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Proactive Disclosure
What Determines the Profitability of a Retail Gasoline Outlet?
A Study for the Competition Bureau of Canada
6. Profitability Analysis
6.1.1 Information Used
Our analysis is based on information provided by the responding petroleum retailers and their dealer operators. Participating retailers were sent an information request setting out the specific requirements, a copy of which is included as Appendix A. We employ comparable profitability data for 2002, 2003, and 2004 for outlets A and B (independent retailers); and outlets C and E (vertically-integrated firms).
6.1.2 Caution on Incomplete Information & Impact of Cost of Petroleum Purchases on Margins
Only the owner of outlet C has responded with complete information for its selected retail outlet comprising its financial information for outlet C and that of the dealer operator. Outlets E, A, and B have responded with information concerning revenues and expenses recorded by them at the corporate level, but we do not have complete information from them with respect to revenues and costs earned/incurred by their dealer operators. For this reason our analysis at this time is incomplete and any observations or conclusions should be treated with caution.
Further, the level of information provided to us does not specifically set out petroleum input costs separately. This information would be useful in identifying cost differences related to the product cost of petroleum sales that may exist between outlets C and E as integrated oil companies that “sell” to their retail outlets at an internal transfer price and outlets A and B as wholesaler purchasers from one of the integrated firms studied.
Outlet C records the cost of petroleum delivered to its retail sites at an internal transfer price determined by it. We understand from discussions with representatives of outlet C that this transfer price is determined with reference to wholesale prices charged to its large volume customers. We do not know the extent to which the application of this transfer price policy approximates arms length prices or the impact that such a policy may have on profits reported by the outlet. We believe that outlet E’s internal transfer price is determined similarly, but we have not been able to confirm this.
However, the analyses in the previous section, suggests the internal transfer price to be quite reliable. Specifically, recall that outlet C’s wholesale price is remarkably similar to corresponding wholesale prices experienced by outlets A and B.
6.1.3 Organization of Operations
Each of the outlets analyzed have similar organization structures with all of them controlling the real estate and petroleum inventories with an independent dealer being the site operator. Therefore, in order to obtain a complete picture of the economic unit that comprises each retail outlet, it is necessary to combine the financial results of each of the component entities. Based on our conversations with industry representatives, it is our understanding that in each case it is the parent firm (whether an independent or vertically integrated firm) that establishes pump prices with the site operator being compensated for each litre sold.
The retail outlets that we analyzed were selected by the participants as being representative of their retail operations in the Greater Toronto Area and adjoining areas. It is not within the scope of our engagement to undertake any procedures or analysis to determine the extent to which the selected outlets are representative and we can offer no assurance of this in this report.
6.2.1 Outlet A (independent retailer)
The site has 4 fuel dispensing pumps and 8 fuelling stations. The site sells three grades of gasoline: regular, mid-grade and premium and also offers ancillary services and other operations.
6.2.2 Outlet B (independent retailer)
The site has 4 fuel dispensing pumps and 8 fuelling stations. The site sells three grades of gasoline: regular, mid-grade and premium. This site offers ancillary services and other operations.
6.2.3 Outlet C (vertically-integrated firm)
The site has 4 fuel dispensing pumps each offering three grades of fuel from both sides of the pump, with a total of 8 fuelling stations. This site offers ancillary services.
6.2.4 Outlet E (vertically-integrated firm)
This outlet is also owned by a vertically-integrated firm. The site has 6 fuel dispensing pumps. This site offers ancillary services.
6.3.1 Organization of Profitability Analysis
Evaluating the profitability of an individual outlet is not straightforward, as it requires assumptions on the relevant product market and the nature of costs, especially given the available data. Specifically, focusing on the individual profitability of outlets A and B implies an exclusive retail gasoline product market.
However, outlets A and B could very well be merely “loss-leaders” for co-located retail stores with which each is affiliated, intended at attracting consumers, in which case true profitability is probably better measured by taking into account some measure of sales and costs at the co-located retail stores.
