CHAPTER 6. MARKUPS ANALYSIS

TABLE OF CONTENTS

6.1 INTRODUCTION

................................ ................................ ................................................. 6-1

6.1.1 Distribution Channels

................................ ............................................................... 6-1

6.2 MARKUP CALCULATION M ETHODOLOGY

.............................................................. 6-3

6.3 APPROACH FOR CALCULA TING OVERALL MARKUP

........................................... 6-3

6.3.1 Baseline Markup: New Construction

................................ ...................................... 6-3

6.3.2 Baseline Markup: Replacement

................................ ............................................... 6-4

6.3.3 Incremental Markups: New Construction

............................................................... 6-5

6.3.4 Incremental Markups: Replacement

................................ ........................................ 6-6

6.3.5 Approach for Calculating Overall Markup of the National Accounts

Distribution Channel

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

6.4 APPROACH FOR CALCULA TING MANUFACTURER MA RKUP

............................ 6-9

6.5 APPROACH FOR CALCULA TING WHOLESALER AND CONTRACTOR

MARKUPS

................................ ................................ ......................................................... 6- 10

6.5.1 Key Data Sources and Assumptions of the Markups Methodology

................... 6- 10

6.5.2 Approach for Wholesaler Markup

................................ ........................................ 6- 12

6.5.3 Approach for Mechanical Contractor Markup

..................................................... 6- 13

6.5.4 Approach for General Contractor Markup

........................................................... 6- 14

6.6 DERIVATION OF MARKUP S

................................ ........................................................ 6- 15

6.6.1 Base Case Manufacturer Markups

................................ ........................................ 6- 15

6.6.2 Wholesaler Markups

................................ .............................................................. 6- 16

6.6.3 Mechanical Contractor Markups

................................ .......................................... 6- 17

6.6.3.1 Aggregate Baseline and Incremental Markups for Mechanical

Contractors

................................ ................................ ................................... 6- 17

6.6.3.2 Baseline Markups for Mechani cal Contractors in the Replacement

and New Construction Markets

................................ .................................. 6- 18

6.6.4 Estimation of General Contractor Markups

......................................................... 6- 19

6.7 SALES TAX

................................ ................................ ....................................................... 6- 20

6.8 OVERALL MARKUPS

................................ ................................ .................................... 6- 21

6.8.1 Estimation of National Account Markups

............................................................ 6- 22

REFERENCES

................................ ................................ ............................................................... 6- 23

LIST OF TABLES

Table 6.1.1 Shares of Market by Distribution Channel

....................................................... 6-3

Table 6.6.2 Manufacturer Markups by Equipm ent Type

.................................................. 6- 16

Table 6.6.3 National Wholesaler Expenses and Markups

................................................ 6- 16

Table 6.6.4 Baseline and Incremental Markups, All Mechanical Contractors (2007 Economic Census data)

................................ ................................................... 6- 18

Table 6.6.5 Baseline Markups for the Replacement and New Construction Markets, Mechanical Contractors (ACCA data)

........................................... 6- 19

Table 6.6.6 General Contractor Expenses and Markups

................................................... 6- 20

6-iTable 6.7.1 Average Sales Tax Rates by Census Division and Large State

.................... 6- 21

Table 6.8.1 Summary of Overall Markups

................................ ........................................ 6- 21

Table 6.8.2 National Account Markups

................................ ............................................. 6- 22

LIST OF FIGURES

Figure 6.1.1 Distribution Channels for PTACs and PTHPs in New Construction Applications

................................ ................................ ........................................ 6-2 Figure 6.1.2 Distribution Channels for PTACs and PTHPs in Replacement Applications

................................ ................................ ........................................ 6-2

6- iiCHAPTER 6. MARKUPS ANALYSIS

6.1 INTRODUCTION

To carry out the life

- cycle cost (LCC) calculations described in C hapter 8 of this technical support document (TSD)

, the U.S. Department of Energy ( DOE ) needed to determine

the cost to the com mercial customer of a baseline packaged terminal air conditioner ( PTAC ) or packaged terminal heat pump ( PTHP ) , and the cost of the more

- efficient unit the customer would purchase under the standards. However, the commercial 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 was able to estimate the commercial customer’s price. T his chapter describes how DOE derived such markups.

The equipment price to the commercial customer depends on how the customer purchases the equipment. The Department defines two primary types of distribution channels to describe how the equipment passes from the manufacturer to the customer : (1) in the first type of distribution channel, the manufacturer sells the equipment to a wholesaler, who in turn may sell it to a mechanical contractor, who in turn may sell it (and its installation) to a general contractor,
who in turn sells it to the customer ; (2) in the second type of distribution channel, the manufacturer sells the equipment directly to the customer through a national account. The Department has further subdivided the distribution channels for new and replacement equipment.

For wholesalers and contractors , DOE estimated a baseline markup and an incremental markup. DOE defined a baseline markup as a multiplier that convert s the manufacturing selling price of equipment with baseline efficiency to the customer purchase price for the equipment at the same baseline efficiency level. An incremental markup is defined as the multiplier to convert

the incremental increase in manufacturing selling price of higher e fficiency equipment to the

customer purchase price for the same higher efficiency equipment. Because companies mark up the price to cover business cost and profit margin at each step in the distribution channel, b oth baseline and incremental markups are de pendent on the particular distribution channe l, as

described in s ection 6.1.1

.

6.1.1 Distribution Channels

The appropriate markups for determining customer equipment pr ices depend on the type of distribution channels through which equipment move s 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.

