Activity-Based Costing and Predatory Pricing: The Case of the Petroleum Retail Industry

DISCUSSION QUESTIONS:

1. What are product-cost subsidizations?

When excessive costs are charged to high-volume products while insufficient costs are charged to low-volume products. One example of how this occurs is when product-costing is based on labor-hours. Products that are produced infrequently will typically require less annual man-hours when compared to major products. Calculating the costs of several products based on a traditional volume-based costing system ignores other costs that are not related to volume. These costs may be engineering, set-up time, material costs, or other variables.

2. What are possible consequences of product-cost subsidizations?

When prices are based on cost, product-cost subsidization can lead to increased demand for undercosted and underpriced low-volume products, which are probably being sold at unprofitable prices. Conversely, companies experience reduced customer demand for overcosted, overpriced high-volume products and services. State and federal laws have been enacted against predatory pricing, which is the selling of products below cost as a deliberate action to drive out the competition. Alternatively, products may appear to be priced below cost because of the use of unrealistic, unit-based traditional costing systems, which results in the appearance of predatory pricing where it does not exist.

3. List alternative approaches to assign costs in a gasoline service center.

Unit-based approach - focuses on the product itself and uses only one criterion or driver for allocating the costs to the products. In our case the activity driver is the gas sold and its average monthly cost (or facility-wide cost) is spread among the three types of gasoline (regular, plus, and premium) based on the percentage of gallons of gas sold per month, calculated and determined for each of the gas types.

Simple-average approach - assigning the average monthly service or product costs equally to the number of services provided or products produced. Simple-average approach is very easy to operate and reduces clerical work, however averaging the costs in this way doesn’t take into account the differences in activities involved and consumption levels and rates regarding the products and services created by the company.

ABC approach - This method of costing first identifies the activities that are being carried out in the organization, and allocates the costs to these activities, technical term cost pools. These cost pools are divided by cost drivers to obtain an ABC rate. This rate is used to allocate cost to the products on the basis of each product increasing cost diver quantity. By then measuring the contribution of each of the activities to the products and services of the enterprise, it is possible to allocate the costs relating to each activity among the products or services which that activity is involved in producing. The intended result is that the costs are assigned to products on a rational basis, and the profitability of each product or service can be more accurately determined. This approach is very useful and helpful to managers in terms of control and planning.

A disadvantage of using the activity based costing approach, is that it can be expensive to implement, requiring detailed observation and measurement of activities and analysis of how these activities relate to particular products and services.

Absorption costing approach - allocating overheads to products based on pre-determined absorption rate. To find the predetermined rate total budgeted overhead cost is divided by activity level. As absorption costing depends on setting allocation criteria in advance, the costs will never be absorbed exactly as there will always be differences between budget forecasts of sales and costs and the actual results. The costs will therefore be under or over absorbed in any particular accounting period.

Target costing approach - This is a modern methodology towards costing. It attempts to find market price of the similar products in advance. Required rate of return is deducted to arrive at target cost. This cost is different from the actual cost. The difference between Target and actual cost is called gap. This gap should be reduced overtime by achieving efficiencies (learning effect), economies of scale and product specification changes by eliminating non-value added activities. Once the target cost is achieved, it should be further reduced as it aims for continuous improvement.

4. Identify cost hierarchy level groups in classifying activities at the retail level of a gasoline service center and give at least one example each.

1-Unit-level activities are undertaken for each gallon of gasoline sold (such as electricity to power pumps when dispensing gasoline);
2-Batch-level activities are the same for each gasoline transaction irrespective of the volume of gasoline purchased (for example, transactions to process customer payments for gasoline by cash, check, or debit/credit card);
3-Product-level activities are conducted for specific gasoline products such as regular, plus, and premium gasoline and motor oil (for instance, gasoline tanks that are dedicated to specific gasoline grades);
4-Customer-level activities are conducted for specific gasoline customers (such as using billboard advertisements to promote the benefits of premium gasoline);
5-Organizational-supporting activities are for the gasoline dispensing organization as a whole and cannot be casually identified with units, batches, or individual products (including payroll and many other centralized activities)

5. What are overheads activity-cost pools pertaining to selling gasoline in a retail gasoline service center and what is the activity level for each of the cost pools?

1- Activity cost pool: gasoline sales attendants (labor). This should be the labor of the attendant, that is receive payments, malfunctioning gasoline pumps, security issue, selling products in the store, changing oil, etc… This is a batch-level activity because payment transactions occur only once for each purchase of gasoline. It does not depend from the quantity of gasoline purchased.

2- Activity cost pool: kiosk facility. It is necessary to allocate a reasonable rental value for the kiosk where the attend works. This is a batch-level activity because the cost is the same for each gasoline transactions made.

3- Activity cost pool: Gasoline-dispensing Facility. It is necessary to allocate a reasonable rental value for the gasoline-dispensing facility. It is classified as a product-level activity because the cost depends by the specific gasoline products such as regular, plus and premium. In fact in every gas station there are a lot of tanks in which is allocated the type of the gasoline.

6. Identify the activity drivers for overheads activity-cost pools identified in this study and explain the reasons for the selection

For Labor Activity:
Kiosk attendants perform batch-level activities at the pre-purchase of fuel or in responding to defective equipment, no matter the volume of fuel purchased. However, assuming that fuel tank capacity is, on average, equal amongst the different octane grades of fuel, volume of each grade purchased is an inexpensive to track analog to the estimated number of batches responded to.
The number of sales directly corresponds to the labor needs for fuel dispensation. With volume roughly being analogous to transactions, this means volume of fuel directly corresponds to the labor needs for fuel dispensation.

For Kiosk Facility Activity:
The best estimate for "reasonable rental value" is required for overhead costing. The size of the kiosk needed is directly proportional to the staff number involved in dispensing fuel. Because labor is proportional to volume of fuel sold, kiosk activity, too, is proportional

Gasoline-Dispensing Activity Cost Pool:
Fixed assets, like signs, cannot be causally linked to any specific grade of gasoline and, so, should be distributed equally amongst all grades
The dispensing equipment and storage container sizes and costs are equal for all grades of gasoline stored in most stations, making the cost of infrastructure for each grade of fuel roughly equal, despite very disparate sales amounts

7. List examples of gasoline-dispensing facilities for a gasoline service center and identify whether each of the facilities is a common or a gasoline grade-specific asset.

Gasoline Sign Common Fixed Asset
Canopy Common Fixed Asset
Cooler Vault Common Fixed Asset
Gasoline Tanks Gasoline Grade-Specific Fixed Asset
Pump & Tank Equipment Common and Gasoline Grade-Specific Fixed Asset
Multi-Product Dispensers (MPDs) Common Fixed Asset
Plumbing Common and Gasoline Grade-Specific Fixed Assets
Electrical—Equipment Common and Gasoline Grade-Specific Fixed Assets
Electrical—Canopy/MPDs Common Fixed Asset
Lighting Fixtures Common Fixed Asset
Area Lighting Common Fixed Asset
Islands Common Fixed Asset
Tank Excavation Gasoline Grade-Specific Fixed Asset
Piping Common and Gasoline Grade-Specific Fixed Assets