But we are handicapped by an obvious lack of data in this regard. As an alternative we have performed a three-tiered analysis. In the first case we will analyze accounting profits by simply evaluating all revenues and costs accruing from gasoline as well as non-gasoline sales for each individual outlet. However, it is important to acknowledge that only outlet C figures are reliable in this regard as they include not only the revenues and costs of the vertically-integrated firm but also of the outlet operator. On the other hand, we do not have data on operator specific revenues and costs with respect to outlets E, A, or B.
In the second case, we evaluate trends in profits by omitting promotional costs for outlets A and B. By doing so, we are implicitly acknowledging that such costs should be taken into account when evaluating the overall profitability of outlets A and B and their co-located retail stores as the product market consists of all goods offered by these firms and are not relevant when exclusively focusing on gasoline.
Finally, the third level of analysis is concerned with the concept of avoidable costs but not from the perspective of conducting an avoidable costs test. Costs associated with owning and operating a retail petroleum outlet can be classified as either unavoidable or avoidable. Unavoidable costs are sunk in nature and include those costs to which the operators of the outlet are committed regardless of future actions. As noted previously, avoidable costs are fixed and variable costs that can be foregone by ceasing operation of the outlet.8 Thus, avoidable costs include those costs that vary with sales levels or are independent of the sales level.
Distinguishing avoidable from unavoidable costs is important as an important aspect of analyzing differences in profitability of retail petroleum outlets is how the nature of costs can impact profitability. For example, labour costs are essentially an avoidable cost, specifically fixed in nature. If an outlet opens it needs one person to control pump operation and to act as cashier. If the outlet does not open it does not incur this expense. However, due to the self serve nature of the operation the amount of labour required is independent of the level of sales. Similarly other costs are avoidable such as electricity used for lighting, heat for kiosks and stores, landscaping and snow clearing services. Outlets with high petroleum sales volumes or that sell merchandize or other services are able to make more efficient use of resources that are represented by avoidable costs than those with lower volumes or that do not have sources of ancillary revenue.
Maximizing revenues is another manner in which outlets with multiple product offerings (i.e. petroleum products, merchandize or car wash) or higher levels of product sales can increase returns on unavoidable or sunk costs. Unavoidable costs include such costs as the cost of owing or leasing the real estate on which the outlet is situated, related structures and equipment. These costs include acquisition or rent costs as well as costs related to such assets such as insurance and property taxes.
Costs that are variable in nature and relate directly to sales volumes such as the cost of petroleum products sold, merchandize costs and water, power and repair and maintenance costs related to car wash operations would not by their nature differentiate one operation from another. Naturally some operations may more efficiently control those costs or have lower costs of supply, which would be a source of variance of profitability. In order to understand the impact of such costs on profitability, we reassess the profits from each individual outlet by omitting labour expenses.
6.3.2 Profitability Calculated from Outlet Specific Revenues and Costs
We begin our analysis by calculating profits as net income before income taxes as reported in the financial information provided by outlets C, E, A and B. In other words, the profitability of the outlet is defined in terms of revenue that is generated from the outlet and is based on gasoline sales and sales from ancillary services.9 Hence, we analyze the profitability of outlets A and B on a stand-alone basis and implicitly assume gasoline as the relevant product market.
Consequently, there are some key differences in contrast to the analyses in the earlier sections of this report. Recall that profits were defined exclusively in terms of gasoline sales with costs being captured by wholesale prices. We are now able to add profits from ancillary services as well as factor in outlet specific operating costs in our attempt to evaluate overall profitability.
In calculating profits from gasoline sales, revenue is obviously retail prices times quantity sold minus associated costs. Associated costs in this case are specifically cost of sales or wholesale price multiplied by quantity sold, corporate and overhead expenses, labour expenses, administrative expenses, and general site expenses. Profits from ancillary services are simply revenue minus associated costs.
