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Student Study Notes - Chapter 8 Establishing Room Rates            Any serious exploration of hotel room rates and their management must include basic information about room rate economics. Room rate economics recognizes that, when the supply of hotel rooms is held constant, an increase in demand for those rooms will result in an increase in their selling price. Conversely, when supply is held constant, a decrease in demand leads to a decreased selling price. Understanding the law of demand is critical because, unlike managers in other industries, hoteliers cannot increase their inventory levels of rooms (supply) in response to increases in demand. Hotel managers must also understand that their own inventory of rooms is highly perishable. If a hotel does not sell room 101 on Monday night, it will never again be able to sell that room on that night, and the potential revenue that would be generated from the sale is lost forever. Since information about supply is readily known, and since forecast data helps to estimate demand, you can learn to accurately gauge the relationship between guestroom supply and demand. Using this information, you can determine the best rates to be assigned to each of your rooms. A rack rate is the price at which a hotel sells its rooms when no discounts of any kind are offered to the guests. Rack rates, however, will vary based upon the type of room sold. Figure 8.1 lists the rack rates that are associated with Paige Vincent’s Blue Lagoon Water Park Resort based on her room mix (the variety of room types) in her hotel. In Figure 8.1, rack rates vary by bed type, by amenities, by location and by size. Some hotels have very strong seasonal demand. These hotels will have a seasonal rate that is higher or lower than the standard rack rate and that is offered during that hotel’s highest volume season. In some cases, it makes sense for hoteliers to create special event rates. Sometimes referred to as “super” or “premium” rack, these rates are used when a hotel is assured of very high demand levels (e.g., Mardi Gras in New Orleans and New Year’s Eve in New York City). Hotels often negotiate special rates for selected guests. In most cases, these negotiated rates will vary by room type. In addition to rack and negotiated rates, hotels typically offer corporate rates, government rates, and group rates. Some hotels have great success “packaging” the guest rooms they sell with other hotel services or local area attractions. When a hotel creates a package, the package rate charged must be sufficient to ensure that all costs associated with the package have been considered. A hotel’s revenue managers can also create discounts at various percentage or dollar levels for each rate type we have examined. The result is that a hotel, with 1   multiple room types and multiple rate plans, may have literally hundreds of rates types programmed into its property management system. A property management system (PMS) is a computer system used to manage guest bookings, online reservations, check-in/check-out, and guest purchases of amenities offered by the hotel. In addition, the use of one or more authorized fade rates, a reduced rate authorized for use when a guest seeking a reservation is hesitant to make the reservation because the price is perceived as too high, can result in even more room rates to be managed. The Hubbart Room Rate Formula          Hoteliers want to maximize their profits and thus collect the highest rate possible for their rooms. However, the rate cannot be so high that it discourages guests from staying at the hotel, nor can it be so low that it prevents the hotel from making a profit. The room rate charged should not result from a mere “guess” about its appropriateness but, ideally, should evolve from a rational examination of guest demand (because it is the most significant factor impacting room rates) and a hotel’s costs of operation with specific and accurate assumptions. Recognized by hoteliers world-wide, the Hubbart Room Rate Formula for determining room rates was developed in the mid-1950s by the national hotel accounting firms of Horwath & Horwath and Harris Kerr Forster. The Hubbart formula is used to determine what a hotel’s average daily rate (ADR) should be to reach the hotel owner’s financial goals. To compute the Hubbart formula, specific financial and operational assumptions are determined. These include dollar amounts for property construction (or purchase), the total cost of the hotel’s operations, the number of rooms to be sold, and the owner’s desired ROI on the hotel’s land, property, and equipment. The Hubbart formula is a “bottom-up” approach because it literally requires you to completely reverse the income statement from the bottom up (see Figure 8.2 for the comparison between the normal format of the income statement and the bottom-up format for the Hubbart formula). Using the bottom-up approach, you start by calculating the desired net income based on the owner’s desired return on investment (ROI) and work your way up the income statement by adding back estimated taxes, non-operating expenses, and undistributed operating expenses and then subtracting out estimated operated departments income (excluding rooms). The result will be the estimated operated department income for rooms. Next, you can separate the estimated operated department income for rooms into rooms revenue and rooms expenses. Once rooms expenses are subtracted out, rooms revenue will remain. This revenue can then be split again to determine number of rooms to be sold and, finally, ADR. The resulting ADR is the average price that should be charged for your rooms in order to achieve the owner’s desired net income (ROI). 