7-i

CHAPTER 7. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

TABLE OF CONTENTS

7.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-1

7.1.1 Baseline Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-2

7.1.2 Incremental Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-3

7.1.3 Overall Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-4

7.2 BASIC ASSUMPTIONS USED TO ESTIMATE WHOLESALER AND 

CONTRACTOR MARKUPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-4

7.3 ESTIMATION OF WHOLESALE MARKUPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-6

7.3.1 Estimation of Wholesale Markup Probability Distribution . . . . . . . . . . . . . . . . 7-7

7.4 ESTIMATION OF MECHANICAL CONTRACTOR MARKUPS . . . . . . . . . . . . . . . 7-8

7.4.1 Markups for Small and Large Mechanical Contractors in the Replacement 

and New Construction Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-9

7.4.2 Estimation of Mechanical Contractor Markup Probability Distribution . . . . . 7-14

7.5 ESTIMATION OF GENERAL CONTRACTOR MARKUPS . . . . . . . . . . . . . . . . . . 7-15

7.5.1 Estimation of General Contractor Markup Probability Distribution . . . . . . . . 7-16

7.6 SALES TAX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-17

7.7 NATIONAL ACCOUNTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-18

7.8 OVERALL MARKUPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-19

LIST OF TABLES

Table 7.3.1 Wholesale Expenses and Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-6

Table 7.4.1 Mechanical Contractor Expenses and Markups . . . . . . . . . . . . . . . . . . . . . . . . . 7-9

Table 7.4.2 Mechanical Contractor Expenses and Markups by Contractor Size . . . . . . . . 7-11

Table 7.4.3 Mechanical Contractor Expenses and Markups by Market Type . . . . . . . . . . 7-12

Table 7.4.4 Baseline Markups by Mechanical Contractor Size and Market Type . . . . . . . 7-13

Table 7.4.5 Incremental Markups by Mechanical Contractor Size and Market Type . . . . 7-14

Table 7.5.1 General Contractor Expenses and Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-16

Table 7.6.1 Distribution of Sales Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-18

Table 7.8.1 Overall Baseline Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-19

Table 7.8.2 Overall Incremental Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-20

LIST OF FIGURES

Figure 7.1.1 Distribution Channels for Commercial Air Conditioners . . . . . . . . . . . . . . . . . 7-1

Figure 7.3.1 Wholesaler Baseline Markup Probability Distribution . . . . . . . . . . . . . . . . . . . 7-8

Figure 7.3.2 Wholesaler Incremental Markup Probability Distribution . . . . . . . . . . . . . . . . 7-8

Figure 7.4.1 Mechanical Contractor Baseline Markup Probability Distribution, Large 

Contractors, New Construction Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-15
7-ii

Figure 7.4.2 Mechanical Contractor Incremental Markup Probability Distribution, 

Large Contractors, New Construction Market . . . . . . . . . . . . . . . . . . . . . . . . . 7-15

Figure 7.5.1 General Contractor Baseline Markup Probability Distribution . . . . . . . . . . . . 7-17

Figure 7.5.2 General Contractor Incremental Markup Probability Distribution . . . . . . . . . 7-17
7-1

Manufacturer

Large

Mechanical

Contractor

General

Contractor

Manufacturer

Wholesaler

Customer

Customer

Small

Mechancial

Contractor

Customer

National Account

General

Contractor

Figure 7.1.1 Distribution Channels for Commercial Air Conditioners

CHAPTER 7. MARKUPS FOR EQUIPMENT PRICE DETERMINATION

7.1 INTRODUCTION

In order to carry out the life-cycle cost (LCC) calculations described in Chapter 8, DOE

needed to determine the cost to the customer of a baseline air-conditioning unit, and the cost of

the more-efficient unit the customer would purchase under the standards. However, the

customer price of such units is not generally known. What is known is the manufacturer’s price

for both baseline equipment and the more-efficient equipment. By applying a multiplier called a

“markup” to the manufacturer’s price, DOE can estimate the customer’s price. This chapter

describes how DOE derived such markups. 

The equipment price to the customer will depend on how the customer purchases the

equipment. The Department defines two types of distribution channels to describe how the

equipment passes from the manufacturer to the customer: (1) in the first distribution channel, the

manufacturer sells the equipment to a wholesaler, who in turn sells it to a mechanical contractor,

who in turn sells it (and its installation) to a general contractor, who in turn sells it to the

customer; (2) in the second distribution channel, the manufacturer sells the equipment directly to

the customer through a national account. Figure 7.1.1 illustrates the two distribution channels

for commercial air conditioners. The Department has further subdivided the first distribution

channel by mechanical contractor size (as measured in annual revenues).

Based on information that equipment manufacturers provided, end-use customers

purchased 50 percent of equipment through small mechanical contractors, 32.5 percent through

large mechanical contractors, and the remaining 17.5 percent through national accounts. In

addition, 30 percent of commercial air-conditioning equipment is purchased for the new

construction market while the remaining 70 percent is assumed to serve the replacement market.
7-2

EQP MFG MU MU MU CUST BASE STD WHOLE MECH CONT GEN CONT = ( ) / ⋅ ⋅ ⋅ ⋅ ST

EQP MFG MU ST CUST BASE STD NATL ACCT = ⋅ ⋅ /

In the case of the replacement market, where equipment is purchased through a mechanical

contractor, the mechanical contractor is assumed to purchase equipment directly from the

wholesaler (i.e., a general contractor is not involved in the distribution of equipment for the

replacement market).

The following equation describes how DOE determines the equipment price if a

mechanical contractor sells the equipment to the customer:

where:

EQPCUST = equipment price to the customer ($),

MFGBASE/STD = manufacturer price of baseline or standard-level equipment ($),

MUWHOLE = wholesaler markup,

MUMECH CONT = mechanical contractor markup,

MUGEN CONT = general contractor markup, and

ST = sales tax.

