CHAPTER 6. MARKUPS TO DETERMINE PRODUCT COST

TABLE OF CONTENTS

6.1 INTRODUCTION

........................................................................................................... 6-1 6.1.1 Distribution Channels

.................................................................................................... .. 6-1 6.2 MARKUP CALCULATION PROCEDURE

.................................................................. 6-1 6.2.1.1 Manufacturer Markups

................................................................................... 6-2 6.2.1.2 Retailer Markups

............................................................................................ 6-2 6.2.1.3 Overall Markup

.............................................................................................. 6-4 6.3 MANUFACTURER MARKUPS

.................................................................................... 6-5 6.4 RETAILER MARKUP

.................................................................................................... 6-6 6.5 SALES TAXES

............................................................................................................... 6 -7 6.6 SUMMARY OF MARKUPS

.......................................................................................... 6-7

LIST OF TABLES Table 6.3.1 Major Appliance Manufacturer Gross Margins and Markups

............................. 6-5 Table 6.4.1 Data Used to Calculate Retailer Markups

............................................................ 6-6 Table 6.5.1 Average Sales Tax Rates by Census Division and Large State

........................... 6-7 Table 6.5.2 Average Sales Tax Rates by Product

................................................................... 6-7 Table 6.6.1 Summary of Markups

.......................................................................................... 6-8

6-iCHAPTER 6. MARKUPS TO DETERMINE PRODUCT COST

6.1 INTRODUCTION To carry out the engineering and life-cycle cost (LCC) analyses, DOE needed to determine the cost to the consumer of a baseline product and the cost of more-efficient units that might meet a revised standard. By applying a multiplier called a “markup” to the manufacturers’ product costs estimated in the engineering analysis, DOE estimated the consumer costs for baseline models and more efficient products.

6.1.1 Distribution Channels The appropriate markups for determining the consumer product cost 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 products to cover their business costs and profit margin. DOE based the distribution channels for room air conditioners and clothes dryers on data from the Association of Home Appliance Manufacturers (AHAM). 1 Because an overwhelming majority of products are sold through retail outlets, DOE estimated that all of the considered products are purchased by consumers from retail outlets.

6.2 MARKUP CALCULATION PROCEDURE In financial statements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold ( CGS ). Inputs for calculating the gross margin are all corporate costs—including overhead costs (sales, general, and administration); research and development (R&D) and interest expenses; depreciation, and taxes—and profits. In order for sales of a product to contribute positively to company cash flow, the product’s markup must be greater than the corporate gross margin. Individual products may command a lower or higher markup, depending on their perceived added value and the competition they face from similar products in the market. In developing markups for manufacturers, retailers, and distributors, DOE obtained data about the revenue, CGS , and expenses of firms that produce and sell the products of interest. DOE’s approach categorizes the expenses into two categories: labor-scaling costs ( LSC ), which are fixed labor and occupancy expenses that increase in proportion to the amount of labor required to produce or sell the product, and non-labor-scaling costs ( NLSC ), which are variable operating costs that do not scale with labor and vary in proportion to CGS . Together, LSC and NLSC represent the gross margin.

6-16.2.1.1 Manufacturer Markups DOE uses manufacturer markups to transform a manufacturer’s product costs into a manufacturer sales price. Using the CGS and gross margin, DOE calculated the manufacturer markup ( MU MFG ) with the following equation:

CGS + GM MFG MFG MU MFG = CGS MFG Where:

MU MFG = Manufacturer markup, CGS MFG = Manufacturer’s cost of goods sold, and GM MFG = Manufacturer’s gross margin.

6.2.1.2 Retailer Markups DOE based the retailer markups on financial data from the U.S. Census Business Expenditure Survey. DOE organized the financial data into balance sheets that break down cost components incurred by firms that sell the products. a The key assumptions that DOE used to estimate the retailer markups using these financial data were:

1. The balance sheets faithfully represent the various average costs incurred by firms selling clothes dryers and room air conditioners.

2. These costs can be divided into two categories:
a. Costs that vary in proportion to the manufacturer sales price (variable costs); and b. Costs that do not vary with the manufacturer sales price (fixed costs).

