HFT 3431 Chapter 8 Cost Approaches to Pricing

HFT 3431 Chapter 8 Cost Approaches to Pricing

Pricing Questions Which Costs Are Relevant in the Pricing Decision? n What Is the Common Weakness of Informal Pricing Methods? n What Are Common Cost Methods of Pricing Rooms? n

Pricing Questions What Are Common Methods of Pricing Food and Beverages? n How May Profitability and Popularity Be Considered in Setting Food Prices? n

Pricing Questions n Will Departmental Revenue Maximization Result in Revenue Maximization for the Hospitality Firm?

Pricing Questions What Is Integrated Pricing? n What Is Price Elasticity of Demand? n

Price Elasticity of Demand Measures How Sensitive Demand Is to Changes in Price n Either Elastic or Inelastic n

Price Elasticity of Demand n Computed by Dividing % Change in Quantity Demanded by Base Quantity BY % Change in Price by Base Price (Q 2 - Q 1) / Q 1 (P 2 - P 1) / P 1

Price Elasticity of Demand Assume Hotel Sells 1, 000 rooms @ $30 n Changes Price to $33 and sells 950 n (950 - 1, 000)/1, 000 (33 - 30)/30 = - 0. 05 / 0. 10 = -0. 50 Inelastic

Price Elasticity of Demand n If Less Than 1 - Inelastic (Demand Is Insensitive to Price Changes) – An increase in price is offset by a smaller decrease in demand – Normally results in more profits with a price increase – An decrease in price is offset by a smaller increase in demand – Normally results in less profits with a price decrease

Price Elasticity of Demand n If Greater Than 1 - Elastic (Demand Is Sensitive to Price Changes) – An increase in price is offset with a higher decrease in demand – Normally results in less profits with a price increase – An decrease in price is offset with a higher increase in demand – Normally results in more profits with a price decrease (up to a point)

Price Elasticity of Demand Competition, Uniqueness Affect Elasticity n When Change Prices, Test for Elasticity n

Informal Pricing Methods Competitive n Intuitive n Psychological n Trial and Error n Follow The Leader n

Informal Pricing Methods Four Modifying Factors Consider First: n Historical Price Changes n Guest Perceptions (Price/value) n Competition n Modify by Rounding n

Mark Up Approaches Ingredient Mark Up n Determine Ingredient Costs n Determine Multiple to Use n Multiply Costs by Multiplier n Adjust Using Qualitative Factors n

Multiplier 1 / Desired Food Cost Percentage n Example 1 / 40% = 2. 5 n

Alternative to Multiplier Divide Costs By Desired Food Cost Percentage n Example $3. 00 Cost / 40% = $7. 50 Selling Price n

Ingredient Mark Up Approach n If total ingredients cost $1. 32 and you have a 40% desired Food Cost – Multiplier = 1/0. 4 = 2. 5 – Suggested Price = $1. 32 * 2. 5 = $3. 30 – Would suggest rounding to $3. 50

Mark Up Approaches Prime Ingredient Mark Up n Determine Prime Ingredient Cost n Some Versions Add in a Fixed Dollar Amount for Other Ingredients n

Mark Up Approaches Prime Ingredient Mark Up (Continued) n Determine Multiple to Use - Higher Than Mark up (Arbitrary) n Multiply Costs by Multiplier n Adjust Using Qualitative Factors n

Prime Ingredient Mark Up Approach n If Prime Ingredients cost $0. 59 and you have a Prime Multiplier of 7. 8 – Suggested Price = $0. 59 * 7. 8 = $4. 60 – Would suggest rounding to $4. 75 – Note, the Prime Multiplier is based on history or industry standards there is not a formula for it. It is usually higher than the ingredient multiplier

Rooms Pricing Traditional Method $1 Per $1, 000 Cost Per Room n Doesn’t Consider Current Value n Doesn’t Consider Other Services n Assumes 70%occupancy n Assumes Profitable Food and Beverage n

Rooms Pricing Traditional Method n If $100, 000 to build a 5, 000 room hotel = 100, 000 / 5, 000 = 20, 000 per room / $1, 000 = $20. 00 per room rate

Rooms Pricing Hubbart Formula “Bottoms Up” n Start With Profit n Determine Pretax Profit n

Rooms Pricing Hubbart Formula Add in Fixed Charges n Add in Undistributed Operating Costs n Estimate Non Room Income (Loss) n Sum Is Rooms Department Income n

Rooms Pricing Hubbart Formula Rooms Revenue Equals Rooms Income Plus Rooms Department Costs n ADR = Room Revenue / Rooms to Be Sold n n See page 371 for example

ADR to Single and Double Rates (Singles Sold * Single Rate) + (Doubles Sold * (Single Rate + Price Differential)) = Average Rate * Rooms Sold n Solve for Each Rate n

Rate Calculation Assume 200 room hotel with occupancy of 75% and double occupancy of 40% with ADR or 67. 81 (doubles are $10 more than singles n Sell (. 75 * 200) 150 rooms per day n 90 singles 60 doubles

