The hospitality industry can greatly benefit from the application of activity based pricing, a new prototype for improving profitability by reducing pricing mistakes and emphasizing revenue maximization. Activity based pricing (ABP) is a pricing method that combines market research data with cost accounting information to establish prices for products and services that result in designed profits (Daly, 2002).
The ABP concept emphasizes that profits can be maximized through knowing how much of a product's price is profit and through the elimination of pricing errors. Many companies sell products at an unintentional loss because they do not fully understand the costs related to the products and customers (Daly, 2002). For example, one method that the lodging industry uses to maximize room revenues is yield management. This technique forecasts demands for market segments that will generate the high est room rates, but it does not incorporate precise product and customer costs.
While most marketing departments of hospitality firms seem adequately equipped to estimate how many products and services they can sell at various prices, without complete cost information they cannot determine whether maximized revenue equals optimal profits. Faulty cost information can have devastating effects, because functions such as budgeting, cost control, product pricing, or any kind of financial analysis are based on the firm's cost information.
In highly competitive market conditions, hospi tality operators cannot afford to be ignorant of their full costs. ABP can improve a company's profitability by providing the marketing and accounting departments with information that allows them to cooperatively establish accurate prices. The ABP process incorporates a technique called activity based costing to determine comprehensive cost information for individual products/services and customers.
Using activity-based costing to conduct ABP
Activity based costing (ABC) is an approach that was originally created for the manufacturing industry. ABC has major advantages over other costing methods through its ability to trace over head costs to individual products, which allows for the calculation of operating profits for each unit produced (Cooper, 1989; Turney, 1991; Cooper & Kaplan; 1992; Garrison & Noreen, 1997). The general conditions that make manufacturing companies good candidates for the application of ABC systems, such as a diversity of resource consumption, a highly competitive environment, and the fact that product and resource consumption are not correlated with traditional cost allocation methods, also exist in the hospitality industry.
Kaplan and Cooper (1988) demonstrated that traditional contribution margin analysis could be greatly enhanced by the use of ABC, because over the last three decades, the costs that have seen the greatest increases in many businesses are overhead costs. Today's hospitality firms are both capital and labor intensive, where undistributed costs represent a large percent of total costs. Although direct costs are distributed to profit centers in the hotel industry, overhead costs most often remain undistributed (Geller & Schmidgall, 1997). Furthermore, the restaurant industry generally does not allocate or trace overhead costs to individual menu items. The restaurant industry commonly establishes menu prices and manages menus by using contribution margin analyses (Bell, 2002).
ABC is conducted using a two step process (O'Guin, 1991). First, all activities and their costs are identified. ABC uses three major categories of activities that drive expenses at the product level and that can be traced to individual products. The three categories are costs at the unit level, costs at the batch or production level, and product sustaining costs. Unit level cost measures the expenses that are consumed proportionally with the number of units produced. For example, in the hospitality industry unit level costs are incurred every time a customer arrives and certain activities must be conducted, such as checking the customer in or seating him or her in the restaurant. Batch related activities are performed each time a batch of goods is produced. Examples of batch related activities for the restaurant business include purchasing, baking, and supervision. The third category includes activities that are performed to enable individual products to be produced and sold, which are labeled as product sustaining activities. Hospitality industry examples are recipe research and testing, cost control, and staff training.
The second step in ABC traces activities back to the product or services that trigger them. Costs are then assigned based on the resources that products or services consume. Overhead costs are traced to certain products/services, which are then revealed in a 'Bill of Activities.' The total product cost is the total cost of all activities involved in producing a particular product or service. Finally, each product receives a unique value based on its individual consumption of resources.
Once ABC costs are calculated, accounting and marketing can cooperatively apply ABP by considering the relationships between volume, price, and cost. For example, if a restaurant wants to introduce a new menu item, management can forecast the number of items that it expects to sell at various price levels. Next, management can consider the relationships between cost and volume, based on a forecasted ABC cost for the menu item in conjunction with the relationship between price and volume. Finally, price can be determined at the point where total profits are maximized (Daly, 2002).
Bell, D. (2002). Food & Beverage Cost Control (Course Packet). Las Vegas: University of Nevada, Las Vegas, Department of Reprographic Services.
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