Michigan State University Extension
Tourism Educational Materials - 33119706
06/06/02
Management Through Figures in the Lodging Industry
Michigan State University
McIntosh, Robert W.
Extension Specialist, Tourist and Resort Program
1972
E0656
33.11
33.41
INTRODUCTION
Every manager wants his business to succeed. Yet, there
are wide variations in profitability among similar
businesses. Why?
One of the most common causes for such variation is the
manager's lack of understanding of accounting statements
and how to put this information to work. The most
successful managers spend many hours each week studying
financial statements. Using various analysis techniques,
they are able to obtain data and formulate decisions
which will increase the earning power of the business.
Developing this improved managerial ability requires
fluency in the language of accounting, understanding and
practice in the use of accounting statements, formulation
of profit objectives, capital budgeting, and experience
in applying and measuring the effects of specific
financial decisions. Since the composition of assets are
largely long-lived assets (compared to inventory,
receivables, and cash), advantageous solutions to
depreciation and obsolescence of long-lived assets are
necessary.
Your own satisfaction and financial success as the
manager of a motel, hotel, resort or similar lodging
business depends largely upon your ability to use figures
and financial statements. This bulletin is designed to
help you develop such skills. Full application of the
concepts and methods described here can only be achieved
through a clear understanding of terms which are used in
accounting and financial management. A glossary of
accounting language for the lodging industry can be found
on later pages.
ACCOUNTING AND THE MANAGEMENT FUNCTION
Accounting services provide an essential part of the
information system that a manager needs to make rational
conclusions and strategic decisions. To formulate the
best short and long-range goals and plans for your
business, you must be concerned with internal controls,
financial planning and objectives, financial statements
and their uses, break-even, setting rates and prices,
capital budgeting, and managing fixed assets.
Internal Controls
Rigorous internal controls, such as accounting for all
funds, are powerful agents of management. Thus,
discretion is important in the supervision of persons who
are involved in handling funds and preparing monetary
reports.
These internal controls are the everyday working tools of
the manager and those supervisors working under him who
are responsible for the orderly, accurate recording and
reporting of bookkeeping transactions. The number and
form of such internal controls depend upon the nature and
size of the business. Some areas of control:
1. Cash received--Cash reported as received by clerks,
waitresses, cashiers or others should be independently
reconciled with the recording of the amounts they "should
be reporting," as received. All cash receipts should be
deposited intact in the bank, thus making payments out
of cash receipts impossible.
2. Bank reconciliations--Made monthly by someone not
involved in cashiering or accounting.
3. Receipts and payment vouchers--Should be recorded by
the accountant, but not handled or controlled by the
accountant.
4. Copies of purchase orders--Sent to the receiving clerk
or steward without showing quantities ordered. Quantities
actually received are entered by the receiving clerk
based upon inspection and count. Additional checks can be
made by having another independent count made by the
storeroom clerk as the items are delivered to the
storeroom. Reports are then compared with original orders
to be sure all items ordered were received.
5. Other departments -Supervisors in other departments
can be designated as property accountability officers and
be required to maintain essential records of property.
These records should include location, number, use,
condition, and replacement schedule. However, such
officers should not have control of property purchase,
transfer, or disposal. Avoid time-wasting duplication of
internal checks. The only purpose of such checks is to
insure honesty and accuracy.
Planning
With good accounting, the manager is in a superior
position to foresee what is likely to happen. Armed with
accurate and complete financial data and ratios, he can
consider a number of alternative courses of action and
fairly accurately predict outcomes. Managerial creativity
is an essential success ingredient and the new goals must
be reasonably attainable. To check the success of a new
plan of operations, several accounts will need to be
reviewed. Be sure that these accounts correspond exactly
with past historical records so that the effect of the
new plan can be determined.
FINANCIAL OBJECTIVES
The manager has two financial objectives---liquidity and
profitability.
Liquidity
Bills owed by the business should be paid when due. Thus,
cash must be kept on hand to pay bills and keep the good
name and credit reputation of the business. However, too
much cash on hand may not be desirable since these funds
could be put to work to maximize the present value of
future earnings.
An important concept to understand is that of cash flow.
Cash flow is the profit left after federal, state, and
local income taxes--the amount of cash actually available
during an accounting period for debt reduction or other
non-operating usage.
If cash flow is readily known and can be predicted with
reasonable accuracy, then the manager can determine what
portion of the cash flow will be available to finance new
additions, expansion, improvement, or other investments.
Cash flow includes funds represented by depreciation
charges (a non-cash expense), even though depreciation is
not usually considered a source of funds.
While an increase in depreciation charges does not
proportionally increase cash flow, there would be an
initial increase in cash flow from an increase in funds
generated after income taxes (providing the business
shows a profit). This is because the increase in
depreciation charges reduces the profit subject to income
tax.
A forecast of cash inflow and outflow is called a cash
budget. The record of actual amounts of cash transactions
which occur during a given period is called a cash
receipts and disbursements statement. Your monthly bank
statement is actually such a cash receipts and
disbursements schedule. The difference between inflow and
outflow of cash equals the change in the cash balance
between opening and closing dates of the bank statement.
These cash statements are not the same as income
statements. To obtain an accurate statement of net
income, charges---whether cash or non-cash---are made
against revenue so that revenue and expense items are
allocated to the fiscal period when incurred. Thus,
profit as shown on the revenue and expense statement, and
cash produced from operations are rarely the same.
Cash balances in most service businesses vary seasonally.
