Establishing Room Rates Part I

Establishing Room Rates 

• Any serious exploration of hotel room rates and their management must include basic information about room rate economics. Room rate economics recognizes that, when the supply of hotel rooms is held constant, an increase in demand for those rooms will result in an increase in their selling price. Conversely, when supply is held constant, a decrease in demand leads to a decreased selling price.
• Understanding the law of demand is critical because, unlike managers in other industries, hoteliers cannot increase their inventory levels of rooms (supply) in response to increases in demand.
• Hotel managers must also understand that their own inventory of rooms is highly perishable. If a hotel does not sell room 101 on Monday night, it will never again be able to sell that room on that night, and the potential revenue that would be generated from the sale is lost forever.
• Since information about supply is readily known, and since forecast data helps to estimate demand, you can learn to accurately gauge the relationship between guestroom supply and demand. Using this information, you can determine the best rates to be assigned to each of your rooms.
• A rack rate is the price at which a hotel sells its rooms when no discounts of any kind are offered to the guests. Rack rates, however, will vary based upon the type of room sold. Figure 8.1 lists the rack rates that are associated with Paige Vincent’s Blue Lagoon Water Park Resort based on her room mix (the variety of room types) in her hotel.
• In Figure 8.1, rack rates vary by bed type, by amenities, by location and by size.
• Some hotels have very strong seasonal demand. These hotels will have a seasonal rate that is higher or lower than the standard rack rate and that is offered during that hotel’s highest volume season.
• In some cases, it makes sense for hoteliers to create special event rates. Sometimes referred to as “super” or “premium” rack, these rates are used when a hotel is assured of very high demand levels (e.g., Mardi Gras in New Orleans and New Year’s Eve in New York City).
• Hotels often negotiate special rates for selected guests. In most cases, these negotiated rates will vary by room type. In addition to rack and negotiated rates, hotels typically offer corporate rates, government rates, and group rates.
• Some hotels have great success “packaging” the guest rooms they sell with other hotel services or local area attractions. When a hotel creates a package, the package rate charged must be sufficient to ensure that all costs associated with the package have been considered.
• A hotel’s revenue managers can also create discounts at various percentage or dollar levels for each rate type we have examined.  The result is that a hotel, with multiple room types and multiple rate plans, may have literally hundreds of rates types programmed into its property management system.
• A property management system (PMS) is a computer system used to manage guest bookings, online reservations, check-in/check-out, and guest purchases of amenities offered by the hotel.
• In addition, the use of one or more authorized fade rates, a reduced rate authorized for use when a guest seeking a reservation is hesitant to make the reservation because the price is perceived as too high, can result in even more room rates to be managed.

The Hubbart Room Rate Formula

• Hoteliers want to maximize their profits and thus collect the highest rate possible for their rooms. However, the rate cannot be so high that it discourages guests from staying at the hotel, nor can it be so low that it prevents the hotel from making a profit.
• The room rate charged should not result from a mere “guess” about its appropriateness but, ideally, should evolve from a rational examination of guest demand (because it is the most significant factor impacting room rates) and a hotel’s costs of operation with specific and accurate assumptions.
• Recognized by hoteliers world-wide, the Hubbart Room Rate Formula for determining room rates was developed in the mid-1950s by the national hotel accounting firms of Horwath & Horwath and Harris Kerr Forster.
• The Hubbart formula is used to determine what a hotel’s average daily rate (ADR) should be to reach the hotel owner’s financial goals.
• To compute the Hubbart formula, specific financial and operational assumptions are determined. These include dollar amounts for property construction (or purchase), the total cost of the hotel’s operations, the number of rooms to be sold, and the owner’s desired ROI on the hotel’s land, property, and equipment.
• The Hubbart formula is a “bottom-up” approach because it literally requires you to completely reverse the income statement from the bottom up (see Figure 8.2 for the comparison between the normal format of the income statement and the bottom-up format for the Hubbart formula).
• Using the bottom-up approach, you start by calculating the desired net income based on the owner’s desired return on investment (ROI) and work your way up the income statement by adding back estimated taxes, non-operating expenses, and undistributed operating expenses and then subtracting out estimated operated departments income (excluding rooms). The result will be the estimated operated department income for rooms.
• Next, you can separate the estimated operated department income for rooms into rooms revenue and rooms expenses.  Once rooms expenses are subtracted out, rooms revenue will remain. This revenue can then be split again to determine number of rooms to be sold and, finally, ADR.
• The resulting ADR is the average price that should be charged for your rooms in order to achieve the owner’s desired net income (ROI).
• To illustrate the Hubbart formula, the Blue Lagoon Water Park Resort’s Income Statement is shown in Figure 8.3.  Assume for the sake of calculating this formula that we do not know the operated department income for rooms, rooms revenues, or rooms expenses. Remember, the point of using the Hubbart formula is to predict rooms revenue, and subsequently, ADR. 
• For a detailed analysis of the Hubbart formula, see Go Figure! in the text.

