Battling the crisis #1: Dumping room rates is not smart. Why actually?

7 April, 2020
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Booking-CEO Glenn Fogel reacted irritably when asked if he would lower commissions because of the Corona crisis. He sees this differently: hotels should lower their room rates. Be very careful with this. Although it is at times unavoidable, it remains really undesirable. Not all hotel owners completely realize the relatively heavy impact that lowering of room rates can have on the overall hotel performance.

The increase of rooms occupancy is actually relatively easy to achieve: this is done by
lowering room rates. Lowering room rates leads to an increase in room nights. It is also
relatively easy to obtain a higher average daily room rate (ADR), simply by increasing the
rate, with the direct effect of lowering rooms occupancy.
The true challenge lies in using both of these performance measurements when making
strategic decisions. Imagine that Monday has 70% occupancy with an average daily room rate
of €90, whilst Tuesday has 90% occupancy with an average daily room rate of €70. If looking
at occupancy, Tuesday was the best day. If the average daily room rate is the assessment
criterion used, then Monday was definitely the better day for the hotel. As these performance
indicators can contradict each other, our industry uses the RevPAR, which for both days is
the equivalent of (70% x €90 =90% x €70=€63). We cannot just simply rely on only one of
the two performance indicators. An advantage of RevPAR is that it also allows us to compare
performance of hotels in the same market. RevPAR has two components: occupancy and
average daily room rate; which of the two weighs most heavily? Or are both components
equally important when determining a hotel’s total performance?

Elasticity
Price elasticity is the degree to which hotel-room-demand changes as a consequence of a
change in room rate. The more sensitive the demand (variable), the more it decreases as a
result of higher room rates. Lowering room rates has a positive opposite effect on demand.
It is thus necessary to estimate how elastic the demand actually is. And to make it even more
complicated, how it differs per market must also be taken into consideration. Business
travelers are often restricted to time of travel for a specific location and number of nights. If
they must come to Amsterdam for a business trip, they will not easily divert to Frankfurt
simply because of lower room rates.

The first chart shows the minimum required increase in occupancy to compensate for a
decrease in average daily room rates. Some hotels have recently chosen to decrease their
average daily room rates by 40%. If their occupancy rate is currently at 20%, it must increase
by at least 66.67% (to 33%) to prevent a loss of revenue. Is it realistic to expect that demand
increases this much due to a lowering of room rates? And is the problem actually not that if
everyone choses to do this, the market does not expand, and every hotel has to suffer from
too little of an increase in occupancy and a too low average daily room rate?

The second chart consequently shows that what you can actually miss in occupancy for a
higher average daily room rate. We do not want to give the impression that all hotels must
increase their average daily room rate in times of crisis, but still, how much will the
occupancy actually suffer from it? 

The first graph shows the results of important research conducted by Cathy Enz (Cornell),
Linda Canina (Cornell) and Jean-Pierre van der Rest (Hotelschool The Hague) a few years ago.
It shows that the 4000 hotels in Europe who, in the period 2004-2013 had a higher average
room rate (ADR) than their direct local market competitors, indeed had a lower occupancy
rate, but yet a higher RevPAR. Lowering average daily room rates, definitely under current
economic conditions and regardless of whether the hotel is independent or part of a chain of
hotels, is not profitable. Further research has also confirmed that most European hotel
markets have an inelastic price elasticity; there is factual proven room for rate increase.

Does the average daily room rate thus weigh more heavily than occupancy? That is a bit too
short sighted: it depends on several factors such as other streams of revenue, think of for
example F&B. It is not for nothing that room rates in Las Vegas are kept low to increase
occupancy: high occupancy means high turnover in other departments, of which of course
the Casino being the most important one. But remember, this is not the case for most hotels
as peripheral revenue (turnover from other departments) is but a small percentage of total
turnover.

Profit
Aside from the power of ADR on turnover, there is still too little talk about the effects on
profitability when changing room rates. The term “revenue management” does not help and
is maybe even a bit outdated. Would it not be better to instead speak of Profit Management?
Actions taken to stimulate turnover can have either a limited, or in some cases, even a
negative effect on profit. The common expression “heads in beds” is not always well thought
through; a higher occupancy in combination with lower daily room rates can in rare cases
lead to a higher RevPAR, but can also still lead to lower profit. Surely, a higher amount of
rooms being sold also brings more costs. Not only variable costs related to rooms (cleaning,
amenities, etc.), but also costs related to other departments, such as, for example, rooms
division.

Flow-through
After 9/11, many hotels have developed a “contingency plan” to put in place in times of
crisis. The “flow-through” principle plays an important role in this. Flow-through indicates
what percentage of turnover increase or decrease flows through to profit. Certain guidelines
apply: turnover that strictly results from occupancy lies around 70%, quickly approaching 90
to 95% as a result of average room rate. This means that all pretty much all turnover
generated from room rate increase or decrease directly streams into profit (or loss). This
flow-through principle works two ways. Turnover loss means less profit; its intensity
dependent on change in occupancy, the room rate, or both. In case of a decrease in
occupancy, it is clear that maintaining a room rate will in any case be less painful (see chart
2). If a hotel can in this way reduce the negative effects, all the better. Van der Rest (Hotel
School The Hague) and Harris (Oxford Brookes) have developed a good rule of thumb when it
comes to this: if two hotels with the same variable cost levels are competing in the same
market, but each with a different average daily room rate, the hotel with the lowest rate will
need a higher increase in occupancy if the competing hotel also lowers their average daily
room rate. The same rule of thumb applies to hotels with the same average daily room rate,
but different variable costs. The hotel with the highest variable costs requires a greater
increase in occupancy as opposed to its competitor if it lowers its average daily room rate, in
order to be able to maintain the same flow-through.

Focus on the guest
Does this mean that hotels may not or should not aim to do better than their competition?
No, of course not. There are indeed alternatives to the lowering of room rates: from product
diversity to segmentation management. The focus on client satisfaction is worth mentioning.
Research has shown a positive correlation between GRI ( Global Review Index) and the
average room rate. An increase of one point of the GRI (on a scale of 100) can lead to an
increase of .89% in average room rate, an increase of .54% in occupancy and an increase of
1.42% in RevPAR. Hotels with a higher GRI are also able to book more rooms via their own
website, sparing costs as well as giving the opportunity for the hotel to offer a more
personalized service.

Hope
We hope, with this knowledge, that hotels will be less inclined to reduce room rates. This
crisis should not lead to a common price-war: this would only result in more victims. We are
a sector to be proud of. Our guests cannot wait to once again be able to enjoy all of the
beautiful experiences that we have to offer. Stay strong!

"This paper was originally published in Dutch by Hospitality-Management.nl"

Click here to read this paper in Dutch.  
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About the author: Paul Griep has trained Revenue managers for generations at Hotelschool
The Hague, where he also works as director of Alumni & Industry Relations. Jean-Pierre van
der Rest is a professor of business studies at Leiden University. He conducts groundbreaking
research into hotel revenue management and business failure.

About the author

Hotelschool The Hague

Hotelschool The Hague was founded and funded in 1929 by the hospitality industry to create a central place where industry partners could gain and share new insight, skills and knowledge. Since its foundation, Hotelschool The Hague has become an international hospitality business school specialised in hospitality management, offering a 4-year Bachelor in Hospitality Management. This degree course is also available as the accelerated International Fast Track programme. Our 13-month MBA in Hospitality Management is designed to deliver the next generation of hospitality innovators.

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