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HOTEL BUSINESS REVIEW

OCTOBER FOCUS: Revenue Management

 

Hotel Statements: A Model of Profit Maximizing Premia and Discounts

By Bram Gallagher Economist, CBRE Hotels' Americas Research | October 2019

Rooms revenue per available room, reported as RevPAR, is perhaps the most scrutinized performance indicator in the hotel business. Although the true aim of a hotel's operation is to maximize profit, the wide availability and frequent reporting of RevPAR may make revenue the hotel manager's most immediate target. Revenue-maximizing is simpler to estimate and requires less information than profit-maximizing.

Specifically, no knowledge of the hotel operations is needed for revenue maximizing, only knowledge or beliefs about demand. For some situations, achieving revenue goals may be sufficient to increase profits, further entrenching the strategy of revenue maximizing.

Recently, increasingly tight margins and more sophisticated management practices have turned attention to bottom-line measures. Aligning the incentives of revenue managers and hotel owners requires a thorough understanding of the differences in the two approaches.

In this paper, I will formulate a model of the hotel business that makes these differences explicit. Then, examining hotel profit and loss statements from different groups of hotels, I will estimate the scale of the differences in ADR that result from the two strategies in different types of hotels.

Theoretical Considerations

The profit of the hotel can be described by the equation:

where TR is total revenue and TC is total cost. To distinguish between the RevPAR maximizing firm and the profit maximizing firm, it is useful to break the total revenue into the RevPAR component and the non-rooms component, producing the per-room, per-day profit equation:

Taking the total derivative yields:

where stars indicate optimal values for profit maximizing. The optimal price has two parenthetical components, the inverse semi-elasticity of occupancy with respect to rate and the net balance of changes to costs and non-rooms revenue for some additional occupancy. This first term, the inverse semi-elasticity term, is a measure of how sensitive potential guests are to ADR changes. Less sensitive guests will tolerate higher ADR than more sensitive ones.

This term also reflects that each individual hotel has some power to control its prices-i.e. the hotel will not completely empty with the slightest price increase. Some travelers may decide to stay elsewhere with a higher price, and some will pay the extra amount. Therefore, the price the hotel manager will set depends on the sensitivity its guests have to price as well as the balance of the second term.

The second term, made up of the difference in marginal costs and marginal non-rooms revenue, is intuitively straightforward to grasp. Each additional percentage point of occupancy may produce additional costs from staffing, cleaning, laundry and utilities. Additional occupancy also means that there are more guests to produce non-rooms revenues from food and beverage, guest laundry or the spa.

If the costs predominate, it is in the hotel manager's interest to raise prices. This reduces the total number of guests that incur additional costs while ensuring that the remaining guests each pay the more generous rate. On the other hand, the hotel manager will want to lower rates, potentially below the cleaning (variable operating) costs, if the non-rooms revenue produced by the additional guests is sufficiently high.

Rooms revenue maximizing is performed in the same manner, without costs and non-rooms revenue. This produces:

where daggers indicate optimal values for revenue maximizing. Although the semi-elasticity term looks identical to that of the profit maximizer, when facing the same group of potential guests, the terms will only be equivalent if either the marginal costs are exactly equal to the marginal non-rooms revenues or if both are zero.

A manager that maximizes RevPAR will also maximize profit if the hotel's operations approximate these conditions. A hotel conventionally represents a relatively large fixed investment-the hotel itself-and marginal costs may be close to zero or low enough to be offset by some incidentals. This is particularly true if there is some slack in the labor inputs. However, if there are important non-room revenue components, or the marginal costs become significant as the slack is taken up through managing efficiencies and increasingly scarce labor, revenue maximizing becomes a less accurate proxy strategy of profit maximizing.

For the cases where the marginal costs and non-rooms revenues are significant, the semi-elasticity term will also differ. Guests become more price-sensitive as prices increase and less price sensitive as prices decrease, so the semi-elasticity will tend to offset price changes motivated by marginal costs and non-rooms revenues. For example, high marginal costs above non-room revenues motivate an ADR premium over the revenue-maximizing price. The higher price increases price sensitivity among guests. The resulting net optimum premium still increases ADR, but by less than the full amount of the marginal costs.