3. Retailer sales prices vary in proportion to retailer and distributor costs that are included in the balance sheets. In support of the first assumption, the balance sheets itemize firm costs into a number of expense categories, including CGS , operating labor and occupancy costs, and other operating costs and profit. Although retailers tend to handle multiple commodity lines, the data provide the most accurate available indication of home appliance expenses. Information obtained from the trade literature pertaining to the heating, ventilation, and air-conditioning (HVAC) contracting industry tends to support the second assumption. This information indicates that retailer and distributor markups should vary according to the quantity of labor and materials used to sell or distribute the products, with markups on labor tending to be much larger than markups on materials. 2 This information also describes markups as varying much more in relation to sales volume than in relation to other factors, including appliance

a The retailers and distributors to whom these fin ancial data refer handle multiple commodity lines.

6-2efficiency. This last finding strongly suggests that labor inputs vary more with sales volume than with appliance cost or efficiency. In the discussion that follows in sections 6.3 and 6.4, DOE assumes a division of costs between those that do not scale with the manufacturer sales price (fixed costs—labor and occupancy expenses referred to above as LSC ), and those that do (variable costs—operating expenses and profit referred to above as NLSC ). This division of costs led to the estimate of retailer markups described below in sections 6.3 and 6.4. In support of the third assumption, the retailer and distributor industries are relatively competitive, and consumer demand for residential hom e appliances is relatively inelastic, i.e. the demand is not expected to decrease significantly with a relatively small increase in price. The large number of household appliance stores and merchant wholesalers of service equipment (i.e., distributors of products) listed by the U.S. Census Bureau in its Statistics of U.S. Businesses indicates the competitive nature of the market. 3 For example, there are more than 10,000 household appliance store establishments and over 5,000 merchant wholesaler establishments of service equipment in the United States. b Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or quickly go out of business. 4
Using the above assumptions, DOE developed baseline and incremental markups to transform the manufacturer sales price into a consumer product cost. DOE used the baseline markups, which cover all of a retailer’s costs (i.e., both LSC and NLSC ), to determine the sales price of baseline models. The baseline markup relates the manufacturer sales price to the retailer sales price. DOE considers baseline models to be products sold under existing market conditions (i.e., without new energy efficiency standards). DOE calculated the baseline markup ( MU BASE ) for retailers using the following equation:

CGS + GM CGS + ( LSC + NLSC ) RTL RTL RTL RTL MU BASE = = CGS RTL CGS RTL
Where:

MU BASE = Baseline retailer markup, CGS RTL = Retailer’s cost of goods sold, GM RTL = Retailer’s gross margin, LSC RTL = Retailer’s labor-scaling costs, and NLSC RTL = Retailer’s non-labor-scaling costs. Incremental markups cover only those costs that scale with a change in the manufacturer’s sales price (i.e., NLSC ). Incremental markups are coefficients that relate the change in the manufacturer sales price of higher-e fficiency models to the change in the retailer or distributor sales price. DOE considers higher-efficiency models to be products sold under market

b DOE determined the number of establishments for ho usehold appliance stores based on the following North American Industry Classification System (NAICS) code and description: 443111, Household Appliance Stores

.
6-3conditions with new efficiency standards. It calculated the incremental markup ( MU INCR ) for retailers using the following equation:

CGS RTL + NLSC RTL = MU INCR CGS RTL Where:

MU INCR = Incremental retailer markup, CGS RTL = Retailer’s cost of goods sold, and NLSC RTL = Retailer’s non-labor-scaling costs.

6.2.1.3 Overall Markup The overall markup is the product of the manufacturer and retailer markups, as well as sales taxes. DOE used the overall baseline markup to estimate the consumer product cost of baseline models, given the manufacturer cost of the baseline models. As stated above, DOE considers baseline models to be products sold under existing market conditions (i.e., without new energy efficiency standards). The following equation shows how DOE used the overall baseline markup to determine the product cost for baseline models.

CPC BASE = COST MFG x 

## ( MU MFG x MU BASE x Tax SALES 

## ) = COST MFG x MU OVERALL

_ BASE
Where:

CPC BASE = Consumer product cost for baseline models, COST MFG = Manufacturer cost for baseline models, MU MFG = Manufacturer markup, MU BASE = Baseline retailer markup, Tax SALES = Sales tax, and MU OVERALL_BASE = Baseline overall markup. Similarly, DOE used the overall incremental markup to estimate changes in the consumer product cost, given changes in the manufacturer cost above the baseline model cost resultingfrom a standard to raise product efficiency. The total consumer product cost for higherefficiency models is composed of two components: the consumer product cost of the baseline model and the change in consumer product cost associated with the increase in manufacturer cost to meet the new efficiency standard. The following equation shows how DOE used the overall incremental markup to determine the consumer product cost for higher-efficiency models (i.e., models meeting new efficiency standards).

