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COST APPROACHES TO PRICING Prof. Dr. M. Selçuk Uslu Başkent Üniversitesi İİBF

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2 Mark Up Approaches To Pricing This method is one of the major methods used in pricing food and beverages. Mark up on cost covers all non product costs such as, labor, utilities, supplies, interest expense etc. This method is one of the major methods used in pricing food and beverages. Mark up on cost covers all non product costs such as, labor, utilities, supplies, interest expense etc. There are two versions of this method as ingredient mark up and prime ingredient mark up. There are two versions of this method as ingredient mark up and prime ingredient mark up.

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3 Four Steps in Ingredient Mark Up Approach 1) Determine the ingredient costs, 2) Determine the multiple to use in marking up the ingredient costs, 3) Multiply the ingredient costs by the multiple to get the desired price, 4) Determine whether the price seems reasonable based on the market.

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4 EXAMPLE: CHICKEN DINNER AND COSTS EXAMPLE: CHICKEN DINNER AND COSTS 1 Ingredient Cost ($) Chicken 2 pieces.59 Baked potato.19 Roll and butter.09 Vegetable.15 Salad with dressing.18 Coffee refills free.12 Total cost 1.32

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5 DETERMINATION OF MULTIPLE: Assume that the desired food cost percentage in the restaurant is 40%. In this case the multiple would be: Assume that the desired food cost percentage in the restaurant is 40%. In this case the multiple would be: 1 /.40 : 2.5, than the price of the chicken meal would be: 1 /.40 : 2.5, than the price of the chicken meal would be: 1.32 * 2.5: $3.3

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6 PRIME INGREDIENT APPROACH: This approach is similar to the ingredient mark up approach. Only difference is that the prime ingredient (chicken) is multiplied with the desired multiple. Assume that the desired multiple is 5.8. The price of the chicken meal would be: This approach is similar to the ingredient mark up approach. Only difference is that the prime ingredient (chicken) is multiplied with the desired multiple. Assume that the desired multiple is 5.8. The price of the chicken meal would be:.59 * 5.8 : $3.42

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7 PRICING ROOMS $1 per $1000 aproach: $1 per $1000 aproach: The above mentioned approach sets the price of a room at $1 for each $1000 of project cost per room. For example if the project cost of a room is $80000 then the price of the room wil be: $80000/$1000: $80 The above mentioned approach sets the price of a room at $1 for each $1000 of project cost per room. For example if the project cost of a room is $80000 then the price of the room wil be: $80000/$1000: $80

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8 Hubbart Formula in room pricing: 8 steps involved in Hubbart Formula: 8 steps involved in Hubbart Formula: 1. Calculate the desired profit by multiplying the desired rate of return (ROI) by the owners investment. 2. Calculate pretax profits by dividing desired profit (step 1) by 1 minus tax rate. 3. Calculate fixed charges and management fees. (depreciation, interest expense, property taxes,insurance, amortization,rent and management fees). 4. Calculate undistributed operating expenses. (administartive and general, data processing, human resources,transportation,marketing, property operation and maintenance, and energy costs. 5. Estimate non room operated income or losses. That is food & beverage, telephone, etc. income.

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9 Continued: 6. Calculate the required rooms department income. That is, step 2 + step 3 + step 4 + step 5. 7. Determine the rooms department revenue. That is step 6 + rooms department direct expenses of payroll and related expenses + other direct expenses. 8. Calculate the average room rate by dividing step 7 by rooms expected to be sold.

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10 EXAMPLE: Kaynak: (Schmidgall, 1997) The Harkins Hotel, a 200 room hotel, is projected to cost $9 900 000 inclusive of land, building, equipment and furniture. An additional $100 000 is needed for working capital: The hotel is financed with a loan of $7 500 000 at 12% annual interest with the owners providing cash of $2 500 000. The owners required rate of return on their investment is 15% annually. A 75% occupancy is estimated; thus 54 750 rooms will be sold during the year (200 *.75 * 365)The income tax rate is estimated 40%. The Harkins Hotel, a 200 room hotel, is projected to cost $9 900 000 inclusive of land, building, equipment and furniture. An additional $100 000 is needed for working capital: The hotel is financed with a loan of $7 500 000 at 12% annual interest with the owners providing cash of $2 500 000. The owners required rate of return on their investment is 15% annually. A 75% occupancy is estimated; thus 54 750 rooms will be sold during the year (200 *.75 * 365)The income tax rate is estimated 40%.