T here are t wo primary types of distribution channels describ ing the way most equipment passes from the manufacturer to the customer

, one involving distributors and contractors and one from manufacturer directly to customer via national accounts. Within these two primary channels, DOE distinguishes between new and replacement applications, as each application has a different mechanical contractor markup

.

6-1Distribution channels for new construction applications are shown in Figure 6.1 .1

. In th e first new construction distribution channel, the manufacturer sells the equipment to a wholesaler

, who in turn sells it to a mechanical contracto r, who in turn sells it to a general contractor, who in

turns sells it to the customer and performs the installation

. In the second new construction distribution channel, the manufacturer sells the equipment to a wholesaler, who in turn sells the equipment to the customer

. In the third new construction distribution channel, the manufacturer sells the equipment directly to the customer through a national account.

Channel 1 Channel 2 Channel 3

Manufacturer Manufacturer

Manufacturer (through

national accounts) Wholesaler

Wholesaler Mechanical

Contractor

General

Contractor

Customer Customer Customer
Figure 6.1 .1 Distribution Channel s for PTAC s and PTHPs in New Construction Applications

Distribution channels for replacement applications are shown in Figure 6.1 .2

. In the first replacement distribution channel, t he manufacturer sells the equipment to a wholesaler, who in

turn sells it to a mechanical contractor, who in turn sells it to a general contractor, who in turns

sells it to the customer and performs the installation. In the second

, the manufacturer sells the equipment to a wholesaler, who in tur n sells the equipment to the customer . In the third, the manufacturer sells the equipment to a wholesaler, who in turn sells it to a mechanical contractor,

who sells it to the customer and performs the installation.

Channel 1 Channel 2 Channel 3

Manufacturer Manufacturer Manufacturer

Wholesaler

Wholesaler Wholesaler

Mechanical

Contractor Mechanical

Contractor General

Contractor

Customer Customer Customer

Figure 6.1 .2 Distribution Channels for PTACs and PTHPs in Replacement Applications

Table 6.1 .1 lists each distribution channel’s share of the full PTAC and PTHP market.

6-2Table 6.1 .1 Shares of Market by Distribution Channel

Distribution Channel New Replacement

Wholesaler

- Customer 30 % 15 %

Wholesaler

- Mech Contractor

- End User 0 % 25 %

Wholesaler

- Mech Contractor

- General Contractor

- Customer 38 % 60 %

National Account 32 % 0 %

Total 100 % 100 %

6.2 MARKUP CALCULATION METHODOLOGY

A

t each point in the distribution channel, companies mark up the price of the equipment to cover their business costs and profit margin. In financial statements, gross margin is the difference between the company revenue and the company cost of sales or cost of goods sold ( CGS ). The gross margin includes company profits and the expenses of compan ies in the distribution channel, which include overhead costs (sale s, general, and administration), research and developm ent (R&D) and interest expenses, depreciation, and taxes

. In order for sales of equipment to contribute positively to company cash flow, the equipment ’s markup must be greater than the corporate gross marg in

. Equipment command s lower or higher markups, depending on company expenses associated with the equipment and the degree of market competition.

Equipment manufacturers sell most of their equipment directly to wholesaler s. Wholesaler s sell to contract ors or customer s at the wholesale price. Wholesaler s absorb short

term imbalances in supply and demand, allowing manufacturers to operate more efficiently and satisfying customer needs for fast deliveries. In addition, wholesaler s are important sources for parts. Most contractors compete at the local level. Many carry more than one brand of equipment , and most install the equipment they sell.

In addition to the wholesale r and mechanical contractor markups, the general contractor adds a markup. In retrofi t installations, sales tax applies to the final customer cost.

6.3 APPROACH FOR CALCULA TING OVERALL MARKUP

6.3.1 Baseline Markup : New Construction

DOE used the overall baseline markup to estimate the customer product price of baseline models, given the manufacturer cost of the baseline models. DOE considers baseline models to

be equipment sold under existing market conditions ( i.e ., without new energy conservation standards). The following equation shows how D OE used baseline markup s to determine the product price for baseline models in the first new construction distribution channel

.

6-3CPP BASE = COST MFG × � MU MFG × MU WHOL E BASE × MU MCONTRAC T BASE × MU GCONTRAC T BASE �

= COST MFG × MU OVERALL

_ BASE

_ 1

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_BASE = b aseline wholesaler markup

, MU MCONTRACT_BASE = b aseline mechanical contractor markup,

MU MGENERAL_BASE = b aseline general contractor markup, and

MU OVERALL_BASE _1 = b aseline overall markup.

The following equation shows how DOE used baseline markup s to determine the product price

for baseline models in the second new construction distribution channel

.

CPP BASE = COST MFG × � MU MFG × MU WHOL E BASE �

= COST MFG × MU OVERALL

_ BASE

_ 2 Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_BASE = b aseline wholesaler markup, and

MU OVERALL_BASE _2 = b aseline overall markup.

6.3.2 Baseline Markup: Replacement

The following equation shows how DOE used baseline markup s to determine the pro duct price for baseline models in the first replacement distribution channel.

CPP BASE = COST MFG × � MU MFG × MU WHOL E BASE × MU MCONTRAC T BASE × MU GCONTRAC T BASE �

× TAX SALES

= COST MFG × MU OVERAL L BASE

_ 1 × TAX SALES

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_BASE = b aseline wholesaler markup,

MU MCONTRACT_BASE = b aseline mechanical contractor markup,

MU G CONTRACT _BASE = b aselin e general contractor markup,

T

AX SALES = s ales tax, and

MU OVERALL_BASE _1 = b aseline overall markup.

