Hospitality Management Accounting_Ch 6 Summary
Terms in this set (13)
Objective #1 - Discuss the advantages and disadvantages of various traditional pricing methods used in the hospitality industry and understand the difference between long-range and tactical pricing.
Pricing theory suggests that the objectives of a hospitality operation should be to maximize sales of its rooms, food, and beverage menu items, control costs, and maximize profits. Ownership will provide a satisfactory return on their investment if prices are properly set.
1. A number of methods are used to set prices, each with advantages and disadvantages. These methods are commonly used because some operators find them easy to implement. Most of the following conceptually outlined methods may offer more disadvantages than advantages
a. The "intuitive" method is to simply set prices, which may be assumed correct as long as customers are willing to pay the prices being asked; its problem is that prices are not related to profits.
b. The "rule of thumb" method uses a technique where menu prices are based on the number of times the cost of the menu item should be covered to achieve a stated cost of sales %. Example: The cost of a menu item should be covered 2.5 times (or 250% higher than cost) to provide a 40% cost of sales. This concept is no longer valid in the highly competitive environment since little or not attention is given to the current competition, the value of money, or the maintenance of price changes to achieve desires profit levels, etc
c The "trial and error" method raises and lowers prices to find the effect on sales revenue and profits until a price is found, which apparently maximizes profit objectives and prices are then stabilized. This technique confuses customers and ignores economic conditions and the competition variables that will have an ongoing effect on sales revenue and cost of sales.
d. The "price cutting" method reduces selling prices to levels below the prices used by the competition and in essence ignores cost of sales. If variable costs are higher than selling prices, profits will quickly disappear. Some restaurant operations will set food menu prices below costs on the risky assumption that profits on alcoholic beverage sales will offset the losses, and a profit level will be maintained.
e. The "high-price" method charges higher prices emphasizing the differences that exist in their enterprise relative to competitors. Differences may stress menu quality, quantity, and service as well as location and atmosphere, which customers may equate to price.
f. The "competitive" method will match prices to those of competitors and use location, atmosphere, and other non-price related factors to increase their customer base. The disadvantage is a lack of knowledge of the differences that exist relative to product and associated costs between one operation and another.
g. The "mark-up" method applies to a known cost of sales percentage to determine the selling prices of a menu item. The MAJOR problem of this method is the use of a cost of sales percentage, which may not be up to date and correct.
Which is the right method to use in setting selling prices?
Techniques to set prices should be oriented to finding a balance between prices and profits and improves the overall profitability of an operation. Strategic and tactical pricing can assist in the development of a sound pricing strategy.
a. Strategic pricing is used on a long-run basis to set prices based on the conditions of the competitive marketplace and supply and demand.
b. A clearly defined pricing strategy develops form the financial objectives of the business and the understanding that the strategic objective may change over the long run.
c. The prices charged controls sales revenue thus, prices affect on the general financial results of business operation; the objective of covering operating costs and producing a net income that is acceptable return on its investment. Price levels also affect budgeting, working capital, cash management, and investment decisions.
Strategic objectives typically may fall into the following categories:
1. Maximize sales revenue.
2. Maximize profitability.
3. Maximize the return to the owners.
4. Maximize business growth in a new operation.
5. Maintain or increase market share of an established operation.
Tactical pricing is the use of short-term pricing policies needed by an operation to take advantage of situation that arise from day to day. These day-to-day situations might include:
1. Reaction to short-run price changes by competitors
2. Adjusting prices because of a new competitor.
3. Knowing how large a discount to offer business groups and still make a profit.
4. Knowing how much to increase prices to compensate for an increase in cost.
5. Knowing how much to increase prices to compensate for renovation made to a premise.
6. Adjusting prices to reach a new market segment.
7. Knowing how much to discount prices in the off season to attract business.
8. Knowing when to offer special promotion prices.
Objective #2 - Explain the concept of using net income after tax as a cost:
Profit (net income after tax) is the bottom line objective of an operation and, as such, profit represents the excess sales revenue after deduction of all operating costs; profit after tax can be treated as a cost and included in the operating budget. In essence, the operating budget can be developed beginning with a defined level of profit after tax and developed from the bottom line of an income statement upwards, covering all known costs and identifying the necessary sales revenue needed to cover all costs. This technique is called the "Bottom-Up" approach used to create a budgeted income statement, which will also set the sales pricing structure.
Objective #3 - Calculate total annual revenue required for a restaurant operation to cover all forecasted costs including net income after tax and convert the annual revenue to an average check amount.
1. The bottom-up approach requires a minimum of four basic assumptions:
a. Sales revenue represents 100% of an income statement.
b. All variable costs such as cost of sales, cost of wages, employee benefits, etc., can be expressed as a percentage of 100% of sales revenue.
c. All known non-variable costs, including net income after tax, and income tax can be identified.
d. The desired income after tax and an appropriate tax rate are known.
