CHAPTER 6. MARKUPS TO DETERMINE EQUIPMENT PRICE

TABLE OF CONTENTS

6.1 INTRODUCTION

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

..................................................................... 6-2
6.2.1 Baseline Markups

................................................................................................. 6-3
6.2.2 Incremental Markups

........................................................................................... 6-4
6.2.3 Overall Markups

.................................................................................................. 6-4
6.3 ASSUMPTIONS USED TO ESTIMATE WHOLESALER AND CONTRACTOR
MARKUPS

........................................................................................................................ . 6-5
6.4 ESTIMATION OF WHOLESALER MARKUPS

............................................................. 6-6 6.4.1 Estimation of Wholesaler Markup Probability Distribution

................................ 6-8
6.5 ESTIMATION OF MECHANICAL CONTRACTOR MARKUPS

.................................. 6-8
6.5.1 Markups for Mechanical Contract ors in the Replacement and New Construction Markets

........................................................................................... 6-9 6.5.2 Estimation of Mechanical Contractor Markup Probability Distribution

........... 6-11
6.6 ESTIMATION OF GENERAL CONTRACTOR MARKUPS

........................................ 6-12
6.6.1 Estimation of General C ontractor Markup Probability Distribution

................. 6-13
6.7 SALES TAX

..................................................................................................................... 6 -14
6.8 OVERALL MARKUPS

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

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

LIST OF TABLES

Table 6.4.1 Wholesaler Expenses and Markups

..................................................................... 6-7 Table 6.5.1 Baseline Markup, All Mechanical Contractors

.................................................... 6-9 Table 6.5.2 Baseline Markups for the Replacemen t and New Construction Markets, All Mechanical Contractors

............................................................................... 6-10 Table 6.5.3 Mechanical Contractor Expenses and Baseline Markup, Residential and Light Commercial

.............................................................................................. 6-10 Table 6.5.4 Mechanical Contractor Expenses a nd Markups Based on Census Bureau
Data

.................................................................................................................... 6-11 Table 6.6.1 General Contractor Expe nses and Markups

....................................................... 6-13 Table 6.7.1 State Sales Tax Rates (Percent)

......................................................................... 6-15 Table 6.8.1 Average Overall Ba seline Markups

................................................................... 6-15 Table 6.9.2 Average Overall Incremental Markups

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

6-iLIST OF FIGURES

Figure 6.1.1 Distribution Channels for CAC Equipment

......................................................... 6-1 Figure 6.4.1 Wholesaler Baseline Markup Probability Distribution

........................................ 6-8 Figure 6.4.2 Wholesaler Incremental Markup Probability Distribution

.................................. 6-8 Figure 6.5.1 Residential a nd Light Commercial Mechani cal Contractor Relative Markup Probability Distribution

........................................................................ 6-12 Figure 6.6.1 Residential Genera l Contractor Relative Markup Probability Distribution

....... 6-14 Figure 6.6.2 Commercial General Contractor Relative Markup Probability Distribution

..... 6-14

6-iiCHAPTER 6. MARKUPS TO DETERMINE EQUIPMENT PRICE

6.1 INTRODUCTION

To carry out the life-cycle cost (LCC) calcu lations described in Chapter 8, the U.S. Department of Energy (DOE) needed to determin e the cost to the customer of a residential
central air conditioner or heat pump (CAC) product. This cost was determined for both baseline equipment and more-efficient equipment th e customer would purchase following the promulgation of new energy conservation standards. However, the customer price of baseline or higher-efficiency equipment is not known and can be determined based on how the equipment is purchased. For the central air conditioner and h eat pump rulemaking, direct information on the
incremental markup on equipment costs for higher efficien cy units is not readily available. This is partially due to the fact that such units ar e often included in the c onstruction costs of new housing or as a package that includes installati on. In addition, because higher efficiency units may have different markups than baseline units at minimum efficiency and higher efficiency units are not produced at the same volume as ba seline units, current incremental equipment costs observed in the market may not be representativ e of the incremental costs under a new standard. The manufacturing selling price (MSP) can be determined for both baseline equipment and the more-efficient equipment as desc ribed in the engineering analysis (Chapter 5). Therefore, by applying a multiplier called a “markup” to the MSP, DOE was able to estimate the customer price of equipment purchased through various di stribution channels. This chapter describes how DOE derived such markups.