6-4The following equation shows how DOE used baseline markup s to determine the product price for bas eline models in the second replacement distribution channel.

CPP BASE = COST MFG × � MU MFG × MU WHOL E BASE � × TAX SALES

= COST MFG × MU OVERAL L BASE

_ 2 × TAX SALES

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_BASE = b aseline wholesaler markup,

TAX SALES = s ales tax, and

MU OVERALL_BASE _2 = b aseline overall markup.

The following equation sho ws how DOE used baseline markup s to determine the product price for baseline models in the third replacement distribution channel.

CPP BASE = COST MFG × � MU MFG × MU WHOL E BASE × MU MCONTRAC T BASE � × TAX SALES

= COST MFG × MU OVERAL L BASE

_ 1 × TAX SALES

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_BASE = b aseline wholesaler markup,

MU MCONTRACT_BASE = b aseline mechanical contractor markup,

TAX SALES = s ales tax, and

MU OVERALL_BASE _1 = b aseline overall markup.

6.3.3 Incremental Markups : New Construction

Similarly, DOE used the overall incremental markup to estimate changes in the customer product price, given changes in the manufacturer cost from the baseline model cost resulting from an energy conservation standard to raise equipment energy efficiency. The total customer product price for more energy

- efficient models is composed of two co mponents: the customer product price of the baseline model and the change in customer 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 incr emental markup to determine the product price for more energy

- efficient models in the first new construction

distribution channel

.

6-5CPP BASE = COST MFG × � MU MFG × MU WHOLE

_ INCR × MU MCONTRACT

_ INCR × MU GCONTRACT

_ IN CR �

= COST MFG × MU OVERALL

_ INCR

Where:

CPP BASE = customer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_ INCR = incremental wholesaler markup,

MU MCONTRACT_INCR = incremental mechanical contractor markup,

MU GCONTRACT

_ INCR = incremental general contractor markup, and

MU OVERALL_ INCR = incremental overall markup.

The following equation shows how DOE used the overall incremental markup to

determine t he product price for more energy

- efficient models in the second new construction

distribution channel

.

CPP BASE = COST MFG × � MU MFG × MU WHOLE

_ INCR �

= COST MFG × MU OVERALL

_ INCR

Where:

CPP BASE = customer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_ INCR = incremental wholesaler markup, and

MU OVERALL_ INCR = incremental overall markup.

6.3.4 Incremental Markups: Replacement

The following equation shows ho w DOE used the overall incremental markup to determine the product price for more energy

- efficient models in the first replacement distribution

channel.

6-6CPP BASE = COST MFG

× � MU MFG × MU WHOLE

_ INCR × MU MCO NTRACT

_ INCR

× MU GCONTRACT

_ INCR × TAX SALES �

= COST MFG × MU OVERALL

_ INCR

_ 1

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_ INCR = i ncremental wholesaler markup,

MU MCONTRACT_INCR = i ncremental mechanical contractor markup,

MU G CONTRACT_INCR = i ncremental general contractor markup,

TAX SALES = s ales tax, and

MU OVERALL_ INCR _1 = i ncremental overall markup.

The following equation shows h ow DOE used the overall incremental markup to determine the product price for more energy

- efficient models in the second replacement

distribution channel.

CPP BASE = COST MFG × � MU MFG × MU WHOLE

_ INCR × TAX SALES �

= COST MFG × MU OVERALL

_ INCR

_ 2

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_ INCR = i ncremental wholesaler markup,

TAX SALES = s ales tax, and

MU OVERALL_ INCR _2 = i ncremental overall markup.

The following equation shows h ow DOE used the overall incremental markup to determine the product price for more energy

- efficient models in the third replacement

distribution channel.

6-7CPP BASE = COST MFG × � MU MFG × MU WHOLE

_ INCR × MU MCONTRACT

_ INCR × TAX SALES �

= COST MFG × MU OVERALL

_ INCR

_ 3

Where:

CPP BASE = c ustomer product price for baseline models,

COST MFG = m anufacturer cost for baseline models,

MU MFG = m anufacturer markup,

MU WHOLE_ INCR = i ncremental wholesaler markup,

MU MCONTRACT_INCR = i ncremental mechanical contractor markup,

TAX SALES = s ales tax, and

MU OVERA LL_ INCR_3 = i ncremental overall markup.

6.3.5 Approach for Calculating Overall Markup of the National Accounts Distribution

Channel

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

of heating, ventilati ng , and air conditioning ( HVAC ) equipment to end users. Large commercial

customer s 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 commercial customer s, 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.

To capture the price savings realized from equipment purchased through na tional 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 whole sale, 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 fr om 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 commercial customer price under a typical chain of distribution. B ecause DOE did not know typical values for the actual “national account” equipment price, it chose a

value of one

- half.

The estimates of national account markups are arrived at through a weighted average of the overall markups for the other new constructi on distribution channels. Of all PTAC and PTHP equipment used in new construction, 30% are sold directly from wholesaler to end user, 38% involve mechanical and general contractors, and the remaining 32% are sold through

national accounts. The national a ccount markups for new construction are calculated using the following equations:

6-8MU OVERALL

_ NA = MU OVERALL

_ BASE

_ 1 × MU OVERALL

_ BASE

_ 2 (Baseline)

Where:

MU OVERALL _BASE_NA = o verall baseline national account markup.

MU OVERALL _BASE_1 = o verall baseline markup for distribution channel 1,

MU OVERALL _BASE_2 = o verall baseline markup for distribution channel 2, and

MU OVERALL

_ NA = MU OVERALL

_ INCR

_ 1 × MU OVERALL

_ INCR

_ 2 (Baseline)

Where:

MU OV ERALL _INCR_NA = o verall incremental national account markup.