2. The needed information being know allows the calculations as follows:
a. Determining the percentage that known costs are as a percentage of sales revenue: Sales revenue at 100% - VC percentages = Known costs as a % of sales revenue.
b. Finding sales revenue: Known costs/ Known cost % = Sales Revenue
c. Finding tax with the net income after tax and tax rate known:
Net Income [AT] / 1- Tax rate = Operating income - Net income [AT] = TAX
or Operating income x tax rate = Tax
Objective #4 - Use existing information to calculate an average check per meal period and explain the effect sales mix of the various menu items will have on the average check.
1. Knowing the forescasted sales revenue allows us to forecast an overall average check or an average check per meal period. A 100-seat restaurant had total sales revenue of $824,850 and served lunch and dinner 6 days a week for 52 weeks a year. Lunch provides 40% of total sales revenue with a seat turn over of 1.25 and dinner provides 60% of total sales revenue with a 0.75 seat turnover.
a. Average Check: Total Sales Revenue/Seats x turnover x Operating days $824,850/ (100 x 2 x 6 x 52) = $824,850/ $62,400 = $13.22
b. Meal period % of total sales revenue x Total Sales Revenue / Seats x turnover x days open
Lunch: 40% x $824,850/ 100 x 1.25 x 6 x 52 = $329,940/$39,000 = $8.46
Dinner: 60% x $824,850/ 100 x 0.75 x 6 x 52= $494,910/$23,400 = $21.15
2. Verification of average checks by meal period:
Lunch: 100 seats x 1.25 turnover x 312 days x $8.46 = $329,940
Dinner: 100 seats x 0.75 turnover x 312 days x $21.15 = $494,910
Total $329,940 + $494,910 = $824,850
3. When customer selections of menu items change, a change in sales mix has occurred. If the change increases the cost percentage, the gross margin is expected to decrease. IF the cost of sales decreases, the gross margin is expected to increase. It is preferable to maximize the sale of menu items with the higher gross margin.
Objective #5 - Discuss the considerations to be kept in mind when pricing a menu item and calculating seat turnover figures. Also discuss integrated pricing for a restaurant.
1. One of the common methods of calculating menu prices depends on calculating the specific cost of each menu item to establish an items standard cost. Each menu item's selling price is calculated by dividing its cost by a cost percentage. If the cost of a menu item is recovered on a 250% markup, the cost percentage will be 40% (100%/250%). If a menu item's cost was $4.50, the selling price would be $4.50/40% or $11.25. In most cases, it may not be practical to apply a standard cost percentage across the total menu, since it is normal for the cost percentages to vary based on different cost and markup percentage for different menu items.
2. Increasing seat turnover is one way to offset a declining average check or customer spending. Seat turnover is found for a specific time period by dividing the total guests for the period by the seats available for the period. A turnover can be calculated daily, weekly, monthly, quarterly, semi-annually, or annually. [Total guests / (Total days x seats available).
3. Integrated pricing means that products should not be priced independently of each other. This is particularly true if the beverage operation is closely tied to the food operation, which means that dining customers generally provide most of the beverage sales revenue. In such cases, food and beverage prices should complement each other to achieve profit objectives.
Objective #6 - Complete a menu engineering worksheet and discuss how to adjust the menu to respond to the results
The menu engineering worksheet, when completed, allows an analysis of each menu item with the major emphasis on the gross margin. On an individual basis, the format shows:
a. The item's menu mix percentage - [Individual items sold/Total menu items sold].
b. The item's food cost.
c. The item's selling cost.
d. The item's contribution margin: [Selling price - Cost].
e. The item's menu cost: [Cost x Number sold].
f. The item's menu revenues: [Selling price x Number sold].
g. The item's menu contribution margin: [ Item CM x Number sold].
h. The item's contribution is evaluated as "L" for low or "H" for high. The high or low category is assigned after comparison to the total average contribution margin of all items on the menu.
i. The item's menu mix category is designated as "L" or "H" after its menu mix percentage is compared to the average popularity and is calculated as; [(100/items) x (70%)].
2. Based on the information identified for each menu item, the individual item's costs column is totaled to report the total cost of the menu items sold. The individual menu item's menu revenues are totaled to report the total menu sales revenue. Additional calculations are made to show the overall food cost percentage for the period [Total menu costs/ Total menu sales revenue], the average total contribution margin of the menu [Menu CM/ Total number of menu items sold], and to the average popularity of all individual menu items [(100/Menu items] x (70%)]. The profit factor is also calculated to show each individual menu item's share of the total menu contribution margin [Menu total CM / Number of menu items = Average contribution margin) / (Menu items total CM / Average CM = profit factor of each menu item)].
3. Classifications are then assigned to each menu item based on contribution margin and popularity.
a.Stars are items with an "H", higher than average contribution margin, and an "H", higher than average popularity, that is "HH" items.
b. Plow horses with an "L", lower than average contribution margin but and "H", higher than average popularity that is "LH" items.
c.Puzzles are items with an "H", higher than average contribution margin, but "L", lower than average popularity that is "HL" items.
d. Dogs have both "L", lower than average contribution margin and "L", lower than average popularity that is "LL" items.
