5

- i CHAPTER 5. MARKUPS FOR PRODUCT PRICE DETERMINATION

TABLE OF CONTENTS

5.1 INTRODUCTION

................................ ................................ ................................ ........... 5

- 1 5.1.1 Distribution Channels

................................ ................................ .......................... 5

- 1 5.2 MARKUP CALCULATION M ETHODOLOGY

................................ ........................... 5

- 2 5.3 APPROACH FOR CALCULA TING CONTRACTOR MARK UPS

............................. 5

- 2 5.3.1 Assumptions

................................ ................................ ................................ ......... 5

- 2 5.3.2 Approach for Mechanical Contractor Markup

................................ ..................... 5

- 3 5.4 DERIVATION OF NATION AL MECHANICAL CONTRA CTOR MAR KUPS

......... 5

- 4 5.5 DERIVATION OF REGION AL MARKUPS

................................ ................................ . 5

- 5 5.6 SALES TAX

................................ ................................ ................................ .................... 5

- 5 5 .7 OVERALL MARKUPS

................................ ................................ ................................ ... 5

- 6

LIST OF TABLES

Table 5.4.1 Mechanical Contractor Expenses and Markups Based on Census Bureau Data

...... 5

- 5 Table 5.7.1 Summary of National Average Markups on CRAC Equipment

............................... 5

- 7

LIST OF FIGURES

Figure 5.1.1 Distribution Channels for CRAC E quipment

................................ .......................... 5

- 25

- 1 CHAPTER 5

. MARKUPS FOR PRODUCT PRICE DETERMINATION

5.1 INTRODUCTION

To carry out its analyses, the U.S. Department of Energy ( DOE ) needed to determine the
cost to the consumer of baseline products and the cost of more

- efficient units the consumer would purchase following the promulgation of new energy conservation standards

. However, the

consumer price of either baseline or higher efficiency equipment is not generally known . For this analysis

, the equipment price ( for either baseline or higher efficiency equipment) w ould be determined based on engineering estimates of manufacturing costs plus appropriate markups based on how the equipment is purchased.

DOE estimated a baseline markup and an incremental markup. DOE defined a baseline markup as a multiplier that convert s the manufacturer selling price (MSP) of equipment with baseline efficiency to the consumer purchase price o f equipment at the same baseline efficiency level. An incremental markup is defined as the mu ltiplier to convert the incremental increase in MSP of higher efficiency equipment to the consumer purchase price for the same equipment. C ompanies mark up the price to cover business cost and profit margin , as described in s ection 5.3

.
In this chapter , DOE first describes the market distribution channel and the methodology used to derive baseline and incremental markups

. DOE then summarizes the results in two sections: (1) national markups estimation and (2) regional markups e stimation. DOE differentiated markups between national and regional estimations because prices for contractors differ between regions of the country

.

5.1.1 Distribution Channels

The appropriate markups for determining consumer equipment prices depend on the typ e 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.

DOE believes that there is o nly one dominant distribution channel that describes how

c omp u ter r oom a ir c onditioning (CRAC) equipment passes from the manufacturer to the

consumer . It is shown in Figure 5.1

. 1

. T his distribution channel applies to both replac ements and new construction

. T he manufacturer or its distributor sells the equipment to a mechanical contractor, who in turns sells it to the consumer and provides installation services

. The prices used in this analysis were derived from manufacturer surve ys. The manufacturer price in each case is a “contractor” price, which includes the cost of delivery to the job site as well as any sales charges or commissions of distributors and manufacturer representatives. Therefore, no separate distributor or whole saler is shown in the di s tribution channel. Because of the specialized nature of the equipment, general contractors typically are not involved. Thus, in this market the only distribution channel markup is that of the mechanical contractor

.5

- 2 Replacement and New Construction

Figure 5.1

. 1 Distribution C hannels for CRAC Equipment

5.2 MARKUP CALCULATION M ETHODOLOGY

As previously discussed, mechanical contractors mark up the price of the equipment to cover their busin ess costs and profit margin s . In financial statements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold. The gross margin includes the company expenses , including overhead costs (sales, general, and administration); research and development and interest expenses; and depreciation and taxes , as well as company profits. In order for sales of a product to contribute positively to company cash flow, the product’s markup must cover the company’s gross margin . Products command lower or higher markups depending on company expenses associated with the product and the degree of market competition. In all installations, sales tax applies to the final consumer cost.