MU OVERALL _INCR_1 = o verall incremental markup for distribution channel 1,

MU OVERALL _INCR_2 = o verall incremental markup for distribution channel 2, and

The half of the overall markup p roportion above cost is then calculated as follows:

ρ NA

_ MU

_ COST = MU OVERALL − 1

2

Where:

ρ NA_MU_COST = national account markup proportion above cost.

MU OVERALL = o verall markup, and

Adding 1 to the national account markup proportion abo ve cost, DOE arrives at the estimated national account markup:

MU OVERALL

_ NA = 1 + ρ NA

_ MU

_ COST

Where:

MU OVERALL _NA = national account o verall markup.

ρ NA_MU_COST = n ational accou nt markup proportion above cost, and

6.4 APPROACH FOR CALCULA TING MANUFACTURER MARKUP

DOE uses manufacturer markups to transform a manufacturer’s product cost into a manufacturer sales price. Using the CGS and gross margin, the manufacturer markup can be

calculated as follows:

6-9MU MFG = CGS MFG + GM MFG
CGS MFG Where:

MU MFG = m anufacturer markup,

CGS MFG = m anufacturer cost of goods sold, and

GM MFG = m anufacturer gross margin.

6.5 APPROACH FOR CALCULA TING WHOLESALER AND CONTRACTOR

MARKUPS

DOE examined the manner in which markups change by efficiency level and other

factors for wholesaler s and contractors

. DOE determined that markups are neither fixed

- dollar, nor proportional to all direct costs, which means that the selling price of equipment may not be

str ictly proportional to the purchase price of the equipment . Using the available data, DOE has

found measurable differences between incremental markups on direct equipment costs and the

average aggregate markup on direct business costs. Additionally, DOE dis covered significant

differences between average and incremental markups for heating, ventilation, air

- conditioning and refrigeration (HVACR) wholesaler s and for HVAC contractors.

The main reason that the selling price of equipment may not be strictly pro portional 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 business’ expense s stays relatively constant. Certain business expenses are uncorrelated with the cost of equipment or cost of goods. For example

, if the unit price of an air conditioner increases by 30 percent, it is unlikely that the cost of secretarial support in an adm inistrative office wi ll increase by 30 percent also.

6.5.1 Key Data Sources and Assumptions of the Markups Methodology

DOE derived the wholesaler and contractor markups from three key assumptions about

the costs associated with PTAC and PTHP equipment. DOE based the wholesaler and mechanical contractor markups on firm

- level income statement data, while it based the general contractor markups on U.S. Census Bureau data for the commercial building construction industry. DOE obtained the firm income state ments from the Heating, Air

- conditioning & Refrigeration Distributors International (HARDI ) 2010 Profit Planning Report and from the Air Conditioning Contractors of America (ACCA). 1

, 2 HARDI and ACCA are trade associations representing wholesaler s and mechanical contractors, respectively. DOE used the financial data

from the 2007 U .S. Economic Census to develop general contractor markups in the same form as

the income sta tement data for wholesaler s and mechanical contractors. 3

, 4 Additionally, DOE used 2007 Economic Census data to supplement the income statement data obtained from

6- 10ACCA. These income statements break down the components of all costs incurred by firms that supply and install air conditioning equipment. a

The key assumptions used to estimate markups using these financial data are:

1. The firm income statement s faithfully represent the industry average for the various costs incurred by firms distributing and installing HVAC equipment including commercial air

conditioners.

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

manufacturer selling price (MSP) of commercial air co nditioners ( variant costs) ; and 2) costs that do not vary with the MSP commercial air conditioners ( invariant costs).

3. Overall

, commercial air

- conditioner wholesaler and contractor prices vary in proportion

to commercial air conditioner wholesaler and contractor costs 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 wholesaler s and contractors tend to handle multiple c ommodity 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 commercial air conditioners

.

Information obtained from the trade literature, and from selected HVAC wholesalers, contractors, and consultants, tends to support the second assumption ; t his information indicates that wholesale and contractor markups vary according to the quantity of labor and materials used

to distribute and install equipment. In its analysis

, 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 t o the estimate of wholesale and contractor markups described subsequently

.

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

, and customer demand for commercial heating and air conditioning is inelastic, i.e.

, the demand is not expected to decrease significantly with an increase in price of equipment. The large number of HVAC firms listed in the 2007 Census indicates the competitive nature of the market. For example, there are more than 700 HVAC manufacturers, 5 5,300 wholesaler s of heat pumps and air

- conditioning equipment, 6 more than 170,000 general residential contractors

, 36,000 commercial and institutional building contractors, 7

, 8 and 91,000 HVAC contractors listed

in the 2007 Census. 9 Additionally, the 2007 Census estimated that the four firm concentration ratio (FF CR) for the HVAC wholesale sector is 29.7%. 10 The FFCR is the market share of the

a Wholesaler s and mechanical contractors to which these reports refer handle multiple commodity lines, including

residential and commercial air -conditioners.