2         To illustrate the Hubbart formula, the Blue Lagoon Water Park Resort’s Income Statement is shown in Figure 8.3. Assume for the sake of calculating this formula that we do not know the operated department income for rooms, rooms revenues, or rooms expenses. Remember, the point of using the Hubbart formula is to predict rooms revenue, and subsequently, ADR. For a detailed analysis of the Hubbart formula, see Go Figure! in the text. For a summary of the Hubbart formula calculations for the Blue Lagoon Water Park Resort, see Figure 8.4. The seven steps required to compute the Hubbart formula are summarized in Figure 8.5. The Hubbart formula is useful because it requires managerial accountants and hoteliers to consider the hotel owner's realistic investment goals and the costs of operating the hotel before determining the room rate. The formula has been criticized for relying on assumptions about the reasonableness of an owner’s desired ROI and the need to know expenses that are affected by the quality of the hotel’s management. Another criticism is that the formula requires the room rate to compensate for operating losses incurred by other areas (such as from telecommunications). The formula’s primary shortcoming may relate to identifying the number of rooms forecasted to be sold. The number of rooms sold is dependent, to a significant degree, on the rate charged for the rooms. However, the Hubbart formula requires that the number of rooms sold be estimated prior to knowing the rate at which they would sell. Despite its limitations, the Hubbart formula remains an important way to view the necessity of developing a room rate that:  Provides an adequate return to the hotel’s owner(s)  Recovers the hotel’s non-operating expenses  Considers the hotel’s undistributed operating expenses  Accounts for all the hotel’s non-room operated departments income (or loss)  Results in a definite and justifiable overall ADR goal The $1.00 per $1,000 Rule     One alternative way that hoteliers have historically determined room rate is the $1.00 per $1,000 rule. This rule states that, for every $1,000 invested in a hotel room, the property should charge $1.00 in ADR. Advocates defend the $1.00 per $1,000 rule of thumb because areas in which building or purchase costs are higher tend to be the areas where ADRs can also be higher. The dollar-per-thousand rule is most accurate for hotels that have high occupancies, high ADRs for their area of operation, and are newly built. On the other hand, large, old properties frequently fail to achieve the dollar-per-thousand standard. Despite some limitations, the $1.00 per $1,000 rule does reflect the tendency for hotel buyers to discuss hotel selling prices in terms of a hotel’s cost per key, which is the average purchase price of a hotel’s guestroom expressed in thousands of dollars. Cost per key is also frequently called average cost per room. 3 Go Figure! Average Cost per Room is calculated as follows: Purchase Price Number of Rooms = Average Cost per Room Then, ADR is calculated as follows: Average Cost per Room $1,000  = ADR It is important to recognize that the rate computed using the $1.00 per $1,000 rule does not become the hotel’s rack rate. Instead, it is the overall ADR that the hotel must achieve when its sells all of its various rooms at all of their respective rates. Alternative Room Rate Methodologies   Additional historical methods of rate determination include those based upon the square footage of guestrooms and rates determined by various “ideal” sales levels of the different hotel room types available to be sold. However, today’s hotel room rate structures have been changed, and changed forever, by the advent of the Internet as the most popular method used for selling hotel rooms. Web-Influenced Room Rate Methodologies   Properly pricing hotel rooms is critical to attracting first time and repeat business. However, close examination of many pricing tactics would reveal that they often use one or more of the following non-traditional, non-cost methods to establish rates:  Competitive Pricing. Charge what the competition charges.  Follow the Leader Pricing. Charge what the dominant hotel in the area charges.  Prestige Pricing. Charge the highest rate in the area and justify it with better product and/or service levels.  Discount Pricing. Reduce rates below that of the likely competitors. As a result of the Internet, consumers can easily compare prices, but so can a hotel’s major competitors. Gone are the times when night auditors or others on the front office staff conducted the nightly call-around to ask other hotels’ night auditors what their hotels were charging for rooms and then used that information (often of questionable accuracy) to make decisions about what their own hotel’s rate offerings should be. 4    While the call-around was standard practice as late as the early 2000s, consider modern hoteliers utilizing one of the many websites similar to http://www.Travelaxe.com and others that allow him/her to easily:  Select competitive hotels whose rates are to be monitored  Obtain real-time room rates offered by these hotels on any number of travel websites advertising the rates  Search the rates and sites as frequently as desired  Perform rate comparisons by specific check-in and check-out dates  Assess rate comparisons based upon room type  Assess rate comparisons based upon date of guest arrival Guests care very little how much it “costs” a hotel to provide its rooms. They care about the lodging value they receive. As a result, a hotel’s rates are heavily influenced by the laws of supply and demand. If, on a given Saturday, all similar hotels in a market area offer guest rooms in the range of $100 - $150 per night, it would be difficult for a single