The cost to the customer depends on how th e customer purchases the equipment. DOE identified two distribution channels, as shown in Figure 6.1.1, to describe how the equipment passes from the manufacturer to the customer for both new construction and replacement markets. In the replacement distribution channel, the manufacturer sells the CAC product to a distributor/wholesaler, who in turn sells it to a mech anical contractor, who in turn sells it directly to the customer. In new construction distributi on channel, the manufacturer sells the equipment to a wholesaler, who in turn sells it to a mechanical contractor, who in turn sells it to the customer through a general contractor who sells it and its installation to the customer. The distribution chain markup consists of a distributor/wholesaler ma rkup applied by distributors and wholesalers, a dealer/contractor markup applie d by dealers and HVAC contractors and a markup for sales tax. For the new housing market, a mark up is also applied by housing developers and builders. The markups applied in the Pre-NOPR analysis for distributor and dealer markups were determined from aggregate average markups for the businesses in the distribution chain. This means at each stage of distribution, direct costs of sales, i.e., purchased equipment and materials and direct labor costs, were compared with th e total volume of business revenues, and the ratio of total business revenues to direct co sts was used to determine the markup.

New Units: Manufacturer → Distributor → Mechanical Contractor → General
Contractor → Customer
Replacement Units: Manufacturer → Distributor → Mechanical Contractor → Customer

Figure 6.1.1 Distribution Channels for CAC Equipment

6-1The analysis detailed here for the Pre-NOPR examined the scaling behavior of markups for wholesalers and contractors, and determined that markups are neither fixed-dollar, nor proportional to all direct costs, but somewhere in-between. Using the available data, we have found measurable differences between incremental markups on direct equipment costs and the

average aggregate markup on direct business costs. Significant differences were found between average and incremental markups for heating, ventilation, air-conditioning and refrigeration (HVACR) wholesalers/distributor s, and for HVAC dealers/cont ractors. Section 6.3 further discusses the differences between average and incremental markups.

The main reason that the selling price of a pr oduct may not be strictly proportional to the purchase price of the equipment is that businesses incur a wide variety of costs. Therefore, when the purchase price of equipment and materials increases, only a fraction of the business expenses increase, while the remainder of the businesses’ expenses stay relatively constant. For example, if the unit price of an air conditioner increases by 30%, it is unlikely that the cost of secretarial support in an administrative office will increase by 30% also. Certain business expenses are relatively uncorrelated with the cost of equipment or cost of goods.

For each of the steps in the distributi on channels presented above, DOE estimated a baseline markup and an incremen tal markup. DOE defined a baseline markup as a multiplier that converts the MSP of equipment w ith baseline efficiency to the customer purchase price for the equipment at the same baseline efficiency leve l. An incremental markup is defined as the multiplier to convert the incremental increase in MSP of higher efficiency equipment to the customer purchase price for the same equipmen t. Both baseline and incremental markups are only dependent on the particular distribution channe l and are independent of the efficiency levels of CAC products.

6.2 MARKUP CALCULATION PROCEDURE

The following equation describes how DOE determined the equipment price if a mechanical contractor sells the equipment to the customer through a general contractor
distribution chain:

EQP CUST = MSP x MU WHOLE x MU MECH CONT x MU GEN CONT x (1+ ST) Eq. 6.1

Where:

EQP CUST = equipment price to the customer ($),
MSP= manufacturer selling price ($),
MU WHOLE = wholesaler markup,
MU MECH CONT = residential and li ght commercial mechani cal contractor markup,
MU GEN CONT = general contractor markup,
ST = sales tax ($).

The markup multiplier to the equipment price is lessened for shorter distribution chains by omitting the applicable markup(s).

The general contractor markup is only applie d to new construction because the general contractor not generally involved in the replacem ent market. The later sections of this chapter

6-2describe the determination of the residential and light commercial mechanical contractor markups and market type (i.e., new or replacem ent). For each of the markups presented above, DOE further differentiated between a baseline ma rkup and an incremental markup, as described below. The overall markup describe s the product of all the markups (baseline and incremental) plus sales tax within a distribution channel.

6.2.1 Baseline Markups

DOE defined baseline markups as cost multip liers that convert the MSP of equipment with baseline efficiency to the customer purchase price for the equipment at the same baseline efficiency level.

New equipment is assumed to be sold to a cu stomer by a mechanical contractor through a general contractor:

EQP GEN CONT BASE = MSP BASE x MU WHOLE BASE x MU MECH CONT BASE x MU GEN CONT BASE x (1+ST) Eq. 6.2

Where:

EQP GEN CONT BASE = general contractor price of baseline equipment ($),
MSP BASE = manufacturer selling price of baseline equipment ($),
MU WHOLE BASE = wholesaler markup on baseline equipment,
MU MECH CONT BASE = mechanical contractor markup on baseline equipment,
MU GEN CONT BASE = general contractor markup on baseline equipment,
ST = sales tax rate.