6-4CPC = COST x MU + I COST x 

## ( MU x MU x Tax 

## ) STD MFG OVERALL

_ BASE MFG MFG INCR SALES

= CPC + I COST x MU BASE MFG OVERALL

_ INCR
Where:

CPC STD = Consumer product cost for models meeting new efficiency standards, CPC BASE = Consumer product cost for baseline models, COST MFG = Manufacturer cost for baseline models, 1 COST MFG = Change in manufacturer cost for higher-efficiency models, MU MFG = Manufacturer markup, MU INCR = Incremental retailer or distributor markup, Tax SALES = Sales tax, MU OVERALL_BASE = Baseline overall markup, and MU OVERALL_INCR = Incremental overall markup.

6.3 MANUFACTURER MARKUPS DOE developed an average manufacturer markup by examining the annual Securities and Exchange Commission (SEC) 10-K reports filed by four publicly-traded manufacturers primarily engaged in appliance manufacturing and whose combined product range includes room air conditioners and clothes dryers. 5 The four manufacturers represent a nearly 50 percent market share for core appliances. Because these companies are typically diversified, producing a range of different appliances, an industry average markup was assumed by DOE to be representative for the manufacture of each type of appliance. DOE evaluated markups for the years between 2002 and 2005, inclusive. Table 6.3.1 lists the average corporate gross margin during the years from 2002 to 2005, and corresponding markups, for each of the four manufacturers. The average markup value based on these four companies is 1.26.
Table 6.3.1 Major Appliance Manufacturer Gross Margins and Markups Mfr A Mfr B Mfr C Mfr D Average Net Revenues (Million) $372 $280 $4770 $12,682 Corporate Gross Margin 15% 28% 16% 22% Markup 1.18 1.39 1.19 1.28 Source: SEC 10-K reports (2002-2005)

6-56.4 RETAILER MARKUP DOE used financial data from the U.S. Census Business Expenditure Survey (BES), in the “Household Appliance Stores” category, to calculate markups used by retailers that apply to room air conditioners and clothes dryers. c, 6 Table 6.4.1 shows the BES data that DOE used and the retail markups for these appliances that DOE estimated following the procedures described above.
Table 6.4.1 Data Used to Calculate Retailer Markups Item Million 1997 Dollars Sales (revenue) 10,343 Cost of Goods Sold (CGS) 7,151 Gross Margin (GM) 3,193 Labor-Scaling Costs (LSC) Payroll 1,366

Fringe Benefits 208 Contract Labor 69 Taxes and License Fees 53 Lease and Rental Payments 238 Telephone and Communications 58

Utilities 70 Repair and Maintenance 36 LCS Subtotal: 2,098 Non-Labor-Scaling Costs (NLSC) Depreciation and Amortization 94

Office Supplies 37 Packaging and Other Materials 0

Advertising Services 274 Legal Services 8 Accounting, Auditing, and Bookkeeping 19 Computer Related Services 10 Other Operating Expenses 389 Net Profit Before Taxes 263 NLCS Subtotal: 1,094 Baseline Markup (MU BASE ) = (CGS+GM)/CGS 1.45 Incremental Markup (MU INCR ) = (CGS+NLSC)/CGS 1.15

c DOE used the 1997 BES because the 2002 BES did not cont ain sufficient data for the calculation of gross margin or cost of goods sold.

6-66.5 SALES TAXES The sales tax represents state and local sales taxes that are applied to the consumer product cost of the product. The sales tax is a multiplicative factor similar to a markup.
DOE derived state and local taxes from data provided by the Sales Tax Clearinghouse. 7 These data represent weighted averages that include county and city rates. DOE then derived population-weighted average tax values for each Census division and large state, as shown in Table 6.5.1 below.
Table 6.5.1 Average Sales Tax Rates by Census Division and Large State Census Division/State Tax Rate New England 4.98% Mid Atlantic 6.07% East North Central 6.56% West North Central 6.65% South Atlantic 5.95% East South Central 7.85% West South Central 8.30% Mountain 6.46% Pacific 4.97% New York State 8.25% California 7.95% Texas 7.95% Florida 6.70%
DOE then derived U.S.-average tax values for each product (as shown in Table 6.5.2 below) based on the product’s saturation within each Census division and large state. It determined the saturations from the DOE Energy Information Administration’s 2005 Residential Energy Consumption Survey. 8
Table 6.5.2 Average Sales Tax Rates by Product Product Tax Rate Room air conditioners 6.75% Clothes dryers 6.78%