Conversely, if non-rooms revenue motivates lower ADR, decreasing price sensitivity will allow the manager to attract extra guests with less than the full discount. The consistency of changes in the direction of price sensitivity means that the effect of occupancy on the balance of marginal non-room revenues and costs can be estimated to establish upper or lower bounds on the premium or discount that should be applied to a revenue maximizing ADR to produce the profit-maximizing ADR for groups of hotels.

Empirical Findings

The differences in the solution rates for the two strategies, ADR†-ADR*, can be approximated by estimating the effect of occupancy on the balance of expenses and non-room revenues:

This estimation makes a few simplifying assumptions. First, it assumes that the costs of accommodating another guest room are constant over the entire range of feasible occupancies. This may not be true if resources (chiefly labor) become increasingly scarce with higher occupancies.

Secondly, this estimation does not account for the elasticity component described earlier. If a manager suddenly considers cost, it's almost certainly true that 100% of the cost cannot be laid directly on consumers in the form of higher prices. Conversely, consumers will not receive the full amount of non-room revenue in the form of lower room rates. In either case, the additional expenses or incomes will be split between the hotel and the guests according to the consumer's elasticity.

In this sense, the model estimated from Equation 6 presents the opposite problem from the revenue-maximizer. Whereas the revenue maximizer does not account for costs but only consumer preferences, Equation 6 only accounts for costs and not consumer preferences. Therefore, the true premium or discount from the revenue maximizing result will lie somewhere between zero and the estimate produced with this model.

The model described by Equation 6 can still be used to estimate the direction of the price change as well as relative magnitudes among different groups of hotels. Estimation is carried out using the CBRE Hotels Trends® data, a database of around 120,000 hotel operating statements collected between 1994 and 2018. There is a potential for large biases to occur in the estimation due to omitted variables related to occupancy.

I mitigate some of these concerns through the use of a fixed-effects panel estimator that will control for time invariant differences. Hotels are also subsampled to isolate specific hotel groups. The hotels are here classified by property type and STR chain scale but could be grouped in any number of arbitrary ways. Exhibit 1 presents the results of the analysis in table form.

Overall, most of the coefficient estimates on occupancy are quite precise, with some exceptions. The simplest of the property types to interpret are the extended stay hotels. With few if any chances for non-rooms revenue, the marginal cost of letting one more room increases with the chain scale and, presumably, with the level of service. All chain scale segments of extended stay should maintain prices above revenue-maximizing levels, with higher segments raising prices proportionally higher.

Limited-service hotels, with a correspondingly limited opportunity for non-rooms revenue, follows a similar pattern, although the balance of costs and non-rooms revenue for an additional room is very nearly the same across upper midscale, upscale, and upper upscale hotels. This may be due to the chief differences in the segments resting in the fixed costs rather than marginal costs or due to expanded opportunities for non-rooms revenue in the upper chain scales.

Full-service hotels, on the other hand, have varied effects. With the exception of midscale full-service hotels, the addition of food and beverage revenues from additional guests outweighs the additional expense. Thus, the maximum premium that the manager of a full-service hotel should place on room rates is smaller than for the limited-service counterpart in the same chain scale segment.

Resort hotels, with the exception of upscale resorts, take this even farther. The balance of additional non-rooms revenues and expenses incurred from an additional room for upper midscale, upper upscale and luxury resorts is statistically indistinguishable from zero. In other words, the revenue maximizing ADR is also the profit maximizing ADR for these types of hotels, on average. The point estimates, while not statistically significant, are even negative for upper upscale and luxury resorts, suggesting that the extra non-rooms revenue from an additional guest may more than make up for the cost. In this case, ADR should be lowered from the revenue-maximizing level in order to maximize profit.

Conclusion

The considerations for revenue maximizing and profit maximizing are different in theoretically significant ways. Strictly speaking, the revenue-maximizing manager can completely ignore operations when setting price. Clearly, this has the potential to create a situation where unprofitable stays can be produced. This occurs when the additional costs incurred by the guest are not recouped by the rooms and non-rooms revenues. Conversely, it may be the case that some guests are excluded by ADRs that are too high when these guests are willing to more than make up for the cost of their stay through non-rooms revenues.

