Abstract:

This case allows you to evaluate the use of different systems of costing in a lawsuit alleging predatory pricing. The setting is a chain of gas station/convenience store service centers which has been accused of selling fuel below cost as defined in government statutes. The judge accepted the volume-based method used by the plaintiff in the lawsuit and issued an injunction which forbade Fill 'n' Shop from selling regular fuel below cost determined by that method. Fill 'n' Shop has hired an accounting professor to serve as an expert witness to defend their use of activity-based costing (ABC), which would provide grounds for a possible appeal of the ruling.

Background:

Fill 'n' Shop owns and operates a national chain of service centers that each contain a gas station and convenience store that sells snacks, coffee and drinks for road trips, magazines, and a limited selection of grocery and household items. The chain is very successful and has been in operation for 40 years.

Fuel sales account for the bulk of Fill 'n' Shop's revenues. The company sells three grades of fuel:

regular (87 octane), plus (89 octane), and superior (93 octane). Each Fill 'n' Shop also sells various items such as coffee, candy, soft drinks, and miscellaneous grocery items.

Fill 'n' Shop's success is mostly due to its low-cost strategy. Since its inception, Fill 'n' Shop has attempted to be a low-cost distributor of fuel, and its operations at each location are designed to be simple in order to keep costs at a minimum. The company tries to avoid spending excessively on things deemed unnecessary to its basic operation and success, such as widespread advertising or extensive, modern facilities. For example, the Fill 'n' Shop uses targeted sales advertising and promotions that have proven successful in the past. Fill 'n' Shop is able to pass those savings on to the customer in the form of fuel at the lowest possible price. It has a good reputation with consumers and has a significant growing market share in its locations across the country.

Because Fill 'n' Shop is a national market leader, is competitors are always trying to entice its customers away. Earlier this year, the CEO of Fill 'n' Shop, Dana Smith, received notice that one competitor, Davis Petroleum (DP) had filed a complaint with the national regulator overseeing fuel retailing. The complaint stated that Fill 'n' Shop was in violation of fuel market pricing regulations by selling regular fuel below cost, thus injuring their competition. The national regulator investigated the complaint and found it to have merit. A hearing was set during which Fill 'n' Shop would need to establish that it was not selling regular fuel at a loss. The regulator would attempt to prove that it was.

This case takes you through the regulations, the court hearing, and Fill 'n' Shop's reaction using an Activity Based Costing analysis.

The Regulations

The regulations over fuel pricing are designed to support healthy and fair competition among those organizations selling fuel. The regulations reflect a belief that citizens and consumer are protected by prohibiting unfair pricing practices and promoting competition.

Among other actions, the regulations prohibit selling fuel at retail prices below "cost" in an attempt to eliminate competition, an action known as predatory pricing. In order to be found guilty of violating these regulators, the regulator must prove that the conduct harmed at least one competitor.

Effectively, the regulations define fuel "cost" as the direct cost of refined fuel (including taxes and transportation; and excluding any allowances and rebates given by the supplier), plus direct labour costs, fuel dispensing costs, and convenience store costs attributable to the fuel-selling function of a company. The regulations state that the minimum direct labour cost equals the full-time-equivalent cost of the salary and benefits of one employee for the number of hours the store is open. The regulations require that a "reasonable rental value" be found for the portion of the convenience store used to sell fuel and the fuel dispensing assets. The various operating costs associated with the convenience store (including utilities, repairs, maintenance, property taxes and insurance) should be added to the reasonable rental value percentage of the building and land costs.

If Fill 'n' Shop is found to be in violations of the regulations, they would have to pay up to $10,000 per day in fines, to a maximum of $250,000. They may also have an injunction issued against them, forcing them to stop selling regular fuel until the price is set above cost. The competitors of Fill 'n' Shop can also file private lawsuits for any financial damages they have suffered.

Fill 'n' Shop's response to subpoena

The CEO of Fill 'n' Shop, Dana Smith, received a subpoena from the national regulator, requesting accounting and other information that the regulator needed to investigate the allegations of predatory pricing. The response follows below:

To: Regulator

From: Dana Smith, CEO of Fill 'n' Shop

Re: Facility Activities

Date: February 17, 2019

In response to your request dated January 3, 2019, I include below information about our fuel sales. The information is provided pursuant to your subpoena to determine if we have committed predatory pricing. Please note that our company is cooperating fully in this investigation, and we are eager to clear our good name.

