Hospitality Finance

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Hospitality Finance

• Budgets and Cost-Volume-Profit

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Welcome

• Notes- Budgets
• Notes-Cost/Volume/Profit
• (omit Balance Sheet notes within this lecture
  packet)
• Assignments
• Business Plan Assg omitted
• Change in Budget spreadsheet

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Budgets
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What is a budget?

• A budget is part of a profit making business's
  annual business plan. The budget is a projection
  of the organization's income statement for the
  next fiscal year. It usually includes estimates
  of sales, expenses and net income. Other
  statistical information is frequently included as
  part of the budget. A budget, in addition to the
  income statement, will also include a cash flow
  projection and a capital expenditure budget.

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Why do companies, such as restaurant companies,
develop budgets?

• Companies develop budgets because of the
  benefits
• It provides the organization with a goal.
• It provides control over revenues and expenses
  during the budget year. Management compares their
  actual results with budgeted forecasts and then
  must account for any significant variances.
  Significantly large budget variances may indicate
  the presence of problems in the restaurant's
  operations.
• It provides contingency plans for potential
  problems that may develop during the budget year.
  
• It requires coordination throughout the
  organization. Each department, or unit, within
  the organization is responsible to prepare its
  part of the budget, which is then coordinated
  with the overall company budget.
• Responsibility is assigned to Management in each
  organizational unit. They are responsible for the
  development of the budget and their department's
  subsequent performance against its budget.
• Budgeting is an integral part of the planning
  process. Successful companies plan for their
  futures through the discipline of preparing an
  annual business plan, stipulating their financial
  and qualitative goals and strategies. The budget
  is an integral part of that plan.

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What are the basics in developing a budget?

• Management needs to collect the following types
  of information in order to prepare an accurate
  and useful budget
• The restaurant's actual operating and budget
  variance figures from the previous year.
• The restaurant's goals
• Sales statistics from the past
• Any change in restaurant operating policies
• Local and national economic conditions
• Sales and expense trends
• Statistics to back up budget numbers, such as
  menu prices, customer preference, portion size
  and food costs
• Payroll statistics.

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• Then management can go through the basic steps to
  prepare the budget
• Estimate sales revenue and volume. The forecast
  of sales is the most important and difficult part
  of the income statement due to its volatility,
  and its pronounced effect on expenses and profits
  
• Estimate expenses that are related of sales.
  Estimate other expenses based on planned
  activities.
• Management consolidates the department and unit
  budgets into an overall comprehensive income
  statement budget.
• The budgeted income statement is submitted to
  upper management for review, negotiation and
  revision.
• After the review and final revisions, the final
  budget and plan is prepared and submitted to the
  appropriate departments within the organization.

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Budget Example

• Budget Example

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Cost-Volume-Profit

• Cost Approaches to Pricing

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Cost Approaches to Pricing

• The concept of price elasticity of demand applies
  to hospitality operations
• Key Concepts
• A basic economic concept states that, all other
  things staying the same, a price increase will
  reduce the quantity demanded for a product or
  service the question a company must answer is,
  by how much will demand drop if we raise prices?
• Price elasticity of demand provides a means for
  measuring how sensitive demand is to changes in
  price
• Elastic demand demand is sensitive to price
  changesthat is, a price increase leads to a
  disproportional reduction in unit sales in other
  words, any additional revenue generated by the
  higher price will be more than offset by the drop
  in demand
• Inelastic demand demand is not very sensitive to
  price changesthat is, a price increase will lead
  to a relatively small drop in quantity demanded
  in other words, the price increase will generate
  more revenue than the drop in demand loses
• Demand is elastic where competition is high due
  to the presence of many operations and where
  products/services are fairly standardized
  (generally, quick-service restaurants, medium-
  and low-priced hotels/motels)
• Demand is inelastic where competition is low or
  nonexistent or where an operation has greatly
  differentiated its products/services (generally,
  some resorts, clubs, high-average restaurants)
• Generally speaking, companies prefer to have
  inelastic demand for their products and services
  because this means that price increases will not
  drive away too many customers when demand is
  elastic, raising prices will be counterproductive

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• Informal approaches to pricing and identify
  factors that modify cost approaches to pricing
• Key Concepts
• Competitive pricing
• Intuitive pricing
• Psychological pricing
• Trial-and-error pricing
• All informal approaches fail to consider costs
• Factors that modify cost approaches to pricing
• Prices charged in the past
• Guests perceptions of value
• Prices charged by the competition
• Price rounding

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• Product Costs and prime product mark-up
  approaches to pricing food and beverage items
• Key Concepts
• Determine ingredient costs
• Determine the multiple to use in marking up the
  ingredient costs (based on desired product cost
  percentage)
• Multiply ingredient costs by the multiple to get
  the desired price
• Determine whether the price seems reasonable
  based on the market

