I’ll start out by identifying the fixed and variable costs of hotel operations. Then I will explain the marginal value of one additional guest at the hotel and finish up with a simple aggregated formula so any hotel operator can easily understand the value of getting heads on beds.
Fixed and Variable Costs in the Hotel Business
If you imagine the hotel operation you can visualize the respective costs they incur. The most obvious is of course the structure itself. Then there are facilities cost including maintenance, landscaping and inspections (elevator, health and pest). Other costs would include utilities, communications and of course staff to operate the facility. The bulk of the staff will be involved in cleaning and food service along with the front desk operations. Some of these costs are fixed in nature while others are variable and only change as the volume of guests increase or decrease. So let’s break down these costs into the two respective groups.
There is one cost each month that drives the cost of operations over any other cost. That’s the mortgage note interest and of course the associated mortgage escrow fees. A typical hotel with 140 rooms will cost around $6 million to construct. Most owners of hotels use 10 year secured market notes and finance around 75% of the total value. So a typical mortgage note for a 140 unit hotel has a principle face value of approximately $4,500,000. Average monthly payments run around $26,587 for the principle and interest components. In addition the taxes will approximate $5,800 per month and building insurance will average $4,200 per month. I’m not going to include any form of replacement reserves nor principle escrow and interest rate cap fees. I’m trying to keep this simple to illustrate my point.
Altogether, the monthly cash payment is $36,587. The interest component in the typical payment is approximately $13,302.
Other fixed costs include taxes and insurance included in our monthly mortgage payment. Continuing with fixed costs we will also find maintenance costs and facility requirements (legal compliance with local codes). From the elevator inspection to maintaining the health license all have to be paid whether we have one guest or we fill the hotel up every night. Believe it or not, the electric bill is mostly fixed in nature. The hotel must be lit up in order to stand ready to receive the first guest. Some of the electric bill will be variable as it will increase as each guest uses a room at night. But in the aggregate, about ½ of the electric and heating bill will exist without any guests.
If you desire to truly understand the concept of fixed costs in business, I urge you to read Fixed Costs. The following is a condensed list of the typical fixed costs in a hotel:
- Mortgage Note Interest and Corresponding Principle
- Insurance (Property, Professional Liability, Errors and Omissions, General Liability)
- Local Revenue/Business License Fee
- Grounds Keeping
- Facilities Maintenance (Pool, Fitness Room, Lounge and Kitchen)
- Principle and Interest on the Furniture/Fixtures/Equipment Note
- Utilities (about ½ is fixed in nature)
- Communications (Internal Phone System, Landlines, Internet Access, Cable and Radios)
- Manager’s Salary/Assistant Management
- Front Desk Clerks
- Back Office Staff
- Professional Fees (Legal & Accounting)
- Subscriptions (Periodicals, Newspaper, Inserts, Flowers)
The key to understanding fixed costs in the hotel industry is the requirement to pay this cost no matter the number of guests. A good example is the annual audit fee paid to the accountants. Most mortgage notes involved in the hospitality industry require an annual audit signed by a Certified Public Accountant. So it doesn’t matter whether there is one guest or 140 each night, you still have to pay this fee.
Altogether, these fixed costs will tally around $79,000 per month for a medium size hotel. Or, if we want to look at it on a per room basis, it is $565 per month or about $19 per night. Now that we have a picture of the fixed costs per room per night, let’s look at the variable costs per room per night.
As I stated above, the variable costs average about 30% of all costs. So what is included in variable costs? Well the most obvious is cleaning. This includes the staff and supplies to clean those rooms used each night. In addition, the laundry aspect of the cleaning has costs too. Remember, each night the towels, sheets, and covers are washed to maintain a clean and hygienic room for our guests. In addition, there is some consumption of supplies including the standard guest room supplies (soaps and paper products).
Other variable costs include the utilities used that night in the room and the food consumed in the morning at our free breakfast bar.
So what about the front desk operations for the guests? I would argue that the front desk is fixed in nature as they must be there whether there are guests or not. Based on the definition provided for variable costs in business (read Variable Costs for a more thorough understanding of this business concept) the front desk clerks are fixed and not variable.
OK, how much do the variable costs add up for one room for one night? Let’s break it down:
So total costs for each room each night is about $35. Note, $19 of this is fixed and $16 is variable. Wait a minute! I said earlier that variable costs run about 30% of all costs. But based on this information, variable costs are 45% of all costs. Well, that is true. But this assumes that each room is filled each night no matter what. Therefore the fixed costs are spread over all 140 rooms. But the reality is that not all the rooms are filled each and every night. I guarantee you will fill all the rooms on Year Year’s Eve, but not necessarily on New Year’s Day. So if your occupancy rate is 50% for the entire year, then what is the ratio? Let’s do the math.
