers

Retailers such as Home Depot, Lowe’s and Sears can also be involved in the distribution

process. However, DO E’s understanding of these retailers is that they function mostly as a lead

generating system for contractors, as the HVAC market is very rarely a do

- it

- yourself market. When the so

- called “Big Box” retailers are involved, customers go to a retailer and as k to be put into contact with a contractor. A distributor usually still supplies a contractor, who still performs the installation. In the end, the costs and markups reflect those in the standard distribution model. Furthermore, DOE believes this reflects a small portion of overall unit sales. Therefore, for the purposes of this analysis, DOE does not consider the role of retailers in this analysis.18

- 16 18.4 DISCUSSION OF REGION AL STANDARD IMPACTS

Through public notices, public meetings, and interviews with industry trade groups, DOE has solicited comments on the impact of regional standards on CACHP and Furnace industry participants. This chapter discusses DOE’s understanding of the potential impacts on key players in the distribution chain.

As noted in Sect ion 18.1.1.1 , it is important to differentiate between the impacts of a higher base national standard and of regional standards. The following secti ons do not assess the impact on market participants of an increase in the efficiency standard. Rather, this chapter focuses on the impacts of having different standards affecting different geographic markets.

The impacts of regional standards are separated here into two categories: non

enforcement issues and enforcement issues. Non

- enforcement issues are those issues that arise irrespective of the actions taken to enforce the regional standards. Enforcement issues are those impacts and costs that are direct ly related to ensuring compliance or that arise from non

compliance. Because DOE has not established an enforcement plan for regional standards, DOE is not able to capture any enforcement impacts in this analysis.

18.4.1 Distributor Impacts

Non

- enforcement Issu es for Distributors

Based on its analysis and research, DOE believes that distributors that serve multiple regions will be impacted by additional ( i.e.

DOE und erstands there to be two types of distributors that will serve multiple standard regions and could be affected by the differentiated regional standards: (1) central distributors shipping to local distributors in multiple regions and (2) local distributors selling to contractors in multiple regions. In general, distributors located near regional standard borders are more likely to serve multiple standard regions , differentiated) regional standards. DOE also believes that d istributors serving markets entirely withi n a single region will not experience any non

enforcement impacts distinguishable from a national amended energy conservation standard. As a result, DOE’s investigation of non

- enforcement issues focuses on distributors that serve multiple regions.

DOE expects that distributors serving multiple standard regions may need to manage more variation in demand. Under a national standard, distributors could expect the bulk of demand to be at the base national level ( e.g. , 13 SEER for CACHP). Under regional standards, however, distributors near boundaries may experience bimodal demand, with the one larg e portion of shipments at the national standard efficiency level ( e.g. , 13 SEER) and a second large portion at a different regional efficiency level ( e.g. , 14 SEER). DOE believes that this bimodal demand does not signify a doubling of necessary inventory, but rather a more diverse inventory. The resulting change in product mix for distributors serving multiple regions could increase inventory investment and inventory management costs because more product models of equipment are required to meet demand.18

- 17 In Section 18.5 , DOE performs a sensitivity analysis that investigates the impact of regional standards on inventory holdings and profitability. The analysis estimates a reasonable range of inventory increases based on industry data and then calculates the impact of those inventory changes on distributor profitability based on sample distributor financials. In general, the analysis finds that only smal l inventor y changes would be required for distributors to meet product demand for multiple regions. Additionally, the sensitivity analysis finds the potential changes in inventory to have only small impacts on distributor profitability.

Enforcement Issues for Distributors

DOE understands that many distributors do business in more than one region. Furthermore, the contractors to whom these distributors sell often do business in more than one region. At this time, however, DOE is not able to accurately asses s impacts of enforcement requirements on market participants

. DOE recognizes the challenges of regional standards enforcement and continues to investigate the most effective means of meeting those challenges. DOE will incorporate all feedback submitted during the standards rulemaking into the enforcement rulemaking. If regional standards are adopted, the enforcement rulemaking will begin within 90 days of the issuance of a final rule, as required by 42 U.S.C. 6295(o)(6)(G)(ii).