Various adjustments are necessary so that bills can be
paid when due, regardless of the month. Advantageous
sales or purchasing schemes may have to be postponed
unless cash is available or can be easily borrowed. The
manager must constantly appraise his liquid position and
maintain his cash balance so that borrowing can be
readily accomplished, if necessary. However, if his cash
balance is in good order, borrowing may not be necessary.
Profitability
The second financial objective of the manager is to
assure that the business returns a satisfactory long-run
return on investment---at least as high as the risk
justifies. This requires two types of managerial effort:
1) An investment of funds in a business that makes the
profit as large as possible, without jeopardizing
necessary liquidity, and
2) the highest possible rate of return on the investment
of funds without incurring too much risk. The nature of
the external environment will affect returns
considerably.
Making the Most Profit
The greater the profit on each dollar of sales and the
more sales made for each dollar of operating assets (such
as land, buildings, furnishings, equipment, and
inventories), the higher the rate of return on each
dollar of operating assets. Methods of maximizing profits
include the following:
1. Improving margin of profit on sales---This can be
accomplished by increasing sales volume more than
expenses. Since many of the expenses of lodging
businesses are fixed, even small increases in sales will
result in improved profits. For example, new, more
effective advertising, might increase sales.
2. Reducing expenses proportionally more than sales--
-Careful examination of each expense item may suggest
methods by which savings can be made with no detriment to
guest service and satisfaction. The use of non-iron
sheets might be a good possibility.
3. Improving turnover---In restaurants and dining rooms,
prompt table clearing makes dining accommodations more
quickly available, for a faster turnover and higher gross
sales.
4. Reducing your investment in certain operating assets--
-If more frequent deliveries can be made by your
suppliers, inventories can be reduced-in effect, your
supplier carries your inventories. This cash can then be
invested in interest-bearing securities or in
improvements or expansion which will help maximize the
present value of future earnings. However, sufficient
cash must be on hand to meet expenses.
5. Raising (or lowering) prices---Problems in the
accommodations industry are never solved by lowering
rates and prices. Experience has shown that demand for
rooms does not rise proportionally. Thus, a review of
your pricing policies (discussed later in this bulletin)
could result in improved profits. Sometimes, small
increases are not resented by guests and customers, but
make a big difference in earnings.
Receiving a Higher Rate of Return
The other avenue to greater profits is to increase your
rate of return on invested capital. Since this involves
certain risks, a compromise must be made between profits
and risk. If you can attract outside money by forming a
corporation and selling preferred stock, you may be able
to pay a lower rate of return on the preferred stock than
the business earns from its present invested capital. For
example, suppose your present earnings from the business,
after income taxes, is 5 percent. If more money is needed
to expand or improve the business and if the corporation
could sell shares of preferred stock on which 4 percent
dividends are paid, then the corporation receives
"leverage" or earns more from the business than is paid
for capital.
The legal form of the business does not really matter.
Whenever you can obtain outside funds on which a limited
return is to be paid, and exceed this rate by the
earnings from the business, you will receive a greater
return and favorable leverage.
FINANCIAL STATEMENTS AND THEIR USES*
* Adapted from Uniform Classification of Accounts for
Motels and Motor Hotels, Washington: Motel Association of
America, 1965.
Every lodging manager knows that he must keep accurate
records of business transactions for tax purposes. In
addition, these accounts can provide valuable guides to
increased profits.
From the managerial point of view, a good accounting
system should enable the operator to:
1. Have a complete and permanent record of business
transactions.
2. Safeguard his assets through internal control.
3. Plan and control every phase of his operation for
greatest profitability.
Permanent Records
The first of these requirements is basic. Without an
initial recording of transactions, there is no way to
carry out the major functions of a classification of
accounts. The actual method of recording is secondary,
for it is of little value in itself. Only the results of
recorded transactions are of value to the manager.
The primary purpose of record-keeping is to satisfy legal
requirements. Law-making bodies demand written evidence
of the history of a business for analysis for tax
purposes and other reasons. Many businessmen are unable
to make the best use of these records because they do not
keep them up-to-date sufficiently to get the needed
information at the proper time. Thus, the other two main
purposes of accounting records are defeated.
Safeguarding Assets
The second function of a well designed accounting system,
safeguarding assets, is accomplished through various
methods of checks and duplications, and is needed to
overcome human error--both intentional and accidental.
Many smaller lodging operators who own their businesses
and operate them only with members of their immediate
families, may scoff at the mention of a need for a system
of check and re-check. But, they overlook the fact that
such a system can help them detect "honest" errors. In
addition, this system can expose fraudulent activities of
hired employees. It is this phase of accounting,
safeguarding assets, that is lacking in many operations.
Managers who fail to place any significance on
depreciation or maintenance policies often are unable to
finance necessary replacement items. A very common error
is to consider cash in the bank and net profits as the
same thing.
Planning and Controlling Operations
The third function of an accounting system is to plan and
control operations. Here, the lodging industry shares a
problem common to other service-type operations---its
merchandise has a total daily perishability. At the end
of a day's operation, any room not rented is merchandise
which has perished. A drop in the rate of occupancy
required, for profitable operations means that any
potential profit may soon be wiped out. If revenue drops
significantly, the uninformed operator may lose his
investment as fixed expenses continue to face him.
Likewise, profitability of related income-producing
activities such as the operation of a restaurant or gift
shop, can be shown by accurate operating data, provided
only through good records.
