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Cost Approaches to Pricing Chapter 8

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

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

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

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

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

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Price Elasticity of Demand n n Computed by Dividing % Change in Quantity Demanded by Base Quantity BY % Change in Price by Base Price (Q2 - Q1) / Q1 (P2 - P1) / P1

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Price Elasticity of Demand n Assume Hotel Sells 1,000 rooms @ $30 n Changes Price to $33 and sells 950 (950 - 1,000)/1,000 (33 - 30)/30 = - 0.05 / 0.10 = -0.50 Inelastic

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Price Elasticity of Demand n 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

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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)

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

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

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

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

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Multiplier n n 1 / Desired Food Cost Percentage n n Example 1 / 40% = 2.5

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Alternative to Multiplier n n Divide Costs By Desired Food Cost Percentage n n Example $3.00 Cost / 40% = $7.50 Selling Price

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Ingredient Up Approach Ingredient Mark Up Approach n 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

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

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

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Prime Ingredient Mark Up Approach n 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

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

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Rooms Pricing Traditional Method n n If $100,000,000 to build a 5,000 room hotel = 100,000,000 / 5,000 = 20,000 per room = 20,000 per room / $1,000 = $20.00 per room rate

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

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

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

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

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Rate Calculation n n Assume 200 room hotel with occupancy of 75% and double occupancy of 40% with ADR or 68.71 (doubles are $10 more than singles n n Sell (.75 * 200) 150 rooms per day 90 singles 60 doubles

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Rate Calculation n n Let X = Single Room Rate n n 90x + 60(x + 10) = 67.81 * 150 n n 90x + 60x + 600 = 10,171.50 n n 150x = 9,571.50 n n x = 63.81 Single Rate x + 10 = 73.81Double Rate

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Yield Management Increasing the Rooms Revenue

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Yield Management n 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

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Why Yield Management ? n 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

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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

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What We Gain Is: n Option 1 Accept the Group 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)

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Menu Engineering A Tool to Increase Food and Beverage Profits

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Breaking Out of the Box n 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?

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Breaking Out of the Box n 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?

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Selling the Entire Menu n 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

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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?

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Food Cost Percentage n 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

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Food Cost Percentage n 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)?

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Labor Cost n 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

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Labor Cost n 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)

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

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

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Popularity Example n 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

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

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

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

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Contribution Margin n 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”

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

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

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Adjust Sales Mix Without Cost n 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

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

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Yield Management A technique used to Maximize Room Revenue Used for reservations of a Perishable Commodity: –Hotel Rooms –Airplane Seats –Rental Cars.

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