by Olivier Harnisch,
The Marginal Impact of Changes
Difficult trading conditions are good opportunities to reconsider basic
business principles which have stood the test of time but have recently
taken a backseat given the continuous emergence of new management techniques.
Most hoteliers have understood that the current environment coupled with
an uncertain future requires them to make appropriate decisions in order
to mitigate the impact of soft demand and low yields on bottom line. Now
is the time in which business leaders need to examine every aspect of their
distribution and operation performances in order to fine-tune both top
and bottom line activities. Taking a fresh look at the economic concept
of marginal analysis may be useful. The textbook definition of marginal
analysis or marginalism is: “The technique of studying economic change
by examining any small rate of change of any one variable relative to another.”
In a nutshell, marginalism suggests that we consider making changes to
individual economic entities and evaluate the net impact which would result
from these changes. What is meant by an economic entity in this context?
It is any identifiable unit which simultaneously generates costs and value.
It can be a menu item, a business process, a working shift, a position,
an outlet, a promotion, an hour of trading, etc …
Averagism vs Marginalism
Hoteliers have grown accustomed to thinking in aggregates and averages.
Our most familiar figures such as food cost, REVPAR, average check, department
profits, business mix, payroll percentage, GOP, etc … are high level concepts,
averaging or summing up various figures. We often apply a top-down approach
to our daily leadership and manage by exception whenever any of the above
indicators fall outside an acceptable range. However: While the often quoted
“look at the big picture” is critical when managing a business strategically,
a detail focussed, bottom-up approach is more appropriate when fine tuning
is in order. Many hotels and hospitality companies have successfully reviewed
their long term strategies over the past years. Thus, fine-tuning may be
the only option available to them. In such cases, the “helicopter view”
is inadequate and may miss out valuable opportunities. For example, it
is simply not sufficient to compare the food and beverage profit margin
or the payroll percentage with reference properties or industry averages
and tick them off if the figures are within an acceptable range of the
mean. Marginal analysis is a more effective approach as it focuses on the
value creation of the entity being analyzed and makes little reference
to industry averages.
Applying Marginal Analysis
Instead of applying a top down perspective on hotel departments and
analyzing aggregate figures, marginal analysis is about identifying the
economic entities within the business and comparing the value to the costs
they generate. Obviously the former should be greater than the latter.
Marginalism is anything but rocket science. Rather, it is a mindset and
requires the willingness to examine every area of a business without taboos.
How much incremental value does an entity generate for the business? By
how much would costs decrease if it was discontinued? By how much would
value increase if it was augmented? Often the analysis comes down to comparing
incremental revenues to the costs generated by the economic entity. This
is however not always the case, as the concept of value encompasses more
than revenues and includes such benefits as the enhancement of guest experience,
increased team-member motivation or improvement of the business’ reputation.
The fundamental principle underlying marginal analysis is the explicit
comparison of the incremental value versus incremental cost generated by
an economic entity. Let’s look at some examples of entities where marginalism
can be useful. This list is far from exhaustive.
The classic menu engineering techniques are very effective methods
to gauge each item’s marginal contribution to food and beverage profit.
Start by calculating the Dollar margin on cost of sales. Then apply a production
cost to each item depending on whether they are high, medium or low in
production intensity. Then multiply by the numbers sold over a definite
time period, to come to a total Dollar contribution by item. Then rank
the items by their contribution within their dish category. Do not use
percentages but absolute Dollar figures. Are all menu items truly profitable?
A focus on absolute rather than percentage margins may yield counterintuitive
results, as items with a higher food cost percentage may actually generate
higher profits. For example, do we inadvertently encourage waiters to sell
a pasta dish with a food cost of 20% and a margin of 6 Dollars rather than
a filet steak with a food cost of 40% but a margin of 15 Dollars?
Operating days and hours of profit and service centers
The trading times of outlets should be reviewed on a regular basis.
What is the cost/benefit ratio of each operating hour? The business hours
of restaurants, bars, fitness clubs, etc … are often based on habits and
rarely questioned. In many hotels, outlet operating hours are the same
for every day of the week, despite potential regular variations in business
patterns and guest demand among them. Is the value generated by each hour
of operation, especially at the beginning and the end of a day, invariably
higher than the costs? If the revenues generated do not cover the costs
incurred, is there another reason for maintaining the hours of operation?
Such reasons may be expectations by the hotel’s guests. In any case, the
value generated must outweigh the costs and it must be stated explicitly.
This analysis can also be extended to operating days. Hotels with several
food and beverage outlets often operate all of them seven days a week,
although some days may notoriously generate low revenues. Closing a bar
or restaurant for a day per week may boost outlet profitability, as all
staff members take their off days simultaneously. This substantially reduces
required staffing to operate the outlet. Annual closings may also have
a positive impact on profit. Closing an outlet for a few weeks per year
during a slow season allows the scheduling of all annual staff vacations
at the same time. This reduces the team size required to run the outlet.
Such decisions are not solely based on financials. Guest expectations,
quality criteria, etc … play an important role in finding the right solution.
Nonetheless it is critical, that the costs and value linked to such decisions
are clearly spelled out. The converse may also apply. An outlet may be
opening too late or closing too early and thus miss valuable revenue opportunities.
Extending operating hours may be beneficial and marginal analysis helps
in making the right decision.
Shifts and working hours
A similar challenge is posed by rota planning. Is the number of shifts
and the work-time schedule truly based on business requirements or once
again driven by habits? A daily productivity measurement tool with some
clear productivity standards by outlet and department will help monitor
an operation’s ability to correlate the scheduling of resources with operational
needs. Often, human resources and money are wasted because of ineffective
scheduling on slow days (i.e. week-ends) and slow periods (i.e. between
meals or early/late hours). This analysis is closely related to the previous
one addressing operating hours, as a change in shift planning may convert
an unprofitable operating hour into a profitable one. The exercise is easier
for shifts in revenue generating positions such as restaurant staff, as
the cost of a shift or of working hours can be directly put against the
incremental revenue generated within the time period being analysed. However
even for non-revenue positions the cost of a scheduled time unit should
be set against the value it generates.