4. To provide effective information for an analysis of the menu items and thus the menu as a whole, a menu engineering worksheet should be completed for each meal period. A separate worksheet should be completed for each menu category, such as appetizers, entrees, and desserts for each menu period.
Ojbective #7 - Calculate an average room rate to cover all forecasted costs including net income after tax and convert the average rate to an average single and average double rate.
The pricing approach discussed earlier can also be used to calculate room rates. It should be noted that apart from selling rooms during the day for meetings or similar purposes, the supply of rooms is limited to a specific number, and rooms turnover cannot be increased as can seat turnover in a restaurant.
1. The "$1 per $1,000" method - is one of the older methods of setting room prices. This method considered the greatest cost in the hotel/motel was the investment in the property and building(s) and assumed that the cost of the investment and room rates were directly related. The $1 per $1,000 developed as a rule of thumb that for each $1,000 of the investment cost, $1 would be charged as a base room rate. If the investment in a 100-room hotel were $2,000,000, the average cost of construction per room would be $20,000 ($2,000,000 / 100) or $20.00 per room ($20,000 / $1,000).
2. The disadvantage in this method - is that it is tied directly to historical costs, and investment costs. The current costs, as well as current financing costs, are not considered. The Bottom-Up or Hubbart formula developed by the American Hotel and Motel Association some years ago effectively overcomes the pit falls of the $1 per $1,000 method.
3. The Bottom-Up approach for room rates uses the same basic techniques as was used to set restaurant prices. The firs step is to find an average room rate based on estimated room occupancy. If a 50-room operation required sales revenue of $854,800 and room occupancy is estimated at 70%, the number of rooms sold will be:
50 x 70% x 365 = $12,775
Sales Revenue / Rooms to be sold = 854,800 / 12,775 = $66.91
a. $66.91 represents an average room rate and not a rate specific type of room. Most large hotels will have a variety of sizes and types of rooms available, each having single and double occupancy rate.
Objective #8 - Calculate room rates based on the basis of room square footage
Another method to determine the room rates of different sized rooms is to allocate daily rooms revenue based on square footage.
Number of Rooms x square footage= total square footage
Total Sq Ft / Occupancy percentage = Sq ft per day to sell
Day Revenue / sq ft to be sold = $ amount per sq ft
Room rate: Sq ft x $ amount of sq ft = room rate
(330 sq ft x $.0219) = $72.27
Objective #10 - Discuss room rate discounting and calculate occupancy percentage for a discount grid. Calculate a potential average room rate and discounted rates for various market segments.
The discounting of rooms on any given day will not achieve the maximum potential revenue for the night. The purpose of calculating an equivalent occupancy rate is to determine the occupancy rate needed to hold room sales revenue, less marginal (variable) costs, constant if the rack rate is discounted.
Equivalent Occupancy =
Rack Rate - Marginal Cost / [Rack rate x (1- Discount %)- Marginal cost]
EO = Max rate - VC per room / [Max rate x (1-Discount %) - VC per room]
Object #11 - Discuss some of the important considerations in pricing such as objectives of an organization, elasticity of demand, cost structure, and competition.
1. Other considerations - the determination of selling prices for food, beverage, and room rates to ensure an adequate return on investment has its shortcomings. Because of the simplicity of the return on investment and the markup methods, they ignore many other factors that should be taken into consideration when establishing prices.
a. Assumptions are made regarding the occupancy of rooms and seat turn over during the process of creating and operating budget. Adjustments can be made during an actual operating period to prices and room occupancy; however, they will produce different variations from those used in the initial calculations.
b. In a typical business situation, a price increase may result in a further decrease in demand for rooms reducing the actual occupancy still further. In normal economic situations, when all other things are equal, the correct thing to do is lower prices to stimulate demand as demand increases.
c. If wrong decisions were made as a result of pricing, a decrease in room occupancy, seat turnover, and profit will result. Similarly, missed profit opportunities may result because prices were not raised above the calculated prices using the markup pricing when market conditions are such that customers were willing to pay those higher prices.
d. Markup pricing can work during periods of low inflation if economic activity is not declining at the same time, and when there is an excess supply of rooms or restaurant seats exists. Many hotels have begun sophisticated systems that take into consideration all relevant factors to be evaluated in the pricing decision.
2. Elasticity of demand - is the demand response for a product when prices are changed. A large change in demand resulting from a small change in price is referred to as elastic demand. A small change in demand following a large change in price is referred to as inelastic demand.
a. The specific cost structure of a business is a major factor that tends to influence pricing decisions. Cost structure refers to how costs are classified as fixed or variable costs.
b. Fixed costs are those that do not normally change in the short-run. Variable costs increase and decrease in proportion to increases and decreases in sales.
c. A business with high fixed costs, relative to variable costs, may experience profit instability as sales revenue increases or decreases. Having the right prices for the right market becomes increasingly important. In the short, variable costs are covered to produce long-run net profits.