Replacement equipment is assumed to be sold to a customer directly by a mechanical

contractor:

EQP MECH CONT BASE = MSP BASE x MU WHOLE BASE x MU MECH CONT BASE x (1+ST) Eq. 6.3

Where:

EQP MECH CONT BASE = mechanical contractor pri ce of baseline equipment ($),
MSP BASE = manufacturer selling price of baseline equipment ($),
MU WHOLE BASE = incremental wholesaler markup,
MU MECH CONT BASE = mechanical contractor markup on baseline equipment,
MU GEN CONT BASE = general contractor mark up on baseline equipment,
ST = sales tax rate.

The use of the markups results in the mechanical contractor ( EQP MECH CONT BASE ), and general contractor ( EQP GEN CONT BASE ) prices of baseline CAC equipment.

6-36.2.2 Incremental Markups

Incremental markups are defined as the co st multipliers to convert the incremental increase in MSP of higher efficiency equipment to the customer purchase price for the same equipment, as shown in the following equations:

If sold to a customer by a mechanical contractor through a general contractor:

EQP GEN CONT INCR = MSP INCR x MU WHOLE INCR x MU MECH CONT INCR x MU GEN CONT INCR x (1+ST) Eq. 6.4

Where:

EQP GEN CONT INCR = incremental general contractor price ($),
MSP INCR = manufacturer incremental selling price ($),
MU WHOLE INCR = incremental wholesaler markup,
MU MECH CONT INCR = incremental mechanical contractor markup,
MU GEN CONT INCR = incremental general contractor markup,
ST = sales tax rate.

If sold to a customer directly by a mechanical contractor:

EQP MECH CONT INCR = MSP INCR x MU WHOLE INCR x MU MECH CONT INCR x (1+ST) Eq. 6.5

Where:

EQP WHOLE INCR = incremental wholesaler price ($).

In these equations, MSP INCR refers to a change in the MSP (e.g., brought about by an increase in equipment efficiency due to am ended energy conservation standards) and MU WHOLE

INCR , MU MECH CONT INCR , and MU GEN CONT INCR refer to the incremental wholesaler, incremental mechanical contractor, and incremental general c ontractor markups, respectively. The use of the incremental markups results in incremental equipment price to the incremental mechanical contractor ( EQP MECH CONT INCR ), and incremental general contractor ( EQP GEN CONT INCR ) prices experienced by the customer.

6.2.3 Overall Markups

The overall markup is the produc t of all the markups, including both overall baseline and overall incremental markups, for the different steps within a distribution channel plus sales tax, as indicated by the following equations:

EQP CUST BASE = MSP BASE x ( WT MECH CONT BASE x MU WHOLE BASE x MU MECH CONT BASE + WT GEN

CONT BASE x MU WHOLE BASE x MU MECH CONT BASE x MU GEN CONT BASE ) x (1+ ST ) = MSP BASE x MU OVERALL BASE Eq. 6.6

6-4EQP CUST INCR = MSP INCR x ( WT MECH CONT INCR x MU WHOLE INCR x MU MECH CONT INCR + WT GEN

CONT INCR x MU WHOLE INCR x MU MECH CONT INCR x MU GEN CONT INCR ) x (1+ ST ) = MSP INCR x MU OVERALL INCR Eq. 6.7

EQP CUST = EQP CUST BASE + EQP CUST INCR Eq. 6.8

Where:

EQP CUST BASE = baseline customer price ($), EQP CUST INCR = incremental customer price ($), EQP CUST = total customer price ($),
MU OVERALL BASE = overall weighted baseline markup th at is the product of all the weights and baseline markups for each step of the distribution channel,
MU OVERALL INCR = overall weighted incremental mar kup that is the product of all the weights and incremental markups fo r each step of the distribution channel,
WT MECH CONT BASE = weight (percent) of baseline e quipment sales through mechanical
contractors, WT GEN CONT BASE = weight (percent) of baseline equipment sales through general
contractors, WT MECH CONT INCR = weight (percent) of higher efficiency equipment sales through mechanical contractors,
WT GEN CONT INCR = weight (percent) of higher efficiency equipment sales through general contractors.

The use of the overall baseline and overall in cremental markups results in the baseline customer price ( EQP CUST BASE ) and the incremental customer price ( EQP CUST INCR ). For a particular higher efficiency level that increases MSP, the total equipment price ( EQP CUST ) to the customer is the sum of the baseline customer price ( EQP CUST BASE ) and the incremental customer price ( EQP CUST INCR ).