Rate Calculation Let X = Single Room Rate n 90 x + 60(x + 10) = 67. 81 * 150 n 90 x + 600 = 10, 171. 50 n 150 x = 9, 571. 50 n x = 63. 81 Single Rate x + 10 = 73. 81 Double Rate n

Yield Management Increasing the Rooms Revenue

Yield Management Take the Guess Work out of Your Rooms Inventory n The Business of Selecting the Most Profitable Reservations n Yield Management Is the Process of maximizing the total revenues, rather than selling more rooms n

Why Yield Management ? Increase Room Revenues n Improve Total Corporate Profitability n Enter New Markets With Strategic Pricing n Identify and Respond More Quickly to Changing Market Trends n Manage Distribution Channels More Effectively n

What We Gain Is: n Assume 100 room hotel and you can sell either to business or group: – Business - ADR = $80 – Business books 1 week out, and have 40 business guests already booked and can book 55 more in the next 3 weeks – Group - ADR = $55 – Groups books 3 week out – It is 4/1/02 and a group wants to book 20 rooms for 4/21 -11/02

What We Gain Is: n Option 1 Accept the Group Rooms 20 * $55. 00 = $1, 100 Business Rooms 80 * $80 = $6, 400 Total $7, 500 n Option 2 - Reject the Group Business Rooms 95 * $80 =$7, 600 n Since only $100 difference look at the overall revenue that will be generated from each option (ie food and bev)

Menu Engineering A Tool to Increase Food and Beverage Profits

Breaking Out of the Box Is It Really Important to Sell Each Guest a Selection From Each Part of the Menu? n Is Food Cost Percentage the Best Measurement of Performance? n

Breaking Out of the Box Can We Determine the Exact Labor Cost for Each Item Sold on the Menu? n Should Selling Prices Be Determined on a Consistent Mark-up Basis? n

Selling the Entire Menu Drives up Check Average and That Is Good n Additional Points of Service Reduces Seat Turnover n Waiting Time for Table May Cause Loss of Customer n

Selling the Entire Menu n Would You Rather Serve a Dessert at a Cost of $2 for $5 or an Entrée at a Cost of $4 for $10?

Food Cost Percentage Ratio of Cost of Goods Sold to Sales n Gross Profit Is Sales Minus Cost of Goods Sold n Objective Is to Increase Gross Profit n

Food Cost Percentage Do You Deposit Percentages or Dollars? n Item “A” Costs $4 and Sells for $12 or 33% n Item “B” Costs $8 and Sells for $20 or 40% n Which One Would You Rather Serve (All Other Things Being Equal)? n

Labor Cost Labor Is a Mixed Cost - a Fixed Component and a Variable Component n Customer Demand Is Variable on a Daily Basis n Daily Labor Is Scheduled Based on Forecasts Which Inherently Are Imprecise n

Labor Cost Therefore, Exact Labor Cost Quantification on a Per Item Basis Is Impossible to Compute n Can Rank Labor Cost Per Item (High or Low Relative to the Items in the Mix) n

Menu Engineering Smith and Kasavana n Analyzes Popularity and Contribution Margin n Two by Two Matrix n Classified Items As Stars, Dogs, Puzzles, or Plowhorses n

Popularity Item Is Popular If Individual Item’s Sales Mix Exceeds 70% of the Average Popularity n Average Popularity = (100% / Number of Items) * (70%) n

Popularity Example 10 Items n Average Popularity = (100% / 10) * (70%) = 7% n If Individual Sales Mix Is > 7%, The item has HIGH Popularity n If Individual Sales Mix Is < 7%, The item has LOW Popularity n

Contribution Margin Selling Price Minus Variable Costs or Gross Profit n Compute for Each Item n

Weighted Average Contribution Margin Calculation Compute Individual Contribution Margin n Multiply Item Contribution Margin by Number of Item Sales n Result Is Total Contribution Margin n

Weighted Average Contribution Margin Calculation Divide Total Contribution Margin by Number of Sales n Result Is Weighted Average Contribution Margin n

Contribution Margin Compare Against Weighted Average Contribution Margin for Menu Section Engineered n If Item CM Is > WACM - Label “HIGH” n If Item CM Is < WACM - Label “LOW” n

Classifications n Star - High Popularity & High CM – Continue promoting item n Plow Horse - High Popularity & Low CM – Re-price the item to increase CM n Puzzles - High CM & Low Popularity – Promote the item to increase popularity n Dogs - Low CM & Low Popularity – - Drop the item from the menu

Menu Engineering Concerns Ignored Variable Portion of Labor Cost n Inconsistent With Performance Evaluation n Difficult to Collect Data n Extensive Calculations n “So What” Theory n

Adjust Sales Mix Without Cost Create Signature Item High in Contribution Margin n Train Staff on Contribution Margin Principles n Provide Periodic Tastings to Public for Items Low in Popularity but High in Contribution Margin n

Adjust Sales Mix Without Cost Use Internal Marketing Tools n Reevaluate Pricing Strategies Using Data, Profit Factor, and Elasticity of Demand n Consider Profitability When Printing Menus n