Pricing Strategy in the Hotel Industry

Subject: Strategic Marketing
Pages: 10
Words: 2906
Reading time:
13 min
Study level: College

Introduction

A pricing strategy is a premeditated option from a number of substitute price schedules or prices, which are employed towards maximizing profits within a given duration, in reaction to a certain situation. Pricing strategy is a very crucial approach in the running of hotel businesses; mainly because the industry presents high fixed costs and minimal variable costs. This implies that cost-control cannot optimize the revenues and profits realized by hotels, therefore, using an effective price strategy is the quickest and most reliable way, through which a hotel venture can maximize its profits and revenues (Kim, Han, & Hyun, 2004; Schmidgall, 2002).

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An effective price strategy can aid a hotel venture by maximizing the variables of price and demand. Price strategy has gone through a revolutionary process, especially after the hotel industry took up the concept of Revenue Management (RM) as a strategy of pricing from the airline industry. The model has revolutionized the hotel industry in a profound manner, for the past few decades. As a result, the RM pricing strategy has grown to influence RM practice in fundamental ways, which is not only because of its financial outlook, but also because of its strong attachment to different aspects of hotel administration and marketing strategies like the forecasting of demand, controlling of the rate of bookings and comprehending consumer price flexibility (Miller, 1999; Cross, 1997).

The principal role of yield management has resulted from the dynamic nature of revenue technologies in revenue management towards maximizing revenues, which explains why price strategies are vital to all hotel ventures. There are three types of pricing models, which are based on the dissimilar perspectives of researchers: the cost-based model, customer value-oriented model, and the competition-oriented pricing model. Each of these models has its strengths and weak points (Armstrong & Kotler, 2011, p. 278).

Cost-Based Pricing

Though the economic analysis model is proper in overall market usage for setting the prices of products, managers face difficulty in placing the cost of given goods and services, due to the limited information. This is what happens when projecting the quantity of a brand, which will be purchased at a certain price, is complicated. Therefore, businesses tend to resolve to the usage of cost-based pricing models. Although these models are easier in terms of usage, managers are required to apply flexibility when using them for different situations (Hambrick & Cannella, 1989; Sanket & Bowman, 2004).

Marketers use the process by totaling all the costs related to the delivery of the product to the market, including production, distribution, transportation and sales expenses. Above the total cost, they will place an amount, which is supposed to cover expenses not previously accounted for – to accommodate the expected profit. The total of the two figures is set as the price for the product. Smaller ventures compute the markup as a ratio or a percentage of the total cost. For example, considering that the overall cost of maintaining a hotel room for a night is USD 100, in case the management wants to set a daily rental price which is 25% above the maintenance costs, the rental rate will be USD 100 + 25% of 100, which is 125 per room (Auty, 1995; Reid & Bojanic, 2010, p. 210).

There are two calculation models for cost-based valuation: profit margin and cost-plus/ mark-up. Cost-plus valuation is grounded upon the cost of the product, which in this case is the maintenance. On the other hand, the profit margin model is founded on the sale value, which in this case is the rental rate. Using the USD 100 maintenance cost case, assigning it a mark-up of 20%. The sale price is computed using the following formula.

Cost/ (100% – Markup %). USD 100/ (100%/ [100% – 20%]) = USD 100 x 100%/80% = USD 125 as the rental value.

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Profit margin will be calculated using (Sales value – cost)/ Sale Price.

USD 125-100/ 125 x 100% = 25/100 x 100 = 20%

The Cost-plus model

It is easy to apply this model; therefore, it is used by many businesses, especially wholesalers and retailers. This approach is best for the hotel business during the pricing of unitary products or classes of products, for example beverages and menu items. In this case, the hotel may use a standard markup rate, which is added to the direct costs of the service or the product to be delivered (Gu, 1997). For the current hotel case, the mark-up rate to be used for food will be 200% and 150% for the beverages. For example, in setting the price of a beverage which uses ingredients worth USD 3.5 and the desired mark-up is 150%, the price will be computed as follows.

Price (excluding VAT) = USD (3.50 + (3.50 x 150/100) = 3.5 + 5.25 = USD 8.75.

The selling price of the drink, inclusive of VAT, will be 8.75 + (8.75 x 13.5/100). = 8.75 + 1.18 = 8.75 + 1.18 = USD 9.93 (Inclusive of VAT) (Backman, 1953).

The Cost-plus model is helpful to the manager in that it is easy to use during the computation of prices, and in making comparisons of the prices and the quality of the hotel services offered by competitors. The comparative account may reflect cost cutting strategies used by the competitors, which are not used at the host hotel. In this case, an example is the substitution of the expensive ingredients used in the preparation of foods and the beverages of the hotel. These ingredients may be substituted with cheaper ones, as that will allow the business realize bigger margins or pass the recovered cost to the consumers in the form of price reduction (Cannon & Morgan, 1990; Reid & Bojanic, 2010).