6.3 ASSUMPTIONS USED TO ESTIMATE WHOLESALER AND CONTRACTOR MARKUPS

DOE derived the wholesaler and contractor markups from three key assumptions about CAC costs. DOE based the wholesaler and mechan ical contractor markups on firm balance-sheet data, while it based the general contractor ma rkups on U.S. Census Bureau data for the
commercial and instituti onal building construction industry. DOE obtained the firm balance sheets from the Heating, Air-conditioning & Refrigeration Distributors International (HARDI) 2008 Profit Planning Report and from the Air Conditioning Contractor s of America (ACCA). 1,2 HARDI and ACCA are trade associations representing wholesalers and mechanical contractors, respectively. DOE used the financial data fro m the 2002 US Census Bureau for developing general contractor markups in 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

6-5firms that supply and install air conditioning equipment. a The key assumptions used to estimate markups using these financial data are:

• The firm balance sheets accurately represent the various average costs incurred by firms distributing and installing commercial ai r conditioning and heating equipment.

• These costs can be divided into two categorie s: (1) costs that vary in proportion to the MSP of commercial air conditioning and h eating equipment (variable costs); and (2) costs do not vary with the MSP of comme rcial air conditioning and heating equipment (fixed costs).

• Wholesaler and contractor prices vary in proportion to CAC and HP wholesaler and
contractor costs included in the balance sheets.

In support of the first assumption, the balan ce sheets itemize firm costs into a number of expense categories, including dire ct costs to purchase or insta ll the equipment, operating labor and occupancy costs, and other operating costs an d profit. Although wholes alers and contractors tend to handle multiple commodity lines (including air conditioners, furnac es, and boilers), the data provide the most accu rate available indication of CAC and HP expenses.

Information obtained from the trade literature and selected heating, ventilating, and air conditioning (HVAC) wholesalers, contractors, and consultants support the second assumption.
This information indicated that wholesaler and contractor markups vary according to the quantity
of labor and materials used to distribute and inst all appliances, with mark ups on labor tending to be much higher than markups on materials. Th e obtained information described markups as varying much more in relation to sales volume than in relation to other factors, including appliance efficiency. This last fi nding strongly suggested that la bor inputs vary more with sales volume than with appliance cost or efficiency . DOE assumed a division of costs between those costs that do not scale with the MSP (labor a nd occupancy expenses), and those costs that do (operating expenses and profit). This division of costs led to the estimate of wholesaler and contractor markups described below.

In support of the third assumption, the HVAC wholesaler and contractor industry is competitive and customer demand for commercial h eating 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 2002 Cens us indicates the competitive nature of the market. For example, there are more than 700 HVAC manufacturers, 4 6,000 wholesalers of heat pumps and air-conditioning equipment, 5 more than 37,000 general contractors, 6 and 87,000
HVAC contractors 7 listed in the 2002 Census. Following standard economic theory, competitive firms facing inelastic demand either set prices in line with costs or quickly go out of business. 8

6.4 ESTIMATION OF WHOLESALER MARKUPS

Wholesalers reported median data in a conf idential survey that HARDI conducted of
member firms. 2 In the survey, HARDI itemized revenues and costs into cost categories, including direct equipment expenses (cost of g oods sold), labor expenses, occupancy expenses,

a Wholesalers and mechanical contractors to which these reports refer handle multiple commodity lines, including
residential and commercial air-conditioners and warm-air furnaces.

6-6other operating expenses, and profit. DOE presents these data in full in appendix C, Detailed Data for Equipment Price Markups. Table 6.4.1 summarizes them as cost-per-dollar sales revenue in the first data column.

Table 6.4.1 Wholesaler Expenses and Markups

Descriptions Per Dollar Sales Revenue $ Per Dollar Cost of Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.730 1.000 Labor Expenses: Salaries and benefits 0.156 0.214 Occupancy Expense: Rent, maintenance, and utilities 0.031 0.042 Other Operating Expenses: Depreciation, advertising, and insurance. 0.052 0.071
Profit 0.031 0.042
Baseline Revenue: Baseline revenue earned per dollar cost of goods sold 1.370 Wholesaler Baseline Markup ( MU WHOLE BASE ) 1.370
Incremental Revenue: Increased revenue per dollar increase cost of goods sold 1.114 Incremental Markup ( MU WHOLE INCR ) 1.114 Source: Heating, Air Conditioning & Refrigeration Distributors International. 2008. 2008 Profit Report (2007 Data). 2

In this case, direct equipment expenses (cost of goods sold) represent about $0.73 per dollar sales revenue, so for every $1 wholesalers ta ke in as sales revenue, $0.73 is used to pay the direct equipment costs. Labor expenses represent $0.16 per dollar sales revenue, occupancy expenses represent $0.03, other operating expe nses represent $0.05, and profit accounts for $0.03 per dollar sales revenue.