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Hubbart Formula

• 1 per 1,000 approach and the Hubbart Formula to
  pricing rooms.
• Key Concepts
• 1 per 1,000 approach
• Sets price of a room at 1 for each 1,000 of
  project cost per room
• Fails to consider current value of facilities
• Hubbart formula
• Desired profits
• Income taxes
• Management fees
• Fixed costs
• Undistributed operating expenses
• () Non-room departmental losses (profits)
• Direct expenses of the rooms department
  Required rooms department revenue
• Bottom-up approach
• Similar approach used for food and beverage

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• Define and apply yield management
• Key Concepts
• Yield management attempts to maximize revenue
  from rooms sold rather than focus on simply
  selling all available rooms
• Before selling a room in advance, an operation
  using yield management will attempt to determine
  if it will be able to sell the room to a client
  from a different market segment later at a higher
  price
• Sophisticated yield management considers the
  total revenue from all sources, not just from
  room sales, in making its pricing and booking
  choicesthat is, one group may be willing to pay
  more for rooms, but the total revenue from a
  group paying less for rooms but also purchasing
  FB and banquet services may be higher

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• Bottom-up approach to pricing
• Key Concepts
• Like the Hubbart approach for pricing rooms, it
  is possible to price meals by starting at the
  bottom of the FB departmental income statement
  and working up from therethat is, by determining
  a desired net income and then adding expenses in
  order to come up with the price that will provide
  this net income

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• How changes in sales mix affect gross profit
• Key Concepts
• Restaurateurs traditional focus on food cost
  percentage sometimes leads to sales mix decisions
  that result in less profit than other sales mixes
  might provide
• Comparing the profitability of potential sales
  mixes reveals which mix provides the highest
  gross profitthis mix will not always be the one
  with the lowest food cost percentage

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• The menu engineering approach to pricing food and
  beverage items.
• Key Concepts
• Considers menu item contribution margin and
  popularity
• Menus items are classified as stars, plow horses,
  puzzles, or dogs
• Menu engineering worksheet
• Emphasis is on gross profit or contribution margin

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• Advantages and disadvantages of integrated
  pricing by hospitality operations.
• Key Concepts
• Advantages
• Maximizes profits for an entire property
• Coordinates pricing in all departments
• Disadvantage generally results in some profit
  centers not maximizing their revenues and their
  departmental incomes however, since overall
  property profits increase, this is not a
  significant disadvantage except as it might be
  perceived by some managers whose departmental
  revenues are being sacrificed for the greater
  good

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Forecasting

• General Formula
• The starting point to forecast covers in a food
  operation is the historical data.
• For example, if we were estimating covers for the
  coming Friday, we would start with last Friday's
  actual covers. Then, the manager would consider
  any trends that might be factored in.
• For example, if this week's covers are running 3
  greater than last week's covers, the manager
  might adjust the Friday forecast upward by 3. As
  the final step, the manager could incorporate his
  own judgment. This would entail all the
  surrounding factors and unusual circumstances
  that might effect the forecast
• for example weather, or special local events that
  could have an influence on the forecast. After
  this the manager would determine the final
  forecast of covers.

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• Popularity Indexes
• Management can break down the forecast of total
  covers to individual menu items by use of a
  popularity index (PI). There are two ways to
  develop the index. One is in terms of the number
  of meals sold
• PI MenuItemMeals    TotalMeals
• This historic factor is multiplied by total
  forecasted covers to arrive at a forecast broken
  down by menu items . Another way to develop the
  index is by use of sales dollars
• PI MenuItemMeals    TotalSales

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Capacity Management

• Capacity management is a strategy whereby
  restaurant operators attempt to achieve full
  utilization of the restaurant's capacity.
  Operators use procedures and methods to increase
  restaurant capacity to handle patrons during busy
  periods and to divert patrons to the slow
  periods.
• Management may employ flexibility capacity
  strategies in order to adjust capacity to handle
  varying levels of patrons . Restaurant capacity
  can be adjusted by the following strategies
• By increasing patron participation, such as
  buffet service.
• Faster seat turnover, which can be achieved by
  technologies or more servers.
• Optimization of kitchen capacity to handle a busy
  periods.
• Increased employee productivity.

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Smoothing demand strategies

• Smoothing demand strategies involves the
  diverting of customers from peak to slower
  periods, thereby utilizing under used capacity.
  Some of these strategies are
• Price incentives.
• Use of reservations.
• Customer queuing.
• Queuing is the situation where customers wait in
  line before being seated. The challenge for
  management is to make the queuing process as
  pleasant as possible to avoid the loss of
  customers. Management can do this through some of
  the following techniques
• A comfortable lounge or waiting area.
• Serve hors d'oeuvres and beverages (can be
  complimentary).
• Take orders while waiting- this will increase
  seat turnover.
• Provide music or video screens to keep customers
  diverted and entertained.

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delivery system

• A restaurant operator needs to determine that her
  restaurant has the food service delivery system
  to handle forecasted customers. The food service
  delivery system comprises the various elements of
  the restaurant operation that determines its
  ability to handle patrons. These elements
  include
• The type and sophistication of the menu and table
  service.
• The reservations capability of the restaurant.
• Parking availability and ease of utilization.
• Ability to track patron arrival and to serve
  them.
• Available production facilities.
• Dining space capabilities.
• Queuing capabilities.
• Availability and effectiveness of the
  restaurant's employees.