18.4.2 Contractor Impacts

Non

- enf orcement Issues for Contractors

During the preliminary analysis phase , the Air

- Conditioning Contractors of America (ACCA) commented that larger units would cause higher transport and handling costs and, in many cases, would not fit in the residential space that housed the previous unit. (ACCA, Public Meeting Transcript, No. 23 at p. 252)

DOE notes that this issue is a function of higher standards, not differential regional standards. P roblems with larger units which result from a higher standard are not dir ectly considered in this chapter. To the extent that regional standards affect cost of goods sold above and beyond a national standard, DOE incorporate s th e effect in its markups analysis discussed in chapter 6 of the TSD . DOE is unaware of any other contr actor concerns with regional standards that do not involve enforcement issues.

Enforcement Issues for Contractors

As with distributors, in general DOE believes that contractors near regional borders could potentially be impacted by enforcement

- related com petitive issues surrounding differential regions. DOE recognizes that non

- compliance can be a problem for contractors as there is an incentive for non

- compliance in the form of being able to offer unknowing homeowners a lower price point for products and H VAC service. DOE recognizes that along border regions, differential standards could exacerbate this disadvantage for complying contractors, particularly if the price difference between the regional

- compliant products is significant.18

- 18 DOE acknowledges that depending on the enforcement mechanisms put in place following a DOE rulemaking, contractors may incur additional administrative compliance costs associated with regional standards, including recording keeping or verification costs. However, as noted above , at this point DOE cannot accurately assess any impacts of compliance due to regional standards because no enforcement mechanisms and compliance requirements have yet been established.

18.4.3 General Contractor Impacts

Non

- enforcement Issues for General Contrac tors
DOE received no comments on any non

- enforcement related regional standard impacts on builders and general contractors, and is not aware of any impacts.

Enforcement Issues for General Contractors

In the preliminary analysis phase, t he National Associa tion of Home Builders (NAHB) commented that a general contractor usually will not have any special HVAC expertise. Therefore, if regional standards are implemented, a builder is likely to use more time and effort double

- checking that units are compliant. T he extra cost of this effort should be included in the payback analysis, the cumulative regulatory burden, the employment impact analysis, and the regulatory impact analysis. NAHB also commented that regional standards would affect home builders, most of w hich are small businesses; as such, a regulatory flexibility analysis would be necessary. (NAHB, No. 21 at pp. 1, 2)

DOE recognizes that there may be impacts on general contractors operating in two different regions. For instance, DOE believes general con tractors working on projects near regional standard borders may experience greater risk of mistakenly installing non

- compliant systems

— or hiring contractors who do so

— and consequently incur greater cost under regional standards than they would under a sing le national standard. DOE expects this impact to be short run in nature as contractors adjust to the new standards

.

18.5 ANALYSIS OF REGIONAL STANDARD IMPACTS

The focus of this section is the impact of regional standards on distributors, particularly those operating near regional boundar ies

. DOE attempts to quantify the financial implications of imposing different efficiency standards in multiple geographic regi ons. As previously noted, until DOE has further developed the enforcement plan for regional standards, it is not possible to provide detailed analysis of enforcement impacts. To understand non

- enforcement impacts, t wo analyses are presented here: (1) an an alysis of inventory impacts under regional standards and (2) an analysis of profitability sensitivity to inventory changes.

The first analysis provides a framework for understanding the magnitude of inventory changes that may result from regional standards

. The second analysis anticipate s how inventory changes due to regional standards may impact distributor profitability. As discussed in 18.3.3

, DOE believes the key driver of distributor profitability is inventory. Therefore, th e s e quantitative analys e s only address changes in inventory costs.18

- 19 Most HVAC distributors carry both residential furnace and central air conditioner and heat pump products. Th ough the analysis models central air conditioner and heat pump inventory, DOE anticipates th e results also apply to furnace products. The analysis is not dependent on equipment or product class.