All numbers we provide are monthly averages based on our most recent 30 months of operation. Each Fill 'n' Shop service station provides two main services: the sale of fuel, and the sale of convenience store items. The average fuel sales of Fill 'n' Shop by grade of fuel and in total are shown in Exhibit 1.

The direct costs of the fuel sales function include motor fuel costs from the wholesaler plus taxes and transportation costs. The direct costs of each grade of fuel are shown in Exhibit 2.

The average monthly indirect costs of the fuel selling activities over the past 30 months were $18,247.

Exhibit 1: Average Fuel Sales of Fill 'n' Shop

	Premium	Plus	Regular	Total
Average litres of gas sold per month	98,178	127,120	342,203	567,501
Percent of total	17.3%	22.4%	60.3%	100%

Exhibit 2: Fill 'n' Shop Direct Costs Associated with Fuel Sales

Fuel Type	Average Direct Cost per Litre
Premium	$.61
Plus	$.60
Regular	$.59

Please contact us if you need any further information.

The Hearing

The following are relevant portions of the transcripts from the hearing concerning the predatory pricing allegations against Fill 'n' Shop. The judge must determine if the regulator, represented by Ms. Barrier, J.D. has proven that Fill 'n' Shop is in violation of the fuel pricing regulations. In this hearing, Mr. Brown,

J.D. of Brown and Kettler Law Firm represents Fill 'n' Shop Corporation (the defense).

Judge: This hearing is to determine the outcome of case number 2019-040, Regulator v. Fill 'n' Shop. Ms. Barrier, you may call your first witness.

Ms. Barrier (regulator): Thank you, your honor. I would like to the call our management accounting expert witness, Mr. Donohoe, CPA. Mr. Donohoe, what were your findings regarding the cost of fuel to Fill 'n' Shop?

Mr. Donohoe, CPA: I used an approach to product costing that is commonly used and has been found to be very accurate and reliable. I assigned the monthly indirect costs generation by the fuel service center to the different grades of fuel based the number of litres sold. This is clearly illustrated in Regulator's Exhibit A (Exhibit 3 in this document). In this exhibit, you can see the average monthly indirect costs for the service centre, as defined in the fuel market pricing regulations, allocated to the three different grades of fuel based on the average amount of fuel sole per month was chosen as the indirect cost allocation base because fuel sales drive this business. It is contented that the monthly indirect costs vary in direct proportion to the number of litres of fuel sold per month. The indirect costs do not change depending on the grade of fuel sold; therefore, each grade is charged the same indirect cost perlitre. When the indirect costs are added to the direct costs, it becomes apparent that the selling price of Fill 'n' Shop Corporation's regular fuel sole is below the average monthly total cost per litre.

Exhibit 3 (Regulator's Exhibit A):

Calculation of Costs and Profits for Fill 'n' Shop Corporation's Fuel ProductsPrepared by Mr. Donohue, CPA

	Regular	Plus	Premium	Total
Average litres of gas sold per month	342,203	127,120	98,178	567,501
% Of total	60.3%	22.4%	17.3%	100.0%
Average Monthly Indirect Costs	$0.0322	$0.0322	$0.0322
Per Litre:	Price	Direct Cost	Indirect Cost	Profit (Loss)
Premium Plus Regular	$0.72 $0.68 $0.62	$.61 $.60 $.59	$0.0322 $0.0322 $0.0322	$.0778 $.0478 ($.0220)

Judge: Mr. Brown, do you have a cross examination for this witness?

Mr. Brown (Defense for Fill 'n' Shop): No, your honor, but we have a rebuttal expert witness, Ms.Faranhat, CPA, who is contending Mr. Donohoe's analysis and findings. Ms. Faranhat, you were given the same information to analyze as Mr. Donohoe to determine if Fill 'n' Shop Corporation is involved in predatory pricing. What were your findings?

