Hospitality Industry Characterized by High Fixed Costs

Hospitality Industry

There is one unique financial characteristic that is synonymous with the hospitality industry; that is high fixed costs. Or another way of stating the same financial attribute is to simply state that the hospitality industry has low variable costs. There are several different cost drivers that force this industry to incur high fixed costs. These include location, initial cost of construction, costs of capital and an economy of scale. Each of these business attributes contribute to the high fixed costs of operations.

In general the hospitality industry takes care of guests for an extended period of time (at least several hours). Some writers indicate that your fancier sit down restaurants are in this industry and they are not. All restaurants are in the food service industry. Hospitality involves longer periods of contact or utility time with the guest than simply the time it takes to consume a meal. 

The hospitality industry is comprised of the following lines of business:

As the following sections explain the cost drivers for high fixed costs, think of the different lines of business as identified above when evaluating theses costs. The first contributing cost driver that forces a high fixed cost is location.

Location, Location, Location

If you haven’t quite figured it out yet most of your hospitality based operations have to operate in more expensive geographical zones. Some may not operate at a particular geographical zone but may operate at a competitive site such as an exit off the highway for a motel or hotel. No matter, the fair market value drives the cost of purchasing a piece of land.

The cost per acre for land on the ocean or with access to the ocean is much more expensive than a comparable piece of property 20 to 30 miles inland. Often the price per acre is six to ten times more expensive. Think of a theme park or a golf course. These lines of business need many acres and this land needs to be located near a community that attracts outside visitors. In Orlando, FL; how much is one acre of land? Answer: nonresidential land near the heart of activity is selling for nearly $500,000 per acre.

Even a piece of land with access to a main thoroughfare is much more expensive than acreage two to three miles further away from the exit. The location of the property is one of the primary cost drivers for the hospitality industry. Once you own the land, now it has to be developed.

Initial Cost of Construction

Every line of business in the hospitality industry has significant initial capital costs. A typical cruise ship costs several hundred million dollars to construct and outfit with the proper equipment and facilities. Your common resort with 200 units will cost $35,000,000 to construct. Construction includes site development, drainage, underground utilities and much more so that guests can enjoy a modern facility with a view.

Couple the initial cost of construction with the cost to purchase the location and you now can determine the primary overall cost driver of high fixed costs. Naturally nobody builds these without incurring debt and debt costs money.

Costs of Capital

One of the common jokes with those in financing is which would you rather have: 1) a 100% return on 10 dollars, OR 2) a 1% return on one million dollars. Well the first one is merely a $10 return. The second one is a $10,000 return. In the form of hard dollars the answer is number two.

Well this is the basis of lending money. Banks would prefer to lend large amounts on relatively safe investments. A typical hotel with a $15 million dollar debt with a 3.7% interest rate only pays $46,250 per month for interest. OK, let me restate this: $46,250 per month for interest! At $100 per night for a room this means you would have to rent out 15 rooms every night of the month just to cover the interest on the debt. I haven’t even broached the subject of the debt service component, i.e. the principle portion of the payment.

The cost of capital for any line of the hospitality industry is relatively high and it is typically the number one fixed cost related to operations. The second cost driver in fixed costs is the principle portion of the debt service.  If the debt portion is spread over 25 years which is customary and this debt service is straight-line amortization you are looking at monthly principle payments of $50,000 per month for that same $15,000,000 loan. This is another 16 rooms per night just to cover the debt service component of the debt.

Thus, a standard 120 unit hotel needs 31 rooms occupied each night of the year just to cover interest and debt service. And we haven’t even addressed the next cost driver which is economy of scale.

Economy of Scale

In order for any of the lines of business in the hospitality industry to be efficient in operations, the size of the operation matters. Basically ‘Economy of Scale’ means you are spreading the costs across a large number of selling units. But before you can sell even the first unit, you must incur more costs to prepare. 

Think of the cruise line in preparation for a one week cruise. First off it must have a staff of several hundred (actually about 1500 for the typical cruise ship) dedicated to that particular week. This includes the ships operations staff, food service workers, cleaning and maintenance staff and the entertainment group. Next, is fuel. Let’s stop here for a moment. Many of you will think this is a variable cost. If we were in the transportation industry I would agree. But in reality fuel for a cruise ship is fixed in nature. It doesn’t matter whether we have 100 passengers or 2400 passengers; the ship requires fuel to operate. Variable cost means that the cost has a high correlation to the unit of sales. This is not the case in the cruise industry. Fuel is a fixed cost.

So to have the ship ready to sail with all the food on board, fuel, terminal fees paid and much more is fixed in nature.  Economy of scale plays a role in reducing this cost per unit (passenger) by increasing the number of units sold to reduce the cost per unit.

The same is true in the hotel industry. The front desk clerk, the back office operations, maintenance crew and even utilities must be paid in order to accept the first guest each night. To take advantage of economy of scale a lot of fixed costs must be incurred to be ready to receive as many guests as possible. How much must Disney pay each day to have the park fully staffed to receive a single guest? In order to spread these costs the particular line of business must be large in nature and this is a part of the definition of the hospitality industry.

Summary – Hospitality Industry (High Fixed Costs)

There are four cost drivers in the hospitality industry that drive up fixed costs. In general, the fixed costs as a percentage of revenue is generally higher than 60% for most hospitality based operations.

The first cost driver is the location of the particular line of business. Since the business relies on many customers to spread the costs, the location is typically in a well traveled or desirable spot to garner guests. The second cost driver is cost of capital.  To bring guests to your business, a hospitality based operation must incur significant cost outlays to build a facility that will attract visitors. This initial cash outlay costs money related to costs of capital. The interest and the principle portion of debt are the two primary drivers of overall cost for any hospitality based operation. The final driver of fixed costs is the economy of scale issue. To spread the associated costs of staff, marketing, utilities to receive the first guest, the line of business must be able to generate large sums of revenue by maximizing the number of guests. Act on Knowledge.

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