Cost Approaches to Pricing

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Cost Approaches to Pricing

• Chapter 8

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Pricing Questions

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

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Pricing Questions

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

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Pricing Questions

• Will Departmental Revenue Maximization Result in
  Revenue Maximization for the Hospitality Firm?

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Pricing Questions

• What Is Integrated Pricing?
• What Is Price Elasticity of Demand?

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Price Elasticity of Demand

• Measures How Sensitive Demand Is to Changes in
  Price
• Either Elastic or Inelastic

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Price Elasticity of Demand

• 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

• Assume Hotel Sells 1,000 rooms _at_ 30
• 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

• 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

• 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

• Competition, Uniqueness Affect Elasticity
• When Change Prices, Test for Elasticity

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Informal Pricing Methods

• Competitive
• Intuitive
• Psychological
• Trial and Error
• Follow The Leader

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Informal Pricing MethodsFour Modifying Factors

• Consider First
• Historical Price Changes
• Guest Perceptions (Price/value)
• Competition
• Modify by Rounding

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Mark Up Approaches

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

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Multiplier

• 1 / Desired Food Cost Percentage
• Example 1 / 40 2.5

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Alternative to Multiplier

• Divide Costs By Desired Food Cost Percentage
• Example 3.00 Cost / 40 7.50 Selling Price

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Ingredient Mark Up Approach

• 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

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

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Mark Up Approaches

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

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Prime Ingredient Mark Up Approach

• 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

• 1 Per 1,000 Cost Per Room
• Doesnt Consider Current Value
• Doesnt Consider Other Services
• Assumes 70occupancy
• Assumes Profitable Food and Beverage

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Rooms Pricing Traditional Method

• 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

• Bottoms Up
• Start With Profit
• Determine Pretax Profit

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Rooms Pricing Hubbart Formula

• Add in Fixed Charges
• Add in Undistributed Operating Costs
• Estimate Non Room Income (Loss)
• Sum Is Rooms Department Income

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Rooms Pricing Hubbart Formula

• Rooms Revenue Equals Rooms Income Plus Rooms
  Department Costs
• ADR Room Revenue / Rooms to Be Sold
• See page 371 for example

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ADR to Single and Double Rates

• (Singles Sold Single Rate) (Doubles Sold
  (Single Rate Price Differential)) Average
  Rate Rooms Sold
• Solve for Each Rate

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Rate Calculation

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

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Rate Calculation

• Let X Single Room Rate
• 90x 60(x 10) 67.81 150
• 90x 60x 600 10,171.50
• 150x 9,571.50
• x 63.81 Single Rate
• x 10 73.81 Double Rate

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Yield Management

• Increasing the Rooms Revenue

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Yield Management

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

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Why Yield Management ?

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

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What We Gain Is

• 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

• Option 1 Accept the Group
• Group Rooms 20 55.00 1,100
• Business Rooms 80 80 6,400
• Total 7,500
• Option 2 - Reject the Group
• Business Rooms 95 80 7,600
• 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

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

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Breaking Out of the Box

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

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Selling the Entire Menu

• Drives up Check Average and That Is Good
• Additional Points of Service Reduces Seat
  Turnover
• Waiting Time for Table May Cause Loss of Customer

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Selling the Entire Menu

• 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

• Ratio of Cost of Goods Sold to Sales
• Gross Profit Is Sales Minus Cost of Goods Sold
• Objective Is to Increase Gross Profit

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Food Cost Percentage

• Do You Deposit Percentages or Dollars?
• Item A Costs 4 and Sells for 12 or 33
• Item B Costs 8 and Sells for 20 or 40
• Which One Would You Rather Serve (All Other
  Things Being Equal)?

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Labor Cost

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

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Labor Cost

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

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Menu Engineering

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

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Popularity

• Item Is Popular If Individual Items Sales Mix
  Exceeds 70 of the Average Popularity
• Average Popularity (100 / Number of Items)
  (70)

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Popularity Example

• 10 Items
• Average Popularity (100 / 10) (70) 7
• If Individual Sales Mix Is gt 7, The item has
  HIGH Popularity
• If Individual Sales Mix Is lt 7, The item has LOW
  Popularity

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Contribution Margin

• Selling Price Minus Variable Costs or Gross
  Profit
• Compute for Each Item

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Weighted Average Contribution Margin Calculation

• Compute Individual Contribution Margin
• Multiply Item Contribution Margin by Number of
  Item Sales
• Result Is Total Contribution Margin

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Weighted Average Contribution Margin Calculation

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

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Contribution Margin

• Compare Against Weighted Average Contribution
  Margin for Menu Section Engineered
• If Item CM Is gt WACM - Label HIGH
• If Item CM Is lt WACM - Label LOW

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Classifications

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

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Menu Engineering Concerns

• Ignored Variable Portion of Labor Cost
• Inconsistent With Performance Evaluation
• Difficult to Collect Data
• Extensive Calculations
• So What Theory

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Adjust Sales Mix Without Cost

• Create Signature Item High in Contribution Margin
• Train Staff on Contribution Margin Principles
• Provide Periodic Tastings to Public for Items Low
  in Popularity but High in Contribution Margin

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Adjust Sales Mix Without Cost

• Use Internal Marketing Tools
• Reevaluate Pricing Strategies Using Data, Profit
  Factor, and Elasticity of Demand
• Consider Profitability When Printing Menus

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