Ms. Faranhat, CPA: I respectfully disagree with Mr. Donohoe's analysis and conclusions. I allocated the average monthly indirect costs generated by the fuel service center evenly to each of the three different grades of fuel. In so doing, in combination with the information provided in exhibit 1, I arrive at the following:

Exhibit 4 (Fill 'n' Shop's Exhibit A):

Calculation of Costs and Profits for Fill 'n' Shop Corporation's Fuel ProductsPrepared by Ms. Faranhat, CPA

	Regular	Plus	Premium	Total
Average monthly indirect costs	$6,082	$6,082	$6,082	$18,247
Average litres of gas sold per month	342,203	127,120	98,178	567,501
Indirect cost per litre sold	$0.0178	$0.0478	$0.0619
Per Litre:	Price	Direct Cost	Indirect Cost	Profit (Loss)
Premium Plus Regular	$0.72 $0.68 $0.62	$.61 $.60 $.59	$0.0619 $0.0478 $0.0178	$.0481 $.0322 $.0122

In this exhibit (that is, Exhibit A for Fill 'n' Shop), you can see the average monthly indirect costs for the service centers allocated to the three different grades of fuel using the simple average approach. The indirect costs are mainly fixed costs that would exist no matter how many different types of fuel are sold and do not change in response to the number of litres of fuel sold. For example, the depreciation of the fuel dispensing pumps and the salary of the sales of attendants are fixed costs. Each type of fuel uses these fixed resources equally, and therefore the costs should be allocated to the different types of fuel equally. Next, the indirect costs allocated to each grade of fuel are divided by the average number of litres of fuel sold per month. When the indirect costs per litre are added to the direct costs and subtracted from the prices, it becomes apparent that Fill 'n' Shop is not selling any of the grades of fuel below cost.

Judge Davies: Ms. Barrier, do you wish to cross-examine this witness?

Ms. Barrier (regulator): No, your honour. We have already presented our view on this matter. We believe that our method is more widely accepted and allocates indirect costs in a more accurate way.

Judge Davies: After reviewing all of this information, my preliminary ruling is that the regulator's analysis is accepted, and Fill 'n' Shops defense is rejected. The regulator's analysis and reasoning seem to more accurately determine the fuel costs. Therefore, I issue an injunction prohibiting Fill 'n' Shop Corporation from selling regular fuel at a price below the cost calculated using the approach used in the accepted analysis.

Fill 'n' Shop Corporation's Next Steps

The following day, Fill 'n' Shop's CEO, Dana Smith, called a meeting with the executive team to discuss the apparent inaccuracy of the company's cost system and the Judge's preliminary ruling. The executives included the Chief Financial Officer (CFO), Chief Operating Officer (COO) and the Vice-president of Marketing (VP Marketing).

Dana Smith (CEO): Well, the judge's decision is a severe setback for us. By issuing an injunction that prohibits us from selling our highest volume grade of fuel at our normal prices, our business is going to be negatively affected in several ways.

CFO: This is right. If we have to use the product costing approach used by the regulator, we will have to raise the price on our regular grade of fuel with which naturally reduce demand and our profits.

VP Marketing: This ruling is a disaster: this industry is so competitive that we are forced to raise our prices, we lose our strategic advantage. Most of our customers based their fuel buying decisions on price. We've built brand loyalty by our low-price strategy. Unless we cut costs in some to maintain our low prices, our marketing efforts will be devastated.

COO: I don't see where we could possibly cut more costs in our service stations. And I still don't understand how two alternative costing systems can produce such different results: I don't think we should give up without a fight. Is there any way to find new evidence that will support our position and allow us to appeal the preliminary ruling?

CFO: In the accounting journals, I've been reading about a problem experienced by many companies called product cost cross-subsidization. Most of the articles deal with a manufacturing context, but it just occurred to me now that this might be the cause of our current legal dilemma. As I understand it, product-cost subsidization occurs when products are over- or undercosted. It is often attributable to indirect costs being allocated inappropriately to the products or services that benefit from them. Moreover, it usually entails an undercosting of low-volume products and an overcosting of high-volume products. Certainly, regular fuel is our high-volume product, so maybe there is a connection. In essence, products produced in small quantities are assigned less than their fair share of indirect costs, and products produced in large quantities are assigned more than their fair share. As a result, the high-volume products subsidize the low-volume products. Produce cost cross-subsidization often occurs in companies using traditional volume-based costing systems, which seems to the type of system used by the regulator's expert witness. Ever since this lawsuit surfaced, I've been researching different cost systems. One that seems to be designed to correct produce cost cross-subsidization is called Activity Based Costing, or ABC for short.

VP Marketing: So how does ABC work? Keep in mind, I'm not a bean counter (no offense).