The value of a good accounting system is seen through the
example of the motel manager who is deciding whether to
provide kitchen facilities for his guests. His decision
should be based on the amount of added revenue a kitchen
unit will produce over that of a hotel-type room, taking
into consideration increased costs incidental to its
operation---china breakage, depreciation and additional
maintenance. Another managerial problem which can best be
solved only by careful analysis of past experience (as
shown by records) concerns what percentage of each room
type-single, double, twin or suite---should be provided.
The specific problems each individual manager must face
vary according to location, type of clientele, seasonal
variations and other factors. Thus, each manager should
be able to identify those items which relate to his own
specific problems.
Keeping Records
Begin by keeping accounts which are true and applicable.
Know the objectives of keeping such accounts. Know their
value to the well-being of your business. Use this
information to improve management, efficiency and
profits.
For motels, organize your accounts in accordance with the
"Uniform Classification of Accounts for Motels and Motor
Hotels" (Available from Motel Association of America,
1025 Vermont Avenue, NW, Washington, D.C. 20005. For
hotels, the "Uniform System of Accounts for Hotels" is
available from the American Hotel and Motel Association,
221 W. 57th St., New York, NY 110019). This
classification has been carefully formulated to meet all
of the qualifications for good managerial application.
When there is a food service or other major
income-producing department involved, similar accounts
should be kept.
These accounts can be used to provide essential data
needed in lodging management. Study the daily and monthly
reports for two types of vital information: (1) actual
dollar results from operations, and, (2) results of any
changes you may have made in managerial policy.
With regard to point 2, the only way in which the effects
of new methods or services can be measured is through
adequate financial reports. You may decide to offer
breakfast or some similar new service, but until you have
reliable figures to reflect these changes, you are in the
dark about their profitability.
Illustrated below is the effect on motel occupancy and
rates for a 40-unit motel which opened a new restaurant
the first of August:
Daily or Monthly Managerial Information
Number of Rooms in July, 40; August, 40.
Number of days in July, 31; August, 31.
Number of rooms available to guests (40 x 31): 1240 July
and August.
Number of rooms occupied (from sales acct's): July, 915;
August 994.
Percentage of occupancy: July, 73.7%; August, 80.1%.
Rooms sales: July, $12,640.25; August, $14,415.30.
Average rate per room: July, $13.81; August, $14.50.
Number of guests registered: July, 1,415; August, 1,522.
Average rate per guest: July, $8.93; August, $9.47.
If this pattern continues, the new restaurant will have a
very good effect on room sales and occupancy in the
motel. An increase in business can also result from more
effective signs or advertisements, more tourists, etc.
Running or cumulative sales totals for each day,
monthly-to-date, and yearly-to-date, can provide
vital management information. For example, total room
sales for the first 10 days in June of this year (monthly
to-date), can be compared to the monthly-to-date sales
for the same period of last year. Yearly-to-date sales
(cumulative sales for the year up to June 10), can also
be compared with those from the same period last year to
quickly determine trends. An example showing how these
figures are presented:
Item: Room Sales
Today: $220.50
To Date: $30,450.00
Year Ago To Date: $28,991.50
Monthly To Date: $2,205.00
Monthly To Date Year Ago: $1,874.50
Monthly Revenue and Expense Statement
(income Statement)
In addition to reviewing daily and monthly managerial
data, it is important to check your monthly record of
operating expenses and income.
To prepare the monthly Revenue and Expense Statement,
first include a summary of room sales for the month.
Then, list controllable operating expenses.
An estimated monthly charge for fixed expenses is
necessary. These are charges such as depreciation,
insurance, taxes and interest, which may be estimated
from this year or previous year figures.
Look carefully at every figure on the monthly statement
to locate any hidden meanings or implications. Why was a
particular amount low or high? Should it have been lower
or higher? What can be done to improve the situation?
Try to find answers to these types of questions.
Important items which should be studied, checked and
compared are: (1) salaries and wages for employees and
the efficiency of these employees, (2) whether expenses
are properly classified for uniform comparisons with
industry trends and ratios, (3) whether rentals paid for
use of assets are reasonable and commensurate, (4) Is
depreciation realistic and in line with current practice
in the industry? (5) Have all risks been covered with
insurance of sufficient amount? (6) Is the level or
amount of profit sufficient to provide a fair rate of
return on investment? Next, compare each item on the
statement with comparable previous periods. Check each
major item to determine trends. Corrective action can
then be initiated, since the basis for action is a solid
foundation of usable, financial facts.
A further use of good individual accounts and
representative trade data is for obtaining credit.
Bankers and other lending institutions require all
obtainable information when deciding whether to grant
credit. The man who is best informed about his own
operations and current trends in the trade is most likely
to get the loan.
Annual Revenue and Expense Statement
(Income Statement)
Like daily and monthly reports, this statement should be
studied carefully---for a longer, overall view of your
operation.
Precise and meaningful interpretations can be made by
determining the ratios between various costs and
earnings, usually expressed as a percentage. For example,
if room sales were $80,000, and salaries and wage
expenses were $20,000, the ratio of these expenses would
be 25 percent, ($20,000 + $80,000.). The $80,000 is a
common denominator for computing each ratio.
Compute the ratios of each of your expense items in
relation to room sales. Room sales are considered to be
100 percent so that the ratios of all of the expenses
plus profits will equal 100 percent.