5.3 APPROACH FOR CALCULATING CONTRACT OR MARK UPS

F or the final rule , DOE examined the manner in which markups change by efficiency level and other factors for mechanical contractors

. DOE determined that markups are neither fixed

- dollar nor proportional to all direct costs, which means that the selli ng price of a product may not be strictly proportional to the purchase price of the equipment

. Based on information from the 2007 Economic Census
, as discussed in section 5.4
, DOE also found measurable differences between incre mental markups on direct equipment costs and the average aggregate markup on direct business costs for mechanical contractors. Section 5.3.2 further discusses the differences between average and incremental mark ups.
The main reason that the selling price of a product may not be strictly proportional to the purchase price of the equipment is that businesses incur a wide variety of costs. When the purchase price of equipment and materials increases, only a fraction of the business expenses increase, while the remainder of the businesses’ expenses stays relatively constant. For example

, if the unit price of CRAC equipment increases by 30 percent, it is unlikely that the cost of secretarial support in an administrativ e office will increase by 30 percent also. Certain business expenses are uncorrelated with the cost of equipment or cost of goods.

5.3.1 Assumptions

DOE derived the mechanical contractor markups from three key assumptions about the
costs associated with furnace s and central air conditioners and heat pumps . DOE based the mechanical contractor markups on firm

- level income statement data from the 2007 Economic Census

. These income statements break down the components of all costs incurred by firms that Manufacturer or Distributor Mechanical Contractor Consumer5

- 3 supply and i nstall air conditioning equipment. a The key assumptions used to estimate markups using these financial data are as follows.

1. The firm income statement s faithfully represent the various average costs incurred by firms installing CRAC equipment

. 2. These costs c an be divided into two categories: ( 1 ) costs that vary in proportion to the MSP of CRAC equipment ( variant costs ) ; and ( 2 ) costs that do not vary with the MSP of CRAC equipment ( invariant costs). 3. Overall

, contractor prices for CRAC equipment vary in propor tion to contractor costs for CRAC equipment 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 contractors tend to handle multiple commodity lines, including room air conditioners, furnaces, central air conditioners and heat pumps , and boilers, the data provide the m ost accurate available indication of the expenses associated with CRAC equipment

. Information obtained from the trade literature, and from selected heating, ventilating, and air conditioning (HVAC) contractors and consultants, tends to support the second a ssumption ; t his information indicates that contractor markups vary according to the quantity of labor and materials used to distribute and install appliances and equipment

. In the following discussion, DOE assumes a division of costs between those that do not scale with the manufacturer price (labor and occupancy expenses), and those that do (operating expenses and profit). This division of costs led to the estimate of contractor markups described in section 5.3.2

. In support of the third assumption, the HVAC 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 the price of equipment )

. The large number of HVAC firms listed in the 200 7 Economic C ensus indicates the competitive nature of the market

. For example, there are more than 700 HVAC manufacturers 1 and 91,000 HVAC
contractors 2 listed in the 200 7 c ensus

. Following standard economic theor y, competitive firms either set prices in line with costs or quickly go out of business. 3

5.3.2 Approach for Mechanical Contractor Markup

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

, DOE collected financia l data from the Plumbing

, Heating, and Air

- Conditioning (NAICS 23822 0 ) series from the 2007 Economic Census.