Additional analysis on the impact of regional standards on markups and costs passed down the distribution chain (including distributors and mechanical contractors) can be found in

c hapter 6 of the TSD

.

18.5.1.1 Data Sources

The analys e s of inventory impact and pro fitability impacts of distributors relies on three sources of information: Heating, Air conditioning and Refrigeration Distributors International 2009 Profit Report (2008 Data), 2002 Economic Census, and 2007 County Business Patterns. The following information can be obtained from these sources:

**•** Number of firms; total and population

- weighted average sales; total and average employment; and firm size distribution by revenue (2002 Economic Census and 2007 County Business Patterns).

The se values are reported for the n ation and by s tate. It is possible to calculate these values for each of the regions affected by the standard (Hot

- Humid, Hot

- dry, and Rest of Country) and for each of the 24 states that borders these regions.

**•** Number of smal l businesses as defined by the Small Business Administration (SBA). The SBA maximum threshold to qualify as a “small business” for NAICS 42373 , warm air heating & AC equip merchant wholesalers, is 100 employees. In 2002, out of 2,773 firms with 5,942 indiv idual establishments nation

- wide, only five firms (0.2%) had 100 or more employees. The national

- level data shows that the distributors are overwhelmingly small businesses. Data is not available at the regional level, but regional analysis would be unlikel y to show a different result.

**•** Typical cost structure and profitability (HARDI Profit Report 2009 , 2002 Census). Variation among firm sizes and types (HARDI data).

The annual HARDI profit reports have detailed cost structure data for typical firms, includ ing pro

- forma income statements and balance sheets (see sample data in Table 18.5

. 1 ). Data related to costs and potential markups are available at the national level and for seven geographic regions. The HARDI geographic regions do not match with the rule making regions. However, it is possible to assign the typical income statements to firms in each state in the HARDI regions and then develop weighted

- av erage balance sheets for each rulemaking region.

Economic Census data is not as financially detailed but has greater geographic specificity. It is used to indicate variation of profitability around the regional averages, and whether border state establishments are significantly different than the regional average.18

- 20 To see how the impact of additional standards is calculated with an estimate of additional inventories, consider the model of a “typical” distributor in the Southeastern United States sh own in Table 18.5

. 1

.18

- 21 Table 18.5

. 1 Typical Southeastern Wholesaler Assets, Liabilities, and Profitabil ity

Profit Margin Asset Turnover

Profit before Taxes $457,467 Total Assets $9,842,389

Net Sales $24,077,230 Net Sales $24,077,230

Ratio 1.9% 2.45

Income Statement Profit Before Taxes Assets Breakdown

Net Sales $24,077,230 Cash and Marketable Securities $125,202

Cost of Goods Sold $17,793,073 Accounts Receivable $2,783,329
Gross Margin $6,284,157 Inventory $5,287,361
Operating Expenses $5,874,844 Other $1,435,003
Operating Profit $409,313 Total $9,630,895

Other Income/Expenses $48,154

Profit Before Taxes $457,467

Financial Leverage Return on Net Worth

Total Assets $9,630,895

Total Net Worth $5,065,851

Ratio 1.90 9.0%

Original % of Asset Value Original Liabilities Modified Liabilities
Accounts Payable 23.1% $2,224,737 $2,224,736.75
Notes Payable 6.1% $587,485 $587,485

Other Current Liabilities 7.9% $760,841 $760,841

Total Current Liabilities 37.1% $3,573,062 $3,573,062
Long

- Term Liabilities 10.3% $991,982 $991,982

Total Liabilities 47.4% $4,565,044 $4,565,044

Net Worth 52.6% $5,065,851 $5,065,851

SOURCE: HARDI Profit Report 200918

- 22 Th e values in the shaded cells in Table 18.5

. 1 can be changed in percentage terms to estimate the sensitivity of profitability, as defined by return on net worth. Data are not currently available to perform comparable calculations on the costs of record

- keeping and reporting activities (changes in operating expenses).