Next, compare your ratios to several kinds of bases or
standards. These standards can be (1) your own judgment
based upon experience and evaluation, (2) past
performance found by comparing this period with the same
period last year, and with other comparable periods, and
(3) typical performances of other similar businesses as
reported in research reports of lodging operating
statements or averages (Examples of sources of such
reports are Motel/Motor Inn Journal, Lodging Hospitality
Magazine, and other journals; Trends in the Hotel-Motel
Business published annually by Harris, Kerr, Forster &
Co., Chicago, and Hotel Operations published annually by
Laventhol, Krekstein, Horwath & Horwath, New York.)
Where the motel dollar goes (Source: Motel/Motor Inn
Journal, July 1971): 16 cents, depreciation expense; 18
cents, other fixed expenses; 28 cents, other operating
expenses; 24 cents, salaries and wages; 14 cents, net
profit.
Universal adoption of the Uniform Classification of
Accounts for Motels and Motor Hotels and the Uniform
System of Accounts for Hotels would result in reliable
data which can be used with confidence. In these manuals,
all of the financial transactions have been classified on
the same basis, Thus, you can see how you are actually
succeeding compared to similar businesses.
Balance Sheet
This statement can also provide significant managerial
data. The successful manager uses the balance sheet to
make comparisons of the amounts and the relationships of
assets, liabilities and proprietorship (the excess of
assets over liabilities). Each part of these three major
divisions of the balance sheet should be studied and
compared to previous balance sheets.
Of particular importance is the amount of the lodging
owner's proprietorship or equity. This should increase as
the business grows and prospers.
Estimating Revenue and Expenses
The following form will be helpful for estimating future
revenue and expenses. The form could be inexpensively
reproduced for making periodic estimates.
The first column of the form is for estimated dollar
amounts. The second column is for the conversion of these
amounts to percentages of "room sales." Thus, if rooms
ales were $50,000 and employees wages and salaries were
$10,000, the latter item would be 20 percent ($10,000
divided by $50,000) of room sales.
This type of study is sometimes called "common-size
analysis" since all amounts are divided by the common
sales figure---in this example, $50,000.
This pro forma statement can be very useful in computing
the break-even point, estimating expenses, profits, cash
flow, and comparing similar businesses.
BREAK-EVEN OR MARGINAL ANALYSIS (From Kemper W. Merriam,
Professor of Accounting, College of Business
Administration, U. of South Florida, Tampa.)
One of the most useful financial tools of the manager is
the break-even concept. The break-even point is that
point during a successful year when revenue from total
room sales exactly equals expenses (Fig. 3). This figure
can be used to make advantageous decisions concerning
rates, prices, effect on operating costs and profits. The
following discussion relates to rental of motel or hotel
rooms, but the method shown can be applied to any small
business.
Before discussing this relationship of prices to profits,
a review of some fundamental assumptions will be helpful.
Basic Assumptions
1.Room rates will not change with changing volume of
business.
2.Costs and expenses can be segregated into their fixed
and variable elements with reasonable accuracy.
3.Total fixed, or stand-by costs will remain nearly
constant during the periods over which estimates are
being made.
4.Variable expenses will generally vary in direct
proportion to the volume of business activity.
5.Where several different room types and rates are
involved, the relationship of these rates will remain
constant.
Knowledge of the break-even concept can be useful to the
individual lodging manager for profit-planning,
decision-making, and general control over the operation.
We shall first examine the break-even point with a very
simple case and then consider it in more detail. All
figures used in the following hypothetical illustrations
have been rounded-off.
Illustration 1
The motel has 10 rooms or units, which are all the same.
Average room rate is $11.00. Fixed costs total $7,500 per
year. Variable costs are $3.20 per room, or 40 percent of
the $8.00 room price.
Break-even is that point in the business year when total
cumulative revenue equals fixed expenses for the year
plus the variable expenses up to that date. The
break-even room-sales point is computed as follows:
Fixed Expenses = $10,500 (60%) = $17,500 (break-even).
If break-even room sales are $17,500, than 1,590 rooms
must be rented to break-even ($17,500 divided by $11.00
room rate). Since there are 10 rooms in the motel, 3,650
rooms are available to rent for the year (10 rooms x 365
days). With a break-even point of 1,590 rooms, then, our
break- even occupancy rate is approximately 43 percent
(1,590 divided by 3,650 rooms).
Our basic assumptions require us to segregate the fixed
and variable elements of a semi-variable cost. The cost
of utilities is an example. The fixed cost of electricity
would be for general grounds, mechanical equipment,
offices, etc., which would be consumed even though no
units were rented. The balance of electrical costs would
represent the variable portion. This involves a certain
amount of guess-work and judgment. After we have made the
necessary analysis of the items of semi-variable expense,
we then differentiate them into fixed and variable
expenses.
All of the above illustrations show only the break-even
point. Any business, however, wants an operating profit.
In the last illustration a 93 percent occupancy rate is
needed just to break-even . . .there is no profit to
this point if average room prices are dropped from $8.00
to $6.00!
Other Uses of Break-Even Analysis
Let us assume that the Friendly Motel is planning to add
a swimming pool, air-conditioning, or something that will
increase costs. Such changes tend to increase only fixed
expenses.
If we assume that such a program will increase fixed
costs by approximately $300 per month, or $3,600 for a
year, fixed costs will then be $31,740 ($28,140 +
$3,600).
Since the new break-even point is $52,900 and the
previous break-even point was $46,900, room sales revenue
must increase by at least $6,000 for the year just to
break-even on this proposed change. With an average room
rate of $8.00, it will be necessary to rent an additional
750 rooms for the year ($6,000 + $8.00).
The new break-even occupancy rate is about 60 percent
compared to 53 1/2 percent before the expansion proposal.