The simple statistical model derived from equations 1-5 and described in equation 6 can offer the manager some guidance as to the direction and scale of the price difference. When applied to a large sample of hotel operating statements, this model produced estimates that align with our intuition. Extended stay and limited-service hotels should always raise rates above the revenue maximizing price to increase profits. Full-service hotels should also raise rates, but frequently by a smaller amount. Resort hotels, with ample opportunities for non-rooms revenue, should maintain the revenue-maximizing ADR, or even lower ADRs to attract more guests.

The statistical model presented here is generalizable to any group of hotels and is seemingly robust enough to generate plausible estimates; however, this model has a significant limitation. It only estimates the operations portion of the manager's problem and ignores the demand elasticity. This provides only an upper limit on the price differential. Further research on demand elasticity could unite the two approaches, providing a two-part model that gives an estimate centered on the actual premium or discount that the profit-maximizing manager should apply to the revenue-maximizing price.

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In the event that you have chosen to have your membership automatically rebilled, unless and until you notify HotelExecutive that you wish to cancel or terminate your membership to HotelExecutive, you hereby agree and authorize HotelExecutive's Internet Payment Service Provider to automatically renew your membership to HotelExecutive on a continuing basis and to charge your credit card (or other payment means you have selected) to pay for the ongoing cost of your membership. You hereby further authorize HotelExecutive's Internet Payment Service Provider to charge your credit card (or other approved payment means you have selected) for any and all purchases of products, services and entertainment provided to in, at, through or in association with HotelExecutive.

13. PRIVACY POLICY

The following is the Privacy Policy for HotelExecutive

We can be reached via telephone, email, or online at our contact page. When you visit our site we do not log any information regarding your domain or email address. Information Sharing: We do not share user information with any third parties other than via press release distribution as described below.

Hotel Newswire is a newswire service that distributes press releases on behalf of our users. If you decide to submit a press release for distribution through our system we will transmit your entire press release including any personal information therein contained to our media contacts and online distribution points including search engines. This is the only redistribution of your information that we engage in. Your submission of press releases through our system indicates consent with this policy. The information we collect during your registration process is used to notify users about updates to our service and inform users of any special events hosted by Hotel Newswire. This information is not shared with other organizations for commercial or non-commercial purposes.

Cookies: Our system requires the use of cookies to enable the user to log back into our website to access information from the newswire, without having to log in each time using the required username and password.

If you do not want to receive email from us in the future, please let us know by following instructions included in our communication with you. Users who supply us with telephone numbers online may receive telephone contact from us regarding their account, or informing them of new products and services available on the HotelExecutive website. If you do not wish to receive such telephone calls, please edit your account and remove your phone number from your account profile. This can be done from your user account menu.

Ad Servers: We do not partner with or have any relationship with any ad server companies. From time to time, we may use customer information for new uses not previously disclosed in our privacy notice. If our information practices change at any time, we will post the policy changes to our website to notify you of these changes and provide you with the ability to opt out of these new uses. If you are concerned about how your information is used, you should check back at our website periodically.

Upon request we provide site visitors with access to all information (including proprietary information) that we maintain about them. Users can access this information by logging in to their account.

Security: We always use industry-standard encryption technologies while transferring and receiving user data exchanged with our site. We have appropriate security measures in place in our physical facilities to protect against the loss, misuse, or alteration of information that we have collected from you on our site. We do not store credit card information in our systems.

If you feel that this site is not following its stated information policy, you may contact us.

Stephanie Smith Create Your Hotel Digital Marketing Strategy Before Jumping Into Tactics
  • By Stephanie Smith, Founder & CEO, Cogwheel Marketing

    • Owners and operators know the importance of online presence, however, they don't always know how to efficiently and effectively impact revenue-generating change. Guests in the pre-booking phase, either transient or group, have so many touchpoints throughout their journey, where do we, as marketers, start?Understanding the Entire Online Space While we ideally want all guests to book direct on the first visit, there are many other places influencing their hotel selection process. Other realms are common, like OTAs (online travel agencies), social media, and Google. When you dig deeper, there are travel agencies, CVBs, reviews, public relations, partnership opportunities, and rates...