6- 11four largest firms in the industry; an FFCR under 40% represents a competitive industry. 11

, 12

Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or quickly go out of business. 13

6.5.2 Approach for Wholesaler Markup

Using the se assumptions, DOE developed baseline and incremental markups fo r wholesaler s using the firm income statement from the (HARDI 2010 Profit Report ). ( See

A ppendix 6 -A.) DOE used the baselin e markups, which cover all of the wholesaler ’s costs (both

invariant costs and variant costs ), to determine the sales price of baseline models. Here variant costs were defined as costs that vary in proportion to the change in MSP induced by increased efficiency standards; in contrast , invariant costs were defined as costs that do not vary in

prop ortion to the change in MSP due to increased efficiency standards. The baseline markup relates the manufacturer sales price to the wholesaler sales price. DOE calculated the baseline markup for wholesaler s using the following equation:

MU WHOLE

_ BASE = CGS WHOLE + GM WHOLE
CGS WHOLE = CGS WHOLE + ( IVC WHOLE + VC WHOLE )

CGS WHOLE

Where:

MU WHOLE_BASE = b aseline wholesaler markup,

CGS WHOLE = w holesaler cost of goods sold,

GM WHOLE = w holesaler gross margin,

IVC WHOLE = w holesaler invariant costs, and

VC WHOLE = w holesaler variant costs.

Incremental markups relate the change in the manufacturer sales price of more energy

efficient models , or those equipment that meet the requirements of new energy conservation standards, to the change in the wholesaler sales price. Incremental markups cover only those costs that scale with a change in the manufacturer sales price ( i.e.

, variant costs, VC ). DOE calculated the incremental markup for wholesaler s using the following equation:

MU WHOLE

_ INCR = CGS WHOLE + VC WHOLE
CGS WHOLE

Where:

MU WHOLE_I NCR = i ncremental wholesaler markup,

CGS WHOLE = w holesaler cost of goods sold, an d

VC WHOLE = w holesaler variant costs.

These data are provided for seven regions, which are defined similarly to Census Divisions. Each state is assigned the baseline and incremental wholesaler markup of the region to which it is assigned by HARDI.

6- 126.5.3 Approach for Mechanical Contractor Markup

Similar financial data to that used to estimat e wholesaler markups are also available for

mechanical contractors and general contractors from ACCA and the 2007 Economic Census

. 2

, 9

To estimate mechanical contractor markups for commercial air conditioners

, DOE collected

financial data from ACCA and from the Plumbing, H eating and Air

- Conditioning Contractors (NAICS 23822) data series of the 2007 Economic Census. This data series provides limited data at the state level and highly detailed national aggregate data. As the Census data is the most recent, DOE relies on it as the primary source for this analysis, using the greater detail of the

ACCA data to refine the estimates.

The 2007 Economic Census data include the number of establishments, payroll for construction workers, value of construction, cost of materials, and cost of subcontracted work at

both the state and national level s . DO E calculated national average and state

- level estimates of the baseline markup for mechanical contractors and general contractors using the following equation:

MU BASE = V CONSTRUCT
PAY + MATCOST + SUBCOST

Where:

MU BASE = b aseline mechanical contractor or general contractor markup,

V

CONSTRUCT = v alue of construction,

PAY = p ayroll for construction workers,

MATCOST = c ost of materials, and

SUBCOST = c ost of subcontracted work.

Analogously to the wholesaler markup , DOE estimated the national average incremental

mechanical contractor markup by only considering those costs that scale with a change in the manufacturer sales price (variant costs, VC ) for higher efficiency equipment

. Necessary data to perform the increm ental markups calculation were not available at the state level. As stated in

s ection 6.5.1 , 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 2007 Economic Census cost data in each major cost category and estimated incremental contractor markups using the following equation:

MU CONTRACT

_ INCR = CGS CONTRACT + VC CONTRACT
CGS CONTRACT Where:

MU CONTRACT_INCR = i ncremental contractor markup,

CGS CONTRACT = c ontractor cost of goods sold, and

VC CONTRACT = c ontractor variant costs.

ACCA financial data provide gross margin (GM) as percent of sales for several market subcategories of mechanical contractor ( e.g., residential and commercial, new construction and

6- 13replacement, small and large companies, etc

. ). In this analysis, DOE distinguishes between replacement and new construction applications. From the ACCA data, baseline mechanical markups are estimated for replacement, new construction, and the overall average of all

mechanical contractors. T he mechanica l contractor markups estimated from the 2007 Economic Census data were scaled by applying the following factors developed from the ACCA data:

MU MKT

_ SEGMENT = SALES MKT

_ SEGMENT (%)

SALES MKT

_ SEGMENT ( % )

− GM MKT

_ SEGMENT (%)

MU FULL

_ MKT = SALES FULL

_ MKT (%)

SALES FULL

_ MKT ( % )

− GM FULL

_ MKT (%)

MKT MODIFIER = MU MKT

_ SEGMENT

MU FULL

_ MKT Where:

MKT_MODIFIER = f actor used to disaggregate replacement and new construction mechanical contractor applications from the 2007 Economic

Census data for the overall market

, SALES MKT_SEGMENT = s ales of the relevant market segment ( i.e., replacement or new construction),

SALES FULL_MKT = s ales of the overall mechanical contractor industry,

GM MKT_SEGMENT = g ross margin of the relevant market segment,

GM FULL_MKT = g ross margin of the overall mechanical contractor industry,

MU MKT_SEGMENT = b aseline markup of the relevant market segment, and

MU FULL_MKT = b aseline markup of t he overall mechanical contractor industry.

DOE estimated state

- level incremental mechanical contractor markups by calculating the ratio of the national average incremental markup to the national average baseline markup. This

ratio was then used to scale the state

- level baseline markups, arriving at a state

- level estimate of incremental mechanical contractor markups.