Rule-of-thumb pricing

The rule of the thumb is a principle with wide application, though not presented as accurate and dependable for every circumstance. It is an easily acquired and used procedure, for approximate calculation or denoting of some value, aimed towards making determination of usage value and prices. An example of these rules guiding the hotel business is the return valuation rule that hotel rooms should generate $ 1 as average daily return per $ 1,000 of value. As per this building-cost-rate derivation model, a room worth $ 1,000 should return, at least $ 1 a day, without making any consideration to the current value of the hotel room in question.

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An example here is a hotel which owns five rooms, estimated to be worth $ 10,000. Using this model, each of the five rooms is worth a project cost of $ 2000. In this case, an ADR of 2 dollars each day must be realized. The computation is as follows: a room at the hotel should be priced as (Dopson & Hayes, 2009, p. 283). One out of the 5 rooms that is valued at $ 2,000 dollars should return a daily rate of not less than $ 2. This can be calculated as 1/5x 10,000/ 1000 = $ 2.

In pricing the rooms of the hotel, no consumer should be allowed to use the hotel room, without paying less than $ 2 dollars a day. Research on the hotel industry indicates that the model is reliable in predicting the future sale prices of hotel services. According to hotel industry research, the ADR rule of the thumb is effective in being applied to the varied types of hotels, though the computation formula may vary from the general $1-per-$1,000 ratio (Finkelstein, 2005; Dopson & Hayes, 2009, p. 283).

Hubbart formula pricing

It is a model of setting the rates of rooms of hotels, in a time when the hotel is to remain open or when the hotel is under renovation. The model was formulated by Roy Hubbart, the then authoritative chair of the commission of the American hotel and motel association, which was instituted towards the generation of a model for use in computing room prices. In 1952, the founder offered the following computation replica (Dopson & Hayes, 2009, p. 277).

The prices of rooms can be calculated, through estimation of the number of hotel rooms to be sold in a year, plus tabulating of the costs of business operation. A set amount representing the estimated ROI is added onto the total cost of operations. The rate is computed as follows: Estimated operating cost + ROI – Income from other revenue centers, divided by the total number of rooms to be sold (Drucker, 1973). An example here is the case of a hotel whose estimated operating costs is USD 10,000. The estimated ROI is 15,000 and the income from other revenue centers, including food and beverage sales is 12,000; the number of hotel rooms to be sold is 100. The computation is as follows: 10,000 + 15,000 – 12,000/ 100 = 130. The rate will stand at USD 130 (Dopson & Hayes, 2009, p. 277).

Break-even pricing

This is a model used towards ensuring that all the costs of the hotel business are covered, as it puts into account the overall fixed and variable expenses of the venture. The model accounts for the minimum sales worth, necessary for the business to realize breakeven. The model is also of great significance in calculating average costs and rates, for example, the average price per meal (taking into account the total operating expenses of a venture) is meant to formulate policies to avoid falling into a loss-making situation (Cespedes & Piercy, 1996).

An example here is that of Veema hotel, which registered sales of 120,000 – from 6,000 visitors spending USD 20 each. Sales volumes from beverages and food stood at 48,000, while the gross margin of the hotel stood at 72,000. Other variable operating expenses, for example energy and utilities were 18,000. Contribution towards fixed costs and profit return (45% of sales volumes) was 54,000. Fixed costs value stood at 40,000, thus, profit value stood at 14,000. The break-even point = fixed expenses (USD 40,000)/ Contribution fringe of 45% = USD 88,889. Average expenditure per customer = sales break-even point/ number of customers = USD 88,889/6,000 = USD 14.81 (Exclusive of VAT) (Netessine & Shumsky, 2002; Webster, 2005).

Customer value-based pricing

It is the model that sets selling prices on the chief consideration of the perceived value of the product or service to the consumer, and not the real cost of production. The prices are set by competitors and the historical value or the market value. The goal of the model is improving the delivery of prices that are more aligned to the value delivered. This model can be used during product management and development, to configure products that offer maximum value for specific consumers. The model is based on the comprehension of how consumers quantify value, through an extensive evaluation of consumer processes (Stephenson, Cron, & Frazier, 1979; Sodhi and Sodhi, 2008).

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An example here is the development of a an accommodation center, for customers who are only interested in using hotel rooms without restaurant facilities, where the express room service will be valued less than that of the rooms at the restaurant. This case is a demonstration of value creation for express room consumers and the elimination of the perceived value of the restaurant and the services associated to it. Using the same example, value-based pricing may be introduced through offering discounts to the users of hotel rooms on the basis of how frequently they use the rooms (Steed & Gu, 2005; Simon, Butscher, & Sebastian, 2003).