In order to preserve confidentiality, our figures are reported in terms of profitability per litre.10 The profitability of the outlets analyzed for the years 2002 to 2004 is summarized in Figure 10 below. Outlet C is considerably more profitable than the other outlets. While outlet E did make profits in 2002 and 2003, it made losses in 2004. On the other hand, outlets B and A have always incurred losses. One general trend consistent across all outlets is the significant decrease in overall profitability from 2002 to 2004. Outlet C’s profit per litre of throughput was considerably higher than either outlet A or outlet B, at $0.07 per litre in 2002, $0.06 per litre in 2003 and $0.03 per litre in 2004. Corresponding figures for outlet E are not that different – with the exception of the $0.1 per litre loss in 2004.
Figure 10 – Total Profit per Litre
Unsurprisingly, ancillary revenues are also an important component of
profitability. Figure 11 sets out the contribution to profits segregated
between “ancillary service-1” and “ancillary service-2”
on a per litre basis.11 Profit by sales type has been derived by
allocating costs that are not directly related to ancillary services, such as
corporate expenses, overhead, and administration costs and site costs to
petroleum sales. This allocation is consistent with the nature of the
operations where petroleum sales are the primary business line.
The key finding that emerges from Figure 11 is the importance of ancillary revenue especially for outlets C and E. Specifically, outlet C made an average annual profit of $0.03 per litre on $0.08 per litre of ancillary service-2 revenue, and $0.02 per litre on $0.03 per litre of ancillary service-1 revenues over the years 2002 to 2004. Although outlet C made a total profit of $0.03 per litre in 2004, the results consisted of ancillary service-1 profits of $0.02 per litre, ancillary service-2 profits of $0.03 per litre and a loss on petroleum of $0.02 per litre. Clearly, ancillary revenues are an important component of profitability.
Figure 11 – Profit per Litre by Sales Type in Dollars
The other important detail is that the above profit figures are quite different than those described in the previous section. This is because those figures were derived by simply subtracting wholesale prices from retail prices and then multiplying it by volumes.12 On the other hand, the numbers in Figure 11 have been calculated by allocating other costs (such as overhead) that are associated with gasoline sales as well as non gasoline revenues and costs. Once that is accomplished, the perception on the relative profitability of stations is changed quite considerably. Outlet E actually made a loss in 2004 while outlets A and B incurred losses from gasoline sales in each year. This is in contrast to the conclusions of successive annual profits made by each outlet, when exclusively relying on gasoline revenues and expenses. The policy implication of this finding is considerable. Specifically, rather skewed perceptions on station profitability can emerge by relying on figures that simply deduct wholesale prices from corresponding retail prices or alternatively, from the belief that gasoline prices are “extraordinarily high”.
6.3.3 Profitability by Omitting Coupons and Discounts
We now revaluate our results by omitting coupons, discounts, and other promotional expenses from our analyses. Figure 12 consists of profits per litre while Figure 13 separates the numbers again in per litre amounts.
Figure 12 – Total Profit per Litre Before Promotion/Discount Expense
Figure 13 – Profit per Litre by Sales Type in
Dollars Before Promotion/Discount Expense
Our previous findings change slightly for outlet A, as Figure 12 indicates that outlet A made a profit in 2003 and a loss in 2004. On the other hand, while outlet B earned a profit in 2002, it continued to make losses in 2003 as well as 2004.
Given the fact that we previously added promotional and coupon expenses to costs of gasoline sales it is unsurprising that Figures 12 and 13 demonstrate enhanced profits specifically with respect to this component of overall profitability. However, only outlet A experiences profits, while outlet B still suffers losses.
6.3.4 Profitability by Omitting Coupons and Discounts and Labour Expenses
As a further sensitivity analysis, we replicate the above analysis by omitting not only coupons, discounts, and other promotional costs, but also labour expenses from our figures. Figure 14 denotes corresponding profits per litre while Figure 15 gives further detail according to type of sale in per litre amounts.
Figure 14 – Total Profit per Litre Before Promotion/Discount & Labour Expenses
Figure 15 – Profit per Litre by Sales Type in Dollars Before Promotion/Discount & Labour Expenses
The main implications are simple to decipher. Figure 14 shows that outlet C as well as outlet A consistently made profits while outlet B only succeeded in earning profits in 2002 and outlet E incurred a loss in 2004. Figure 15 is quite similar to corresponding figures from 6.3.3. However, one must be very careful in drawing strong inferences given the incomplete nature of the data. Specifically, we do not possess complete information on labour costs incurred by the operators for outlets E, A, and, B.