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Kara Freedman Maximizing Hotel-Influencer Partnerships: A Marketing Director's Perspective
  • By Kara Freedman, Complex Director of Marketing, Conrad New York Downtown & Conrad New York Midtown

    • In today’s digital landscape, influencer marketing has evolved from an experimental tactic to an essential strategy for hotels looking to reach engaged audiences. As a marketing director with years of experience in the hospitality industry, I’ve witnessed first-hand how the right influencer partnership can transform a property’s online presence and drive meaningful bookings. However, not all collaborations yield equal results, and the difference often lies in the approach. The relationship between hotels and influencers has matured significantly over the past few years. What began as simple exchanges—a free night in exchange for a social media post—has developed into...

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Robert O'Halloran Recruiting Is About Quality Hiring, Great Service and Efficient Cost
  • By Robert O'Halloran, Professor & Director, Hospitality Management, East Carolina University

    • Doesn’t it appear that everyone is hiring in the hospitality industry? Are we always hiring or are there not enough people, or is it that the jobs are not those that people want? Think for a moment about the attractiveness of the industry and what draws people to it. As is often repeated a driver of the attraction for the industry, is in part, due to the fact that some are drawn by their attraction to people. The interaction, the interest etc. Guo and Ayoun noted that the opportunity for meeting new people is one of the popular reasons why...

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Heidi Yorke The Influence of Gen Z on the Hotel Industry
  • By Heidi Yorke, Associate Professor- CHE, The State University of New York at Delhi

    • Gen Z (born 1997 to 2012) also known as Zoomers or post-millennials are entering the Hospitality world as guests and consumers. This generation is unique in that members have never experienced the world without the internet. They have been emersed in a digital age that equips them with access to an abundance of resources, choices and ability to connect with the world as they desire. It is crucial that Hospitality industry leaders recognize the importance of personalization and customized experiences for incoming generations. In hotel and lodging properties young adults are conditioned to converting most of their interactions socially,...

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Cynthia Mejia Today's Recruiting Sells The "Steam"
  • By Cynthia Mejia, Associate Professor, University of Central Florida Rosen College of Hospitality Management

    • Prior to Covid 19, the hospitality industry’s reputation struggled in terms of providing career opportunities and growth. Covid and post-COVID exacerbated this situation, doing no favors for the lodging industry. Documented facts include: As of April, 2024, the number of Accommodations and Food Service “quits” in the United States from 2020-2024 was the largest four-year period since 2000 (Source: Federal Reserve Economic Data – FRED) …. as thousands of former employee/associates did not return to the hospitality industry. For the first four months of 2024, the Accommodations and Food Service “quits rate” was more than double the average...

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Kelly Meerbott From Burnout to Flow: Why Your Grind Mindset is Killing Your Leadership
  • By Kelly Meerbott, Executive Leadership Coach, YOU Loud & Clear, Inc.

    • Let’s take off the starched white collar and get brutally honest for a minute. If you’re a hotel executive reading this between back-to-back meetings—eyes twitching from your fourth double espresso, inbox overflowing, calendar packed—consider this your permission slip to stop performing and start recalibrating. You’re not tired because you’re weak. You’re exhausted because you’ve been lied to. You’ve been conditioned to believe that relentless motion equals effective leadership. That staying late, skipping meals, and answering emails on vacation earns credibility. That the “grind” is the price of greatness. But here’s the real cost: Your leadership...

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Robert O'Halloran Complete the Circle: from Mentee to Mentor
  • By Robert O'Halloran, Professor & Director, Hospitality Management, East Carolina University

    • Have you had a mentor in your career? Perhaps it depends on what you call a mentor, someone you like or someone older with more experience that can give you feedback and help you sort out or vet an issue. In my career, I have known many people, but I can say I have not had a formal mentor. I have usually identified people that were “go to” people, someone to help sort out a tough situation and help see issues from all sides. The word “mentor” comes from the character Mentor in Homer’s Odyssey. When Odysseus, King of...

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