Break-Even Cash Requirements
The cash break-even point is that point in the year when
all cash received just equals all cash paid out. This
includes cash paid as principal on mortgages, income tax
payment, or payments on durable equipment or furnishings.
To find the cash break-even point instead of profit
break-even point, merely substitute fixed cash mortgage
payments and other monthly payment obligations in place
of the depreciation and interest figures in the original
fixed expense computations. All other expenses already
represent cash outlays.
The cash break-even point may be considerably higher than
the profit break-even point if the motel is faced with
heavy mortgage and installment contract payments.
Profit-Estimating or Profit-Planning
It is also possible to use the findings of the Friendly
Motel example for profit-planning or guidance. If
variable expenses are 40 percent, then each dollar of
sales after the break-even point represents a 60 percent
profit.
This is because 40 cents of each dollar of room sales
revenue goes toward the variable costs per room, and the
balance of each dollar contributes toward the payment of
the fixed expenses. But, at the break-even point, all of
the fixed expenses have been covered. Thus, for the
remainder of the fiscal year, only the variable expenses
must be met, leaving a 60 percent profit.
Increasing Average Room Rates
We have considered only the result of a room price
decrease, but you may also wish to consider the effect of
a price increase on needed occupancy percentage and
profits.
Using data from the Friendly Motel where fixed costs were
$28,140 and variable costs $4.80 per room, let's assume
prices are increased to $14.00 per room. This would make
variable expenses 34 percent ($4.80 divided by $14.00).
If the break-even point is $42,636 and average room rate
is $14.00, we must rent a total of 4,264 rooms or have a
38 percent occupancy rate to break-even. Furthermore,
every dollar of room sales beyond the break-even point
will yield a 68 percent profit.
Effect of a Wage Increase to Hourly Workers
Let's revise our present hourly wage rate and fringe
benefits from $1.80 per hour to $2.00. Fringe benefits
will cost another 50 cents per hour so that the actual
cost is $2.50 per hour. If we assume that it takes a maid
one-half hour to clean a room, variable room costs will
increase from $4.80 to $5.15 (the 35-cent increase is
one-half the 70-cent increased cost per hour).
If the average room rate of $12.00 remains unchanged, the
new variable expenses will be 43 percent ($5.15 divided
by $12.00).
The new break-even sales point of $49,368 as compared
with our previous break-even point of $46,900 indicates
that we must obtain additional room sales revenue of
$2,468 for the year just to break-even on this 700/hour
wage increase. This means that we must rent an additional
206 rooms ($2,468 divided by $12.00 room rate) to cover
this added expense.
Free coffee, newspapers, guest kits, and similar items
will also result in an increase in variable expenses. The
effect of such programs may be analyzed in this same
manner.
ROOM RATE FORMULAS FOR TODAY'S MARKET (From John Weber
III, President, Avalon Motor Inn, Waukesha, WI)
Historically, managers adjust room rates haphazardly.
Sometimes action is prompted by competition down the
street. Most of us adjust room rates when we feel we are
working more and keeping less!
We need to review what we are charging from a more
scientific approach. A market study is one method, but it
is usually costly and time-consuming. Instead, a simple
mathematical equation can be used to study rate of
adjustment. Of course, the law of diminishing returns
must be taken into account when setting or adjusting
rates. Too high a figure might severely cut into your
profit or possibly eliminate it entirely!
Hubbart formula
The Hubbart Formula is a simple approach to the solution
of a complex problem: How much profit can I make and
still stay competitive? Here's the formula:
Where:
X = Room Rate (average) to be charged
0 = Estimated annual total cost of operations
I = Expected return on equity capital (your own actual
investment)
R = Estimated number of rooms to be sold
Applying the formula X = 0 + I divided by R
X = $118,000 plus 10% times ($180,000) (365 days times 50
rooms times 65% expected occupancy).
X = $118,000 plus $18,000 divided by 11,900.
X = 136,000 divided by 11,900 = $11.40.
The $11.40 represents the daily charge that must be made
for each occupied room for a 10 percent return on your
own actual investment. If you want to make a 12 percent
profit, adjust the formula, making sure to adjust the
occupancy percentage as well as the desired return on
equity capital. Raising rates above a rather narrow range
will likely affect occupancy. Also, the amount to be paid
on mortgage principal and for income taxes (if necessary)
should be added to expenses when making these
calculations.
Let's also assume that your double room rates are 50
percent more than your single rates. Thus, a $10.00
single rents for $15.00 as a double.
To find out what your average daily single and double
rates should be, we will use another f formula: (Ns)Sr
plus (Nd)Dr = Ro times X.
Where:
Ns = Number of Rooms sold singly
Nd = Number of Rooms sold doubly
Sr = Single average rate to be charged
Dr = Double average rate to be charged
Ro = Rooms occupied
X = Average room rate
Remember that our Dr was 1.5 our Sr and average room rate
was $11.40. If we assume that 200 people rented 150 rooms
during a given week, 200 guests divided by 150 rooms
equals 1.33 guests per room per day.
With 150 rooms sold and occupied by 200 guests, assume we
had sold 100 singles and 50 doubles. Our single rate
should now be:
100 Sr plus 50 Dr = 150 times $11.40
10O Sr plus 50 (1.5 Sr) = $1,710
10O Sr plus 75 Sr = $1,710
175 Sr = $1,710
Sr = $9.77 per day and Dr = 1.5 times $9.77 or $14.66 per
day.