Value-based pricing

This strategy is used in the setting of the prices of products or services, on the basis of the value and the benefits it offers to the customers. This model, unlike the cost-plus model, does not take into account the cost of producing the goods or rendering the services. The model is used by companies offering extremely valuable or unique products and services, as opposed to those offering commodities and services that are relatively indistinguishable from those of their rivals. The benefit of this model to revenue mangers is that it offers them the opportunity to continually evaluate the value perceptions and the needs of the customers regarding the product (Seale, 2004; Kimes, 1999; Nagle & Holden, 2002; Orkin, 1990).

Under this model is good-value pricing, where the price set is determined relative to the premium and the economy price of the given product or service. Using the case of a hotel next to a tourist attraction center, the competitor hotel at the same location may set a price between that offered by hotels away from the location and the high rate offered by the highest priced competitors at the same location (Ingold, Yeoman, & Ingold, 1997). The advantage of the model is that the hotel will use price reduction as a source of competitive advantage. The disadvantage is that, in the event that the hotels offers their rooms at rates comparable to those of the lowest offering hotels, they may not be able to meet their running expenses, and thus incur losses (Myers, Cavusgil, & Diamantopoulos, 2002).

Competition-based pricing

It is a model that engages the setting of prices on the basis of what the rivals of the hotel are charging. In case there is a strong competition within the market, the consumers are left with many choices regarding who they should buy from. In such a case, they are likely to buy from the suppliers offering the least price or the ones offering the best customer services – with reference to the prices that they consider normal or reasonable in the market, at that given time.

Most players within a competitive market do not posses enough power, to enable them set prices above those offered by their rivals. As a result, they resort to using the “going rate pricing”, which is the process of adopting a price that is in line with those set by direct competitors. In such a case, the firm is a price taker because they adopt the going price, which is determined by the twin forces of supply and demand (Matzler et al., 1996; Orkin, 1988).

One advantage of this model is that the prices set are in line with those of rivals, therefore, price does not act as a source of competitive advantage. The disadvantage is that the firms operating in such a model are obligated to find other ways of attracting consumers, which are outside the price methods of competition. An example here is the case of a beach hotel, set up next to two other beach hotels offering their rooms at USD 100 per night.

For the new entrant, setting a price below the competitor price will mean that they will not be able to cover all the expenses incurred in offering the room services, as they are subjected to similar expense margins (Cross, Higbie, & Cross, 2009; Kimes, 1990). Therefore, the hotel will have to offer the rooms at the same rate as the competitors, and then work on distinctive models of attracting customers (Monroe, 2002; DeKay, Yates, & Toh, 2004).

An example of the models that they can use to attract customers to the hotel would include improving their customer service abilities. This can be realized through placing of a customer attraction center at the tourist drop off point, where they may present them with brochures documenting their services and their rates. A second model is providing distinctive customer service, where the hotel may offer taxi services from the drop-off point at substituted rates, and offer discounts to returning customers or administer other services that the consumers may require. Examples of such services may include offering tour guide services to visiting tourists and the outsourcing of the products needed by the customers while at the hotel.

The usefulness of the model to managers is that it allows them to formulate strategies of creating competitive advantage for their business, which is done creatively to outweigh the associated value of their competitors (Govindarajan, 1989; Jacobson, 2007).

Price-adjustment strategies are used, when regulating the prices to account for the varied consumer differences and changing considerations. The models used in price-adjustment strategies include discounting and segmentation. Under discounting and allowance pricing are a number of forms, which are offered to reward customers for their credibility in the areas of purchase volumes, timely payments, and off-season purchasing.

The different forms include cash discounts, which are offered to the consumers who pay for their purchases or bills promptly; quantity discount, which is offered to buyers who purchase in large amounts; and functional discount, which is offered to trade channel parties – for example lower level sellers and seasonal discount, which is offered to purchasers buying products during off-seasons. Others include allowances; for instance, trade-in allowances, which are offered to customers who return old products when purchasing new ones (Relihan, 1989; Weatherford, Kimes, & Scott, 2001).

The advantage of price-adjustment strategies, which revenue managers can benefit from include that they result in an increased cash-flow for the business, as customers are lured into making more purchased and becoming loyal to the given service center. Another advantage is that the model allows businesses become more competitive as compared to their rivals. The disadvantage with the model is that it reduces the revenues earned by the business from the services traded. This strategy aids revenue management in strategizing towards increasing customer flow, as it forms a customer attraction model (Docters et al., 2004; Ingenbleek et al., 2003; Mattila & Choi, 2005).

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