Revenue Management Basics – 3 Concepts Every Hotel Employee Must Understand

30th Jul 2012

Bill KotrbaNB: This is an article written By : Bill Kotrba – 

After location, of course, the three most important profit levers for a hotel are price, price and price. Suppose you are given the opportunity to make a 10 percent improvement in occupancy, price, fixed costs or variable costs. All things being equal, a top-line price increase drives the most dollars in bottom-line profit. This is not a new discovery, although with the intense focus on cost-cutting that many businesses have embraced, it bears repeating.

Good revenue managers know intuitively that setting the “right” price can drive success or failure for any business. But for hotels and other businesses with the combination of low marginal costs, high fixed costs and perishable capacity, pricing decisions take on the utmost importance and complexity.

So it should not come as a surprise when I say that, as a consultant and solution vendor, the most common concern I hear from individual hotels is that they have trouble choosing what price levels to set. Similarly, at the chain level, executives responsible for revenue generation have serious concerns that many general managers and franchise owners blindly follow unsophisticated competitors up and down, unsure about what the true impact on revenue will be. Others may treat pricing solely as a lever to drive occupancy, with limited visibility into whether or not their efforts are creating a more favorable total revenue outcome.

Having heard numerous misconceptions and biases about how to approach pricing strategy in the hospitality industry as well as other industries, it never hurts to revisit three basic revenue management concepts and ensure that every employee in the hotel, or at least all those who interact with pricing and customers, understands them. The three concepts are:

1- 1- Increasing prices does not always increase revenue.

 2- The only reason to offer discounts is if it results in more revenue.

3- The best revenue management is a “win-win” for customers and hoteliers.

Increasing Prices Does Not Always Increase Revenue

In the oversimplified example above, given a choice between a 10 percent improvement in occupancy, price or costs, the idea of “all else being equal” does not exist in real life. Price and demand are in constant interplay, as a matter of degree that is measured by price elasticity. When prices go up, fewer rooms get sold. The million-dollar question is how many fewer rooms will get sold? Will the incremental revenue from customers who are willing to pay the higher price be enough to offset the lost revenue from customers who aren’t, or don’t book, or choose a competitor?

Econ 101 review: When a price increase generates more total revenue, demand is said to be inelastic. When a price increase generates less total revenue, demand is elastic. (Note: Several U.S. hotel chains have adopted price optimization solutions that measure elasticity and can identify the price at which maximum revenue or profit is generated.)

Despite an intuitive grasp of this, many hoteliers operate under the assumption that price increases are universally good. Conversely, there is much consternation over the fact that since the economic downturn in 2008, the average daily rate (ADR) in some market segments has not recovered. Why do we automatically assume this is bad? Total hotel demand in the U.S. has recovered nicely since the recession, and given the oversupply of rooms that existed going into the downturn, perhaps as an industry, rooms are priced optimally. U.S. hotel industry RevPAR overall was up more than 8 percent in 2011(i)

A great example of an industry particularly prone to the belief that prices translate directly to revenue is public transportation. When faced with a revenue shortfall, public transportation authorities go to the City Council and request approval to increase rates—as though this will automatically guarantee an increase in revenue. Surprise—a year later, ridership is down because more people chose to take their own car or carpool or stay home, rather than pay a higher bus fare. Evidently, some public transit riders are price-elastic, and some have access to alternate means of transportation. Another shortfall.

Danger: Destructive Discounting

The only reason to offer discounts is if it results in more revenue. The key to effective discounting is to understand the effects of demand stimulation and revenue dilution.

When prices increase, we need only worry about how much demand is lost as customers stay home or book with competitors—and whether that offsets the revenue gained by charging the remaining customers a higher price. When prices decrease, demand for a hotel is generated (or “stimulated”) as customers book away from competitors, or in some cases decide to travel when they might otherwise have stayed home. However, there is a cost to generating this demand—revenue “dilution.” If a discount is offered universally to customers who would have booked without a discount, then the revenue from those customers is said to be diluted, as they were willing to pay more than they actually paid.

Many hoteliers operate with eyes only on occupancy, assuming that higher occupancy is universally good, and that low occupancy must be bad. But driving higher and higher occupancy usually requires discounting, and with that comes the potential for revenue dilution. Constant, undisciplined discounting to drive occupancy, without regard to revenue dilution, can ultimately cause destructive price wars that ripple through markets. Stimulation and dilution can be quantified together in the form of price elasticity, the same as for a price increase. If a discount results in more total revenue, demand is said to be elastic. If a discount generates less total revenue, demand is inelastic.

However, the key to effective discounting is to understand stimulation and dilution separately and, most importantly, to find ways to stimulate demand while avoiding revenue dilution. Segmentation and fenced discounts are the best examples. Hotels don’t have any particular reason to be nice to senior citizens and auto club members—even if it generally feels like a good thing to do. In a way, it is almost the opposite. Seniors and AAA members do hoteliers a favor by being easy to identify and target with exclusive discounts not offered to the general public—creating an opportunity to stimulate demand and avoid dilution of other revenue.

Revenue Management = Win-Win

Customers win when industries practice good revenue management. Although there are still a few customers grumbling that price discrimination is unfair, and no one wants to be the person bumped from a flight or walked from a hotel when it’s inconvenient, as a nation we have generally accepted segmentation and overbooking in the travel and hospitality industries. Paying a different room rate this week versus last week at the same property is not unusual, and we are no longer the least bit surprised when we overhear another person checking out of a hotel paying a lower or higher rate. Customers receive discounts in exchange for flexibility or satisfying certain booking requirements or committing to a particular length of stay that benefits the hotel in some way. This is considered the norm and a fair business practice, providing value to the customer and additional revenue to the hotel.

Revenue management is a mechanism that creates opportunities to satisfy more customer demand and provide more customer choices. The ability to forecast late-booking business travel and price specifically to this market segment creates last-minute available rooms that would otherwise be sold out. The ability to offer fenced discounts to specific groups without diluting other revenue drives more total demand, more properties overall that customers can choose from, and more competition that helps keep prices down.

Overbooking has become more customer-friendly in general, as airlines and hotels have learned that the process works most smoothly, with fewest complaints, when customers are compensated for volunteering to be bumped from a flight or walked to a different property. Of course, some organizations are better at this than others!

Early revenue management approaches and traditional yield management systems focused on “yielding out” or rejecting certain customer segments on nights when hotels were expected to sell out. These offered little guidance to hoteliers struggling with how much to charge in the first place. The emerging solutions in hospitality focus on identifying optimal prices and helping hoteliers hit the “sweet spot” when discounting or increasing rates—whether the hotel is sold out or not.

Winning the Battle, Winning the War

With prices on display 24/7 on the Web, side-by-side for comparison with local competitors and hundreds of customer reviews, hoteliers cannot afford to take a dull knife to this gunfight. Matching the price across the street and hoping for the best is no longer going to cut it. Making sure every manager understands the basics of price elasticity and the real relationship between pricing, demand, occupancy and profits is a good start. It may keep you from missing a revenue opportunity or worse, starting an unnecessary and destructive price war

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