The mechanical contractor markup is a function of contractor size (as measured in annual

revenues) and whether the contractor serves primarily the new construction or the replacement

market. The later sections of this chapter describe the determination of mechanical contractor

markups as a function of contractor size and market type.

For equipment that the customer purchases directly from the manufacturer through a

national account, the following equation defines the equipment price:

where:

EQPCUST = equipment price to the customer ($),

MFGBASE/STD = manufacturing price of baseline or standard-level equipment ($),

MUNATL ACCT = national account markup, and

ST = sales tax.

For each of the markups presented above, DOE further differentiated between a baseline

markup and an incremental markup, as described below. A third type of markup, the overall

markup, describes the product of all the markups within a distribution channel. 

7.1.1 Baseline Markups

The Department defines baseline markups as coefficients that relate the manufacturer

price of baseline equipment to the wholesale or contractor baseline sales price, as shown in the

following equations:
7-3

EQP MFG MU WHOLE BASE = BASE WHOLE BASE ⋅

EQPMECHCONT BASE WHOLE BASE MECHCONT BASE =EQP MU ⋅

EQPGEN CONT BASE = EQPMECH CONT BASE GEN CONT BASE ⋅ MU

EQP MFG MU WHOLE INCR INCR WHOLE INCR = ⋅

EQPGEN CONT INCR = EQPMECH CONT INCR GEN CONT INCR ⋅ MU

EQPMECH CONT INCR EQP MU WHOLE INCR MECH CONT INCR = ⋅

where:

MFGBASE = manufacturer price of baseline commercial air conditioners ($),

MUWHOLE BASE = wholesaler markups on baseline commercial air conditioners,

MUMECH CONT BASE = mechanical contractor markups on baseline commercial air

conditioners,

MUGEN CONT BASE = general contractor markups on baseline commercial air

conditioners,

EQPWHOLE BASE = wholesaler prices of baseline commercial air conditioners,

EQPMECH CONT BASE = mechanical contractor prices of baseline commercial air

conditioners, and

EQPGEN CONT BASE = general contractor prices of baseline commercial air conditioners. 

The use of the markups results in the wholesaler (EQPWHOLE BASE), general contractor

(EQPGEN CONT BASE), and mechanical contractor (EQPMECH CONT BASE) prices of baseline commercial

air conditioners. 

7.1.2 Incremental Markups

Incremental markups are coefficients that relate changes in the manufacturer price of

baseline equipment to changes in the wholesaler or contractor sales price, as shown in the

following equations:

where:

EQPWHOLE INCR = incremental wholesaler prices,

EQPMECH CONT INCR = incremental mechanical contractor prices,

EQPGEN CONT INCR = incremental general contractor prices,

MFGINCR = change in the manufacturer price brought about by an increase in

equipment efficiency due to new standards,

MUWHOLE INCR = incremental wholesaler markups,
7-4

EQP MFG MU MU MU ST

MFG MU

CUST BASE BASE WHOLE BASE MECH CONT BASE GEN CONT BASE

BASE OVERALL BASE

= ⋅ ⋅ ⋅ ⋅

= ⋅

EQP MFG MU MU MU ST

MFG MU

CUST INCR INCR WHOLE INCR MECH CONT INCR GEN CONT INCR

INCR OVERALL INCR

= ⋅ ⋅ ⋅ ⋅

= ⋅

MUMECH CONT INCR = incremental mechanical contractor markups, and

MUGEN CONT INCR = incremental general contractor markups.

In these equations, MFGINCR refers to a change in the manufacturer price (e.g., brought

about by an increase in equipment efficiency due to new standards) and MUWHOLE INCR, MUGEN

CONT INCR, and MUMECH CONT INCR refer to the incremental wholesaler, incremental general contractor,

and incremental mechanical contractor markups, respectively. The use of the incremental

markups results in the incremental wholesaler (EQPWHOLE INCR), incremental general contractor

(EQPGEN CONT INCR), and incremental mechanical contractor (EQPMECH CONT INCR) prices.

7.1.3 Overall Markups

Overall markups, including both overall baseline and overall incremental markups, relate

the manufacturer price to the customer price as indicated by the following equations:

where:

MUOVERALL BASE = baseline overall markup that is the product of all the other baseline

markups,

MUOVERALL INCR = incremental overall markup that is the product of all the other

incremental markups,

EQPCUST BASE = baseline customer price, and

EQPCUST INCR = incremental customer price.

 The use of the baseline overall and incremental overall markups results in 

the baseline customer price (EQPCUST BASE) and the incremental customer price (EQPCUST INCR). For

a particular standard level that increases manufacturer price, the total equipment price to the

customer is simply the sum of the baseline customer price (EQPCUST BASE) and the incremental

customer price (EQPCUST INCR).

7.2 BASIC ASSUMPTIONS USED TO ESTIMATE WHOLESALER AND

CONTRACTOR MARKUPS

The Department derived the wholesaler and contractor markups from three key

assumptions about commercial air-conditioner costs. It based the wholesaler and mechanical

contractor markups on firm balance sheet data, while it based the general contractor markups on

U.S. Census data for the commercial and institutional building construction industry. The

Department obtained the firm balance sheets from the trade associations representing
a

 Wholesalers and mechanical contractors to which these reports refer handle multiple commodity lines, including

residential and commercial air-conditioning and warm-air furnaces.

b

 One HVAC spokesman advocates pricing according to the amount of labor and material inputs, based on the

concept of Dual Overhead Accounting. Stated markups for mechanical contractors were 15 percent on equipment

and materials and 200-300 percent on labor.

7-5

wholesalers1 and mechanical contractors.2 It put the U.S. Census building construction data used

for developing general contractor markups into the same form as the balance sheet data for

wholesalers and mechanical contractors.3 These balance sheets break out the components of all

costs incurred by firms that supply and install air conditioners.a The key assumptions used to

estimate markups using these financial data are: 

C The firm balance sheets faithfully represent the various average costs incurred by firms

distributing and installing commercial air-conditioning.