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11 Estimated additional expenses: Property taxes $ 250 000 Property taxes $ 250 000 Insurance 50 000 Insurance 50 000 Depreciation 300 000 Depreciation 300 000 Administrative & general 300 000 Administrative & general 300 000 Information systems 120 000 Information systems 120 000 Human resources 80 000 Human resources 80 000 Transportation 40 000 Transportation 40 000 Marketing expense 200 000 Marketing expense 200 000 Property oper. & mainten. 200 000 Property oper. & mainten. 200 000 Utility costs 300 000 Utility costs 300 000

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12 Estimated other operated departments income or losses: Food $ 90 000 Food $ 90 000 Beverage 60 000 Beverage 60 000 Telephone (50 000) Telephone (50 000) Rentals & other income 100 000 Rentals & other income 100 000 Rooms department direct expenses are $10 per room sold. Rooms department direct expenses are $10 per room sold.

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13 ÇÖZÜM: Desired net income (2 500 000 *.15) $ 375 000 Pretax income (375 000 / 1 -.40) 625 000 Interest expense (7 500 000 *.12) 900 000 Income before interest & taxes 1 525 000 Dep., prop. Taxes & ins. 600 000 Income after undistr. Oper. Exp. 2 125 000 Undistr. Oper. Exp. 1 240 000 Required oper. Depart. Income 3 365 000 Less:Food income (90 000) Beverage income (60 000) Rentals & other income (100 000) Plus: Telephone department loss 50 000 Rooms department income 3 165 000 Rooms depar. Direct exp. (54 750 * 10) 547 500 Rooms revenue 3 712 500

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14 Continued: Required average room rate: 3 712 500 / 54 750: $67.81 Required average room rate: 3 712 500 / 54 750: $67.81 Calculation of single and double room rates: Calculation of single and double room rates: Usually double rooms are sold at a diferent price than the single rooms. Usually double rooms are sold at a diferent price than the single rooms. Assume that in Harkins Hotel a double occupancy rate is 40% and price difference with single is $10.

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15 Calculations: Doubles sold in one day:.40 * 200 *.75: 60 Doubles sold in one day:.40 * 200 *.75: 60 Singles sold in one day: 150 – 60: 90 Singles sold in one day: 150 – 60: 90 Let x be the single room rate, than; Let x be the single room rate, than; 90x + 60(x + 10) : 67.81 * 150: $63.81 90x + 60(x + 10) : 67.81 * 150: $63.81 Double room rate: 63.81 + 10: $73.81 Double room rate: 63.81 + 10: $73.81 Alternatively the double rate can be set as a percentage of the single rate. 15% mark up on single rate. The equation will be as follows: Alternatively the double rate can be set as a percentage of the single rate. 15% mark up on single rate. The equation will be as follows: 90x + 60x(1.15) : 67.81 * 150: $63.97 90x + 60x(1.15) : 67.81 * 150: $63.97 Double rate: 63.97 * 1.15: $73.57 Double rate: 63.97 * 1.15: $73.57

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16 Bottom-up Approach To Pricing Meals An approach like Hubbart Formula can be used to determine the average meal price. An approach like Hubbart Formula can be used to determine the average meal price. Example: Example: ItemAmountOther Owners investment $200 000 Desired ROI: 12% Funds borrowed 500 000 500 000 ınterest rate: 10% ınterest rate: 10% Tax rate 30% Fixed charges 100 000 100 000Annual Controllable exp. 500 000 500 000annual Cost of food perc. 40% Seat turnover 2 times per day Days open 313 days

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17 Calculation: ItemCalculationAmount Desired net income 200 000 *.12 $ 24 000 Pretax profits 24 000 /.70 34286 34286 Interest 500 000 *.10 50 000 50 000 Total expenses and income $ 684 286 Total food revenue 684 286 /.60 $ 1 140 477 Meals sold 313 * 100 * 2 62 600 62 600 Average meal price 1 140 477 / 62 600 $ 18.22

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18 Dividing food revenue between lunch and dinner: Assume food revenue will be divided between lunch and dinner as 40% and 60% respectively. Luncheon seat turnover 1.25 and dinner seat turnover is.75. Assume food revenue will be divided between lunch and dinner as 40% and 60% respectively. Luncheon seat turnover 1.25 and dinner seat turnover is.75. Revenue per meal period: Revenue per meal period: Lunch: 1 140 477 *.40: $456 191 Lunch: 1 140 477 *.40: $456 191 Dinner: 1 140 477 *.60: $684 286 Dinner: 1 140 477 *.60: $684 286 Meals sold per meal: Meals sold per meal: Lunch: 100 * 313 * 1.25: 39 125 Lunch: 100 * 313 * 1.25: 39 125 Dinner: 100 * 313 *.75: 23 475 Dinner: 100 * 313 *.75: 23 475 Average meal prices: Lunch: 456191/39125: $11.66 Average meal prices: Lunch: 456191/39125: $11.66 Dinner: 684286 / 23475: $29.15 Dinner: 684286 / 23475: $29.15

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