18.5.1.2 Sample Inventory Calculation for Southeastern Border CACHP Wholesaler

In general, DOE believes distributors operating in a single standard region will not see any inventory impacts that are different from the impacts resulting from a change in the national standard. However, distributors operating in multiple regions may have to adjust to business impacts that are unique to the introduction of multiple standard regions.

The following analysis provides guidance on the potential impacts of regional standards on inventory for distributors serving more than one standard region. The model assumes that a Southeastern border wholesaler would have financials similar to the typical f irm in Table 18.5

. 1

. The wholesaler makes half of its sales in its home region (Hot

- Humid Region) and half in a different region (Rest of Country). The example border wholesaler is assumed to have the following characteristics:

**•** Sales to dealers and contractors average 200 units a week, 100 in each region.

**•** Sales of different efficiency products have the same approximate distribution as the national sales of split

- system air conditioners and heat pumps

.

**•** Sales at each efficiency level follow a Poisson statistical distribution.

**•** The wholesaler orders monthly from the manufacturer and keeps enough inventories on hand to meet quarterly sales forecasts.

Based on Table 18.5

. 1 , known manufacturer costs, and wholesale markups for central air conditioner and heat pump equipment, the assumed 200 units per week is close to the sales of a “typical” HARDI wholesaler in t he southeastern United States in 2008. Based on HARDI information, an average order cycle of 4 weeks and forecast period of 14 weeks are reasonable. The average lead time from placement of order to receiving units for inventory is about 5.1 weeks. Wholesal e markup factors are 1.37 and estimated delivered cost of a unit of inventory is $1,200. These values are consistent with the values of sales and inventories in Table 18.5

. 1 and with observations that complete units constitute 70% of sales and average stock turnover is 3.6 times per year

. Sales are distributed as follows by efficiency level based on approximate national sales of split

- system air conditio ners (numerical results are somewhat affected by the percentages, but the general takeaway does not change with a different efficiency mix):

**•** SEER 13: 50.1 %

**•** SEER 14: 17.3 %

**•** SEER 15: 15.1 %

**•** SEE R 16: 15.4 %

**•** SEER 18 (above 16): 2.2 %

Sales at each efficiency l evel follow a Poisson statistical distribution. This distribution is commonly used in applied statistics to characterize the probability and number of comparatively18

- 23 rare observed events (for example, purchase of air conditioning units by a household) that occur in repeated samples (for example, weekly totals of sales). It is used frequently in studies of inventory and other logistics problems. A convenient attribute of a Poisson distribution is that the variance of the distribution equals its mean and there fore its standard deviation equals the square root of the mean.

The wholesaler orders monthly from the manufacturer and keeps enough inventories on hand to meet quarterly sales forecasts. Because sales vary week to

- week, the wholesaler’s “standard of serv ice” is that it always carries enough inventory to meet a level of quarterly sales of any of its offered products at least two standard deviations above the mean, plus 1 unit. This gives the wholesaler a 98% chance of meeting any order.

Four cases showing differe nt shifts in demand for CA CHP equipment are considered, driven by a SEER 14 minimum efficiency standard.

**•** Case 1: SEER 14 is imposed in both regions. The result is a “rollup” of demand, which shifts all SEER 13 demand to SEER 14 without affecting we ekly demand for SEER 15, 16, or 18. SEER 14 sales change from 5 percent to 86 percent of sales in both regions after the shift. SEER 15, 16, and 18 sales are unaffected

**•** Case 2: SEER 14 is imposed only in the Hot

- Humid Region, while SEER 13 remains the

sta ndard in the Rest of Country region. The impact on demand is a “rollup” but only in the Hot

- Humid region.