6.5.4 Approach for General Contractor Markup

To estimate general contractor markups, DOE collected data from the Commercial and

Institutional Buil ding Construction series from the 2007 Economic Census (NAICS 236220)

. As

for mechanical contractors , t he 2007 Economic Census data include the number of establishments, payroll for construction workers, value of construction, cost of materials, and

cost o f subcontracted work at both the state and national level s . DOE estimated the baseline markup for general contractors using the following equation:

6- 14MU BASE = V CONSTRUCT
PAY + MATCOST + SUBCOST

Where:

MU BASE = b aseline general contractor markup,

V

CONSTRUCT = v alue of construction,

PAY = p ayroll for construction workers,

MATCOST = c ost of materials, and

SUBCOST = c ost of subcontracted work.

DOE estimated the national average incremental general contractor markups by considering only those costs that scale with a change in the manufacturer sales price (variant

costs, VC ) for higher efficiency equipment

. Necessary data to perform the incremental markups

calculation was not available at the state level. As stated in s ection 6.5.1 , 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 2007 Economic Census cost data in each major cost category and estimated incremental general contractor markups using the following equation:

MU CONTRACT

_ INCR = CGS CONTRAC T + VC CONTRACT
CGS CONTRACT Where:

MU CONTRACT_INCR = i ncremental contractor markup,

CGS CONTRACT = c ontractor cost of goods sold, and

VC CONTRACT = c ontractor variant costs.

DOE estimated state

- level incremental general contractor markups by calculating the

ratio of the national average incremental markup to the national average baseline markup. This

ratio was then used to scale the state

- level baseline markups, arriving at a state

- level estimate of incremental general contractor markups.

6.6 DERIVATION OF M ARKUPS

6.6.1 Base Case Manufacturer Markups

DOE developed a set of base case manufacturer markup s using data developed as part of the 2008 Final Rule for PTACs and PTHPs (73 FR 58772 ). DOE then solicited feedback on its markup estimates during confidential manufacturer interviews. Based on this content and manufacturer comments, DOE calculated and applied an average baseline markup of 1.27 for all equipment classes analyzed. This markup includes selling, general and administrative expenses (SG&A), research and development (R&D) expenses, interest, and profit.

6- 15Table 6.6 .1 M anufacturer Markups by Equipment Type

Equipment Type Cooling Capacity (Btu/h) Baseline Markup

PTAC <7,000 Btu/h 1.27

≥7,000 Btu/h and ≤15,000 Btu/h 1.27

>15,000 Btu/h 1.27

PTHP <7,000 Btu/h 1.27

≥7,000 Btu/h and ≤15,000 Btu/h 1.27

>15,000 Btu/h 1.27

6.6.2 Wholesaler Markups

Wholesaler s reported median data in a confidential survey that HARDI conducted across its members . In the survey, HARDI it emized revenues and costs into categories, including direct equipment expenses (cost of goods sold), labor expenses, occupancy expenses, other o perating expenses, and profit. DOE presents these data in full , by HARDI region, in A ppendix 6 -A, Detailed Data for Equipment Price Markups. Table 6.6 .2 summarizes HARDI wholesaler data

, aggregated to the national level, in terms of cost

- per

- dollar sales revenue in the first data column

and in terms of cost

- per

- dollar of cost of goods sold in the second column

.

Table 6.6 .2 National W holesaler Expenses and Markups

Descriptions Per Dollar

Sales Revenue $ Per Dollar Cost

of Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.73 7 1.000 Labor Expenses: Salaries and benefits 0.151 0.205 Occupancy Expense: Rent, maintenance, and utilities 0.036 0.049 Other Operating Expenses: Depreciation, advertising, and

insurance. 0.055 0.075

Operating Profit 0.020 0.027

Baseline Revenue: Baseline revenue earned per dollar cost of goods sold 1.357 Wholesaler Baseline Markup ( MU WHOLE BASE ) 1.357

Incremental Revenue: Increased revenue per dollar increase cost of goods sold 1.103 Incremental Markup ( MU WHOLE INCR ) 1.103 Source: Heating, Air Conditioning & Refrigeration Distributors International. 2012. 2012 Profit Report (20 10 Data).

In this case, direct equipment expenses (cost of goods sold) represent about $0.7 4 per dollar sales revenue, so for every $1 wholesaler s take in as sales revenue, $0.7 4 is used to pay the direct equipment costs. Labor expenses represent $0.1 5 per dollar sales revenue, occupancy expenses represent $0.04, other operating expenses represent $0.0 6 , and profit accounts for $0.0 2 per dollar sales revenue.

DOE converted the expenses per dollar sales into expenses per dollar cost of goods sold, by dividing each figure in the first data column by $0.7 4 ( i.e., cost of goods sold per dollar of sales revenue). F or every $1.00 the wholesaler spends on equipment costs, the wholesale r spends

6- 16$0.205 to cover labor costs, $0.0 49 to cover occupancy expenses, $0.07 5 for other operating expenses, and $0.0 27 in profits. This totals to $1.3 57 in sales revenue earned for every $1.00 spent on equipment costs. Therefore, the wholesaler baseline markup ( MU WHOLE BASE ) is 1.3 57 ($1.357 ÷ $1.00).

DOE also used the data in column two to estimate the incremental markups. The incremental markup depends on which of the costs in Table 6.6 .2 are variant or invariant with
respect to MSP . For example, for a $1.00 increase in the MSP, if all of the other costs scale with the MSP ( i.e., all costs are variant ), the increase in wholesale price will be $1.3 57 , implying that the incremental markup is 1.3 57 , or the same as the baseline markup. At the other extreme, if no other costs are variant , then a $1.00 increase in the MSP will lead to a $1.00 increase in the

wholesale price, for an incremental markup of 1.0.