hotel of the same type to command a rate of $250 per night even if its operating costs justify this rate. The rate at which a hotel first sells its rooms to guests may not be the rate those guests will ultimately pay. A guest can make a hotel reservation at a given rate, and, every day until the date of arrival, can go online to shop for an even lower price for the same room. If a lower rate were to be found, the guest could recontact the hotel, cancel the original reservation, and secure the new, lower rate. Revenue Management   Revenue management, also called yield management, is a set of techniques and procedures that use hotel specific data to manipulate occupancy, ADR, or both for the purpose of maximizing the revenue yield achieved by a hotel. Yield is a term used to describe the percentage of total potential revenue that is actually realized. Revenue managers are responsible for making decisions regarding the pricing and selling of guest rooms in order to maximize yield. Go Figure! A hotel’s yield would be calculated as follows: Total Realized Revenue Total Potential Revenue  = Yield RevPAR is a combination of ADR and occupancy % and is calculated using the following formula: ADR x Occupancy % = RevPAR 5          To increase yield simply means to increase the hotel’s RevPAR. Therefore, any change (decrease or increase) in either or both of the factors comprising RevPAR will change the yield of the hotel’s revenue. Because hotel rooms are highly perishable, the goal of revenue management is to consistently maintain the highest possible revenue from a given amount of inventory. Revenue management techniques are used during periods of low, as well as high, demand. Although the actual revenue management techniques used by hoteliers vary by property, in their simplest form, all these techniques are employed to:  Forecast demand  Eliminate discounts in high demand periods  Increase discounts during low demand periods  Implement “Special Event” rates during periods of extremely heavy demand Sophisticated mathematical programs that help hoteliers manage revenues are built into most property management systems (PMS) used in the industry today. Using information gleaned from the hotel’s historical sales data, revenue management features in a PMS can:  Recommend room rates that will optimize the number of rooms sold  Recommend room rates that will optimize sales revenue  Recommend special room restrictions that serve to optimize the total revenue generated by the hotel during a specific time period  Identify special high consumer demand dates that deserve special management attention to pricing PMS systems can “remember” more important dates than can an individual hotelier. However, it is hotelier’s skill and experience that is most critical to the revenue maximization process. The goal of a talented revenue manager is to increase RevPAR, not only on a daily basis, but on a long-term basis as well. In the hotel industry, a competitive set (comp set) consists of those hotels with whom a specific hotel competes and to which it compares its own operating performance. To fully evaluate RevPAR changes, hoteliers look to the relative performance of their comp set. They do so to better understand the room rate economics that affected their own property during a specific time period, as well as how the hotel’s management responded to the supply and demand challenges they faced during that period. To better understand the shortcomings of an over-emphasis on RevPAR, it is important to take a closer look at its two fundamental components, occupancy % and ADR. Occupancy Percentage  It might seem that the occupancy percentage for a hotel would be a straightforward calculation. A room revenue statistics report generated from the 6 Blue Lagoon Water Park Resort’s property management system produced the information needed to calculate their occupancy percentage (refer to Figure 8.6). Go Figure! Exactly how should Paige at the Blue Lagoon Water Park Resort compute her occupancy percentage? Should she: 1. Include only sold rooms in her computation? If so, her formula would be: Rooms Sold Total Rooms in Hotel 2. = Occupancy % Include complimentary rooms as well as sold rooms in her computation? If so, her formula would be: Rooms Sold + Comp Rooms Occupied Total Rooms in Hotel 3. Subtract non-sellable out-of-order rooms from her rooms available count? If so, her formula would be: Rooms Sold Total Rooms in Hotel – OOO Rooms 4. = Occupancy % = Occupancy % Subtract non-sellable on change rooms from her rooms available count? If so, her formula would be: Rooms Sold Total Rooms in Hotel – On-Change Rooms = Occupancy % ADR  Average daily rate (ADR) is also a critical component of RevPAR. Generally, hotel managers calculate ADR using one of the two following formulas: Total Rooms Revenue Total Number of Rooms Sold = ADR or Total Rooms Revenue Total Number of Rooms Occupied 7 = ADR   Notice that the only difference in the two formulas are the words sold and occupied. See Go Figure! in the text for further illustration of the difference between these two formulas for calculating ADR. Despite the slight differences in these two ADR computations, neither is as useful to the hotel’s owners and managers as the computation of the net ADR yield. Net ADR Yield  Net ADR Yield is the percentage of ADR actually received by a hotel after subtracting the cost of fees and assessments associated with the room’s sale. For a single room it is computed as: Room Rate - Reservation Generation Fees Room Rate Paid = Net ADR Yield         To really understand net ADR yield, you must first understand how hotel rooms were sold in the past as well as how they are sold in today’s competitive marketing environment. In the distant past, hotels clearly