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Forecasting Methods

• There are four basic methods of making customer
  forecasts
• Judgmental methods are where management uses
  experience and intuition to forecast customer
  counts.
• The census or counting method is where management
  takes a sample of a selected population and use
  that information to project customer counts.
• Time series are quantitative methods projecting
  customer counts on the basis of historic trends.
  We will look at two of these methods moving
  averages and exponential smoothing.
• Causal methods are used to project customer
  counts based on other related statistical data.
  An example of this would be a hotel restaurant
  projected restaurant customer counts could be
  estimated on the basis hotel room reservations.

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Moving Averages

• A moving average forecast of daily customers "C"
  for "n" periods is determined by the following
  formula
• The moving average is illustrated in the
  following table.
• The forecast for day four is
• 225 224 194            3 214
• The moving average for day five is
• 224 194 168            3
  195
• The following slide shows moving averages out to
  day 18

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• The following graph shows the relationship
  between the moving average forecast and actual
  customer counts

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Exponential Smoothing

• Another forecasting time series method is
  exponential smoothing. Under this method, the
  difference between the previous day's forecast
  and actual is multiplied by a smoothing factor,
  "a," which is added to the previous day's
  forecast to arrive at the current day's forecast.
  This is reflected in the following formula, where
  "C" is actual customers, "F" is the daily
  forecast of customers, "a" is the alpha factor,
  and "i" is the dayThe most customary "a"
  factor is .5. Using the previous example's data
  the forecast for day two is300 (225 - 300).5
  263
• The forecast for day three is 263 (244 -
  263).5 244
• The following table illustrates the exponential
  smoothing method out to day 18. The first day's
  forecast was a guess of 300 thereafter
  exponential calculations are used.

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Qualitative Forecasting Methods

• Market research
• Jury of executive opinion
• Sales force estimates-from staff
• The Delphi method- measures the degree of
  consensus among the panel regarding future
  events.
• Forecasting Method Selection Factors
• Effectiveness of the method
• Costs of using the method
• Frequency with which forecasts will be updated
• Turnaround required for an updated forecast
• Size and complexity of the hospitality operation
• Forecasting skills of personnel involved
• The purposes for which the forecasts are made

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Cost/Volume/ProfitDecision Making, Part Two
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Cost/Volume/Profit (Relationship Factor)

• One cannot assume that "good" cost to sales
  relationships automatically result in profit or
  that higher or lower cost percentages are
  necessarily desirable. What is desirable is to
  have the best relationship that yields the best
  profit
• Prime Costs cost of sales (food, beverage ,
  etc) and cost of labor
• Example
• Sales 925,000 100.00
• Cost of Sales 309,875 33.50
• Cost of Labor 231,250 25.00
• Cost of Overhead 277,500 30.00
• Profit 106,375 11.50
• Satisfactory profit has been earned. However, it
  is also possible to earn acceptable profit at
  some sales level other than 925,000, even if
  prime cost increases
• Sales 1,300,000 100.00
• Cost of Sales 520,000 40.00
• Cost of Labor 390,000 30.00
• Cost of Overhead 277,500 21.35
• Profit 112,500 08.65

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Cost/Volume/Profit Equation

• Salescost of sales cost of labor cost of
  overhead profit
• Which also equates to Sales variable cost
  fixed cost profit
• S VC FC P
• Within the normal range of business, the
  relationship between VC and S should remain
  relatively constant. This is why we watch our
  cost percentages (variable)
• Fixed costs remain constant in dollar terms,
  mutually exclusive to changes in dollar sales
  volume
• You can take an Income Statement and plug the
  figures in to the equation

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variable rate, contribution rate, break-even
point and contribution margin

• The concept of Variable Rate ratio of variable
  cost to dollar sales
• Contribution Rate percent of dollar sales needed
  to cover variable costs
• Break-Even Point dollar sales covers both
  variable and fixed costs exactly
• Example
• Sales 925,000
• Variable Costs 402,375
• Fixed Costs 416,250
• Profit 106,375
• Variable Rate .435
• Contribution Rate .565
• Variable Cost 402,375 Sales 925,000
• VR Variable Cost (402,375) / Sales (925,000)
• VR .435

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Break Even Point

• Sales FC P / CR (this formula is used to
  determine the level of dollar sales required to
  earn any profit that one might choose to put into
  the equation)
• 925,000 416,250 106,375 / .565
• 925,000 522,625 / .565
• 925,000925,000
• S FC P / CR
• S 416,250 0 / .565
• S736,726

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What is Variable Cost you can have beyond the
break even point?

• This determines based on a certain amount of
  sales, what can the VC be
• 1. Actual Sales BE Sales
• 925,000 - 736,726 (sales) 188,274
• VC S x VR
• VC 188,274 x .435
• VC 81,899

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Budget Exercise

• Questions