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

, value of construction, cost of materials, and cost of subc ontracted work at both state and national level s . DOE calculated the baseline markup for mechanical contractors using the following equation:

a M echanical contractors to which these reports refer handle multiple commodity lines, including resid ential and commercial air conditioners and warm

- air furnaces.5

- 4 SubCost MatCost Pay V MU CONSTRUCT BASE + + =
Eq. 5

. 1

Where:

BASE MU = b aseli ne mechanical contractor markup,

CONSTRUCT V = v alue of construction, 

### Pay = p ayroll for construction workers

, MatCost = c ost of materials, and SubCost = c ost of subcontracted work.

Analogously, DO E estimated the incremental mechanical contractor markups by only marking up those costs that scale with a change in the manufacturer’s sales price ( variant costs , V

C

) for higher energy efficiency products. DOE assumes a division of costs between those tha t do not scale with the manufacturer price (labor and occupancy expenses), and those that do ( other operating expenses and profit). Hence, DOE categorized the c ensus cost data in each major cost category and estimated markup s using the following equation :

CONT CONT CONT INCR CGS VC CGS MU +

=
Eq. 5

. 2

Where:

MU INCR = i ncremental contractor markup, CGS CONT = c ontractor cost of goods sold, and VC CONT = c ontractor variant costs.

5.4 DERIVATION OF NATION AL MECHANICAL CONTRA CTOR MARKUPS

The HVAC contractors, defined here as mechanical contractors

, are covered by d ata from the 2007 Economic Census. Aggregate data are shown in Table 5.4.1

. DOE converted expenses per dollar sales into revenue per do llar cost of goods sold by dividing each figure in the first data column by $0. 678 . For every $1.00 the mechanical contractor spends on equipment costs, the mechanical contractor earns $1.00 in sales revenue to cover the equipment cost, and $0. 474 to

cover the other costs. This totals $1. 474 in sales revenue earned for every $1.00 spent on equipment costs, for a baseline markup ( MU MECH CONT BASE ) of 1. 474 for mechanical contractors, because the contractor earns $1. 474 in sales revenue for every $1.00 spent to purchase the equipment. This is the beginning point for the determination of mechanical contractor markups.

Calculation of the incremental markups for each market type required separation of the invariant and variant costs. DOE used detailed 2007 Census Bureau data for all plumbing, heating, and air

- conditioning contractors. The Census Bureau data were used to calculate the baseline and incremental markups as shown in Table 5.4.1

. (Appendix 5 A

. 1 contains the full set of data used to calculate the incremental markup .)5

- 5 Table 5.4

. 1 Mechanical Contractor Expenses and Markups Based on 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 0.6 7 8 1.00 0 Labor Expenses: Salaries (indirect) and benefits 0.17 5 0.2 58 Occupancy Expense: Rent, maintenance, and utilities 0.02 3 0.03 2 Other Operating Expenses: Deprecia tion, advertising, and insurance. 0.0 40 0.0 58 Net Profit Before Taxes 0.0 86 0.1 27 Baseline Markup ( MUMECH BASE ): Revenue per dollar cost of goods 1.47 4 Incremental Markup ( MUMECH INCR ): Increased revenue per dollar increase cost of goods sold 1.18 4

Sou rce: U.S. Census Bureau

. 200 7. Plumbing, Heating, and Air

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

, Detailed Statistics for Establishments

, 2007

. Using the data in Table 5.4

. 1 , the incremental m arkup is 20 percent lower than the baseline markup. DOE assumed that this deviation applies equally to the baseline markups calculated for the replacement and new construction markets.

5.5 DERIVATION OF REGION AL MARKUPS

The 2007 Economic Census prov ides Geogr aphic Area Series for the Plumbing

, Heating, and Air

- Conditioning (NAICS 23820 ) sec tor , which contains state

- level sale s and cost data

, including value of construction, cost of subcontract work, cost of materials, and payroll for construction workers . By u sing Eq. 5

. 1 , DOE estimate d baseline markups for each state.