preferred that guests arrive with a previously made reservation. Of course, if the hotel had vacant rooms, the front office agent would quote a rate (often higher than that quoted to other guests) to the non-reserved guest and the room would be sold. Today, most hotel guests already have a room reservation prior to arrival, and the reservation distribution channels (sources of reservations) used to make their reservations will charge the hotel widely varying fees for making them. When a guest makes a reservation via the Internet, no less than three reservationgeneration fees are typically charged to the hotel, including fees from:  Internet Travel Sites - websites for booking travel to end-users  Global Distribution System (GDS) - system that books and sells rooms for multiple companies  Central Reservation System (CRS) – system used by companies to centrally book reservations Consider the information in Figure 8.7. As you can see, the hotel pays “zero” reservation fees on a walk in reservation and pays several fees for the reservation made by the Internet user. If the reservation is made by a travel agent, additional fees are charged. With increased usage of high priced distribution channels, a room’s selling price (quoted) and the ADR the hotel actually receives can be radically different. For a further illustration of net ADR yield, see Go Figure! in the text. Clearly, it is the ADR after the cost of reservation generation fees that should be most important to hoteliers and their attempts to increase RevPAR. If net ADR yield is not used, hotel owners and managers run the risk of significantly over inflated RevPARs accompanied by significantly reduced profits as well. 8 Flow-Through  Flow-through is a measure of the ability of a hotel to convert increased revenue dollars to increased gross operating profit dollars. Consider the simplified income statements detailing revenue and expenses for January 2010 and for the same month of the prior year for the Blue Lagoon Water Park Resort (see Figure 8.8). Go Figure! From Figure 8.8, the Blue Lagoon’s flow-through for January 2010 is calculated as the change in gross operating profit (GOP) from the prior year divided by the change in total revenues from the prior year as follows: GOP This Year- GOP Last Year Total Revenues This Year – Total Revenues Last Year = Flow-Through   Gross operating profit (GOP) is, in effect, total hotel revenue less those expenses that are considered directly controllable by management. Flow-through was created by managerial accountants to measure the ability of a hotel to covert increases in revenue directly to increases in GOP. When flow-through is high (over 50%), it reflects efficiency on the part of management in converting additional revenues into additional profits. For most hotels, flow-throughs that are less than 50% indicate inefficiency in converting additional revenues into additional profits. GOPPAR    Gross operating profit per available room (GOPPAR) is defined as a hotel’s total revenue minus its management’s controllable expenses per available room. For example, the costs of a hotel’s lawn care services, utility bills, and even food and beverage expenses are considered when computing GOPPAR. These same expenses are not, of course, considered when computing RevPAR. In most cases, those managers directly responsible for revenue generation do not control the majority of costs used to compute GOPPAR. How did it become popular to suggest GOPPAR as a method of evaluating the decision making of those revenue managers? For a simple example of why this is so, consider a hotel that elects to launch a major advertising campaign in its local market, which costs $100,000 per month, and increases RevPAR by $15,000 per month. Despite the fact that RevPAR certainly did increase, the amount of money spent by the hotel to increase RevPAR exceeded, by far, the actual amount of the revenue increase. Clearly, the short-term effect on hotel profitability will be a negative one. 9   Thus, there are still some pitfalls to be aware of when analyzing a hotel's performance based solely on RevPAR. For example, in those cases where room revenue accounts for only 50 to 60% of total revenue (as is the case in large convention hotels), RevPAR represents only half of the hotel’s revenues and neglects to consider all other sources of incremental revenues. It is for shortcomings such as these that hoteliers now consider an analysis of a hotel’s GOPPAR to be of such importance. Go Figure! GOPPAR is calculated as follows: Gross Operating Profit Total Rooms Available to Be Sold = GOPPAR   GOPPAR, because it reflects the gross operating profits (not revenue) of a hotel, actually provides a clearer indication of overall performance than does RevPAR. RevPAR indicates the performance of a hotel in terms of rooms inventory sales and marketing, however, it provides no indication of how much money the hotel actually is, or should be, making. GOPPAR takes into consideration the cost containment and management control of the hotel and must be considered in any effective rooms pricing strategy. The difficulty is not that RevPAR is a poor measurement, but rather it is the fact that RevPAR should not be the only measurement of a hotel’s revenue manager’s effectiveness. Non-Room Revenue  Non-room revenue is important to the managers of both limited service and fullservice hotels. It is common for limited service hotels to generate 5-20% of their total revenue from non-room sources. In full-service hotels, the non-rooms revenue generated may range from 20-50% of total revenue. Non-room revenue on a hotel’s income statement is attributed to one of the following categories:  Food  Beverage  Telecommunications  Garage and Parking  Golf Course  Golf Pro Shop  Guest