Another important facet of the rate problem is keeping
rates current. The primary reason for this concern is the
advent of a scheduled increase in minimum wages. To
counteract these anticipated labor cost increases,
re-determine your position each year as minimum wage
increases come into effect. Then, re-compute your
expenses and rates for the new year.
Setting Room Rates on an Annual Basis
Sometimes managers wish to rent rooms on an annual basis.
This creates a problem concerning rate of charge. Several
procedures are suggested: 1) Discount the regular rate
for the room 15 percent, or 2) Compute the rate based
upon actual fixed and variable costs for the room plus
the pro-rated amortization of indebtedness plus normal
profit, and 3) Obtain an agreement whereby the room may
be rented like any other room by a certain time. The
company is then credited with 25 percent of the rate
received.
CAPITAL BUDGETING
Capital expenditure planning is especially significant
since it usually involves large sums of money and the
investment has a useful life which often extends for many
years. Thus, any errors in formulation of these plans
could be disastrous.
Capital and operating expenditures are basically the same
since both are incurred to create a business organization
which produces goods and services desired by customers.
The difference lies in time---we usually think of
operating expenditures as those consumed in about 1 year
and capital expenditures as those made for durable goods
whose useful life extends beyond 1 year.
Owning vs. Leasing
To illustrate an application of capital budgeting, let's
consider owning versus leasing new furnishings for a new
dining facility which has been added to the hotel. We
assume that the benefits to the hotel in increased
patronage and profitability from the new dining room will
be the same whether the furnishings are purchased or
leased.
If the furnishings are purchased, the owner will deduct a
charge for annual depreciation in arriving at estimated
net income from the dining room. If he estimates the
average useful life of the furnishings at 4 years, there
would probably be a small salvage value when he disposes
of the furnishings.
The rate of return (profit divided by cost) would be
calculated as follows:
1. Estimate the average net income per year from the
dining room for 4 years. Determine what percentage of the
entire investment is represented by the furnishings.
Subtract as an expense the annual charge for depreciation
of the furnishings.
2. Estimate the salvage value of the furnishings. Rate of
return is calculated as shown in Equation 1, below. The
denominator of Equation 1 includes the fraction since we
are determining average purchase cost and the value of
the furnishings will diminish constantly in the 4 years
of its useful life. Thus, the mid-point (or value at the
end of two years, plus the salvage value) is the average
cost of the furnishings.
Leasing
As a lessee, you would deduct the annual lease payment as
a business expense. From this lease expense, however, you
should deduct an "interest charge" ---equal to the
average interest you would pay per year, if you had
borrowed the money from your bank at your normal
borrowing rate.
Illustration 1 - owning vs. leasing
On the basis of these calculations, ownership would bring
a higher rate of return on the investment than leasing.
(This illustration is not intended to indicate actual
situations.)
Furnishings as a percentage of total dining room
investment: 10%
Purchase cost of furnishings: $10,000.
Life of furnishings: 4 years.
Term of lease: 4 years.
Annual operating income generated (pro-rated by
furnishings: $12,000.
Average annual depreciation: $2,125.
Average investment (1/2 of $10,000): $5,000.
Salvage value: $1,500.
Annual lease payment: $2,750.
Financing value (interest) of lease @ 7% on $5,000
average investment: $350.
Present Value or Time Value
Money has an "opportunity cost" meaning that a dollar on
hand today can be put to work immediately earning more
money or interest. If that dollar were received a year
from now, the earnings that could have been made from it
are lost. Thus, the present value of $1.00 received a
year from now, discounted at 8 percent is $0.926 (Source:
Anthony, R. N., Management Accounting, Homewood,
Illinois; Richard D. Irwin, Inc., 1960.) Compounded
annually, a dollar invested today is worth more in 2
years than it is in one year. Conversely, the present
value of a dollar 2 years from now would be less than a
dollar received one year from now. Therefore, we can't
just compare dollars, now and in the future, because
future dollars are worth loss and must be discounted.
Dollars to be received in the future, such as rental
income during the useful life of the lodge, must be
discounted in order to make a true comparison with the
cost of the lodge, which must be paid upon acquisition.
For example, a rental dollar to be received in December,
1985, has a present value of 31 1/2 cents.
Calculating the Profitability Index
An investment proposal can be evaluated through use of a
profitability index---the relationship between the
present value of the net cash benefits to be received and
the present value of the outlays or costs. For example,
suppose you are considering the addition of 10 rooms.
Assume the cost of capital to be 8 percent and the time
stream (length of useful life) or annual cash benefits to
be 15 years. The remaining figures for the new addition
are:
Investment $7,000/room: $ 70,000
Mortgage: $20,000
Owner's Equity: $50,000
Increased Sales: $20,000/ year for 15 years - $300,000
Expenses: $169,000
Controllable: $79,000
Fixed: $90,000
Profit: $131,000
Less Income tax: $39,300 (30%) - $91,700
Add back depreciation: $70,000 - $161,700
Cash flow: $161,700
Present value from the investment is computed by dividing
cash flow by time stream (years) and multiplying this by
the discount factor given in Table 1. Thus, $161,700
divided by 15 years = $10,780.
Referring to Table 1, follow the 15 year line to the 8
percent column to arrive at the 8.559 discount factor.
Present value equals 8.559 x $10,780, or $92,270.
The profitability index can then be calculated by
dividing the present value of net cash benefits by the
present value of cash outlay required. Thus, the
profitability index for the 10 new rooms would be $92,270
divided by $70,000, or $1.32.
This means that for every dollar invested in the new
rooms, the estimated profitability, in terms
of the present value of the stream of benefits, would be
$1.32.