DOE converted the expenses per dollar sales in to revenue per dollar cost of goods sold, by dividing each figure in the first data colu mn by $0.73 (i.e., cost of goods sold per dollar of sales revenue). The data in co lumn 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, $0.214 to cover labor costs, $0.042 to cover occupancy expenses, $0.071 for other operating expenses, and $0.042 in profits. This totals to $1.370 in sales revenue earned for every $1.00 spent on equipment costs. Therefore, th e wholesaler baseline markup ( MU WHOLE BASE ) is 1.37 ($1.37 ÷ $1.00).

DOE also used the data in column two to estimate the incremental markups. The incremental markup depends on which of the co sts in Table 6.4.1 are variable and which are fixed. 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 variable), the increase in wholesaler price will be $1.370, implying that the incremental markup is 1.370, 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 MSP 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 MSP (i.e., be variable). In this case, for a $1.00 increase in the MSP, the wholesaler price will increase by $1.114, giving a wholesaler incremental markup ( MU WHOLE INCR ) of 1.114.

6-76.4.1 Estimation of Wholesaler Markup Probability Distribution

DOE characterized the markups developed from the above financial da ta with probability distributions from statistics published by the U.S. Census Bureau for wholesalers (see appendix C). The analysis provided a standard de viation on the markups of wholesaler firms in the U.S. DOE then applied the standard deviati on 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 relative standard deviation as 7.7 percent as a percenta ge of the baseline mar kup of 1.362, which resulted in a standard deviation of 5.7 percent as described in appe ndix C. DOE assumed that the variation determined for the ba seline markup applied to the incr emental markup as well. For the baseline markup of 1.370, a standard deviation of 7.7 percent translates into an absolute value of
5.6 percent. For the incremental markup of 1.114, a relative standard deviation of 7.7 percent translates into an absolute value of 6.9 percent.

Figure 6.4.1 and Figure 6.4.2 show the probability distributions that DOE used to characterize the wholesaler ba seline and incremental markups.

Figure 6.4.2 Wholes aler Incremental Markup Probability Distribution Figure 6.4.1 Wholesaler Baseline Markup Probability Distribution

Note that for the incremental markup, the st andard deviation of 6.9 percent results in markup values that are less than 1.0. Since a ma rkup value of less than 1.0 would not allow the wholesaler to recover its costs, DOE trun cated all values less than 1.0 from the normal distribution as shown in Figure 6.4.2.

6.5 ESTIMATION OF MECHANICAL CONTRACTOR MARKUPS

The HVAC contractors, defined here as mech anical contractors, reported median cost data in an ACCA financial analysis of the HVAC industry. 3 These data are shown in Table 6.5.1.

6-8Table 6.5.1 Baseline Markup, All Mechanical Contractors

Description Contractor Expenses or Revenue

Per Dollar Sales Revenue $ Per Dollar Cost of Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.73 1.00 Gross Margin: Labor, occupancy, operating expenses, and profit 0.27 0.37
Revenue: Baseline revenue earned per dollar cost of goods 1.37 Baseline Markup ( MU MECH CONT BASE ) 1.37 Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry. 2

Data reported in this analysis are not as de tailed as that provided by the other sources, containing only cost of goods sold and gross margin. Since the gross margin is the sum of labor, occupancy expenses, operating expenses, and profit, the gross margin allows for the determination of the baseline markup. The first data column in Table 6.5.1 provides the cost of goods sold and gross margin as expenses per dollar sales revenue. The only important difference is that the direct cost of equipment sales in this table includes installation costs as well as the cost of goods sold. As shown in the table, the dir ect cost of sales represents about $0.73 per dollar sales revenue to the contractor and the gro ss margin is $0.27 per do llar sales revenue. The mechanical contractor expenditures per dollar sales revenue in Table 6.5.1 are quite similar to the wholesaler expenditures per dollar sales revenue reported in Table 6.4.1.

DOE converted these expenses per dollar sales into revenue per dollar cost of goods sold by dividing each figure in the first data column by $0.73. For every $1.00 the mechanical contractor spends on equipment co sts, the mechanical contractor earns $1.00 in sales revenue to cover the equipment cost, and $0.37 to cover the ot her costs. This totals $1.37 in sales revenue earned for every $1.00 spent on equipment costs, for a baseline markup ( MU MECH CONT BASE ) of 1.37
for mechanical contract ors, since the contractor earns $1.37 in sales revenue for every $1.00 spent to purchase the equipment.

6.5.1 Markups for Mechanical Contractors in the Replacement and New Construction
Markets

The baseline markup derived above for mechanic al contractors is the average value for all contractors including the replacement and ne w construction markets. This section describes how DOE further derived the baseline and incremen tal markups for these latter two markets. As above, the ACCA financia l data provided gross ma rgin data, which allows for the determination of only the baseline markup for the two markets, since the gross margin is the sum of all contractor labor and operating expenses plus pr ofit. Calculation of the incremental markup uses Census Bureau data, because this was not possible with the ACCA data as the variable costs are not provided separately.

