Cost Approaches to Pricing
Chapter 8
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?

Pricing Questions
What Are Common Methods of
Pricing Food and Beverages?
 How May Profitability and Popularity
Be Considered in Setting Food
Prices?

Pricing Questions

Will Departmental Revenue
Maximization Result in Revenue
Maximization for the Hospitality
Firm?
Pricing Questions
What Is Integrated Pricing?
 What Is Price Elasticity of Demand?

Price Elasticity of Demand
Measures How Sensitive Demand Is
to Changes in Price
 Either Elastic or Inelastic

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
Price Elasticity of Demand
Assume Hotel Sells 1,000 rooms @ $30
 Changes Price to $33 and sells 950

(950 - 1,000)/1,000
(33 - 30)/30
= - 0.05 / 0.10 = -0.50 Inelastic
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
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)
Price Elasticity of Demand
Competition, Uniqueness Affect
Elasticity
 When Change Prices, Test for
Elasticity

Informal Pricing Methods
Competitive
 Intuitive
 Psychological
 Trial and Error
 Follow The Leader

Informal Pricing Methods
Four Modifying Factors
Consider First:
 Historical Price Changes
 Guest Perceptions (Price/value)
 Competition
 Modify by Rounding

Mark Up Approaches
Ingredient Mark Up
 Determine Ingredient Costs
 Determine Multiple to Use
 Multiply Costs by Multiplier
 Adjust Using Qualitative Factors

Multiplier
1 / Desired Food Cost Percentage
 Example 1 / 40% = 2.5

Alternative to Multiplier
Divide Costs By Desired Food Cost
Percentage
 Example $3.00 Cost / 40% = $7.50
Selling Price

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
Mark Up Approaches
Prime Ingredient Mark Up
 Determine Prime Ingredient Cost
 Some Versions Add in a Fixed Dollar
Amount for Other Ingredients

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

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
Rooms Pricing Traditional
Method
$1 Per $1,000 Cost Per Room
 Doesn’t Consider Current Value
 Doesn’t Consider Other Services
 Assumes 70%occupancy
 Assumes Profitable Food and
Beverage

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
Rooms Pricing Hubbart
Formula
“Bottoms Up”
 Start With Profit
 Determine Pretax Profit

Rooms Pricing Hubbart
Formula
Add in Fixed Charges
 Add in Undistributed Operating
Costs
 Estimate Non Room Income (Loss)
 Sum Is Rooms Department Income

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
ADR to Single and Double
Rates
(Singles Sold * Single Rate) +
(Doubles Sold * (Single Rate + Price
Differential)) = Average Rate * Rooms
Sold
 Solve for Each Rate

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
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

Yield Management
Increasing the Rooms Revenue
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

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

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
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)
Menu Engineering
A Tool to Increase Food and
Beverage Profits
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?

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?

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

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?
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

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)?

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

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)

Menu Engineering
Smith and Kasavana
 Analyzes Popularity and Contribution
Margin
 Two by Two Matrix
 Classified Items As Stars, Dogs,
Puzzles, or Plowhorses

Popularity
Item Is Popular If Individual Item’s
Sales Mix Exceeds 70% of the
Average Popularity
 Average Popularity = (100% / Number
of Items) * (70%)

Popularity Example
10 Items
 Average Popularity = (100% / 10) *
(70%) = 7%
 If Individual Sales Mix Is > 7%, The
item has HIGH Popularity
 If Individual Sales Mix Is < 7%, The
item has LOW Popularity

Contribution Margin
Selling Price Minus Variable Costs or
Gross Profit
 Compute for Each Item

Weighted Average
Contribution Margin
Calculation
Compute Individual Contribution
Margin
 Multiply Item Contribution Margin by
Number of Item Sales
 Result Is Total Contribution Margin

Weighted Average
Contribution Margin
Calculation
Divide Total Contribution Margin by
Number of Sales
 Result Is Weighted Average
Contribution Margin

Contribution Margin
Compare Against Weighted Average
Contribution Margin for Menu
Section Engineered
 If Item CM Is > WACM - Label “HIGH”
 If Item CM Is < WACM - Label “LOW”

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
Menu Engineering Concerns
Ignored Variable Portion of Labor
Cost
 Inconsistent With Performance
Evaluation
 Difficult to Collect Data
 Extensive Calculations
 “So What” Theory

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

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