**•** Case 3: SEER 14 is imposed in both regions , but the percentages of sales at levels above SEER 14 are significantly affected (efficiency distribution shift). The average distribution in both regions after the SEER 14 standard is imposed are:

o SEER 13: 0.0%

o SEER 14: 37.2 0%

o SEER 15: 25.2 %

o SEER 16: 25.4 %

o SEER 18: 1 2

. 2 %

**•** Case 4: SEER 14 is imposed only in the Hot

- Humid Region

, but the percentages of sales at levels above SEER 14 are significantly affected (efficiency distribution shift). The average distribution described in Case 3 is applied to the Hot

- Humid region.

The results of this analysis for these four cases are shown in Table 18.5

. 2

.18

- 24 Table 18.5

. 2 Border Wholesaler Required Inventory

Scenario No. Units in Inventory

Base Case 3117

Case 1 3 084

Case 2 3 120

Case 3 3 110

Case 4 3 132
Impact of Regional Standards on Value of Inventories
Rollup (Case 2 / Case 1) 1. 2 % Increase
Shift (Case 4 / Case 3) 0 .7 % Increase

The base case scenario shows the inventory holdings required if there are no changes in the efficiency standard. The wholesaler must hold 3 117 units in inventory in order to meet the “standard of service” conditions of the model.

Case 1 shows the impact of a single national standard with a rollup scenario. In this case, SEER 13 units are no longer sold, and it is no longer necessary to stock them. There is some compensating increase in inventory for SEER 14 units, but the overall inventory service is simpler and the inventory stock drops.

Case 2 correspon ds to a regional standard with a rollup scenario. It is still necessary for the border wholesaler to stock slightly more than half as many SEER 13 units as before to serve the Rest of Country, although these units can no longer be sold in the Hot

- Humid reg ion. In addition, more SEER 14 inventory must be carried to serve both regions. The difference in inventory between Case 1 and the Base Case is 0.1 percent; however, Case 2 (regional standard) requires about 1. 2 percent more inventory than Case 1 (national standard).

Case 3 corresponds to a single national standard with a market shift scenario. Once again, the elimination of 13 SEER units reduces the overall inventory that must be held. There is some compensating increase in inventory as sales of efficient equipment over several higher efficiency levels increase. O verall required inventories go down by 0.2 percent compared with the Base Case

. Case 4 corresponds to a regional standard with a market shift scenario. This case requires 0.7 percent more inventory than Case 3.

18.5.2 Profitability Analysis of Regional Standard Impacts

The increases in required physical units of inventory range from 0.7 percent to 1.2 percent higher for a regional standard than with a national standard for distributors serving two regions. Thu s , the impacts appear to be on the order of 1 percent

. Table 18.5

. 3 and Table 18.5

. 4 present the modeled impacts of these inventory changes on ‘ profit as a percentage of total sales’18

- 25 and on ‘return on net worth

, ’ respectively

. The tables also present t he impacts of changes in inventory changes that are twice as large ( 2 percent increase) and ten times as large (10 percent increase) to demonstrate the sensitivity of profitability to such changes.

The values in Table 18.5

. 3 and Table 18.5

. 4 are derived from the model in Table 18.5

. 1 by assuming increases to inventory and the associated increase in interest expense necessary to finance that additional working capital. Additionally, for illustrati ve purposes, DOE applied a range of inte rest rates for the capital required to finance the additional inventory.

Table 18.5

. 3 Profitability Impacts of Inventory Cost Increases

Profit before Taxes (% of Sales)
% Change in Inventory
Interest Rate for Inventory 0% 1% 2% 4% 10%

6% 1.9% 1.9% 1.9% 1.8% 1.8%

8% 1.9% 1.9% 1.9% 1.8% 1.7%

10% 1.9% 1.9% 1.9% 1.8% 1.7%

12% 1.9% 1.9% 1.8% 1.8% 1.7%

Table 18.5

. 3 indicates that the impacts of additional inventory on profitability are not

o bservable at one percent and two percent inventory change s , except at the highest modeled interest rates. Table 18.5

. 3 also indicates that an inventory increase of 10 percent financed at 12 percent interest could reduce pretax margins by approximately 20 bas is points , a decline of approximately 10 percent

.

