Topic 2

Pricing Decisions in Hotels

 Lecture Outline

▶ Bottom-up Pricing (refer to Reading on BB site)

▶ Pricing Decisions
▶ Elements affecting pricing
▶ Review “Elasticity of Demand”
▶ Different pricing methods
▶ Compare Strategical & Tactical Pricing
Bottom up pricing Method
▶ Assumptions:
▶ Sales are shown as a 100% value on income
statement
▶ All variable costs can be expressed as a
percentage of 100% of sales revenue
▶ All known repetitive overhead costs and the dollar
value of each cost can be identified.
▶ A desired income after tax and an appropriate tax
rate are known.
Bottom up pricing Method
▶ Key Formulas

Costs as a % of sales revenue =

Sales revenue @ 100% - VC percentages

Sales Revenue = Known Costs

Known Cost %

Net Income before Tax = Net Income After Tax

1 – Tax rate

Tax = Operating Income – Net Income after tax

Bottom – Up Pricing a 6 Step Process
▶ Step 1
▶ What is the profit after tax paid, also called:
1. Return to owner
2. Return on equity
3. Reward for owner
▶ Step 2
▶ Calculate the tax to be paid on profit
▶ Step 3
▶ Calculate important fixed costs –
1. Depreciation on assets purchased.
2. Interest paid on any loans by the business
Bottom – Up Pricing a 6 Step Process
▶ Step 4
▶ Calculate TOTAL Known Costs (add them up):
▶ This is the total of all costs given as part of the data in the
question, PLUS
▶ The cost calculated in Step 3 (Depreciation and Interest
expense), PLUS
▶ The tax to be paid, PLUS
▶ The return to owner
▶ = TOTAL Known Costs
Bottom – Up Pricing a 6 Step Process
▶ Step 5
▶ Costs as a % of sales revenue
▶ This is given by the formula
▶ Sales revenue @ 100% - VC% = Costs %

▶ Step 6
▶ Now Calculate REQUIRED revenue
A working Example - Exhibit 6.1 from page
250 of your reading for this week
▶ Step 1 - What profit required

20% of $220,000 = $44,000 After Tax

▶ Step 2 - Next Calculate tax to be paid:

Before tax value = After tax $ / (1 – Tax rate)
= $44,000 / (1 - .36)
= $44,000 / 0.64
= $68,750
Tax paid will =$68,750 - $44,000
=$24,750
A working Example - Exhibit 6.1 from
page 250 of your reading for this week
▶ Step 3
▶ Calculate any depreciation and interest
▶ 10% X $220,000 = $22,000 depreciation
▶ There is no interest in this example
▶ Step 4
▶ Add all the costs together = $182,750
▶ Step 5
▶ Sales (100% - VC (79%) = 21%
▶ Step 6
▶ Revenue = $182,750 / 21% = $870,238 ANSWER!
A working Example – Exhibit 6.2
▶ On page 251 of the reading, we need to understand a key relationship
– after we know the profit, if we know all other costs we may
calculate the Total Revenue.
Total Revenue = Variable costs – all other costs
▶ Variable costs are made up of:
▶ Food 37%
▶ Labour 27%
▶ Other 15%
▶ Total = 79%

100% SALES = 79% (Variable Costs) - all other costs (including Tax and
return to owner)
The Final Step
What is the expected Sale per customer
▶ Calculation of Average Check
▶ The formula is
Average Check = Total annual Sales Revenue
(Seats X Seat Turnover X (No. of Days)

▶ Calculation of Average Room Rack Rate

▶ The formula is
Average Room Rate = Total annual Sales Revenue
(No. of Rooms X OCC % X No. of Days)
Pricing Decisions
▶ Once the concept and the calculation of costs is understood attention
turns to price setting.

▶ While profit maximisation may be a desired result, due attention

must be given to customer behaviour and cost recovery.

▶ Now we need to review elements that may have an effect on price

decisions.
Pricing Decisions
Pricing is a significant and challenging aspect of hospitality management
because:

1) There a large number of distinct products and services to be

priced.

2) The opportunity to benchmark to duplicate products and

services is limited.

3) There can be large cross-product differences in % contribution

margins.
Factors affecting pricing
a) Price elasticity
A highly price elastic service is one where a change in price results in a
relatively high change in demand for the service. A service with low
price elasticity, on the other hand, is one where a change in price results
in a relatively low change in the demand for the service.
% change in quantity demanded
 

Price elasticity =
% change in price

Price elasticity is an important concept for hospitality managers as it

represents a key contextual factor to consider when developing a pricing
strategy. Price elasticity for rooms is likely to vary between the busy and
quiet seasons (relatively elastic in the quiet season).
Elasticity of demand