Rate of Return
Another method for evaluating proposals for capital
expenditures is rate of return. Management needs to know
what the annual rate of return will likely be from any
investment. Rate of return can be thought of as an
interest rate corresponding to the income which the
investment will yield in addition to the original cost of
the investment.
After this rate of return has been estimated, cost of
capital is calculated. If rate of return is lower than
the cost of funds, there is something wrong with the
investment.
Let's use an example to calculate rate of return. What
would the rate of return be for a $3,000 piece of
equipment that would save $800 per year for 5 years?
The stream of benefits would total $4,000, ($800 x 5
years). Benefits should exceed the investment, otherwise
the decision would be questionable. To compute the rate
of return, divide the investment by annual benefit or
return. Then, referring to Table 1, use the 5-year line
to find the number which most closely approximates the
benefit which you will receive. Thus, $3,000 $800 = $3.75
present value. This means that the equipment investment
should result in a rate of return slightly over 10
percent, but well under 12 percent.
We can find a more precise rate of return by
interpolation (estimate of a value between two known
values).
First, we must understand that we should be investing
$3,033 (3.791 x $800) to receive the 10 percent rate of
return. Likewise, we would invest $2,884 (3.605 x $800)
for a 12 percent rate of return. Since we are investing
only $3,000, we must use interpolation to find a more
precise interest rate.
Any actual figures of an investment possibility can be
substituted and the rate of return calculated.
Comparisons of investment alternatives can then be made.
Uncertainties
Estimating returns on investments involves uncertainties.
No one can foresee future prices, costs, or sales
volumes, but one way to approach this problem is to
calculate optimistic and pessimistic rates of return. In
this way, you can establish a reasonable range of return,
such as, between 8 and 12 percent.
One other possibility should be mentioned---the proposed
investment might not produce any benefits at all.
Therefore, managerial judgement is required to decide
whether a likely yield of 10 percent is high enough for
the risks involved.
MANAGING LONG-LIVED ASSETS
Because such a large percentage of the total investment
in a lodging business consists of fixed assets, managing
and safeguarding these assets becomes an important part
of the manager's responsibilities.
Maintenance
The first consideration is maintenance. Proper
functioning of fixed assets is imperative for successful
operation. Timely preventative maintenance repairs and
upkeep of property are important. Economy in lengthening
useful life plus better functioning and appearance are
benefits from such a policy.
Capacity Use
Using fixed assets at their full capacity is also
desirable. When the capacity or output of the asset is
known, then using the asset at its fullest capacity is
most efficient and productive.
Cost of Fixed Assets
To work with fixed asset figures, the full cost of such
assets must be known. The following elements apply:
1. Cost of capital investment
- The net investment
- Equipment or tools needed to maintain investment
2. Cost of space occupied by investment
- Maintenance costs
- Taxes
- Depreciation costs
- Heating
- Rental space
- Utilities
3. Servicing costs of equipment or other investment
- Property taxes
- Insurance
- Maintenance & repairs
- Depreciation
4. Ownership risk costs
- Obsolescence
- Style or efficiency changes
Depreciation
An investment in fixed assets implies that prices on
rates charged to the customer will include a sufficient
amount to "recapture" the original fixed asset investment
over its time span-its useful life. The annual recapture
of such costs is called depreciation.
Since depreciation is deductible for income tax purposes,
determination of the method to be used affects the net
profit shown and the amount of tax to be paid. Several
excellent references are recommended for choosing the
most appropriate method* (*Tax Guide for Small Business.
Published annually by the Internal Revenue Service, U.S.
Dept. of the Treasury, available from Internal Revenue
Offices; Merriam, Kemper W., The Motel Tax Trap, Temple,
Texas; Tourist Court Journal, 1967.).
One of the primary purposes of good accounting is to
safeguard assets. Use of the funds represented by
depreciation is a financial decision of major importance.
There are several alternatives:
Depreciation Methods
1. An amount equal to the annual depreciation can be
deposited in a special bank account. The purpose of such
a reserve would be to provide the funds for replacements,
modernization, upgrading, or enlargement of fixed assets.
An example is modernization of an older
hotel-installation of air-conditioning, better parking
facilities, and a swimming pool.
One of the problems associated with this alternative is
the inflationary increase in building and remodeling
costs. The compounding of interest on this fund should
just about offset the annual increase in the cost of
replacement.
2. The amount can be used as payment on the principal of
the mortgage or other long or short-term debts. An
example would be a new business which has heavy debt
commitments in its early years. An accelerated method of
charging for depreciation expense might be advantageous
(depending on the amount of profit, if any, made). This
lowers the amount of net profit against which the income
tax is charged and makes funds available for debt
payments.
A warning is needed here, however. If no funds are set
aside for eventual modernization and replacement of the
fixed assets (as intended by income tax laws) then in
effect, the capital asset is being currently consumed.
Prudent financial management dictates that if funds are
used to retire debts, that this practice be strictly
limited to emergency-type financing and discontinued as
soon as practical.
3. The amount can be invested in interest-bearing
securities which can be cashed-in in the future to
provide funds for modernization or replacement.
4. Funds can be used as equity-working capital to build
additions or purchase furnishings or equipment. However,
the same warnings apply since no funds would be available
when modernization or replacement is necessary.
Whatever your policy may be, a capable legal or tax
advisor should be consulted before making the final
decision.
GLOSSARY OF ACCOUNTING
Accounting: Reporting, recording, analyzing and
interpreting the financial transactions of a business
enterprise.