If occupancy is 50% then we really only need to double the fixed costs per room as those rooms being used must absorb the fixed costs for the entire hotel that night. This means fixed costs at 50% occupancy equals $38 per night per occupied room. The variable costs for that room are the same at $16; therefore $16 is 30% of the total costs (16 divided by 54 total costs) for that night.
So how can one guest make a difference?
Marginal Value of One Guest (Head on a Bed)
Alright, let’s remember that every guest that comes into our hotel costs $16 to serve that night. So if we have a guest that just walks in off the street and says I want to rent a room, how much is he going to cost, $16. So as long as we charge at least $16, we will have lost nothing in the exchange. He uses one of the rooms and he neither costs us money nor makes us money. So let’s say we charge him $86 for the one night. His use of the room contributes $70 ($86 – $16) towards payment of the fixed costs. That is, he is generating a marginal $70 of value for the hotel. This is where the saying heads on beds is sourced. He is contributing cash towards paying the fixed costs of the hotel.
Now I know a lot of you are shaking your head because think about it; he is one guest and really is $70 that lucrative? In the overall scheme of things, $70 is not that significant. It will barely dent the $79,000 of fixed costs. But let’s make some reasonable assumptions and do some more math. Let’s say that our occupancy is 30% and we charge $90 per night for the room. Now I know we have different rates for different rooms but let’s just for the sake of analyzing the marginal value of a guest make every room a one bed room and for some strange reason, only individuals rent the rooms. If we have a typical 30 day month then we will rent out 1,260 bed nights (140 rooms X 30 Days X 30% Occupancy), which means we will generate $113,400 of revenue for the hotel.
Now in accordance with our variable costs formula from above, the variable costs will equal $20,160 (1,260 bed nights X $16 in variable costs). So right now our financial report will look like this:
Single Bedroom Stays (1,680 Bed Nights) $113,400
Variable Costs 20,160
Gross Margin $ 93,240
We know fixed costs are $79,000 and therefore we will generate a profit of $14,240. Well, this is great! We made money this month. But if we rented to the one more guest as identified above, our profit will increase $70 to $14,310. Not a big deal is it? Well it is a ½ % increase in profit. Really ½ of 1% increase; you may not think of this as a lot but let’s carry this a bit further and rent one more bed for each night. So now we’ll have a 30 day increase at (let’s stick to the standard rate of $90 per night) which equals $74 per night for 30 nights. That is an increase of $2,220 or a 15.5% increase in profit.
So one more head on a bed each night makes a significant difference in the hotel’s bottom line. This is due to the high fixed costs and low variable costs. If variable costs were $30 each night and the fixed costs remained at $79,000, with a 30% occupancy rate at $90 per night, our gross margin would equal $75,600. This is $3,400 shy of the amount we need to cover fixed costs.
The math simply reinforces the value of a single additional head on a bed when the variable costs are so low in comparison to the rental income earned for that one night.
Aggregated Value of Exercising Heads on Beds
To really drive home the point, I’ll illustrate this concept with three different approaches for the hotel. The first column will represent the hotel using the national registration system exercised by its franchisor and occupancy is 35%. The next column identifies where the hotel uses the local chamber of commerce and a secondary website registration system to increase the occupancy to 37%. The final column represents what happens when one of the clerks negotiates a deal with the local university whereby any guests arriving in town and using this hotel will be charged only $65 per night. The university guarantees 200 guests per year and that is exactly the number that shows up throughout the year.
Again, the conditions are the same as above, the rent is $90 per night, variable costs are $16 per night and our fixed costs remain at $79,000 per month. Let’s see the value of adding 200 more heads on beds at a discounted rate.
35% Occupancy 37% Occupancy 37% w/University Contract
17,885 Bed Days 18,907 Bed Days 19,107 Bed Days
Single BR Stays $1,609,650 $1,701,630 $1,714,630
Variable Costs 286,160 302,512 305,712
Gross Margin $1,323,490 $1,399,118 $1,408,918
Fixed Costs 948,000 948,000 948,000
Profit $375,490 $451,118 $460,918
Wow, look at the difference! The additional 200 bed days at a discounted rate ($65 instead of $90) equates to an additional $9,800 of profit. Look at the difference of 37% occupancy over 35%. This is a marginal 1,022 bed nights over the course of a year and the profit increases a staggering $75,600! This is a mere 3 additional guests per night to achieve a 20% increase in profit.
This truly illustrates the value in the aggregate of getting more heads on beds. So those programs of aligning with certain organizations to house their guests when they come into town or any other program that shows any slight opportunity will make a big difference in the bottom line. This is because in this industry, variable costs are so low, any marginal increase in guests (heads on beds) adds a lot of cash to the coffers. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.
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If the above didn’t drive home the point of adding more dollars to your till, then read another article that is similar in nature but takes it to another level and it is in a different segment of the hospitality industry. Read Absolute Dollars .