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Managing capacity costs and COGS standards drive profitability

25 October 2022
Hotel owners focus too much on the cost since this is the easy part of operating a hotel. Instead, hotel owners should focus more on the revenue side of the business because, without enough revenue, it is impossible to make money even with tight cost control. So let's start by sorting out the different costs since this is the focus for most people in the industry.

Costs behave very differently

All costs can be sorted into three buckets, fixed, capacity, and variable. Hoteliers manage each cost type differently and must make very different decisions to keep the costs on the right level and under control.

Fixed costs

The fixed costs are all the costs that the hotel has even if it is closed and there are no guests nor any revenue. There is a time component to fixed costs. For example, if the hotel is closed on Sundays, the fixed costs are probably higher than if the hotel is closed for six months. Over a more extended period, the hotel can eliminate some fixed costs.

Capacity costs

Capacity costs are costs to keep the hotel open at a specific capacity. For example, the revenue manager forecasts that the hotel will sell 100 of its 200 rooms on a particular day. The cost will be the same regardless of if the hotel sells 90 or 100 rooms. The hotelier has to decide on the operational capacity. The general manager must determine the opening hours for restaurants, bars, and other outlets for full-service hotels depending on the expected demand. A good practice is to work with different demand scenarios, similar to a game plan in team sports, when setting various capacities. When the demand is low, the capacity costs should be lower, and when demand is high, the capacity costs will be higher. The capacity cost is not variable once the general manager has set the operational capacity. Therefore, managing capacity costs will impact profitability the most.

Variable costs or cost of goods sold (COGS)

The third bucket is the variable costs. Variable or cost of goods sold means that the cost only occurs if the hotel sells something. For example, if a guest occupies the room, it has to be cleaned. If the hotel does not sell the room, there is no cleaning cost. If the guest eats in the restaurant, there is food cost. If no one eats, there is no food cost. The only way to control variable costs is to set standards. A few examples are that cleaning a room would take 30 minutes, the guest amenities cost 2 USD, the laundry cost is 5 USD per bed, the food cost for the menu item is 7 USD, and so on. Every hotel must keep track of the variable cost to avoid cost leakage.

The hotel room is a perishable good

The industry defines a hotel room as a perishable good since it vanishes each night if it does not sell the room. A perishable good usually has a cost attached to it, but this is not the case for a hotel room. There is no variable cost because there is not anyone in the room—no costs to clean the room and no costs for guest amenities. However, the fixed and capacity costs are there regardless of whether a guest stays in the room. Hotels think there is a cost to the lost opportunity to create revenue and profit from an unsold hotel room, but there are no actual costs when the room sits empty.

Marginal costs

The marginal cost is the extra cost when selling one more room without increasing the capacity. The marginal cost consists of the variable costs (COGS) and any variable customer acquisition costs. The marginal cost for a reservation varies depending on the type and number of guests in the room, length of stay, and commissions and transaction fees for the reservation. Therefore, the marginal cost is unique for every reservation. The easiest way to track the marginal cost is to have a set standard COGS for different room types, number of guests, and length of stay. In addition, the hotel needs to keep track of the customer acquisition cost.

Marginal profit contribution

A hotel with a good understanding of the marginal cost can sell the rooms at a rate that will maximize the marginal profit contribution. Even if it is better to sell the room with a small marginal profit contribution, it is still a balancing act in terms of protecting the brand and the expected price level for the property type. Selling at a too low rate too often will damage the brand and drive down the long-term average rate, which will decrease the profits over time.

Long-term financial sustainability

A hotel's success will always be determined by how successfully it captures the demand in its market. However, if the hotel does not manage the capacity costs based on the demand, has a standard for COGS, and keeps a tight grip on customer acquisition costs, the hotel will not be able to maximize the profit.