• For a summary of the Hubbart formula calculations for the Blue Lagoon Water Park Resort, see Figure 8.4.
• The seven steps required to compute the Hubbart formula are summarized in Figure 8.5.
• The Hubbart formula is useful because it requires managerial accountants and hoteliers to consider the hotel owner's realistic investment goals and the costs of operating the hotel before determining the room rate.
• The formula has been criticized for relying on assumptions about the reasonableness of an owner’s desired ROI and the need to know expenses that are affected by the quality of the hotel’s management.  Another criticism is that the formula requires the room rate to compensate for operating losses incurred by other areas (such as from telecommunications).
• The formula’s primary shortcoming may relate to identifying the number of rooms forecasted to be sold.  The number of rooms sold is dependent, to a significant degree, on the rate charged for the rooms. However, the Hubbart formula requires that the number of rooms sold be estimated prior to knowing the rate at which they would sell.
• Despite its limitations, the Hubbart formula remains an important way to view the necessity of developing a room rate that:

Ÿ  Provides an adequate return to the hotel’s owner(s)

Ÿ  Recovers the hotel’s non-operating expenses

Ÿ  Considers the hotel’s undistributed operating expenses

Ÿ  Accounts for all the hotel’s non-room operated departments income (or loss)

Ÿ  Results in a definite and justifiable overall ADR goal

The $1.00 per $1,000 Rule

• One alternative way that hoteliers have historically determined room rate is the $1.00 per $1,000 rule.  This rule states that, for every $1,000 invested in a hotel room, the property should charge $1.00 in ADR.

·         Advocates defend the $1.00 per $1,000 rule of thumb because areas in which building or purchase costs are higher tend to be the areas where ADRs can also be higher.

·         The dollar-per-thousand rule is most accurate for hotels that have high occupancies, high ADRs for their area of operation, and are newly built. On the other hand, large, old properties frequently fail to achieve the dollar-per-thousand standard.

• Despite some limitations, the $1.00 per $1,000 rule does reflect the tendency for hotel buyers to discuss hotel selling prices in terms of a hotel’s cost per key, which is the average purchase price of a hotel’s guestroom expressed in thousands of dollars.  Cost per key is also frequently called average cost per room.

Go Figure!                                                                                                                            

Average Cost per Room is calculated as follows:

Purchase Price          

Number of Rooms     = Average Cost per Room

Then, ADR is calculated as follows:

            Average Cost per Room

                        $1,000                         = ADR

                                                                                                                                               

• It is important to recognize that the rate computed using the $1.00 per $1,000 rule does not become the hotel’s rack rate. Instead, it is the overall ADR that the hotel must achieve when its sells all of its various rooms at all of their respective rates.

Alternative Room Rate Methodologies

• Additional historical methods of rate determination include those based upon the square footage of guestrooms and rates determined by various “ideal” sales levels of the different hotel room types available to be sold.
• However, today’s hotel room rate structures have been changed, and changed forever, by the advent of the Internet as the most popular method used for selling hotel rooms.

Web-Influenced Room Rate Methodologies

• Properly pricing hotel rooms is critical to attracting first time and repeat business.  However, close examination of many pricing tactics would reveal that they often use one or more of the following non-traditional, non-cost methods to establish rates:

·         Competitive Pricing.  Charge what the competition charges.

·         Follow the Leader Pricing.  Charge what the dominant hotel in the area charges.

·         Prestige Pricing.  Charge the highest rate in the area and justify it with better product and/or service levels.

·         Discount Pricing.  Reduce rates below that of the likely competitors.

·         As a result of the Internet, consumers can easily compare prices, but so can a hotel’s major competitors.  Gone are the times when night auditors or others on the front office staff conducted the nightly call-around to ask other hotels’ night auditors what their hotels were charging for rooms and then used that information (often of questionable accuracy) to make decisions about what their own hotel’s rate offerings should be.

·         While the call-around was standard practice as late as the early 2000s, consider modern hoteliers utilizing one of the many websites similar to http://www.Travelaxe.com and others that allow him/her to easily:

·         Select competitive hotels whose rates are to be monitored

·         Obtain real-time room rates offered by these hotels on any number of travel websites advertising the rates

·         Search the rates and sites as frequently as desired

·         Perform rate comparisons by specific check-in and check-out dates

·         Assess rate comparisons based upon room type

·         Assess rate comparisons based upon date of guest arrival

·         Guests care very little how much it “costs” a hotel to provide its rooms. They care about the lodging value they receive. As a result, a hotel’s rates are heavily influenced by the laws of supply and demand.  If, on a given Saturday, all similar hotels in a market area offer guest rooms in the range of $100 - $150 per night, it would be difficult for a single hotel of the same type to command a rate of $250 per night even if its operating costs justify this rate.

·         The rate at which a hotel first sells its rooms to guests may not be the rate those guests will ultimately pay. A guest can make a hotel reservation at a given rate, and, every day until the date of arrival, can go online to shop for an even lower price for the same room.  If a lower rate were to be found, the guest could re-contact the hotel, cancel the original reservation, and secure the new, lower rate.