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.
Olivier Harnisch | Olivier 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.