Laundry  Health Center  Swimming Pool  Tennis  Tennis Pro Shop  Other Operated Departments 10   Rentals and Other Income Not every hotel will create revenues in every non-room revenue area. Food and Beverage Revenue         Food and beverage revenues typically make up the largest portion of a hotel’s non-room revenue. The pricing of a hotel’s food and beverage products is not identical to that of a restaurant, and in many cases, it is not even similar. A restaurant manager wants to financially support the restaurant itself through sales. In a properly managed hotel food and beverage (F&B) department, the department head wants to financially support the hotel through sales. The philosophical and practical differences between the two approaches are immense. For example, in many hotels, complementary breakfast is served to all overnight guests. The food and beverage department in such a property may be reimbursed for the “cost” of providing the breakfast, but the actual “sales” value of the breakfast, including a profit, would not likely be transferred. The amount of profit generated by a traditional restaurant is relatively easy to calculate. All revenue is generated from the sale of food and/or beverage products in the restaurant and all expenses normally will be clearly identified in the accounting records of the establishment. The process of assigning revenues and expenses applicable to the F&B department in a hotel is more difficult. For example, a holiday weekend package plan that includes one night’s stay, dinner, and breakfast is sold to guests for one price. How should the revenue generated from the guests be split between room revenue and the F&B department? Consider applicable expenses also. How much, if any, of the salary paid to the hotel’s general manager, controller, and other staff specialists along with other expenses including utilities, landscaping, and marketing, should be allocated between departments (including F&B) within the hotel? It is, then, difficult to compare the profitability of a restaurant directly with that of its F&B counterpart in a lodging property. Hotel F&B face significant challenges to profitability. For example, traditional restaurants are open at the times when the majority of their guests want to be served, while a hotel restaurant will most likely remain open for three meal periods daily to serve hotel guests. As a result, payroll related costs in hotel F&B departments tend to be higher than their restaurant counterparts. Food service is often viewed as an amenity to attract guests and to provide food and beverage alternatives to increase the hotel’s revenues. The role of the F&B department is, appropriately, secondary to that of those departments that sell and service guest rooms. Experienced managerial accountants understand this and resist the temptation to aggressively and expensively seek to market the F&B operation to non-hotel guests living in the local area. In addition to the restaurants and lounges found in hotels, for those hotels with liquor licenses (many limited service hotels do not have them), income statements will be prepared that include revenue and expense detail one or more of the following categories: 11    Room Service  Banquets  Breakfast  Lunch  Dinner  Meeting room rental  Meeting room set-up and décor  Audio and Visual (A/V) equipment rental  Service Charges Service charges are properly reported as F&B income because, unlike a tip, a service charge is a mandatory addition to a guest’s food and beverage bill. Typical service charge rates in full service hotels range from 15-25 % of the guest’s total pre-tax food and beverage charges. The portion of the hotel’s mandatory service charge that is not returned to employees is often considered a direct contribution toward F&B profits. Telecommunications Revenue       In the not so distant past, in-room telephone toll charges contributed a significant amount of money to a hotel’s annual revenue. Today, however, the advent of cell telephones, and the reputation for excessive charges that has plagued hotels have lead to significant declines in this revenue source. Many hotel brands have had to reduce or even eliminate their local telephone charges. As a result, for most hoteliers, focus on the telephone department has shifted from a “pricing” concern to a “cost” accounting and management concern. When guests make telephone calls outside the hotel, it is in the best interest of the hotel to route those calls in a way that minimizes the hotel’s cost. When a call is made, the hotel will, depending on the distance and length of the call, add a charge to the guest’s folio to offset the cost of that call. The procedure for doing so involves programming the hotel’s call accounting system, to generate telephone toll charges based upon:  Time of day  Call length  Call distance (local or long distance)  Use or non-use of international service providers (carriers) Note that these cost factors are the same factors that will ultimately affect the hotel’s own monthly telephone bill. As a result, all of these should indeed be considered when establishing appropriate in-room guest telephone charges. An effective call accounting system, when interfaced (electronically connected) with the hotel’s property management system will post these charges directly to the guest’s folio and provide the documentation (call date, time and number that was called) required to justify the collection of these charges when the guest checks out. Other Operated Departments Revenue 12  Most hoteliers will encounter and need to fully understand the following “other” revenue generating areas or departments:  Pay-per-view movies  Pay-per-play in-room games  In-room safes  Internet access charges  Miscellaneous other income 13