To Discount or Not to Discount

Whenever a recession looms on the horizon, caused by either wars, terror attacks, a pandemic such as SARS or the present day H1N1 virus, political instability (Thailand for example), sales and profit begin to decline, market share often shrinks and management raises the inevitable question – by how much do we discount our price points in order to galvanize business?  So, in this present time and age hotel managers and sales directors start the ambiguous game of discounting rates with a highly uncertain outcome. It appears our industry has become obsessed with (high) ADR instead of RevPar and market share performance. Rate “dropping” is a myopic answer that anybody can do – there is no real skill required. This current economic malaise requires a more structured and intelligent approach than just reducing the rate. Reducing room rate does (normally) NOT generate more volume per se in low market demand situations. It is a fallacy to think it does, there is no empirical evidence that supports that notion.

Hotel operators should concentrate on increasing revenue share through intelligent sales and marketing initiatives. Then management companies will be surprised how much money they lose as sales declines in proportion to reduced ADR. Furthermore, hotels erode hard earned market share, diminish current and future earning potential and ultimately damage the brand’s reputation. Below are two simple, but realistic scenarios illustrating that discounting rates is not the answer to attract business.

Example I
A hotel sells 5,000 rooms per month for U$ 180 generating sales of U$ 900,000. Let us assume variable cost is U$ 8 dollars per room sold. That leads to a gross profit of U$ 860,000. Management assumes by decreasing rate by over 50 percent (times are tough) significant volume will be stimulated that will lead to higher revenue and profit.

Example II:

With the new strategy the hotel now sells 9,000 rooms (an increase of 80 %!!). Variable cost of U$ 8 dollars per room remains, after all operating standards have to be maintained. Management decides the new promotional rate is U$ 95. In spite of an attractive rate decrease of almost 50%, we see growth of 4,000 rooms. This attractive promotion generates sales of U$ 855,000 (lower by U$ 45,000); subtracting the variable cost of U$ 8 dollars per occupied room leads to a profit of U$ 783,000, compared to U$ 860,000 in the previous model.

These two models capture in essence of what is flawed with the notion that discounting is the solution to a complex problem. In this case a lower rate attracts more volume (in a real business simulation there is absolutely NO guarantee that a lower rate offer assures more volume hence I note it is a very risky endeavor) but generate less revenue and profit. Unfortunately it is also not as simple as these two samples illustrate. There is no “one size fits all” approach as every market reacts differently to price fluctuations and macro economic circumstances differ from each nation to another. Generating demand is only in some measure the responsibility of the private sector. Governments have an equally important stake in this equation and it is their responsibility to engage in destination marketing and restore confidence in consumer markets. The hypothesis of discounting a product to result in a guaranteed higher volume is by no means assured.

The assumption of discounting and consequently stimulating growth works on the premise that a sharp drop in rate is being compensated by an equally strong (or stronger) growth pattern in volume. That assumption is flawed; largely it assumes that a rate drop is the only answer to volume woes. It might work as an academic exercise but reality on the ground is far from different. Sir Isaac Newton’s third law claims that to every action there is an equal and opposite reaction. This clearly does not work here. Another, often overlooked aspect of rate slashing is once a hotel starts cutting rates it is just a question of times before competitors follow suit and the outcome is a dangerous downward spiral that is very difficult to stop; a classic lose lose scenario unfolds – there are no winners aside from the end consumer. To recover, collectively as an industry, from an ensuing price war takes years.

Generally there are several schools of thoughts regarding discounting. One group is a proponent of discounting as the assumption is additional clients in the hotel will increase discretionary spending mainly in bars and restaurants, internet and laundry etc. (that is a fallacy that is even more compounded as cheap tours have breakfast included and do not spend any money on laundry or telephone). Aside from a decline in profit the wear and tear on the product should discourage most hoteliers pursuing such an avenue. An acceptable parallel of thought prescribes to the notion that guest rooms are a perishable product – if not sold today the revenue opportunity is lost forever and so as long as variable cost is covered it provides an acceptable solution in optimizing revenue.

Some hoteliers rather have guest rooms empty than occupied with the wrong kind of clientele. The wrong client might cost more in terms of upsetting the right client. Protecting image is everything. There are good times and there are bad times. In bad times hotels need to project an image of stability, confidence and consistency in terms of quality and services. Consequently rates should remain. General Managers rather opt for value add’s, complimentary early check in or late check outs, added amenities, free internet, but protect the integrity of the rate.

The third school of thought principally represents the notion that discounting, especially in the upper upscale hotels is insupportable. Companies, especially high-end luxury brands, have to protect the integrity of their brand. Customers have certain expectations and associate their preferred hotel brand with a cachet of luxury. Bvlgari, Louis Vuitton or Tiffany do not discount their luxury merchandise if the market goes south all in anticipation of stimulating demand. Such a strategy would destroy their coveted image that they have spent years and significant dollars to develop. The prime concern of a luxury brand is at all times to protect their image and reputation. The previously mentioned companies have no real tangible assets. They derive their value proposition from the image they have created. In the case of Bvlgari and Tiffany since 1884 and 1837 respectively. The notion that luxury brands are immune to the danger of recession need to be dispelled. But they act with more dignity and style in the sales generation process; there is less of an atmosphere of panic selling. Price integrity is of paramount importance to the long-term reputation of a luxury brand.

In times of this global business contraction there is very little or no price elasticity. A classic example is the hotel industry in Bali. In the late 90′s hotels in Bali enjoyed healthy occupancy levels and relatively high ADR’s. In the aftermath of the first Bali bomb in October 2002 tourists left the island in throngs. Hoteliers slashed rates by over 50 percent all in anticipation of attracting business. Alas, that strategy did not produce the expected growth. Hotels in Hong Kong in 2003 at the peak of SARS were showing occupancy levels in single digits. During times of crisis people do not travel irrespective of how cheap a hotel advertises its rate. This was evident in the aftermath of the first gulf war in the early nineties and again after September 11 in 2001. Life is more precious than a cheap vacation in a dangerous holiday destination.

It took Bali almost three years to recover their rates to “pre bomb” levels. Hotels offered rates as low as U$ 50 including breakfast and still people did not travel to the beaches of Bali. Something should have been learned form this!

In conclusion, discounting in an economically depressed environment does not deliver the desired results. Furthermore, when will our industry learn that reducing rate is neither a panacea nor the short-term solution to a very complex, and partially undiagnosed problem caused by factors beyond our control?  Conventional sales and marketing strategies don’t work in an uncertain, recessionary environment with only limited access to highly fluid and imperfect information. Discounting will always be a controversial and ambiguous subject with an ambivalent outcome at best. Each company has its own perfectly rational explanation, and philosophy, to pursue without justification – provided it makes commercial sense and protects all stakeholders. Discounting to grow volume following a decrease assumes one fatal flaw – that the rate is the reason for the volume drop in the first place.  More often than not, when we engage in this type of pricing strategy, the core reason for the drop in volume was not due to rate!  When put like this isn’t the answer so simple?  We are providing a remedy to a problem that doesn’t exist!  We should be attacking the reason for the volume drop with sales and marketing strategies, not applying a medicine that actually misses the crucial point in the first place. The present challenge our industry faces is that of demand generation. We cannot influence demand factors, they are largely beyond our internal control mechanism, in particular in Thailand with all its socio-economic and political problems. There is no such thing as a blanket approach to rate dropping. It is all managing the details, account by account, segment by segment.  It is a tedious and resource consuming endeavor. But done intelligently the rewards are above average.