Table 18.5

. 4 Return on Net Worth Impacts of Inventory Cost Increases

Return on Net Worth
% Change in Inventory
Interest Rate for Inventory 0% 1% 2% 4% 10%

6% 9.0% 9.0% 8.9% 8.8% 8.4%

8% 9.0% 8.9% 8.9% 8.7% 8.2%

10% 9.0% 8.9% 8.8% 8.6% 8.0%

12% 9.0% 8.9% 8.8% 8.5% 7.5%

Table 18.5

. 4 shows the impact of inventory changes on distributor Return on Net Worth

, which is calculated as pretax profit divided by net worth, where net worth equal s assets less liabilities. At the exp ected one to two percent inventory change, impacts on return on net worth18

- 26 are again small. However, the impacts could be significant for distributors with high borrowing costs and where there are significantly higher inventory requirements.

18.6 CONCLUSIONS

EISA instructs DOE to “consider the impacts of the additional regional standard on consumers, manufacturers, and other market participants” before proposing regional standa r ds. ( 42 U.S.C. 6295(o)(6)(D)(ii)) The impacts on consumers are presented in the LC C described in chapter 8 of the TSD; the impacts on manufacturers are presented in the MIA described in chapter 12 of the TSD; and the impact on market participants is analyzed in this chapter.

DOE understands the term market participants to consist of d istributors, mechanical contractors and general contractors. The participants termed dealers, contractors, and installers have overlapping or identical functions to distributors, mechanical contractors and general

contractors.

In determining the effects of regional standards on distributors, mechanical contractors and general contractors, DOE differentiates between enforcement and non

- enforcement impacts. Enforcement

- related impacts vary depending on the enforcement path proposed by DOE. Examples include the additional cost and complexity of potential reporting, compliance, and labeling requirements. Non

- enforcement impacts are not dependent on the choice of enforcement mechanisms. Examples for distributors include the expense of carrying additional invent ory to manage greater diversity in demand and the over head of educating contractors about regi onal boundaries . At this stage, no enforcement plans or requirements have been proposed. As such, DOE does not attempt to quantify enforcement

- related impacts in this chapter. This chapter focuses on the non

- enforcement impacts of regional standards on distributors, mechanical contractors and general contractors.

Additionally, in this chapter, DOE differentiates between the impacts of higher standards and the impa cts of introducing regional standards. This chapter focuses on the impacts of “establishing separate standards by geographic region”. Impacts that are the result of higher standards, which would occur under an amended energy conservation standard that did not specify regions, are not considered in this chapter.

Based on DOE’s research and industry feedback, the Department has not identified any

non

- enforcement impacts from regional standards on mechanical and general contractors. Most contractor issues identified in public meetings, written comments, and intervie ws have been related to the increase in size and the additional complexity of products. These issues are the result of higher standards rather than regional standards and are beyond the scope of this chapter. (Discussion of the impacts of a higher standar d on installation costs and on contractor labor requirements are included in the discussion of markups in chapter 6 of the TSD.) Additional concerns raised were related to the burdens of enforcement and the competitive impacts of insufficient enforcement. Enforcement impacts will be evaluated as part of the enforcement rulemaking, which is required if regional standards are adopted.

For distributors, DOE separately considered those that operate within the bounds of a single region and those that operate w ithin multiple regions. For distributors that service a single18

- 27 region and are far from regional borders, DOE expects regional standards to have impacts that are similar to a single national standard. Those distributors are not expected to incur additional costs or complications due to the implementation of multiple regional standards. However, distributors that serve multiple regions or are near border regions may have non

- enforcement impacts directly tied to the introduction of regional standards.