6.3.5 Petroleum Sales Volume and Grade Mix
Since the sale of gasoline is obviously the key business, it is important to evaluate the determinants of trends in gasoline sales volumes. Gasoline sales volume is also a basis of comparison for outlet locations and their ability to generate customer traffic for sales of ancillary products.
Figure 16 compares the percentage of the sales volume of the three grades of gasoline to the total volume sold for the years 2002, 2003 and 2004. In this respect, Figure 16 clearly demonstrates the significant success of vertically-integrated firms (outlet C and outlet E) with respect to premium blends. Specifically, outlets C and E had the highest percentage of higher-grade gasoline volume sold with a mix of 30% and 36% premium grades (mid-grade and premium), respectively, over the years 2002 to 2004, compared to only 15% premium grades for outlet A and 20% for outlet B.
Figure 16 – Petroleum Sales Volume Grade Mix Percentage
Of course, gasoline revenue is a function of sales volume as well as the price per litre of gasoline sold, net of taxes.
Hence, Figure 17 compares the gasoline revenue mix as a percentage of total gasoline revenues for the three outlets. As can be seen in Figure 17, premium grades contribute significantly more to the outlet C outlet’s revenues at an average of 32% than they do for either outlet A or outlet B at averages of 16% and 18% respectively. Outlet E’s proportion of revenue sales from premium grades is also high at 39%.
Figure 17 – Petroleum Revenues Grade Mix Percentage
6.3.7 Revenues by Sales Type
Figure 18 compares revenues from petroleum sales and ancillary services.
Ancillary revenues (i.e. revenues from sources other than gasoline sales) are
important as they indicate the extent to which an outlet maximizes profits by
leveraging off of unavoidable costs, which are required to generate gasoline
revenues. While outlets C, E, and B each have car wash operations, outlet
A does not. Again, it is important to note that we do not possess complete
revenue/cost figures for site operators with respect to outlets E, A, or
B.
The numbers imply that outlet C had the highest percentage of
ancillary revenues with a mix of 80% gasoline revenues, 5% ancillary service-1
revenues and 15% ancillary service-2 revenues, compared to: outlet E at 92%,
6%, 1%; outlet B at 85%, 10%, 5%; and outlet A at 97%, 0%, 3%.
Figure 18 – Revenues by Sales Type Percentage
In order to compare the different outlets’ ability to derive ancillary revenues from gasoline sales, the various types of revenues can be divided by the volume of gasoline sold. Figure 19 compares revenue per litre from the three sales types for each outlet over the years 2002, 2003 and 2004.
Outlet C derived the most ancillary revenues per litre of gasoline sold on average over the years 2002 to 2004 with $0.08 of ancillary service-2 revenue per litre and $0.03 of ancillary service-1 revenue per litre, compared to outlet B with $0.02 of ancillary service-1 revenue per litre and $0.04 of ancillary service-1 revenue per litre and outlet E with $0.01 of ancillary service-2 revenue per litre and $0.04 of ancillary service-1 revenue per litre. Outlet A only derived $0.01 of ancillary revenue per litre, all from ancillary service-2 sales. Consistent across all the outlets is the trend of ancillary revenues per litre remaining fairly constant as gasoline revenue per litre increased for each outlet from 2002 to 2004.
On the other hand, gasoline revenue per litre increased for each outlet from 2002 to 2004. Of particular interest is that outlet C and outlet E had significantly higher revenues per litre (0.50 and 0.48 cents/litre, respectively) than either outlet A or outlet B. This difference in part is explained by the grade sales mix of both outlet C and outlet E; possessing a higher proportion of premium grades with related higher prices. Outlet C enjoyed an increase in gasoline sales from $0.41 per litre in 2002 to $0.48 in 2004, while outlet E experienced an increase from $0.43 to $0.50 cents/litre over the same time period. In comparison, outlet A experienced an increase from $0.39 per litre in 2003 to $0.46 per litre in 2004 and outlet B saw a rise from $0.31 in 2002 to $0.43 per litre in 2004.