CFO: As I understand I, ABC assigns indirect costs on the basis of the activities a product or service uses on its way to the customer. The exhibit below presents the general idea:

Step 1:Identifyan activity and its costs.	-	Step 2: Identifyan appropriate costdriverfor the activity.	-	Step 3:Usethecost driver toassigntheactivity costto the individualproducts/services.	.-...	Step 4: Identifyanother activity andrepeatsteps1-3 untilall indirect costshave beenassigned.
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According to ABC, activities drive indirect costs for a product or service. ABC uses cost drivers, or factors that cause indirect costs to assignindirect costs. By using these cost drivers, or activity drivers as they are sometimes called, the indirect costs are more accurately assigned to the products or services that use them. There's an accounting professor, Dr. Linda Bean, CPA, working at our local university who o has written several articles about it.

Dana Smith (CEO): Great work! Can you contact Dr. Bean to see if she is interested in helping us? If so, I'll prepare an engagement letter.

Fill 'n' Shop Corporation

Engagement Letter

To: Dr. Linda Bean, CPA

From: Dana Smith, CEO

Re: Activity Based Costing System

The purpose of this engagement letter is to secure your services to determine the effect of an Activity Based Costing (ABC) system on the assignment of indirect costs to the different grades of fuel we sell.

As our CFO explained to you, our interest in ABC is to determine if it is worthwhile to appeal a predatory pricing injunction handed down against us last week. If so, this case will be appealed next month, when we must present evidence that we are not in violation of national fuel pricing regulations.

During your conversation with our CFO, you requested a detailed breakdown and analysis of Fill 'n' Shop's activities associated with fuel sales. Upon cursory consideration, we note that three primary activities are involved in selling fuel in our service stations. These activities are processing fuel payments (labour), housing attendants in a portion of the convenience store, and using fuel-dispensing equipment.

Sales attendants are needed to collect payments for fuel sales and to deal with any related problems. For instance, sales attendants are needed to deal with any difficulties customers encounter processing credit card or debit card transactions at the pump. One attendant per shift should be able to cope with fuel sales and any related problems, which is consistent with the fuel pricing regulations. Each employee earns $7.50 per hour plus 16 percent for benefits. Fill 'n' Shop service stations are open 20 hours each day, divided into two shifts of 10 hours each, with each attendant working four days in a seven-day period. The estimated monthly labour costs are $5,220 per month. ^[1]

National regulations clearly stipulate how the non-labour costs associated with the sale of motor fuel are to be calculated, which are captured under the umbrella of "reasonable rental value". For a typical Fill 'n' Shop fuel service statement, the reasonable monthly rental value for motor fuel sales is calculated as $13,027, including utilities, property taxes, insurance, and environmental compliance costs. Therefore, the total estimated monthly costs association with motor fuel sales are $18,247 ($5,220 + $13,027).

The average cost to construct a convenience store is $385,000, and if there were no convenience store sales, it is estimated that it would cost 20% of this amount to build a kiosk to house a fuel sales attendant.

Also, fuel storage and dispensing assets are necessary to support the fuel-selling activities. The costs of these assets were obtained from the company's fixed-asset master listing and are shown below:

Exhibit 5: Breakdown of Fill 'n' Shop Fuel Dispensing Assets for a Typical Service Station

Activity Type	Resources Used	Cost
Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing Fuel Dispensing	Holding Tanks Pumping Equipment Plumbing Piping Multi-Product (M-P) Dispensers Signage Canopy Islands Electrical Equipment Lighting Fixtures	$49,682 38,330 27,726 22,311 64,086 16,313 67,914 48,241 44,473 22,187
Total Activity Costs		$401,261

Some of the fuel dispensing assets are specific to the different fuel grades and some are common to all types of fuel as shown below:

Exhibit 6: Fuel Dispensing Activity

Dominant Asset Characteristics

Activity	Grade Specific	Common
Holding Tanks Pumping Equipment Plumbing Piping Multi-Product (M-P) Dispensers Signage Canopy Islands Electrical Equipment Lighting Fixtures	X X X X	X X X X X X

We would like you to provide us with an ABC analysis of fuel sales to see if this imporves our costing of fuel and supports challenging the injunction.

Thank you for your time and consideration.

Dr. Bean's Analysis

Dr. Bean submitted the analysis contained in Exhibits 5 through 8. Dana Smith convened another meeting of the senior executives to consider Dr. Bean's work. The senior executives were pleased and believed it presented a strong case for appealing the injunction.