As stated in section 6.5

, DOE believes that the labor and occupancy costs are invariant with respect to MSP, while other opera ting costs and profit are variant with respect to MSP . In this case, for a $1.00 increase in the MSP, the wholesale price will increase in line with changes in the categories “other operating costs ” and “ operating profit ”; these approximately amount to $ 0.067, which when divided by $0.737 cents in cost of goods sold yields an increase of $0. 103

, giving a wholesaler incremental markup ( MU WHOLE INCR ) of 1. 10 3 . See A ppendix 6

- A for cost

details.

These data are provided for seven regions, which are defined similarly to C ensus Divisions. Each state is assigned the baseline and incremental wholesaler markup of the region to which it is assigned by HARDI.

6.6.3 Mechanical Contractor Markups

6.6.3.1 Aggregate Baseline and Incremental Markups for Mechanical

Contractors

DOE derived nationa l average markups for mechanical contractors from U.S. Census

Bureau data. The 2007 U.S. Census data for mechanical contractors include detailed statistics for establishments with payrolls, similar to the data reported by HARDI for wholesalers. The primary difference is that the U.S. Census Bureau reports itemized revenues and expenses in total dollars for the industry as a whole, 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. Table 6.6 .3 summarizes the national

average expenses for general contractors as expenses per dollar sales revenue in the first data

c olumn . (A ppendix 6 -A contains the full set of data .) The process used to calculate markups from the table values is analogous to the process explained in detail in section 6.6.2.

6- 17Table 6.6 .3 Baseline and Inc remental Markup s , All Mechanical Contractors (2007 Economic Census data)

Descriptions Per Dollar

Sales Revenue $ Per Dollar Cost

of Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.68 1.00 Labor Expenses: Salaries and benefits 0.18 0.26 Occupancy Expense: Rent, maintenance, and utilities 0.02 0.03 Other Operating Expenses: Depreciation, advertising, and

insurance. 0.08 0.12

Operating Profit 0.04 0.06 Wholesaler Baseline Markup ( MU WHOLE BASE ) 1.48 Incremental Markup ( MU WHOLE INCR ) 1.18 Incremental Markup as % of Baseline Markup 80 %

Source: U.S. Census Bureau. 2007 Economic Census, Plumbing, Heating, and Air -Conditioning Contractors. Sector 23: 238220. Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007.

The markup s derived for mechanical contractors are the national average value s for all contractors, including large and small contractors serving the replacement an d new construction

markets. The results of this calculation are subsequently scaled based on state

- level data also

obtained from the 2007 U.S. Census Geographic Area Seri es for mechanical contractors. 3 The following section describe s how DOE further derived the baseline and incremental markups for

two distinct categories of mechanical contractors: (1) contractors in the replacement market and (2) contractors in the new con struction market.

6.6.3.2 Baseline Markups for Mechanical Contractors in the Replacement and

New Construction Markets

The ACCA Financial Analysis for the HVACR Contracting Industry report is used to disaggregate markups for the replacement an d new construction ma rkets. ACCA financial data provided only gross margin data, which allows for the determination of only the baseline markup

for the two types of contractor s , as the gross margin is the sum of all contractor labor and operating expenses plus profit.

Table 6.6 .4 summarizes the gross margin and resulting national baseline markup data for mechanical contractors that serve the replacement and new const ruction markets.

6- 18Table 6.6 .4 Baseline Markups for the Replacement and New Construction Markets,

Mechanical Contractors (ACCA data)

Description Contractor Expenses or Revenue by Market Type Replacement New Construction

Per Dollar

Sales

Revenue $ Per Dollar

Cost of

Goods $ Per Dollar

Sales

Revenue $ Per Dollar

Cost of

Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.703 1.000 0.745 1.000

Gross Margin: Labor, occupancy, operating expenses, and profit 0.297 0.422 0.255 0.342

Baseline Markup ( MUMECH

CONT BASE ): Revenue per dollar cost of goods NA 1.42 NA 1.34

% Difference from Aggregate

Mechanical Contractor Baseline

MU NA 3.6% NA

- 2.2%

Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry

.

Using the baseline markup data for replacement and new construction contractors from

Table 6.6 .4 , DOE calculated that the baseline markups for the replacement and new markets are 3.6 percent higher and 2.2 percent lower, respectively, than that for all mechanical contractors serving all market s shown in Table 6.6 .3

. These percentage differences are applied to the previously calculated state

- level incremental and baseline markups based on U.S. Census data to estimate separate national and state

- level markups for the two categories of mechanical

contractor of interest.

6.6.4 Estimation of General Contractor Markups

DOE derived markups for general contractors from U.S. Census Bureau data for the

commercial building construction sector. The commercia l construction sector includes establishments primarily engaged in the construction of commercial and institutional buildings

, including new construction work, additions, alterations, and repairs.

Th e 2007 U.S. Census data for the commercial construction sector include detailed statistics for establishments with payrolls, similar to the data reported by HARDI for

wholesaler s. The primary difference is that the U.S. Census Bureau reports itemized reven ues and expenses in total dollars for the commercial c onstruction industry as a whole, 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. The results of this calculation are subsequently scaled based on state

- level data also obtained from the 2007

U.S. Census. Similar to th e data for wholesaler s, Table 6.6 .5 summarizes the national average expenses for general contractors as expenses per dollar sales revenue in the first data column

.

6- 19(A ppendix 6 -A contains the full set of data

. ) The process used to calculate markups from the table values is analogous to the process explained in detail in section 6.6.2.