Figure 19 – Revenue per Litre by Sales Type in Dollars
6.3.8 Gross Margin by Sales Type
For the purpose of this report, we have derived gross margins from the financial data provided by firms C, E, A and B for their respective outlets by taking revenue for the various sales types, deducting cost of sales as itemized in the financial data provided, and deducting other expense items which can be identified as being directly attributable to the various sales types. For example, where repairs and maintenance expenses and utility expenses (e.g. water expense related to car wash revenue) were identified in the data to a specific sales type, we allocated the expense item to cost of sales to arrive at gross margin. Gross margin percentages were derived by dividing gross margin by revenues. The expense items not allocated to cost of sales for this analysis were labour costs, corporate and overhead expenses, administrative expenses, general site expenses, interest and depreciation.
Gross margin is a primary profitability factor as it provides a measure of profit after deducting from revenues costs directly associated with sales made. Figure 20 compares gross margin percentage by sales type for the three outlets for the calendar years 2002, 2003 and 2004. Outlet C had the highest gasoline gross margin percentages at approximately 18% for 2002, 14% for 2003 and 7% for 2004. With the exception of 2004, figures from outlet E are quite similar. As is evident, outlet A and outlet B outlets had lower gasoline gross margin percentages.
Based on the level of information provided by the participants, one must be cautious in evaluating the impact that petroleum acquisition costs may have on the differences in gross margins reported by outlets C and E, compared to outlets A and B. Outlets A and B purchase the petroleum products that they sell from integrated oil companies. Therefore petroleum costs included in their cost of sales would be at purchase cost. On the other hand, outlets C and E sell petroleum products that they themselves refine. With respect to outlet C, the petroleum supply cost included in the cost of sales is based on an internal transfer price determined by the outlet. We understand from representatives of outlet C that their transfer price is based on wholesale prices. The analyses contained in the previous section generally confirms this, as the internal transfer price reported by outlet C is remarkably similar to corresponding wholesale prices experienced by outlets B and A.
Outlet C derived the highest gross margin percentage from ancillary service-1 operations at an average of 84% over the years 2002 to 2004. Again, outlet E’s figures are quite similar, with the exception of 2004. Outlet B had a lower ancillary service-1 gross margin percentage at an average of 35%. Outlet B had the ancillary service-2 gross margin percentage at an average of 87% over the years 2002 to 2004, compared to outlet C’s margin of 34% and outlet A’s margin of 27%.
Figure 20 – Gross Margin Percentage by Sales Type, Before Labour Costs
These figures suggest that outlets can earn significant profits from ancillary services. However, it should be noted that sales from ancillary services are probably driven by throughput. The likelihood of maintaining significant profits from the sale of ancillary services with declining gasoline throughput is probably quite remote.
6.3.9 Summary of Costs Attributable to Petroleum Revenue
Figure 21 compares the costs attributable to petroleum revenues on a per litre basis. This analysis indicates that petroleum acquisition costs appear to be approximately equal for outlet C, outlet E, and outlet A and slightly lower for outlet B. Outlet B’s general and administrative costs on a per litre basis are significantly higher than either of the other outlets. This is due at least in part to the outlet B outlet’s significantly lower petroleum volumes, increasing the average cost per litre. Given its high volumes it is unsurprising that outlet C has the lowest per unit cost across most categories.
Figure 21 – Costs Attributable to Petroleum Revenues per Litre
Footnotes
8 This definition is consistent with the one employed by the Competition Tribunal (ht tp://www.ct-tc.gc.ca/CMFiles/CT-2001-002_0145a_40QXN-4132004-736.pdf)
9 That is, exclusive of the operators of the co-located retail store
10 Profits are net income before income taxes as reported in the financial information provided by Outlet C, Outlet E, Outlet A and Outlet B.
11 In order to preserve confidentiality we cannot reveal what services are exactly covered in ancillary service-1 and 2.
12 Of course, the retail profit margins from the economic analyses are not strictly comparable to these profitability figures because of differences in time periods as well as outlets.