DOE then calculated a state

- level relative baseline markup

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

. A relative mechanical contractor markup value was calculated for each state. The relative values are multiplied by the national markups for both baseline and incremental markups. For example, as shown in Appendix 5 A , the relative mechanical contractor markup value for Californ ia is 1.043, which would be multiplied by the mean markup factor of 1. 474 , yielding a mechanical contractor baseline markup of 1.5 37

. If instead the incremental markup were neede d , the 1.043 relative markup value would be multiplie d by the mean incrementa l markup factor of 1. 184 , yielding a mechanical contractor markup value of 1. 235

.

5.6 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 increa ses the consumer equipment price.

DOE derived state and local taxes from data provided by the Sales Tax Clearinghouse. 4 These data represent weighted averages that include county and city rates. Detailed sales tax data by each state can be found in A ppendi x 5 A

.5

- 6 5.7 OVERALL MARKUPS

The overall markup for each distribution channel is the product of the appropriate markups, as well as sales tax ( Table 5.7.1 )

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

## ( )
BASE OVERALL MFG SALES BASE MFG BASE MU PRICE Tax MU PRICE CPP

_ × = × × = Eq. 5

. 3

Where:

CPP BASE = c onsumer product price for baseline models, PRICE MFG = m anufacturer sales price (distributor delivered price) for baseline models, MU BASE = b aseline mechanical contr a ctor markup

, Tax SALES = s ales tax, and MU OVERALL_BASE = b aseline overall markup.

Similarly, DOE used the overall incremental markup to estimate c hanges in the consumer product price, given changes in the manufacturer 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 i s composed of two components: (1) the consumer product price of the baseline model and (2) 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 consumer product price for more energy efficient models ( i.e. , models meeting new energy conservation standards). 

## ( )

INCR OVERALL MFG BASE SALES INCR MFG BASE OVERALL MFG STD 

### MU PRICE CPP Tax MU PRICE MU PRICE CPP

_ _ 

### × ∆ + = × × ∆ + × =

Eq. 5

. 4

Where:

CPP STD = c onsumer product price for models meeting new energy conservation standards, CPP BASE = c onsumer product price for baseline models, PRICE MFG = m anufacturer sales price for baseline models, Δ

PRICE MFG = c hange in manufacturer sales price for higher energy efficient models, MU INCR = i ncremental markup

, Tax SALES = s ales tax, MU OVERALL_BASE = b aseline overall markup (product of mechanical contractor markup and sales tax), and MU OVERALL_INCR = i ncremental overall markup.5

- 7 National average baseline and inc remental markups for each market participant are summarized in Table 5.7.1

.

Table 5.7

. 1 Summary of National Average Markups on C RA C Equipment

Baseline Markup Incre mental Markup Mechanical Contractor 1.474 1.184 Sales tax (National population

- weighted average) 1.07 1 1.07 1 Overall Markup 1.5 79 1.2 695

- 8 REFERENCES

1

. U.S. Census Bureau. 2007 Economic Census, Table EC0731I1: Detailed Statistics by Industry for the Un ited States: 2007. Air

- Conditioning and Warm Air Heating Equipment and Commercial and Industrial Refrigeration Equipment M a nufacturing . (Last accessed April 25, 2012 .) Data can be accessed by searching for the Table EC0731I1 at

< http://factfinder2.census.gov/faces/nav/jsf/pages/searchresults.xhtml?refresh=t#none >.

2

. U.S. Census Bureau. 2007 Economic Census, Construction Geographic Area Series: Table EC0723 A 1: Detailed Statistics for Establishments: 2007. Plumbing, Heating, and Air

Conditioning Contractors. (Last accessed April 25, 2012.) Data can be accessed by searching for the Table EC0723A1 at

< http://factfinder2.census.gov/faces/nav/jsf/pages/searchresults.xhtml?refresh=t#none >

.

3

. Pindyck, R. and Rubinfeld, D. 2000. Microeconomics : Fifth Edition . Prentice Hall : Upper Saddle River, NJ

.

4

. The Sales Tax Clearinghouse. (Last accessed January 11, 2012.)

< https://thestc.com/STRates.stm >