C These costs can be divided into two categories: (1) costs that vary in proportion to the

manufacturer price of commercial air conditioners (variable costs); and (2) costs that do

not vary with the manufacturer price of commercial air conditioners (fixed costs).

C Commercial air conditioner wholesaler and contractor prices vary in proportion to

commercial air conditioner wholesaler and contractor costs included in the balance

sheets.

In support of the first assumption, the balance sheets itemize firm costs into a number of

expense categories, including direct costs to purchase or install the equipment, operating labor

and occupancy costs, and other operating costs and profit. Although wholesalers and contractors

tend to handle multiple commodity lines, including air conditioners, furnaces, and boilers, the

data provide the most accurate available indication of commercial air-conditioner expenses.

Information obtained from the trade literature and selected heating, ventilating, and airconditioning (HVAC) wholesalers, contractors, and consultants tends to support the second

assumption. This information indicates that wholesale and contractor markups vary according to

the quantity of labor and materials used to distribute and install appliances, with markups on

labor tending to be much larger than markups on materials.b,4 The obtained information

describes markups as varying much more in relation to sales volume than in relation to other

factors, including appliance efficiency. This last finding strongly suggests that labor inputs vary

more with sales volume than with appliance cost or efficiency. In the following discussion, the

Department 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 leads to the estimate of wholesaler and contractor markups described below. 

In support of the third assumption, the HVAC wholesaler and contractor industry is

extremely competitive and consumer demand for commercial air-conditioning is inelastic, i.e.,
7-6

the demand is not expected to decrease significantly with an increase in price. The large number

of HVAC firms listed in the 1997 Census indicates the competitive nature of the market. For

example, there are more than 5,500 HVAC wholesalers,5 more than 37,000 general contractors,6

and 84,000 HVAC contractors7 listed in the 1997 Census. Following standard economic theory,

competitive firms facing inelastic demand either set prices in line with costs or quickly go out of

business.8

7.3 ESTIMATION OF WHOLESALE MARKUPS 

Wholesalers reported median data in a confidential survey that the Air-Conditioning &

Refrigeration Wholesalers Association (ARW) conducted of 37 member firms.1

 In the survey,

ARW itemized revenues and costs into cost categories, including direct equipment expenses

(cost of goods sold), labor expenses, occupancy expenses, other operating expenses, and profit. 

The Department presents these data in full in Appendix K; Table 7.3.1 summarizes them as cost

per dollar revenue in the first data column. For example, the direct equipment expenses (cost of

goods sold) represent about $0.74 per dollar sales revenue; in other words, for every $1

wholesalers take in as sales revenue, they use $0.74 to pay the direct equipment costs. Labor

expenses represent $0.15 per dollar sales revenue, occupancy expenses represent $0.04, other

operating expenses represent $0.06, and profit accounts for $0.03 per dollar sales revenue.

Table 7.3.1 Wholesale Expenses and Markups

Wholesale Firm Expenses or Revenue

Per Dollar Sales

Revenue*

Per Dollar Cost of

Description Goods

Direct Cost of Equipment Sales: Cost of goods sold $0.74 $1.00

Labor Expenses: Salaries, Payroll, Benefit plans $0.15 $0.20

Occupancy Expenses: Rent, Utilities $0.04 $0.05

Other Operating Expenses: Insurance, Depreciation $0.06 $0.07

Profit $0.03 $0.04

Baseline Markup (MUWHOLE BASE): Revenue per dollar cost of goods 1.36

Incremental Markup (MUWHOLE INCR): Increased revenue per dollar

increase cost of goods sold 1.11

* Values do not add up to $1.00 due to independent rounding.

Source: ARW, Wholesaler Profit Survey Report, 1998. See Appendix K for complete breakdown of costs.

The second data column of Table 7.3.1 shows the data converted from costs per dollar

revenue into revenue per dollar cost of goods sold. The Department accomplished this

conversion by dividing each cost category in the first data column of Table 7.3.1 by $0.74 (i.e.,

equipment expenditure per dollar revenue). The data in column two show that, for every $1.00

the wholesaler spends on equipment costs, the wholesaler earns $1.00 in sales revenue to cover

the equipment cost, $0.20 to cover labor costs, $0.05 to cover occupancy expenses, $0.07 for

other operating expenses, and $0.04 in profits. This totals to $1.36 in sales revenue earned for
7-7

every $1.00 spent on equipment costs. Therefore, the wholesale baseline markup (MUWHOLE BASE)

is 1.36, since the wholesaler earns $1.36 in sales revenue for every $1.00 spent to purchase the

equipment.

The Department also used the data in column two to estimate the incremental markups.

The incremental markup will depend upon which of the costs in Table 7.3.1 are variable and

which are fixed. For example, for a $1.00 increase in the manufacturer equipment price, if all of

the other costs scale with the manufacturer price (i.e., all costs are variable), the increase in

wholesaler price will be $1.36, implying that the incremental markup is 1.36, or the same as the

baseline markup. At the other extreme, if none of the other costs is variable, then a $1.00

increase in the manufacturer price will lead to a $1.00 increase in the wholesaler price, for an

incremental markup of 1.0. Actually, DOE believes that the labor and occupancy costs will be

fixed and that the other operating costs and profit will scale with the manufacturer price (i.e., be

variable). In this case, for a $1.00 increase in the manufacturer price, the wholesaler price will

increase by $1.11, giving a wholesale incremental markup (MUWHOLE_INCR) of 1.11. 

7.3.1 Estimation of Wholesale Markup Probability Distribution

The Department characterized the markups developed from the above financial data with

probability distributions through a statistical analysis of U.S. Census data for wholesalers.9 The

statistical analysis provided a standard deviation on the markups of wholesaler firms in the U.S.

The Department then applied the standard deviation to the single-point baseline and incremental

markups calculated above to create normal probability distributions for these markups.