Table 6.5.2 summarizes the gross margin and resulting baseline markup data for all mechanical contractors that serve the replacement and new construction markets.

6-9Table 6.5.2 Baseline Markups for the Replacement and New Construction Markets, All
Mechanical Contractors

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 0.70 1.00 0.75 1.00

Gross Margin: Labor, occupancy, operating expenses, and profit 0.30 0.43 0.25 0.33

Baseline Markup ( MU MECH CONT BASE ): Revenue per dollar cost of goods NA 1.43 NA 1.33

Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry. 3

Using the baseline markup data from Tabl e 6.5.2 and results of a financial analysis 3 , DOE calculated that the baseline markups for the replacement and new markets are 4.4 percent higher and 2.9 percent lower, respectively, than that for all mechanical contractors serving all markets.

DOE then used the ACCA data to calcu late the baseline markup of 1.32 for the residential and light commerc ial building construction section as shown in Table 6.5.3.

Table 6.5.3 Mechanical Contractor Expenses and Baseline Markup, Residential and Light Commercial

Description Contractor 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 Gross Margin: Labor, occupancy, operating expenses, and profit 0.24 0.32 Baseline Markup ( MU MECH CONT BASE ): Revenue per dollar cost of goods 1.32 Source: Air Conditioning Contractors of America. 2005. Financial Analysis for the HVACR Contracting Industry. 3

The markup deviations derive d above (i.e., 4.4 percent higher and 2.9 percent of lower for the replacement and new construction markets, respectively) were then applied to the baseline markup of 1.32 for the re sidential and light commercial building construction section.
This resulted in baseline mar kups of 1.38 and 1.28, respectively, for the replacement and new construction markets served by mechanical cont ractors for the residential and light commercial building construction.

Calculation of the incrementa l markups for each market type required separation of the fixed and variable costs. Since this was not possible using the ACCA data, DOE used more detailed 2002 Census Bureau data for all plumbing, heating, a nd air-conditioning contractors. 7

The Census Bureau data were used to calculate the baseline and increm ental markups as shown in Table 6.5.4.

6-10Table 6.5.4 Mechanical Contractor Expenses and Markups Based on Census Bureau Data

Description Contractor Expenses or Revenue
Per Dollar Sales Revenue $ Per Dollar Cost of Goods $ Direct Cost of Equipment Sales: Cost of goods sold 0.66 1.00 Labor Expenses: Salaries (indirect) and benefits 0.17 0.26 Occupancy Expense: Rent, maintenance, and utilities 0.02 0.03 Other Operating Expenses: Depreciation, advertising, and insurance. 0.03 0.05
Net Profit Before Taxes 0.12 0.18 Baseline Markup ( MU MECH BASE ): Revenue per dollar cost of goods 1.52 Incremental Markup ( MU MECH INCR ): Increased revenue per dollar increase cost of goods sold 1.23 Source: U.S. Census Bureau. 2002. Plumbing, Heating, and Air-Conditioning Contractors: 2002. Report EC02-231-238220, Table 4, Detailed Statistics for Establishments: 2002. 7

Using the data Table 6.5.4, the incremental markup is 19.1 percent lower than the baseline markup. DOE assumed that this devia tion applies equally to the baseline markups calculated for replacement of 1.38 and new constr uction markets of 1.28. This yields incremental markups of 1.12 and 1.04, respectively, for the re placement and new construction markets served by mechanical contractors.

6.5.2 Estimation of Mechanical Contract or Markup Probab ility Distribution

DOE characterized the markups develope d from the ACCA financial data with probability distributions through a statistical analysis of U.S. Census data for plumbing, heating, and air-conditioning contractors. The statistical analysis provi ded a standard deviation on the markups of mechanical contractors in the U.S. DOE 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 mechanical contractors, DOE calculated a relative standard deviation of 3.7 percent for the baseline markup as described in appendix A. DOE assumed that the variation determined for the baseline markup applied to the incremental markup as well. For the baseline markup of 1.38 and 1.28 for the replacement and new construction markets, respectively, a relative stan dard deviation of 3.7 percent translates into respective absolute values of 0.051 and 0..047. Fo r the incremental markups of 1.12 and 1.04 for the replacement and new construction markets, re spectively, a standard deviation of 3.7 percent translates into respective absolute values of 0.041 and 0.038.