DOE ide ntified the most significant non

- enforcement impacts on distributors serving multiple regions to result from changes in inventory. DOE expects that distributors serving multiple standard regions will need to manage more variation in demand. The resulting change in product mix for distributors serving multiple regions could increase inventory investment and inventory management costs because more product models of equipment are required to meet standards. Using HARDI data for a typical distributor ’s financi als, DOE estimates that a Southeast distributor se rving two regions would need a 1 to 2 percent increase in inventory to meet changes in demand due to regional standards. A 2 percent change in inventory would reduce distributor profits by as much as 5.3 pe rcent annually. DOE also models the impacts of larger inventory changes and different costs of capital in section 18.5

.18

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2 "HVAC Repair | HVAC Contractors." Furnace Repair | Heating and A/C HVAC Contractors

. Web. 08 Feb. 2010. <http://www.serviceexperts.com/Services/HVAC

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- 2

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6 IBID 5

7 IBID 5

8 IBID 5

9 Maynard, Michael. “Standing Tall for Distributors.” HVACR Distribution Business Feb. 2008: pp. 22. Web. 04 Nov. 2009.

10 Maynard, Michael. “National Presence, L ocal Service

- Grainger Makes It Easy for the Customer.” HVACR Distribution Business June 2006: pp. 22

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12 Stratman, Scott. “Cycle Counting: Penicillin for Distributors.” HVACR Distribution Business April 2005: pp. 28. Web. 04 Nov. 2009.

13 Peric’, Tom S. “A View from the Top.” HVACR Distribution Business Feb. 2006: pp. 48. Web. 04 Nov. 2009.

14 IBID 5

15 IBID 5

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17 IBID 1618

- 29 18 Maynard, Michael. “Staying Ahead of the Technology Curve.” HVACR Distribution Business June 2007: pp. 17. Web. 04 Nov. 2009.

19 U S Census Bureau. Plumbing, Heating, and Air

- Conditioning Contractors: 2002

.

20 US Census Bureau. Plumbing, Heating, and Air

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.

21 2008 Annual Report . Rep. Comfort Systems USA. Web. Dec. 2010. < http://phx.corporate

ir.net/External.File?item=UGFyZW50SUQ9MzMyMTA2fENoaWxkSUQ9MzE0MzY5fFR5cG U9MQ==&t=1>. pp. 55

22 US Census Bureau, Plumbing, Heating, and Air

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.

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. 1 Apr. 2008. Web. <http://hvacrdistributionbusiness.com/mag/sanyo_hvac_solutions_2/#>.

25 IBID 24

26 Harris, Angela D. “Economics Challenge Contractors: Workforce Issues and Home Building Slowdown.” Air Conditioning, Heating & Refrigeration News March 2007: pp. 20. Web. 04 Nov. 2009.

27 Hinshaw, Jim. "HVAC Turns 13!: Life After 13 SEER: The Sales Process, What People Want." Air Conditioning, Heating & Refrigeration News , 23 Oct. 2006. Web.

< http://www.achrnews.com/Articles/Feature_Article/c9614976c6e2e010VgnVCM100000f932a8 c0>.

28 Harris, Angela. "Economics Challenge Contractors: Workforce Issues and Home Building Slowdown." Air Conditioning, Heating & Refrigeration NEWS . 26 Mar. 2007. Web. <ht tp://www.achrnews.com/Articles/Cover_Story/BNP_GUID_9

- 5

- 2006_A_10000000000000074453>

29 IBID 18

30 Ciuffreda, Albert. “Getting a Handle on Your Overhead.” Air Conditioning, Heating & Refrigerating News 237.16 (2009): pp. 20. Business & Company Resource Cente r . Web. 27 Oct. 2009.

31 IBID 30

32 IBID 1