Based on the analysis of U.S. Census data for wholesalers, DOE calculated a standard

deviation of 8.2 percent for the baseline markup. Appendix K describes this calculation. The

Department assumed that the variation determined for the baseline markup applied to the

incremental markup as well. For the baseline markup of 1.36, a standard deviation of 8.2 percent

translates into an absolute value of 0.112. For the incremental markup of 1.11, a standard

deviation of 8.2 percent translates into an absolute value of 0.091.

Figures 7.3.1 and 7.3.2 show the probability distributions that DOE used to characterize

the wholesale baseline and incremental markups. Note that for the incremental markup, the

standard deviation of 0.091 results in markup values that are less than 1.0. Since a markup value

of less than 1.0 would not allow the wholesaler to recover its costs, DOE truncated all values less

than 1.0 from the normal distribution. To retain the same mean value of 1.11, DOE truncated an

equal percentage of markup values from the high end of the normal distribution as well.
7-8

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

0.04

1.00 1.09 1.18 1.27 1.36 1.45 1.54 1.63 1.72

Wholesaler Baseline Markup

Probability

Figure 7.3.1 Wholesaler Baseline Markup

Probability Distribution

0

0.01

0.02

0.03

0.04

0.05

0.06

0.99 1.03 1.07 1.11 1.15 1.19 1.23

Wholesaler Incremental Markup

Probability

Figure 7.3.2 Wholesaler Incremental Markup

Probability Distribution

7.4 ESTIMATION OF MECHANICAL CONTRACTOR MARKUPS

The HVAC contractors, defined here as mechanical contractors, reported median cost

data in an Air Conditioning Contractors of America (ACCA) financial analysis of the HVAC

industry.2

 Data reported in that analysis are similar to the itemized revenues and costs reported

by wholesalers, including expenses broken out by direct cost of equipment sales, payroll

expense, occupancy expense, other operating expense, and profit categories. For convenience,

the first data column in Table 7.4.1 summarizes these expenses as expenses per dollar sales

revenue (Appendix K contains the full set of data). The only important difference is that the

direct cost of equipment sales in this table includes out-of-pocket installation costs as well as the

cost of goods sold. As shown in the table, the direct cost of sales represents about $0.65 per

dollar sales revenue to the contractor. Labor expenses represent $0.15 per dollar sales revenue,

occupancy expenses represent $0.01 per dollar sales revenue, other operating expenses are $0.14

per dollar sales revenue, and profit is $0.05 per dollar sales revenue. Interestingly, the contractor

expenditures per dollar sales revenue in Table 7.4.1 are quite similar to the wholesaler

expenditures per dollar sales revenue reported earlier. 
7-9

Table 7.4.1 Mechanical Contractor Expenses and Markups

Contractor Expenses or Revenue

Per Dollar Sales

Revenue

Per Dollar of

Description Direct Sale Costs

Direct Cost of Equipment Sales: Cost of goods sold; Installation cost $0.65 $1.00

Labor Expenses: Salaries, Payroll, Benefit plans $0.15 $0.23

Occupancy Expenses: Rental and other occupancy costs $0.01 $0.02

Other Operating Expenses: Advertising, Depreciation, Insurance $0.14 $0.21

Operating Profit and Other Income: Profit, Other income $0.05 $0.07

Baseline Markup (MUMECH CONT BASE): Contractor revenue per dollar 1.53

Incremental Markup (MUMECH CONT INCR): Increased revenue per dollar

increase direct cost of sales 1.28

Source: ACCA, Financial analysis for the HVACR Contracting Industry, 1995 Edition, 1995. See Appendix K for complete

breakdown of costs.

The Department converted these expenses per dollar sales into revenue per dollar cost of

goods sold by dividing each figure in the first data column by $0.65. 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, $0.23 to cover labor costs, $0.02 to cover occupancy

expenses, $0.21 for other operating expenses, and $0.07 in profits. This totals to $1.53 in sales

revenue earned for every $1.00 spent on equipment costs. This tells us that the mechanical

contractor baseline markup (MUMECH CONT BASE) is 1.53, since the contractor earns $1.53 in sales

revenue for every $1.00 spent to purchase the equipment.

As with the wholesaler data in the previous section, DOE can use the data in column two

in the table above to estimate the incremental markups. The incremental markup will depend on

which of the costs in Table 7.4.1 are variable and which are fixed. At one extreme, if all of the

other costs scale with the equipment price (i.e., all costs are variable), the increase in mechanical

contractor price will be $1.53, implying that the incremental markup is 1.53, or the same as the

baseline markup. At the other extreme, if none of the other costs is variable, then a $1.00

increase in the equipment price will lead to a $1.00 increase in the mechanical contractor price,

for an incremental markup of 1.0. The Department expects the labor and occupancy costs to be

fixed and the other operating costs and profit to scale with the equipment price (i.e., be variable). 

In this case, for a $1.00 increase in the equipment price, the mechanical contractor price will

increase by $1.28, giving a mechanical contractor incremental markup (MUMECH CONT INCR) of 1.28.

7.4.1 Markups for Small and Large Mechanical Contractors in the Replacement and New

Construction Markets

The baseline and incremental markups derived above for mechanical contractors are

average values for all contractors, both small and large, and across both the replacement and new

construction markets. This section describes how DOE further disaggregated these markups into

those pertaining to small versus large contractors (as measured by annual revenues), and further
7-10

disaggregated each of these contractor types into the replacement and the new construction

market. The goal was to calculate baseline and incremental markups separately for the following

four categories: (1) small contractors in the replacement market; (2) small contractors in the new

construction market; (3) large contractors in the replacement market; and (4) large contractors in

the new construction market. The ACCA financial data provide contractor gross margin data as

a function of contractor size and market type. Since the gross margin is the sum of all contractor

labor and operating expenses plus profit, the gross margin allows for the determination of a

baseline markup. Although the financial data allow for the determination of disaggregated

markups, the data are not disaggregated in such a way as to allow for the calculation of baseline

markups separately for each of the above four categories of contractors (i.e., small/replacement,

small/new, large/replacement, and large/new). The data do allow for the development of

contractor markups as a function of contractor size and by contractor type. Thus (as will be

discussed below), DOE developed a process to further disaggregate the markups into each of the

above four contractor categories. 