DOE calculated a relative standard deviation of 3.7 percent for m echanical contractor markups but applied the relative markups on a state-by-state basi s. Figure 6.5.1 illustrates the probability distribution that DOE used to characterize the mechanical contractor baseline and incremental markups for the replacement and new markets. The relative values are multiplied times the mean markups for all four categories of mechanical contractor markup: both baseline and incremental markups for both new constr uction and replacements. The probability of purchasing a CAC or heat pump unit is different in the different U.S. states, and the relative markup is different in each state. While the actual probability of a sale in a particular state depends on a number of climate, product-specific, regulatory, and population factors, Figure 6.5.1 shows what the distribution of rela tive markups looks like if population were the

6-11only determinant. The far right-hand bar shows, for example, that based on population, there is a
12.1 percent chance that a given CAC sale woul d be in California (which had an estimated
12.1 percent of the U.S. population in July, 2008). The relative mechanical contractor markup value for California is 1.037, which would be multiplied times the mean markup factor of 1.28 for a new baseline unit, yielding a mechanic al contractor markup of 1.327. If instead the incremental markup on a replacement unit were needed, the 1.037 relative markup value would be multiplied times the mean incremental markup f actor for replacement units of 1.12, yielding a mechanical contractor markup value of 1.161.

Figure 6.5.1 Residential and Light Commercial Mechanical Contractor Relative Markup Probability Distribution

6.6 ESTIMATION OF GENERAL CONTRACTOR MARKUPS

DOE derived markups for general contractor s from U.S. Census Bureau data for the commercial and institutional building construction sector. 4 This sector includes establishments primarily engaged in construction work, includi ng 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 ACCA for wholesalers. 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 ra ther 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. Similar to the data for wholesalers, Table 6.6.1 summarizes the expenses for general cont ractors as expenses per dollar sales revenue in the first data column (appendix A contains the full set of data).

6-12Table 6.6.1 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 0.78 1.00 Labor Expenses: Salaries (indirect) and benefits 0.08 0.10 Occupancy Expense: Rent, maintenance, and utilities 0.02 0.03 Other Operating Expenses: Depreciation, advertising, and insurance. 0.01 0.01
Net Profit Before Taxes 0.12 0.15 Baseline Markup ( MU GEN CONT BASE ): Revenue per dollar cost of goods 1.29 Incremental Markup ( MU GEN CONT INCR ): Increased revenue per dollar increase cost of goods sold 1.17 Source: U.S. Census Bureau. 2002. Commercial and Institutional Building Construction: 2002. Report EC02-231-236220, Table 4, Detailed Statistics for Establishments: 2002. 7

For example, the direct cost of sales repres ents about $0.78 per dollar sales revenue to the general contractor. Labor expenses represent $0.0 8 per dollar sales revenu e, occupancy expenses represent $0.02 per dollar sales revenue, other operating expenses represent $0.01, and profit makes up $0.12 per dolla r sales revenue.

DOE converted these expenses per dollar sales into revenue per dollar cost of goods sold, by dividing each figure in the first data colu mn by $0.78. The data in column two show that, for every $1.00 the general contractor spends on equi pment costs, the general contractor earns $1.00 in sales revenue to cover the equipment co st, $0.10 to cover labor costs, $0.03 to cover occupancy expenses, $0.01 for other operating ex penses, and $0.15 in profits. This totals to $1.29 in sales revenue earned for every $1.00 sp ent on equipment costs. Thus, the general contractor baseline markup ( MU GEN CONT BASE ) is 1.29.

DOE was also able to use the data in colu mn two in the table above to estimate the incremental markups by being able to separate the fixed and variable costs. 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 $1.29, implying th at the incremental markup is 1.29, 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 $1.0 0 increase in the general contractor price, for an incremental markup of 1.0. DOE believed the labor and occupancy costs to be fixed and the other operating costs and profit to scale with the e quipment price (i.e., be variable). In this case, for a $1.00 increase in the equipment price, the general contractor price will increase by $1.17, giving a general contractor incremental markup ( MU GEN CONT INCR ) of 1.17.

6.6.1 Estimation of General Contractor Markup Probability Distribution

DOE characterized the markups developed a bove with probability di stributions derived from a statistical analysis of U.S. Census data for general contractors engaged in commercial and institutional building construction. The statistical analysis provided a standard deviation on the markups of general contractors in the United States. DOE then applied the standard deviation to the single-point baseline and incremental markups calculated above to create normal probability distributions for these markups.

6-13Based on the analysis of U.S. Census data for general contractors, DOE calculated a standard deviation of 9.0 per cent for the baseline markup as described in appendix A. DOE assumed that the variation dete rmined for the baseline markup a pplied to the incremental markup as well. For the baseline markup of 1.29, a standard deviation of 9.0 percent translates to an absolute value of 0.116. For the incremental mark up of 1.17, a standard deviation of 9.0 percent translates to an absolute value of 0.105.