Accounting Period: Any time unit decided upon by
management. A fiscal year is a 12 month accounting
period.
Accounts Receivable: Amounts due the business from
guests, customers, credit card agencies and similar
sources.
Acid Test or "Quick Ratio:" An approximate measure of the
ability of a business to meet its current obligations.
Thus, only immediately "liquid" assets of cash, accounts
and notes receivable and marketable securities would be
used.
Amortization of Intangibles: Annual charge for
improvements made to leased assets.
Asset: The cost of goods or services which have been
acquired. They may be utilized in either the present or
in the future.
Average Rate per Rented Room: Total room revenues divided
by number of rooms rented during accounting period.
Balance Sheet: Summary of the organization's assets,
liabilities, and owner's equities as of a particular
date.
Bonds: Written obligations to repay a given sum of money
on a specific date with interest at a fixed rate.
Bookkeeping: The process of collecting, classifying, and
recording money transactions. It is a part of the
accounting function.
Break-Even: A point in the accounting period when total
accumulated revenues are equal to total variable expenses
to that particular date, plus fixed expenses for the
year.
Capital Budgeting: Planning capital expenditures for the
most favorable long-range returns.
Cash Flow: Profit (net profit) after federal, state, and
local income taxes, plus added back depreciation; the
amount of cash actually available to management during an
accounting period--for debt reduction or other
non-operating usage. Additional cash flow could be
obtained from borrowing or by issuing securities. These
are external sources of cash and are not used in
comparing investment alternatives. Similarly, sale of
fixed assets increase cash flow but are usually not apart
of cash flow projection.
Classification of Accounts: Grouping account titles under
standard headings and definitions, to make possible
meaningful comparisons among lodging establishments.
Control: Function of management concerned with
arrangement of operations and the reporting system to be
employed for the protection of owners. Involves
enforcement of corrections needed to achieve goals and
promote efficiency.
Current Ratio: Approximate measure of the ability of the
business to meet current liabilities. Computed by
dividing current assets by current liabilities.
Debt to Net Worth: Comparison of dollars invested in the
business by creditors (shown as short and long-term
debt), with dollars invested by owners. Computed by
dividing total debt by tangible net worth (Net worth
items such as goodwill, organizational or development
expenses are deducted.)
Depreciation: Costs represented by fixed assets, the
original cost of which is partly recaptured, currently.
Can also be thought of as lost usefulness or expired
utility.
Expenditure: Transaction involving present or future
payment of cash or other property for goods or services.
Expense: Cost of goods or services which have already
been used up or consumed during the current accounting
period.
Fixed Expenses: Expenses which do not change as business
volume changes, such as real estate taxes, interest on
mortgage, depreciation, insurance, manager's salary and
similar items.
Funds: Net working capital, figured by subtracting
current liabilities from current assets; synonymous with
"cash."
Goodwill: Above normal earning power of a business. An
amount paid for a successful business that exceeds the
fair value of the tangible assets purchased.
Income Statement: Summary of revenue and expense
transactions occurring during the reporting period.
Leverage: Earning a higher return on investments as
residual owners of common stock in a corporation than
would be paid as a fixed return to holders of preferred
stock.
Liquidity: Convertibility of assets to cash.
Long-lived Assets (fixed): Real and personal property
which provide needed facilities and services. These costs
(except land) are gradually charged as operating expenses
over their useful lives through depreciation or
amortization.
Long-term Liabilities: Creditor equities which help make
possible purchase of fixed assets. Such liabilities must
be ultimately liquidated through cash funds created by
operations.
Loss: A reverse of the conditions required for a net
profit.
Net Cash Benefits: Present value of the total cash flow
which is obtained through operations during the useful
life of the business investment.
Owner's Equity (net worth): Total investments made in the
business plus profits earned through operations which
have remained in the business (retained earnings).
Present Value: Comparison of dollars to be received in
the future with dollars at hand today using various
discount percentages; important when comparing today's
costs of providing business assets with profits to be
received in a future time stream.
Profit: Whenever revenues exceed expenses during a given
accounting period, a profit has been made.
Profitability Index: Fraction, ratio, or index number
which compares the present value of cash outlay with the
present value of total estimated future net cash
benefits. Computed by dividing present value of net cash
benefits by present value of the cash outlay. In
comparing various investment alternatives, the higher the
profitability index, the better the investment.
Revenue: In-flow of assets from transactions involving
the provision of services to guests, or the sale of goods
to customers.
Semi-variable Expenses: Expenses which are partly fixed
and partly variable (electricity). Part of the
electricity expense, such as outside lighting, must be
incurred regardless of the volume of business, while
other uses (guest-room lamps and TV) will vary directly
with room occupancy or activity; must be allocated---part
to fixed expense, and the remainder to variable expenses.
Stocks: Shares of ownership in a corporation---common or
preferred. Preferred owners receive dividends first and
common owners last.
Variable Expenses: Expenses incurred in the production of
revenues which are directly related to volume of sales.
Laundry is a good example.
Stream of Benefits: Net profits estimated over the total
future useful life of the investment.
Working Capital: Excess of current assets over current
liabilities.
This information is for educational purposes only. References
to commercial products or trade names does not imply
endorsement by MSU Extension or bias against those not
mentioned. This information becomes public property upon
publication and may be printed verbatim with credit to MSU
Extension. Reprinting cannot be used to endorse or advertise
a commercial product or company.
This file was generated from data base TD on 09/30/03.
Data base TD was last revised on 06/06/02.
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