Table 7.4.2 summarizes the gross margin and resulting baseline markup data for

contractors as a function of contractor size. The table presents data for contracting businesses

earning annual revenues in each of the four following categories: (1) below one million dollars;

(2) from one to two million dollars; (3) from two to five million dollars; and (4) over five million

dollars. The Department aggregated the data into two categories: contractors earning annual

revenue above two million dollars and contractors earning annual revenue below two million

dollars. This aggregation was accomplished through the use of data on the total annual value of

business done by HVAC contractors.10
7-11

Table 7.4.2 Mechanical Contractor Expenses and Markups by Contractor Size

Contractor Expenses or Revenue by Contractor Annual Revenue

Less than $1M $1M to $2M $2M to $5M Greater than $5M

Per

Dollar

Sales

Revenue

Per

Dollar of

Direct

Sale

Costs

Per

Dollar

Sales

Revenue

Per

Dollar of

Direct

Sale

Costs

Per

Dollar

Sales

Revenue

Per

Dollar of

Direct

Sale

Costs

Per

Dollar

Sales

Revenue

Per

Dollar of

Direct

Sale

Description Costs

Direct Cost of Equipment Sales:*

Cost of goods sold; Installation cost $0.60 $1.00 $0.61 $1.00 $0.64 $1.00 $0.68 $1.00

Gross Margin: Operating and

Labor Expenses plus profit $0.40 $0.66 $0.39 $0.63 $0.36 $0.56 $0.32 $0.48

Baseline Markup (MUMECH CONT

BASE): Contractor revenue per dollar

direct cost of sales

1.66 1.63 1.56 1.48

Dollar Value of Business Done $19,098,557 $15,227,328† $12,740,950‡ $40,576,202

Contractor Revenue: Less than $2M Contractor Rev.: Greater than $2M

Aggregated Baseline Markup

(MUMECH CONT BASE) 1.65 1.50

* Direct cost of equipment sales determined by subtracting the gross margin from $1.00.

†

 Gross margin data are provided for contractors with revenues between $1 to $2 million. Revenue data from the U.S. Census

Bureau are actually for contractors with revenues between $1 to $2.5 million.

‡

 Gross margin data are provided for contractors with revenues between $2 to $5 million. Revenue data from the U.S. Census

Bureau are actually for contractors with revenues between $2.5 to $5 million.

Source for Gross Margin: ACCA, Financial analysis for the HVACR Contracting Industry, 1995 Edition, 1995.

Table 7.4.3 summarizes the gross margin and resulting baseline markup data for

contractors as a function of market type. The table presents data for contracting businesses

serving the residential and light commercial market.
7-12

Table 7.4.3 Mechanical Contractor Expenses and Markups by Market Type

Contractor Expenses or Revenue by Market Type

All Residential and

Light Commercial

New Construction

Resid. and Light Comm. 

Replacement

Resid. and Light Comm.

Per Dollar

Sales

Revenue

Per Dollar of

Direct Sale

Costs

Per Dollar

Sales

Revenue

Per Dollar of

Direct Sale

Costs

Per Dollar

Sales

Revenue

Per Dollar of

Direct Sale

Costs Description

Direct Cost of Equipment Sales:*

Cost of goods sold; Installation cost $0.64 $1.00 $0.71 $1.00 $0.62 $1.00

Gross Margin: Operating and

Labor Expenses plus profit $0.36 $0.57 $0.29 $0.41 $0.38 $0.62

Baseline Markup (MUMECH CONT

BASE): Contractor revenue per dollar

direct cost of sales

1.57 1.41 1.62

* Direct cost of equipment sales determined by subtracting the gross margin from $1.00.

Source for Gross Margin: ACCA, Financial analysis for the HVACR Contracting Industry, 1995 Edition, 1995.

The aggregation of the primary data did not allow for the calculation of the baseline

markups separately for each of the four categories (small/replacement, small/new,

large/replacement, and large/new). Therefore, DOE took the following approach to disaggregate

the small and large contractor markups presented in Table 7.4.2 into separate values for the

replacement and new construction markets for each contractor type. Using the data in Table

7.4.3, which is for all sizes of contractors, DOE calculated that the markup for the replacement

market is 3.2 percent higher than the markup across all market types, and the markup for the new

construction market is 10.2 percent lower than the markup across all market types. The

Department assumed that these same percentage differences would apply between the

small/replacement and small/new categories, and between the large/replacement and large/new

categories. In other words, DOE assumed that the markup for small contractors in the

replacement market would be 3.2 percent higher than the markup for small contractors across all

markets, and the markup for small contractors in the new market would be 10.2 percent lower

than the markup for small contractors across all markets. Likewise, DOE assumed that the

markup for large contractors in the replacement market would be 3.2 percent higher than the

markup for such contractors across all markets, and the markup for large contractors in the new

market would be 10.2 percent lower than the markup for such contractors across all markets. 

This procedure gives estimates for the small and large new construction baseline markups

of 1.48 and 1.35, respectively, and estimates for the small and large replacement baseline

markups of 1.70 and 1.55, respectively (Table 7.4.4).
7-13

Table 7.4.4 Baseline Markups by Mechanical Contractor Size and Market Type

Residential and Light Commercial Small

Contractors

Large

Contractors

Baseline Markup

Percent Difference with

Market Type New & Replacement Baseline Markup Baseline Markup

All 1.57 - 1.65 1.50

New Construction 1.41 10.3% 1.48* 1.35*

Replacement 1.62 3.1% 1.70† 1.55†

* Estimated based on 10.3 percent difference between new construction and all residential and light commercial contractors.

†

 Estimated based on 3.1 percent difference between replacement and all residential and light commercial contractors.

