Research Paper: Number of Different Factors

Pages: 9 (3152 words)  ·  Bibliography Sources: 6  ·  Level: Master's  ·  Topic: Energy  ·  Buy This Paper

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[. . .] The other thing Edgar has to think about here is that even people who continue to patronize his gas station will have less money for discretionary items if the price of gas continues to rise. So not only will he have fewer customers, but the remaining customers will spend less as well. The latter trend will be evident in the short-run, too, whereas the former trend is mainly going to be long-run.

All of this means is that an increase in gas prices does not necessarily mean an increase in revenue. It might, in the short run, though customers could just substitute discretionary purchases in the store in favor of the higher gas, which will cannibalize higher-margin goods, but in the long run Edgar might break even or less, depending on the products he stocks, the income characteristics of his neighborhood, the volatility of gasoline prices, the prevailing price elasticity of demand (it fluctuates, as noted above), and Edgar's bargaining power over his customers (so competition, differentiation, etc.).

Profit

So far, some key issues have been raised with Edgar with respect to the revenue side of his income statement. There is also the cost side. There are two factors to be taken into consideration. These are the costs of gasoline and the costs of other goods. There is a difference, in that Edgar needs to understand when he is setting his prices what the profitability of gasoline is -- is it a loss leader or just on a slimmer margin. If gas isn't a loss leader for Edgar in his current business plan, he needs to consider that it is a loss leader for his competitors, and they might be Wal-Mart and Costco. They'll undercut him on both gas and "stuff" (AP, 2008; Tuttle, 2011; Feldman, 2011). This means that Edgar is going to need to understand -- keenly -- his breakeven point, and if one of these companies moves into the area his stop loss point as well.

The Energy Information Administration (2014) outlines the price of gas. Regular gasoline comes in at an average of 12% taxes, 10% distribution and marketing, 14% refining, and 65% is the cost of crude oil. Note that all of the potential profit is in that 10% distribution and marketing, which also includes trucking it to the gas station, and all of the advertising that these companies pay for as well. Thus, Edgar's profit margin on gas is slim, if he has one at all.

We don't know Edgar's costs, so we can't figure out a breakeven point, but we do know that Edgar is going to have slim margins. Let's say he makes 0.1% on a gallon and has $400,000 in fixed costs. That means his breakeven point is 4 million gallons in a year. That is 10,958 gallons per day, or 456 gallons per hour. That's 7.61 gallons per minute just to break even. With ten pumps working that could happen, but Edgar has to know what the volume sales of the station are, because there is only so much he will do to change that.

The profit point on non-gas items is higher, so the breakeven point is lower, which is why Edgar has to realize that it is the ancillaries that will make or break his business. Variable costs are lower relative to revenues -- the margins are better so these are the items that will contribute to covering the fixed costs.

The good news for Edgar is that there is very little marginal cost to his gas station. What is the marginal cost of a gallon of gas, at a station that is already open? Not much. There are marginal costs associated with ancillary goods, however. A small store is much cheaper to run than a comprehensive highway rest stop. Marginal revenue has to be above marginal cost in order to turn a normal profit. Taken together, the ancillary goods and the gasoline must have an average total cost that is above the average variable cost. Taken together, they probably will, even if the gasoline does not on its own. But MR has to be above MC, so if Edgar decides to build a larger service station in order to increase his revenues, he has to increase them at a level that will justify the increased costs. That is why most gas stations do not build giant highway service centers -- only on highways where they have local monopolies do they do this. In competitive markets, gas stations only build to the size of their lot, but understand that ultimately they have to undercut others on gas or their giant attractive station will not generate MR above the MC level, and the station will have to go out of business at that point. Edgar has to know his market well, and tailor his service/product offering in line with the prevailing market conditions.

Market Structure

I want to press home an important point for Edgar, why I keep talking about those ancillary services. The market structure for gasoline is simple. It is perfect competition, more or less. I say less because consumers have very little knowledge about the cost inputs, but otherwise they have a high knowledge of gas prices -- there are apps that make this very easy -- and there is little to nothing that differentiates one company's gasoline from another. In a perfectly competitive market there is no opportunity for profit. That is why hardly anybody even tries to make money on the gas. Edgar might make a razor thin margin every once in a while, but he should count on making basically nothing on gas -- and remember there are competitors will to sell at below marginal cost in order to attract customers.

The ancillaries -- those other products Edgar wants to sell -- they are where a gas station can differentiate itself. That side of the business is in a state of monopolistic competition. Consider those undercutters over at Costco and Wal-Mart. They are differentiated because they attach their stations to their large stores, which is substantially different from what most companies in the industry do. But the more adventurous and distinctive the offering Edgar has, the more likely he will be able to draw customers in this business model; whereas it is only with price that he can entice people to buy his gas. Enticing people with his ancillary offering is the only way to get this business to an economic profit, because there is no economic profit possible on the perfect competition side with the gasoline.

Recommendations

It is recommended that Edgar think twice about his assumptions. It does not look like that gas station has favorable conditions. First, the gains from higher prices as gas prices rise are going to be offset, if not in the short run then definitely in the long run, by reduced demand. Further, higher gas prices are likely going to cut into income, reducing the positive effect that income has on gasoline consumption. Also, higher gas prices leave less money left over for spending on other goods. Considering the reality of the gas station business, where those ancillary goods are the only profitable part of the business, any trend that reduces the sales of ancillary items is not favorable at all.

Ultimately gasoline itself is an a perfectly competitive market. This means there is no opportunity for economic profit, and that is why all gas stations offer something other than gas. It is with the ancillary offering that there is potential for economic profit. This is to the point where some companies use gas as a loss leader to win the business and make up the different with economic profits on ancillary goods. The stop loss point for gas stations will be when the marginal costs of sales of ancillary goods are higher than the marginal revenues. So Edgar really needs to have a differentiated offering and needs to know his market in order to create as much gap between marginal revenue and marginal cost as possible.

All things considered, though, Edgar is misunderstood about the economics of gas stations. He is overstating the profit potential considerably. An efficient market will price that station at fair value, given all known information. If on the balance of his economic analysis, Edgar thinks that the station under his management will make more than this fair market value, he can purchase it, but given the above analysis, the prevailing conditions for gas stations are not favorable and he should reconsider his decision to get into this business.

References

AP. (2008). Stations hope you fill up with more than gas. NBC News. Retrieved May 23, 2014 from http://www.nbcnews.com/id/23904590/ns/business-retail/t/stations-hope-you-fill-more-gas/

Energy Information Administration. (2014). Gasoline and Diesel fuel update. Energy Information Administration. Retrieved May 23, 2014 from http://www.eia.gov/petroleum/gasdiesel

Feldman, A. (2011). The tiger in Costco's tank. Fast… [END OF PREVIEW]

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