Figure 6.6.1 and Figure 6.6.2 show the relative probability distributions that DOE used to characterize the residential general contractor and commercial ge neral contractor markups. Both are for new construction, because general contract ors are not part of the distribution channel for replacement CACs. The same relative markups ap ply to both baseline and incremental markups, but they are multiplied times different mean valu es (1.29 for baseline, 1.17 for incremental). The state incremental values are applied in the same way as the mechanical contractor values discussed in section 6.5.2.

Figure 6.6.1 Residential General Contractor Relative Markup Probability Distribution Figure 6.6.2 Commercial General Contractor Relative Markup Probability Distribution

6.7 SALES TAX

The sales tax represents State and local sales taxes that are applied to the customer price of the packaged terminal equipment. The sales tax is a multiplicative factor that increases the customer equipment price. DOE derived sales ta xes representative of both State and local sales taxes from The Sales Tax Clearinghouse, 9 shown in Table 6.7.1.

6-14Table 6.7.1 State Sales Tax Rates (Percent)

State Combined State and Local
Tax Rate State Combined State and
Local Tax Rate State Combined State and
Local Tax Rate
Alabama 8.15 Kentucky 6 North Dakota 5.75
Alaska 1.45 Louisiana 8.75 Ohio 6.85
Arizona 7.15 Maine 5 Oklahoma 8.1
Arkansas 8.2 Maryland 6 Oregon

-­ California 9.0 Massachusetts 5 Pennsylvania 6.25 Colorado 6.4 Michigan 6 Rhode Island 7 Connecticut 6 Minnesota 6.85 South Carolina 7.05
Delaware

-­ Mississippi 7 South Dakota 5.5
Dist. of Columbia 5.75 Missouri 7.10 Tennessee 9.4
Florida 6.7 Montana

-­ Texas 8.05 Georgia 6.95 Nebraska 6 Utah 6.7 Hawaii 4.4 Nevada 7.5 Vermont 6.05
Idaho 6.05 New Hampshire

-­ Virginia 5
Illinois 8.4 New Jersey 6.95 Washington 8.75
Indiana 7 New Mexico 6.4 West Virginia 6
Iowa 6.8 New York 8.25 Wisconsin 5.4
Kansas 6.9 North Carolina 6.8 Wyoming 5.40

The State level combined tax rates can be applied to the estimated value of State level CAC equipment shipments to obtain the total purchase cost to the customer located in any state.

The distribution of sales tax rates ranges from a minimum of zero percent to a maximum of 9.4 percent with a population-weighted m ean value of 6.99 percent, or approximately
7.0 percent. DOE applied sales taxes to the customer equipment price irrespective of the
distribution channel and the market in which the customer is located.

6.8 OVERALL MARKUPS

DOE multiplied the wholesaler, mechanical a nd general contractor , and national account markups described above by the sales tax to obtain the overall ba seline and incremental markups shown in Table 6.8.1 and Table 6.8.2, respectively.

Table 6.8.1 Average Overall Baseline Markups
Replacement
Market New Construction
Market
Wholesaler 1.370 1.370
Mechanical Contractor 1.380 1.280
General Contractor

- 1.290
Sales Tax 1.071 1.071
Overall 2.025 2.422

Table 6.8.2 Average Overall Incremental Markups
Replacement
Market New Construction
Market
Wholesaler 1.114 1.114
Mechanical Contractor 1.120 1.040
General Contractor

- 1.170

6-15Sales Tax 1.071 1.071
Overall 1.336 1.452

6-16REFERENCES

1. Heating, Air Conditioning & Refrigeration Distributors International. 2008. 2008 Profit Report (2007 Data).

2. Air Conditioning Contract ors of America. 2005. Financial Analysis for the HVACR Contracting Industry.

3. U.S. Census Bureau. 2002. Commercial a nd Institutional Building Construction: 2002. Report EC02-231-236220.

4. U.S. Census Bureau. 2002. Air-Conditioning and Warm Air Heating Equipment and Commercial and Industrial Refrigeration Equipment Manufacturing: 2002. Report EC02-311-333415.

5. U.S. Census Bureau. 2005. Produc t Lines: 2002. Report EC02-42SL-LS.

6. U.S. Census Bureau. 2002. Commercial a nd Institutional Building Construction: 2002. Report EC02-231-236220.

7. U.S. Census Bureau. 2002. Plumbing, Hea ting, and Air-Conditioning Contractors: 2002. Report EC02-231-238220.

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

9. The Sales Tax Clearinghouse at https://thestc.com/STRates.stm (Accessed on June 4, 2009)

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