In order to calculate the incremental large and small mechanical contractor markups for

each market type, DOE needed to be able to separate the variable from the fixed costs for each

contractor type in each market type. However, the data are only divided into direct costs and

gross margin for each of these categories. The direct costs are a variable cost, but the gross

margin includes labor costs, which are fixed, and non-labor costs, which are variable. The

Department used the data in Table 7.5.1 to divide the gross margin into labor and non-labor

components. From Table 7.5.1, the average gross margin (which is the sum of all labor and

operating expenses plus profit) for all contractor types in all market types is $0.35. The nonlabor component of gross margin is the sum of the other operating expenses plus profit ($0.14 +

$0.05), which is $0.19. The non-labor (variable) component of gross margin is thus 53 percent of

the total gross margin. The Department assumed for each of the four sub-categories that the nonlabor component of the total gross margin was also 53 percent. Following this assumption, DOE

estimated the small new and small replacement incremental markups to be 1.26 and 1.36,

respectively. Similarly, DOE estimated the large new and large replacement incremental

markups to be 1.18 and 1.29, respectively (Table 7.4.5).
7-14

Table 7.4.5 Incremental Markups by Mechanical Contractor Size and Market Type

Small New

Construction Small Replacement Large New

Construction Large Replacement Description

Baseline Markup

(MUMECH CONT BASE) 1.48 1.70 1.35 1.55

Per Dollar

Sales

Revenue

Per Dollar

of Direct

Sales Cost

Per Dollar

Sales

Revenue

Per Dollar

of Direct

Sales Cost

Per Dollar

Sales

Revenue

Per Dollar

of Direct

Sales Cost

Per Dollar

Sales

Revenue

Per Dollar

of Direct

Sales Cost

Direct Cost of Equipment

Sales (per dollar sales

revenue)

$0.68* $1.00 $0.59* $1.00 $0.74* $1.00 $0.65* $1.00

Gross Margin (per dollar

sales revenue) $0.32 $0.48 $0.41 $0.70 $0.26 $0.35 $0.35 $0.55

Non-Labor percent of Gross

Margin 53% 53% 53% 53%

Non-Labor (per dollar sales

revenue) $0.17 $0.26 $0.22 $0.37 $0.14 $0.18 $0.19 $0.29

Incremental Markup

(MUMECH CONT INCR) 1.26 1.37 1.18 1.29

* Determined from Baseline Markup (1 / MUMECH CONT BASE)

7.4.2 Estimation of Mechanical Contractor Markup Probability Distribution

The Department characterized the markups developed from the ACCA financial data

with probability distributions through a statistical analysis of U.S. Census data for plumbing,

heating, and air-conditioning contractors.10 The statistical analysis provided a standard deviation

on the markups of mechanical contractors in the U.S. The Department then applied the standard

deviation to the single-point baseline and incremental markups calculated above to create normal

probability distributions for these markups.

The Department calculated a standard deviation of 3.0 percent for the contractor

markups. Figures 7.4.1 and 7.4.2 show the probability distributions that DOE used to

characterize the mechanical contractor baseline and incremental markups for large contractors in

the new construction market. The probability distributions for the three other sets of contractor

markups have similar shapes. Appendix K details the analysis to determine the standard

deviation of baseline mechanical contractor markups.
7-15

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

1.20 1.25 1.30 1.35 1.40 1.45 1.50

Mechancial Contractor Baseline Markup

Large Contractors, New Contraction Market

Probability

Figure 7.4.1 Mechanical Contractor Baseline

Markup Probability Distribution,

Large Contractors, New

Construction Market

0.00

0.02

0.04

0.06

0.08

0.10

0.12

1.06 1.10 1.14 1.18 1.22 1.26 1.30

Mechancial Contractor Baseline Markup

Large Contractors, New Contraction Market

Probability

Figure 7.4.2 Mechanical Contractor

Incremental Markup Probability

Distribution, Large Contractors,

New Construction Market

7.5 ESTIMATION OF GENERAL CONTRACTOR MARKUPS

The Department derived markups for general contractors from U.S. Census Bureau data

for the commercial and institutional building construction sector.11 This sector includes

establishments primarily engaged in construction work, including new construction work,

additions, alterations, and repairs. The U.S. Census Bureau data for the construction sector

include detailed statistics for establishments with payrolls, similar to the data reported by ARW

for wholesalers and, as will be discussed in the next section, ACCA for mechanical contractors. 

The primary difference is that the U.S. Census Bureau reports itemized revenues and expenses

for the construction industry as a whole in total dollars rather than in typical values for an

average or representative business. Because of this, DOE assumed that the total dollar values

that the U.S. Census Bureau reported, once converted to a percentage basis, represented revenues

and expenses for an average or typical contracting business. As with the data for wholesalers,

Table 7.5.1 summarizes the expenses for general contractors as expenses per dollar sales

revenue, in the first data column (Appendix K contains the full set of data). For example, the

direct cost of sales represents about $0.81 per dollar sales revenue to the general contractor. 

Labor expenses represent $0.07 per dollar sales revenue, occupancy expenses represent $0.01

per dollar sales revenue, other operating expenses represent $0.01, and profit makes up $0.10 per

dollar sales revenue. 
7-16

Table 7.5.1 General Contractor Expenses and Markups

Contractor Expenses or Revenue

Per Dollar Sales

Revenue *

Per Dollar of

Description Direct Sale Costs

Direct Cost of Equipment Sales: Cost of goods sold; Installation cost $0.81 $1.00

Labor Expenses: Salaries, Payroll, Benefit plans $0.07 $0.09

Occupancy Expenses: Rental and other occupancy costs $0.01 $0.01

Other Operating Expenses: Advertising, Depreciation, Insurance $0.01 $0.01

Operating Profit and Other Income: Profit, Other income $0.10 $0.12

Baseline Markup (MUGEN CONT BASE): Contractor revenue per dollar 1.24

Incremental Markup (MUGEN CONT INCR): Increased revenue per dollar

increase direct cost of sales 1.13

* Values do not add up to $1.00 due to independent rounding.

