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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 METHODOLOGY........................................................... 5-2

5.3 APPROACH FOR CALCULATING CONTRACTOR MARKUPS ............................. 5-2

5.3.1 Assumptions......................................................................................................... 5-2

5.3.2 Approach for Mechanical Contractor Markup..................................................... 5-3

5.4 DERIVATION OF NATIONAL MECHANICAL CONTRACTOR MARKUPS......... 5-4

5.5 DERIVATION OF REGIONAL 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 Equipment.......................................................... 5-2
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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) would 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 converts the manufacturer selling price (MSP) of equipment with 

baseline efficiency to the consumer purchase price of equipment at the same baseline efficiency 

level. An incremental markup is defined as the multiplier to convert the incremental increase in 

MSP of higher efficiency equipment to the consumer purchase price for the same equipment.

Companies mark up the price to cover business cost and profit margin, as described in section

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 estimation. 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 type 

of distribution channels through which products move from manufacturers to purchasers. At each 

point in the distribution channel, companies mark up the price of the equipment to cover their 

business costs and profit margin. 

DOE believes that there is only one dominant distribution channel that describes how 

computer room air conditioning (CRAC) equipment passes from the manufacturer to the 

consumer. It is shown in Figure 5.1.1. This distribution channel applies to both replacements 

and new construction. The 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 surveys. 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 wholesaler is shown in the distribution 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.
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Replacement and New Construction

Figure 5.1.1 Distribution Channels for CRAC Equipment

5.2 MARKUP CALCULATION METHODOLOGY

As previously discussed, mechanical contractors mark up the price of the equipment to 

cover their business costs and profit margins. 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 CONTRACTOR MARKUPS

For 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 selling 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 incremental 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 markups.

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 administrative 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 furnaces 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 Consumer
5-3

supply and install air conditioning equipment.a The key assumptions used to estimate markups 

using these financial data are as follows.

1. The firm income statements faithfully represent the various average costs incurred by 

firms installing CRAC equipment.

2. These costs can 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 proportion 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 most 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 assumption;

this 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 2007 Economic Census indicates the competitive nature of 

the market. For example, there are more than 700 HVAC manufacturers1 and 91,000 HVAC 

contractors2 listed in the 2007 census. Following standard economic theory, 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 financial data from the Plumbing, Heating, and Air-Conditioning

(NAICS 238220) 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 subcontracted work at both state and national 

levels. DOE calculated the baseline markup for mechanical contractors using the following 

equation:

 a Mechanical contractors to which these reports refer handle multiple commodity lines, including residential and 

commercial air conditioners and warm-air furnaces.
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Pay MatCost SubCost

V MU CONSTRUCT

BASE + + =

Eq. 5.1

Where:

MUBASE = baseline mechanical contractor markup,

VCONSTRUCT = value of construction,

Pay = payroll for construction workers,

MatCost = cost of materials, and

SubCost = cost of subcontracted work.

Analogously, DOE 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, 

VC) for higher energy efficiency products. DOE assumes a division of costs between those that 

do not scale with the manufacturer price (labor and occupancy expenses), and those that do 

(other operating expenses and profit). Hence, DOE categorized the census cost data in each 

major cost category and estimated markups using the following equation:

CONT

CONT CONT

INCR CGS

CGS VC MU + =

Eq. 5.2

Where:

MUINCR = incremental contractor markup,

CGSCONT = contractor cost of goods sold, and

VCCONT = contractor variant costs.

5.4 DERIVATION OF NATIONAL MECHANICAL CONTRACTOR MARKUPS

The HVAC contractors, defined here as mechanical contractors, are covered by data from 

the 2007 Economic Census. Aggregate data are shown in Table 5.4.1. DOE converted expenses 

per dollar sales into revenue per dollar 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 (MUMECH 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 5A.1 contains the full set 

of data used to calculate the incremental markup.)
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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 0.678 1.000

Labor Expenses: Salaries (indirect) and benefits 0.175 0.258

Occupancy Expense: Rent, maintenance, and utilities 0.023 0.032

Other Operating Expenses: Depreciation, advertising, and insurance. 0.040 0.058

Net Profit Before Taxes 0.086 0.127

Baseline Markup (MUMECH BASE): Revenue per dollar cost of goods 1.474

Incremental Markup (MUMECH INCR): Increased revenue per dollar increase cost of goods 

sold

1.184

Source: U.S. Census Bureau. 2007. 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 markup 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 REGIONAL MARKUPS

The 2007 Economic Census provides Geographic Area Series for the Plumbing, Heating, 

and Air-Conditioning (NAICS 23820) sector, which contains state-level sales and cost data,

including value of construction, cost of subcontract work, cost of materials, and payroll for 

construction workers. By using Eq. 5.1, DOE estimated 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 5A, the 

relative mechanical contractor markup value for California is 1.043, which would be multiplied 

by the mean markup factor of 1.474, yielding a mechanical contractor baseline markup of 1.537. 

If instead the incremental markup were needed, the 1.043 relative markup value would be 

multiplied by the mean incremental 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 increases 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 Appendix 5A.
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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 products 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.

( ) CPPBASE = PRICEMFG × MUBASE ×TaxSALES = PRICEMFG × MUOVERALL _ BASE

Eq. 5.3

Where:

CPPBASE = consumer product price for baseline models,

PRICEMFG = manufacturer sales price (distributor delivered price) for baseline models,

MUBASE = baseline mechanical contractor markup,

TaxSALES = sales tax, and

MUOVERALL_BASE = baseline overall markup.

Similarly, DOE used the overall incremental markup to estimate changes 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 is 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). 

( )

BASE MFG OVERALL INCR

STD MFG OVERALL BASE MFG INCR SALES

CPP PRICE MU

CPP PRICE MU PRICE MU Tax

_

_

= + ∆ ×

= × + ∆ × ×

Eq. 5.4

Where:

CPPSTD = consumer product price for models meeting new energy conservation standards,

CPPBASE = consumer product price for baseline models, 

PRICEMFG = manufacturer sales price for baseline models,

ΔPRICEMFG = change in manufacturer sales price for higher energy efficient models,

MUINCR = incremental markup,

TaxSALES = sales tax,

MUOVERALL_BASE = baseline overall markup (product of mechanical contractor markup and sales 

tax), and

MUOVERALL_INCR = incremental overall markup.
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National average baseline and incremental markups for each market participant are 

summarized in Table 5.7.1. 

Table 5.7.1 Summary of National Average Markups on CRAC Equipment

Baseline Markup Incremental Markup

Mechanical Contractor 1.474 1.184

Sales tax (National population-weighted average) 1.071 1.071

Overall Markup 1.579 1.269
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REFERENCES

1. U.S. Census Bureau. 2007 Economic Census, Table EC0731I1: Detailed Statistics by 

Industry for the United States: 2007. Air-Conditioning and Warm Air Heating Equipment 

and Commercial and Industrial Refrigeration Equipment Manufacturing. (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 

EC0723A1: Detailed Statistics for Establishments: 2007. Plumbing, Heating, and AirConditioning 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>