Do profit centers truly deserve their name or do they simply generate
revenue without profit margin? A food and beverage department yielding
a low profit as per Uniform System of Accounts for the Lodging Industry
will often effectively make losses when all relevant costs are attributed
to it. Whilst the USALI allocates direct costs to their respective departments,
marginal analysis goes further and considers all costs directly generated
by a profit center, including opportunity cost. The fact that such analysis
is complicated does not diminish the importance of the exercise. Energy,
credit card commissions, G&A resources, etc … are considered undistributed
operating expenses under USALI. They need however to be included in marginal
analysis in order to calculate the true profitability of a profit center.
While the cost of energy has often been neglected in the past, the increases
of recent years have made energy a critical cost factor. Opportunity cost
refers to the foregone benefits of an alternative operation. For example:
Is the marginal value generated by an F&B outlet higher than if the
space was leased out or converted into meeting space? This question may
be relevant in hotels with several food and beverage outlets. Outside catering
is also an area worthy of detailed analysis. Hotels not specialized in
this business often overestimate the profitability of out-of-house catering.
The P&Ls of events (when they are done at all) frequently do not consider
such items as the time spent on booking, planning and preparing the event.
They also overlook such costs as time spent on invoice preparation, account
collection, energy, credit card commission, increased loss and breakage
of equipment, etc ….
Marketing campaigns, training activities, F&B promotions etc …
fall under the category of business processes. Such economic entities are
more difficult to analyze in the context of marginalism as: 1) The value
generated is often less tangible and difficult to state in monetary terms;
and 2) The value often comes with a time lag and sometimes over several
years, whereas the costs are incurred within a year. Despite these difficulties,
marginal analysis should still be applied. One major advantage of the exercise
is that objectives, costs and expected value creation have to be explicitly
stated. In reality, a positive net effect of such processes is often taken
for granted without explicit attempt to define it. While an F&B promotion
can easily be analysed in terms of incremental costs versus revenues generated,
this is more complicated for image campaigns or training programmes. But
here also the value created has to be higher than the costs incurred, and
it must be stated with a clear time frame.
Other uses of marginal analysis
Marginal analysis can also be applied to customer segments or single
accounts. Does a hotel maintain any transactions and contracts that are
unprofitable after accounting for all direct costs? Such costs pertain
to distribution (GDS fees, travel agent commissions, …), the variable cost
of stay, revenue collection, opportunity cost (displacement of alternative
business), etc … The costs of distribution or channel costs can
shave off a good portion of the room rate and are often underestimated.
An account with a high room rate and high distribution costs may be less
profitable than an account with a lower rate and distribution cost. At
the same time, third party channels frequently generate incremental profitable
business otherwise unavailable to a hotel, despite potentially high distribution
costs. On the other hand, is the hotel rejecting business which might be
detrimental to departmental profit percentages but would yield a positive
profit margin? A strong orientation towards departmental profit percentages
increases this risk. From a purely financial perspective and in the short-run,
rooms must be sold at rates covering at least their variable costs in order
to generate a profit. Taking in groups at deeply discounted rates may make
financial sense in low demand periods, when servicing can be ensured through
the base staffing of a hotel. Once extra staff has to be scheduled (breakfast
cooks & waiters, porters, check-in staff) the low margins are often
eroded by an increase in variable cost.
Reward systems must be aligned with the ultimate objectives of the company.
This is important in the context of marginalism. Are Sales Managers for
example rewarded based on REVPAR or market share development, rather than
GOPPAR? In such cases, they will likely pay less attention to the profitability
of business and rather focus on room revenue maximization. Executive Chefs’
bonuses are sometimes based on food cost percentages instead of total F&B
profit in Dollar terms. This encourages them to focus on low food cost
percentage rather than high dollar margin items. In addition, Chefs who
have menu pricing discretion may set prices at excessively high levels,
harming the volume-margin mix. This may be beneficial to the food cost
percentage but negatively impact total F&B profit in monetary terms.
Marginal analysis is a powerful tool to optimize the value creation
ability of a business. It is detail oriented and does not replace high
level strategic planning. What’s more, the decisions made and the actions
taken in marginal analysis must be compatible with the overall, long-term
strategy of the company. But within the context of a specific businesses
strategy, marginal analysis is useful to ensure that the operation is run
as effectively as possible. The costs and value generated by economic entities
must be explicitly defined. In reality this happens too rarely. When the
value created is of non-monetary nature, the analysis is more complicated
but remains nonetheless critical. High-level average and aggregate figures
are useful for reporting and benchmarking purposes. For fine-tuning and
action planning however, marginal analysis is more powerful. It can be
applied to all economic entities within a business.
Harnisch, MBA, MSc, CHA, currently holds the position of Vice President
International Operations Germany and Switzerland at Hilton Worldwide. He
began his career in 1986 as Commis de Rang at the world famous Hôtel
Negresco in Nice, France, after completing an apprenticeship as a Restaurant
Specialist in Briançon, France. He has worked on 4 continents since.
Olivier Harnisch holds a Hotel Management Degree from the Berlin School
of Hotel Administration, an MBA from Heriot-Watt University in Edinburgh,
and an MSc Degree in Organizational Behaviour from the University of London.
He has also been awarded the designation of “Certified Hotel Administrator
(CHA)” by the American Hotel and Lodging Association. He speaks 6 languages
and lives with his family in Wiesbaden, Germany.