Table 6.6 .5 General Contractor Expenses and Markups

Description Wholesale Firm Expenses or

Revenue

Per Dollar

Sales

Revenue $ Per Dollar

Cost of

Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.76 1 .00 Labor Expenses: Salaries (indirect) and benefits 0.0 8 0.10 Occupancy Expense: Rent, maintenance, and utilities 0.01 0.01 Other Operating Expenses: Depreciation, advertising, and insurance. 0.03 0.04

Net Profit Before Taxes 0.1 2 0.15 Baseline Markup ( MUGEN CONT BASE ): Revenue per dollar cost of goods 1.31 Incremental Markup ( MUGEN CONT INCR ): Increased revenue per dollar increase cost of goods sold 1. 19

Source: U.S. Census Bureau. 2007. Sector 236220 (Commercial and Institutional Building Construction). Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007.

6.7 SALES TAX

The sales tax repre sents state and local sales taxes that are applied to the customer price of the equipment. The sales tax is a multiplicative factor that increases the customer equipment price.

DOE derived state and local taxes from data provided by the Sales Tax Clearin ghouse. 15

These data represent weighted averages that include state, county

, and city rates. DOE then derived population

- weighted average tax values for each Census division and large state, as

shown in Table 6.7 .1

. The average sales tax presented in the bottom row of the table is the weighted average accounting for commercial building floor space with packaged cooling by Census division, calculated using CBECS 2003

. Detailed sales tax data by state can be found in

A ppendix 6

- A.

6- 20Table 6.7 .1 Average Sales Tax Rates by Census Division and Large State

Census Division/State Tax Rate (201 4 )

New England 5.68%

Mid Atlantic 7.47%

East North Central 6.90%

West North Central 7.09%

South Atlantic 6.47%

East South Central 8.01%

West South Central 8.13%

Mountain 6.44%

Pacific 7.65%

New York 8.40%

California 8.45%

Texas 7.90%

Florida 6.65%

U.S. Average 7.15%

Source: The Sales Tax Clearinghouse at https://thestc.com/STRates.stm ( Accessed February 2014)

6.8 OVERALL MARKUPS

The overall markup for each distribution channel is the product of the appropriate markups, as well as sales tax in the case of replacement applications ( Table 6.8 .1 )

.

Table 6.8 .1 Summary of Overall Markups

Distribution Channel Segment Replacement New Construction

Baseline Markup Incremental Markup Baseline Markup Incremental Markup

Manufacturer 1.27

- 1.27

- Wholesaler 1.36 1.10 1.36 1.10

Mechanical Contractor 1.52 1.22 1.43 1.15

General Contractor 1.34 1.22 1.34 1.22 Sales tax (replacements) 1.07 1.07

-- -- Overall Markup 3.76 1.75 3.31 1.54

6- 216.8.1 Estimation of National Account Markups

DOE derived markups for national accounts for new construction through a weighting of the overall markups estimated for the other new construction distribution channels. To capture the price savings realized from equipment purchased through national accou nts , DOE applies a national account markup one half of that of a typical chain of distribution , as described in section

6.3.5 ( Table 6.8 .2 ).

Table 6.8 .2 National Account Markups

Market Baseline Markup Incremental Markup

New Construction 2.14 1.47

6- 22REFERENCES

1. Heating Air Conditioning & Refrigeration Distributors International, 2010 Profit Report

, 2010.

2. Air Conditioning Contractors of America, 2005 Financial Analysis for the HVACR Contracting Industry , 2005.

3. U.S. Census Bureau, Data set for Sector 23, EC0723A1, Construction: Geographic Area Series, Detailed Statistics for Establishments

, 2007.

4. U.S. Census Bureau, Data set for Sector 23: EC0723I1, Construction: Industry Series, Preliminary Detailed Statistics for Establishments, 2007.

5. U.S. Census Bureau, Manufacturing Industry Series: Detailed Statistics for the United

States: 20 07. Air

- Conditioning and Warm Air Heating Equipment and Commercial and Industrial Refrigeration Equipment Mnufacturing. Data set for Sector 31: EC073111

. 2007.

6. U.S. Census Bureau, Wholesale Trade: Industry Series: Preliminary Summary Statistics for th e United States: 2007. HVAC Equipment Merchant Wholesaler. Data set for Sector

42: EC0742111

, 2007.

7. U.S. Census Bureau, Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007. Commercial and Institutional Building Cons truction , 2007.

8. U.S. Census Bureau, Construction: Industry Series: Preliminary Detailed Statistics for Establishments: 2007. New Single

- Family General Contractors, New Multifamily Housing Construction (Except Operative Builders), New Housing Operative Builders

Residential , 2007.

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

- Conditioning Contractors. Sector 23: 238220. Construction: Industry Series, Preliminary Detailed Statistics for Establishments, 2007.

10. U.S. Census Bureau, Wholesale Trade: Subject Series: Estab and Firm Size: Summary Statistics by Concentration of Largest Firms for the United States: 2007. Data set for

Sector 42: EC074373

, 2007.

11. University of Maryland University College, Note on Industry Structure, 2002. (Last accessed February, 2013.)

< http://info.umuc.edu/mba/public/AMBA607/IndustryStructure.html >

12. QuickMBA, Industry Concentration, 2010. (Last accessed February, 2013.)

< http://www.quickmba.com/econ/micro/indcon.shtml >

13. Pindyck, R. and D. Rubinfeld, Microeconomics , Fifth Edition . 2000. Prentice Hall.

6- 2314. Security Exchange Commission, SEC 10

- K Reports, 2006

- 2011. < http://www.sec.gov/ >

15. The Sales Tax Clearinghouse, 2014. (Last accessed February 2014.)

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

6- 24