▶ Elastic demand – small price changes lead to large

changes in demand

▶ Inelastic demand – large price changes lead to small

changes in demand
Factors affecting pricing
b) Product or service perishability
Imaginative approaches to pricing are called for when a product or service is
highly perishable.
Imagine that the unit variable cost of making a cream cake is $0.50, and that
immediately following production, the cake is priced at $4. If the cake is not
sold within two days of production, it will be thrown away. Accordingly, a
manager might be justified in dropping the retail price of the cake to $0.25
one hour before the cake shop is due to close on the day following the cake’s
production.
This simple example is significant as it illustrates how a manager can be
justified in dropping a perishable product’s selling price below its variable
cost.
When dropping the price of a perishable product, do not price below any
incremental costs arising from the sale (eg., think of pricing a room).
Traditionally applied pricing methods
a) Food & Beverage Pricing
Cost-plus pricing is extensively applied in food and beverage management.
The approach involves identifying costs traceable to the food or beverage
item to be priced and marking the cost up by a multiple in order to
determine a selling price.
Applying cost-plus pricing to beverages is fairly straight forward as the cost
is usually readily identifiable, and most beverages contain only one or two
ingredients. The situation is very different, however, when costing food
items. Meals can comprise many ingredients, and some ingredients are
subject to seasonal and daily cost fluctuations.
The following example demonstrates the application of cost plus pricing
for a particular meal on a restaurant’s menu.
Pricing methods – Mark up
Imagine the following cost schedule has been compiled for a particular
restaurant meal:

If the restaurant marks up its cost of ingredients by a factor of 8, then a

price of $22.40 (8 X $2.80) results. For marketing reasons, this “raw”
figure might be rounded to $22.90 or $21.90.
In some cases, the mark-up is based on the main ingredient alone. In this
instance, the restaurant may mark-up its main ingredient by a factor of
11. If this is done, we achieve a price of $22 (11 X $2).
Percentage mark up vs percentage profit
margin
Managers frequently confuse % mark up with % profit margin. The following
simple example highlights the difference in these two widely-used terms.
Imagine a restaurant buys its house wine for $16 per bottle and prices it on the
menu at $20.
The cost mark up (ie, profit relative to cost) as a percentage is:

$4 ÷ $16 X 100 = 25%

The profit margin (ie, profit relative to price) as a percentage is:

$4 ÷ $20 X 100 = 20%

Different Pricing Methods

▶ Rule of thumb
▶ An historical value base on a very general knowledge of the
activity.
▶ Trial and error
▶ Constant changing of prices and product offering, tends to
confuse customers
▶ Price cutting
▶ Risky strategy, short term method only
Different Pricing Methods
▶ High Price
▶ Workable only if customer sees a valued added difference in
the product offered.
▶ Competitive
▶ Driven by competitors but also includes issues of location
and / or facilities
▶ Mark-up
▶ Used to calculate the sales price provided all costs are
known. Must still be monitored to ensure realistic in the
current market.
Strategic and Tactical Pricing
Which policy to adopt?
Strategic – long run decision. Management need to match pricing with
firm's objectives,

1. The key here is to reach the firm’s planned objective in

reasonable yearly steps over the designated time period.

Think through the following example of a hotel wishing to achieve a net

operating profit of 18% over a four year period.
Strategic and Tactical Pricing
Which policy to adopt?
Tactical – short run. Take advantage of situations arising on a day to day
basis, e.g.:
▶ React to a competitor's price change, or a new competitor
▶ Group discounts and promotional prices
▶ Increased costs
▶ Attracting new market segments
▶ Off-season prices
Room Discounting
▶ Objective is to vary prices among customer segments. In practice this
means reducing prices below the maximum rate (rack rate).

▶ Can calculate an equivalent occupancy rate which determines the

occupancy rate needed to hold room sales revenue, less variable
costs, constant of the rack rate is reduced.
Yield Management
▶ Management objective is to maximise sales revenue (yield) from
available rooms.

▶ Use of information, operational procedures and statistics to increase

revenue while satisfying customer’s needs. (Lieberman, 1993).

▶ Requires management controls. “Right” type of room to the “right”

type of guest at the “right” price.

▶ Identifying market segments - detailed analysis of past customer

practices to identify characteristics of each different market group.
Traditionally applied pricing methods

▶ b) Setting room rates Applying yield management

The application of pricing strategies designed to maximise revenue is often
referred to as “yield management” Yield management involves developing pricing
plans that recognise factors such as whether a reservation pertains to a quiet or
busy season, weekday or weekend and also the nature of a customer’s market
segment. The key feature of yield management concerns its focus on maximising
revpar.
Imagine a hotel has 200 rooms and charges $80 per room for advanced bookings
except for those placed by tour operators who are granted a 25% discount. A tour
operator wants to book 30 rooms for three nights in two months time. The hotel
has already sold 170 of its rooms for the three day period, and the sales
department projects that if the sale is not made to the tour operator, 80% of the
remaining rooms will be sold to full rate paying guests.
Should the tour operator reservation be granted?
Traditionally applied pricing methods
The easiest way to tackle this type of problem is to compare the projected total
revenue if the tour operator reservation is made with the total revenue if the tour
operator reservation is not made.

As total revenue is greater if the sale is not made to the tour operator, the
reservations office should not reserve rooms for the tour operator.
Conclusion

▶ You should be able to complete and understand the Bottom-Up Pricing

Method

▶ You should be able to understand the different costing/pricing methods

▶ Attempt your questions for this week