6.6 SUMMARY OF MARKUPS Table 6.6.1 summarizes the markups at each stage in the distribution channel and the overall baseline and incremental markups, as well as sales taxes, for each product.

6-7Table 6.6.1 Summary of Markups Room Air Conditioners Clothes Dryers Markup Baseline Incremental Baseline Incremental
Manufacturer 1.26 1.26 Retailer 1.45 1.15 1.45 1.15 Sales Tax 1.068 1.068
Overall 1.95 1.55 1.95 1.55
The example for room air conditioners, provided below, illustrates how DOE used the baseline and incremental markups to derive a consumer product cost. Assuming the baseline manufacturer cost is $225 and the change in manufacturer cost to meet a given energy efficiency standard is $10, the resulting baseline consumer product cost ( CPC BASE ) and higher-efficiency product cost ( CPC STD ) are:

CPC = COST x 

## ( MU x MU x Tax 

## ) BASE MFG MFG BASE SALES

= $225 x 1.26 x 1.45 x 1.068 = $439

CPC = CPC + I COST x 

## ( MU x MU x Tax 

## ) STD BASE MFG MFG INCR SALES

= $225 + ($10 x 1.26 x 1.15 x 1.068) = $439 + $15 = $464

6-86.6.1 Validation of Estimated Markups As part of its market data collection, DOE assemb led a data base with retail Internet prices for a large number of clothes dryer m odels at baseline efficiency. Additionally, DOE used detailed sales data from NPD Group, a market research firm, to estimate room air conditioner retail prices at baseline efficiency for three of the product classes. d For each model, DOE divided the retail price by the estimated manufacturer cost for the appropriately-sized clothes dryer or room air conditioner (estimated as described in chapter 5) to derive an implicit markup. This markup would include the manufacturer markup and the retail markup. To be comparable with the overall markups shown in Table 6.6.1, DOE added U.S.-average sales tax values for each product. See appendix 6-A, Detailed Data for Product Cost Markups, for the derivation of the implicit markups. For electric clothes dryers, the implicit markups for standard and compact models average 2.08, which is slightly higher than the calculated overall markup (1.95). For room air conditioners, the implicit markups average 1.91, close to the calculated overall markup (1.95). Exact agreement should not be expected, since the actual manufacturing costs may be different from the costs estimated by DOE and the price data from the NPD dataset does not cover all retail sales.

d For the other product classes , there was an imperfect match between effici ency levels of retail data and those used to estimate manufacturing cost.

6-9REFERENCES

1. Association of Home Appliance Manufacturers, AHAM 2003 Fact Book . 2003. Washington, DC.

2. Skaer, M., What should you charge? Try These Tested Formulas

. The Air Conditioning, Heating, and Refrigeration News , 2001< http://www.achrnews.com/CDA/ArticleInformation/features/BNP__Features__Ite m/0,1338,23113,00.html >

3. U. S. Department of Commerce - Bureau of the Census, Statistics of U.S. Businesses. , 2004. Washington, DC.

4. Pindyck, R. S. and D. L. Rubinfeld, Microeconomics . 5th ed. 2000. Prentice Hall: New Jersey.

5. Security Exchange Commission, SEC 10-K Reports, Various dates, 2002-2005. Security Exchange Commission. < http://www.sec.gov / >

6. U.S. Census Bureau, 1997 Economic Census, Business Expenses Survey, Retail Trade, Electronics and Appliance Stores. , 1997. Washington, DC

7. Sales Tax Clearinghouse Inc., State Sales Tax Rates Along with Combined Average City and County Rates, 2006. < http://thestc.com/STrates.stm >

8. U.S. Department of Energy - Energy Information Administration, Residential Energy Consumption Survey: 2005 Public Use Data Files, 2005.
< http://www.eia.doe.gov/emeu/recs/recspubuse05/pubuse05.html >

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