Source: Commercial and Institutional Building Construction, 1997 Economic Census, EC97C-2333B, U.S. Department of

Commerce, January 2000, Table 4 (Detailed Statistics for Establishments with Payroll: 1997). See Appendix K for complete

breakdown of costs.

The Department converted these expenses per dollar sales into revenue per dollar cost of

goods sold, by dividing each figure in the first data column by $0.81. The data in column two

show that, for every $1.00 the general contractor spends on equipment costs, the general

contractor earns $1.00 in sales revenue to cover the equipment cost, $0.09 to cover labor costs,

$0.01 to cover occupancy expenses, $0.01 for other operating expenses, and $0.12 in profits. 

This totals to $1.24 in sales revenue earned for every $1.00 spent on equipment costs. This tells

us that the general contractor baseline markup (MUGEN CONT BASE) is 1.24, since the general

contractor earns $1.24 in sales revenue for every $1.00 spent to purchase the equipment.

As in the previous sections, DOE can also use the data in column two in the table above

to estimate the incremental markups. The incremental markup will depend on which of the costs

in Table 7.4.1 are variable and which are fixed. At one extreme, if all of the other costs scale

with the equipment price (i.e., all costs are variable), the increase in general contractor price will

be $1.24, implying that the incremental markup is 1.24, or the same as the baseline markup. At

the other extreme, if none of the other costs are variable, then a $1.00 increase in the equipment

price will lead to a $1.00 increase in the general contractor price, for an incremental markup of

1.0. The Department believes the labor and occupancy costs to be fixed and the other operating

costs and profit to scale with the equipment price (i.e., be variable). In this case, for a $1.00

increase in the equipment price, the general contractor price will increase by $1.13, giving a

general contractor incremental markup (MUGEN CONT INCR) of 1.13.

7.5.1 Estimation of General Contractor Markup Probability Distribution

The Department characterized the markups developed from the above financial data with

probability distributions through a statistical analysis of the same U.S. Census data for the

general contracting industry.12 Appendix K details the analysis to determine the standard
7-17

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

1.08 1.12 1.16 1.20 1.24 1.28 1.32 1.36 1.40

General Contractor Baseline Markup

Probability

Figure 7.5.1 General Contractor Baseline

Markup Probability Distribution

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

1.00 1.04 1.08 1.12 1.16 1.20 1.24

General Contractor Incremental Markup

Probability

Figure 7.5.2 General Contractor Incremental

Markup Probability Distribution

deviation of markups. The statistical analysis provided a standard deviation on the markups of

general contracting firms in the U.S. The Department then applied the standard deviation to the

single-point baseline and incremental markups above to create normal probability distributions

for these markups.

The Department calculated a standard deviation of 3.9 percent for the baseline markup. 

It assumed the variation determined for the baseline markup applied to the incremental markup

as well. For the baseline markup of 1.24, a standard deviation of 3.9 percent translates into an

absolute value of 0.048. For the incremental markup of 1.13, a standard deviation of 3.9 percent

translates into an absolute value of 0.044.

Figures 7.5.1 and 7.5.2 show the probability distributions that DOE used to characterize

the general contractor baseline and incremental markups.

7.6 SALES TAX

The sales tax represents State and local sales taxes that are applied to the customer price

of the equipment. The sales tax is as a multiplicative factor that increases the customer

equipment price.

The Department derived sales taxes representative of both State and local sales taxes

from 1997 States sales tax data13 and 1997 local sales tax data.14 Using State unitary airconditioner shipment data from 1994,15 DOE weighted the State and local sales tax data by the

percentage of unitary air conditioners shipped to each State, to derive a probability distribution

of sales taxes. The sales tax data were than aggregated into one-percentage-point bins (i.e., sales

taxes from 5 to 5.99 percent, sales taxes from 6 to 6.99 percent). 

The distribution of sales tax rates ranges from a minimum of zero percent to a maximum

of 10 percent with a mean value of 6.7 percent. The Department applied sales taxes to the

customer equipment price irrespective of the distribution channel and the market in which the
7-18

customer is located. Table 7.6.1 provides the distribution of sales tax rates based on the

percentage of unitary air-conditioner shipments in each sales tax bin.

Table 7.6.1 Distribution of Sales Tax Rates

Sales Tax Rate

0% 5% 6% 7% 8% 10%

Probability of Rate 1% 10% 29% 37% 22% 1%

7.7 NATIONAL ACCOUNTS

Equipment purchased through national accounts is an exception to the usual distribution

of HVAC equipment to end-users. Large customers of HVAC equipment use national accounts

to circumvent the typical chain of distribution, thereby allowing them to negotiate equipment

prices directly with the manufacturer. Due to the large volume of equipment purchased, large

customers, such as national retail chains, are able to purchase equipment directly from the

manufacturer at significantly lower prices than could be obtained through the typical distribution

chain. 

In order to capture the price savings realized from equipment purchased through national

accounts, DOE derived a “national account” markup, assuming that the resulting equipment

price increase was one-half of that realized from a typical chain of distribution. In other words,

if the price increase resulting from the product of the wholesale, mechanical contractor, and

general contractor markups is $100, the “national account” markup is such that the price increase

is one-half of that, or $50. The Department based the use of a “national account” markup that is

one-half of that realized from a typical chain of distribution on the assumption that the resulting

“national account” equipment price must fall somewhere between the manufacturer price (i.e., a

markup of 1.0) and the customer price under a typical chain of distribution. Because DOE did

not know typical values for the actual “national account” equipment price, it chose a value of

one-half.