Exhibit 7

Estimated Cost of Kiosk and Fuel Dispensing Assets Used to Assign the Reasonable Rental Value

Description	Amount	Percent
Cost of Assets: Cost of Fuel Dispensing Facilities (Exhibit 5) Cost of Convenience Store Building Kiosk Cost Estimate versus Existing Convenience Store Imputed Kiosk Cost ($385,000*20%) Total Imputed Cost of Facilities without Convenience Store and Excluding Land ($401,261+$77,000)	$401,261 $385,000 20% $77,000 $478,261	83.9%[2] 16.1%c 100%
Assignment of Reasonable Rental Value: Reasonable Rental Value including Utilities, Property Taxes, Insurance, and allowed Environment Compliance Costs assigned to Fuel Sales Reasonable Rental Value Assigned to Activity Cost Pool 2, Kiosk[3] Reasonable Rental Value Assigned to Activity Cost Pool 3, Fuel Dispensinge Total Costs	$13,027 $2,097 $10,930$13,027	16.1% 83.9%100.0%

Exhibit 8

Dr Bean's ABC Method

Activity Cost Pools	Activity Driver	Regular Calculation	Regular Cost	Plus, Calculation	Plus, Cost	Premium Calculation	Premium Cost
Pool 1: Labour Cost ($5,220)	Litres of Fuel sold	$5,220*60.3%	$3,148	$5,220*22.4%	$1,169	$5,220*17.3%	$903
Pool 2: Kiosk ($2,097)	Litres of Fuel sold	$2,097*60.3%	$1,264	$2,097*22.4%	$470	$2,097*17.3%	$363
Pool 3: Fuel Dispensing ($10,930)	1/3 Each Grade	$10,930*33.3%	$3,643	$10,930*33.3%	$3,643	$10,930*33.3%	$3,643
Total Indirect Cost ($18,247)			$8,055		$5,282		$4,909
Cost per litre of Fuel Sold		$8,055/342,203	$0.024	$5,282/127,120	$0.042	$4,909/98,178	$0.050

Exhibit 9:

Dr Bean's ABC Method Results

Per Litre:	Price	Direct Cost	Indirect Cost	Profit (Loss)
Premium Plus Regular	$0.72 $0.68 $0.62	$.61 $.60 $.59	$0.050 $0.042 $0.024	$0.060 $0.038 $0.006

Exhibit 10: Comparison of Profit/Loss under the Three Cost Assignment Methods Per Litre of Fuel Sold

	1 Price	2 Direct Cost	3 Indirect Cost	4 Profit/(Loss) 1-(2+3)	5 Indirect Cost	6 Profit/(Loss) 1-(2+5)	7 Indirect Cost	8 Profit/(Loss) 1-(2+7)
				Assignment Method
			Simple Averages[4]	Unit-Based (Litres)	Dr Bean's ABC
Regular Plus Premium	$0.62 $0.68 $0.72	$0.59 $0.60 $0.61	$0.018 $0.048 $0.062	$0.012 $0.032 $0.048	$0.0322 $0.0322 $0.0322	($0.0220) $0.0478 $0.0778	$0.024 $0.042 $0.050	$0.006 $0.038 $0.060

Questions for Group Submission

1. Why do you believe the judge chose the regulator's costing approach over the original approach of Fill 'n' Shop Corporation?

1. Explain why Dr. Bean's analysis included the cost of a hypothetical "kiosk".

1. Explain how the costs in the case behave with respect to the following cost hierarchy:

unit-level, batch-level, product-level, and organization-level, including specific examples of each hierarchy level.

1. Explain why Dr. Bean's ABC analysis yields a result between the extremes of the other two costing approaches that had been used in the earlier court hearing.

1. To what extent do Dr. Bean's calculations represent an application of ABC, based upon your understanding of ABC? Please explain.

1. Critique the regulator's use of "cost" in assessing whether predatory pricing of fuel has occurred.

1. Explain whether you think the judge should lift the injunction on Fill 'n' Shop, following consideration of Dr. Bean's ABC analysis.

^[1] $7.50 hourly wage*1.16 to include benefits = $8.70 per hour * 20 hours per day *30 days per average month = $5,220 estimated labour costs per month.

^[2] Percentage of total imputed cost of assets used by Dr Bean to assign the reasonable rental value ($13,027) to Activity Cost Pool 3 (see footnote e below) ^c Percentage of total imputed cost of assets used by Dr Bean to assign the reasonable rental value ($13,027) to Activity Cost Pool 2 (see footnote d below)

^[3] $13,027*16.1% = $2,097 ^e $13,027*83.9% = $10,930

^[4] Simple averages charges 1/3 of indirect costs to each grade of fuel, which is then spread over the litres of that grade of fuel sold, as seen in Exhibit 4.