To illustrate the development of the “national account” markup further, this section

provides the following example of how DOE derived it. Using a baseline manufacturer price of

$2098 for 7.5-ton air conditioners and baseline wholesaler, general contractor, and mechanical

contractor markups of 1.36, 1.24, and 1.53, respectively, the resulting baseline customer

equipment price without sales taxes is $5413 ($2098 C1.36 C 1.24 C 1.53). (Note that the

mechanical contractor baseline markup is an average value representing all contractors

irrespective of size and market served.) The dollar value increase due to the above distribution

channel markups is $3315 ($5413 - $2098). Under the assumption that national account

customers realize equipment price increases equal to one-half of that due to a typical channel of

distribution, the dollar value of the equipment price increase under the national account is $1658

(one-half of $3315). The resulting equipment price is $3756 ($1658 + $2098), which results in a

deduced “national account” markup of 1.79 percent ($3756 ÷ $2098).
7-19

7.8 OVERALL MARKUPS

The Department multiplied the wholesale and contractor markups described above by the

sales tax to obtain the overall baseline and incremental markups shown in Tables 7.8.1 and 7.8.2,

respectively. It based overall markups on one of three assumed distribution channels as well as

whether the equipment is being purchased for the new construction or replacement market. The

Department based the distribution channel on whether equipment is purchased through: (1)

small mechanical contractors; (2) large mechanical contractors; or (3) national accounts. Thus,

Tables 7.8.1 and 7.8.2 present six overall markups each for both the overall baseline and

incremental markups. In addition, the tables show a weighted-average overall markup assuming

that (1) the new construction and replacement markets represent 30 percent and 70 percent of the

market, respectively, and (2) end-use customers purchase 50 percent of equipment through small

mechanical contractors, 32.5 percent through large mechanical contractors, and the remaining

17.5 percent through national accounts. The weighted-average overall baseline markup equals

2.31, while the weighted-average overall incremental markup equals 1.56. 

The Department used the overall markup to estimate the customer price of baseline

equipment, given the manufacturer cost of baseline equipment. For example, if the manufacture

price of a baseline commercial air conditioner is $100, DOE can multiply this by the weightedaverage overall baseline markup to estimate that the baseline customer price of the commercial

air conditioner is $231. Similarly, DOE used the overall incremental markup to estimate

changes in the customer price, given changes in the manufacturer price above the baseline price

resulting from a standard to raise equipment efficiency. For example, if a standard increases the

commercial air-conditioner manufacturer price by $100, DOE can multiply this by the weightedaverage overall incremental markup to estimate that the customer price will increase $156.

Table 7.8.1 Overall Baseline Markups

New Construction Replacement

WeightedAverage

Small

Mech.

Large

Mech.

National

Account

Small

Mech.

Large

Mech.

National

Market Sector Account

Wholesale 1.36 1.36 1.69 1.36 1.36

Mechanical Contractor 1.48 1.35 1.70 1.55 1.60

General Contractor 1.24 1.24 NA NA

Sales Tax 1.07 1.07 1.07 1.07 1.07 1.07

Overall 2.66 2.42 1.80 2.47 2.24 1.71 2.31
7-20

Table 7.8.2 Overall Incremental Markups

New Construction Replacement

WeightedAverage

Small

Mech.

Large

Mech.

National

Account

Small

Mech.

Large

Mech.

National

Market Sector Account

Wholesale 1.11 1.11 1.27 1.11 1.11

Mechanical Contractor 1.26 1.18 1.37 1.29 1.24

General Contractor 1.13 1.13 NA NA

Sales Tax 1.07 1.07 1.07 1.07 1.07 1.07

Overall 1.68 1.59 1.35 1.63 1.53 1.32 1.56
7-21

1. Air-conditioning & Refrigeration Wholesalers Association (ARW), 1998 Wholesaler

PROFIT Survey Report, Based on 1997 Wholesaler Operations, 1998. Boca Raton, FL. 

 <http://www.arw.org>

2. Air Conditioning Contractors of America (ACCA), Financial analysis for the HVACR

Contracting Industry, 1995 Edition, 1995. Washington, DC.

3. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Commercial and Institutional Building Construction, 1997 Economic Census,

Construction, Industry Series, issued January, 2000. Washington, DC. Report No.

EC97C-2333B. 

4. Mark Metoyer as reported in Mark Skaer, “What should you charge? Try These Tested

Formulas”, Air Conditioning, Heating and Refrigerator News, March 26, 2001.

5. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Establishment and Firm Size (Including Legal Form of Organization), 1997

Economic Census, Wholesale Trade, Subject Series, issued September, 2000. 

Washington, DC. Report No. EC97W42S-SZ. Table 1.

6. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Commercial and Institutional Building Construction, 1997 Economic Census,

Construction, Industry Series, issued January, 2000. Washington, DC. Report No.

EC97C-2333B. Table 1.

7. U.S. Department of Commerce, Economics and Statistics Administration, U.S. Census

Bureau, Plumbing, Heating, and Air-Conditioning Contractors, 1997 Economic Census,

Construction, Industry Series, issued July, 1999, Washington, DC. Report No. EC97C2351A. Table 1.

8. Pindyck, R. and D. Rubinfeld, Microeconomices, Prentice Hall. 2000.

9. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Gross Profit, Employment, and Gross Margin for Merchant Wholesalers for

NAICS 42173. By State: 1997. Washington, DC.

10. U.S. Department of Commerce, Economics and Statistics Administration, U.S. Census

Bureau, Plumbing, Heating, and Air-Conditioning Contractors, 1997 Economic Census,

Construction, Industry Series, issued July, 1999, Washington, DC. Report No. EC97C2351A.

11. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Commercial and Institutional Building Construction, 1997 Economic Census,

Construction, Industry Series, issued January, 2000. Washington, DC. Report No.

REFERENCES
7-22

EC97C-2333B. Table 4.

12. U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the

Census, Gross Profit, Employment, and Gross Margin for Merchant Wholesalers for

NAICS 42173. By State: 1997. Washington, DC. Tables 2 and 3.

13. Federal Trade Administration, January 1998.

14. Sales Tax Institute, 1999.

15. Air-Conditioning and Refrigeration Institute (ARI), Report U-SEER-5-Q ,1994.

Arlington, VA.