Accounting Principles for Hospitality and Tourism (HTB2004) Temasek Polytechnic

TOPIC 8: COSTING & PRICING OF A PRODUCT / SERVICE

Learning Objectives

At the end of the lecture, you should be able to:

1 Explain Direct Costs and Indirect Costs in relation to cost objectives.

2 Explain why costs are allocated and compute allocated costs using some common bases.
3 Explain basic cost concepts such as controllable costs, differential costs, relevant costs, sunk
costs, opportunity costs and standard costs.
4 Explain cost approaches to pricing, compute price of product / service using these approaches.
5 Discuss the practice of Yield Management.

Reading:
Chp 6 & 8: Hospitality Industry Managerial Accounting by Raymond Schmidgall
Chp 15: Financial Control for your Hotel by Michael M Coltman

Introduction
In the hospitality industry, understanding how costs are accumulated and how costs are measured is
an important managerial function. The management is usually interested in the measurement of cost
as this would have an impact on the various decisions such as:
 What prices to charge for the product or services?
 Which products to continue / discontinue?
 Is it cheaper for the firm to produce or to acquire from external parties?
 Should a particular department be expanded? Should the manager be promoted or rewarded?

Most of the sales revenue in a hotel or food service enterprise is consumed by costs. Therefore, cost
management is important ie. looking at ways to control and manage costs to improve net income. In
order to manage costs and make better decisions, there is first a need to recognize and understand
that there are many types of costs. These costs are also classified in different ways according to the
immediate needs of management.

Cost Classifications for Assigning Costs to Cost Objects

Direct and Indirect Costs

Costs are assigned to _________ for a variety of purposes including pricing, profitability,
studies and control of spending.

A cost object is any activity or any item for which cost data are desired – including products,
product lines, customers, projects/events and departments.

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Examples of cost objects:

 Products - ______________ in F&B outlet; ______________ in hotel
 Projects/Events - ________________________________ in F & B outlet.

 Departments - Individual profit and cost centres in a hotel

such as: Rooms, F&B, Health Club, Telephone department - ________ centres

Sales & Marketing, Accounting, Human Resource, ___________

Engineering centres

For purposes of assigning costs to cost objects, costs are classified as either direct or
indirect.
 Direct Costs
Costs that can be easily and conveniently __________ to a particular cost object. Eg.
food cost is a direct cost for the Food Department.

 Indirect Costs
Costs that _____________ be easily and conveniently traced to a particular cost
object. Eg. maintenance cost is an indirect cost for the Food Department.
Are these costs considered direct or indirect?
Costs Incurred Direct or Indirect Cost Object
Cost?
1. Room Division Supervisor’s salary Room Department
2. Room Division Supervisor’s salary Room Sold
Costs of bringing in the Turkish chef
3.
(Chef’s salary, airfare, accommodation) F&B Promotional
4. Advertisement for event Event (Invitation of a
Turkish chef for a
5. Food cost incurred for this promotion special Turkish Food
6. F&B Director’s salary promotion in the
coffee house)
7. Stewarding Department costs

Note: The answer depends on the particular cost object we’re looking at.

This clarification of the cost objective is important because department heads (in charge of a
particular cost object) are responsible for the __________costs of their departments since
they exercise _________ over them; however, they are normally not responsible for the
indirect costs.

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Cost Accumulation and Allocation

In order to ensure all the costs / expenses of the organization are properly
captured and accounted for, the accounting system is designed such that
 cost data are collected in some organized way (cost accumulation) and
 costs are then allocated (traced) to cost objects such as departments,
products, or activities (cost_________________).

Figure: Measurement and Tracking of Costs

Cost Objects

………………
….
Actual
Costs
Incurred
…………
………………
……
………….

COST
ACCUMULATION COST ALLOCATION

Bases of Cost Allocation

When allocating costs, the appropriate cost drivers should be used as the basis for cost
allocation.

A cost driver is a factor that causes costs to be incurred. These cost drivers have a direct
impact on the results ie. if an inappropriate base is used, it may result in distorted results.

Some suggested allocation bases (ie. cost drivers) are:

Allocated Costs Allocation Bases
Rent Expenses _______________________
Telephone No. of telephone extensions
Executive Office No. of employees
Marketing Ratio to Sales
Engineering _______________________

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Illustration
The F & B Division in Hotel X has two cost centres - F & B Admin and Stewarding and two F
& B outlets (Coffee House & Chinese Restaurant). Operating results of the F&B Division are
as follows:
Coffee Chinese
House Restaurant Total

Sales revenue $ 225,000 $ 675,000 $ 900,000

Direct costs 150,000 400,000 550,000
Departmental profit 75,000 275,000 350,000
F&B Administration department costs 200,000
Stewarding department costs 50,000
Operating profit $ 100,000

Other information:
Stewarding hours worked 6,400 1,600 8,000
No. of meals served 30,000 60,000 90,000

Management believes that the costs of the 2 cost centres should be allocated to the profit
centres on the following basis:
Stewarding Department no. of hours that Stewarding staff worked for a particular outlet.
F & B Admin Department Sales revenue earned for that outlet

Required:
1. What is the cost per meal for each outlet before allocation?
2. What is the cost per meal for each outlet after allocation?

Solution:
1. Before Allocation:
Coffee House Chinese Restaurant
Cost per meal before allocation $ $

= $5 = $ 6.66

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2. Allocation ratios:
Coffee House Chinese Restaurant
Stewarding hours 6,400 / x 100 = 80% / x 100 = 20%
Sales revenue / x 100 = 25% / x 100 = 75%

After Allocation:

Cost Centres F&B Outlets

F&B Admin Stewarding Coffee House Chinese Rest
Direct Costs $ 200,000 $ 50,000 $ 150,000 $ 400,000
Stewarding
F&B Admin
Total Cost $ $ $ $

Cost per meal after allocation $ $

=$ 8 = $ 9.33

Why do we need to allocate the costs of the Stewarding Dept

and the F&B Admin (cost centres) to the 2 F&B outlets?

Controllable Costs
Controllable costs are costs over which a person is able to exert an .
Managers should generally hold their subordinates responsible only for those costs they can
control; to do otherwise may be counterproductive. The manager of a profit centre has
control over the direct expenses of its department.

Does the manager have control over the cost that has been
allocated to it from another cost centre?

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Cost Classifications for Predicting Cost Behaviour

Cost Behaviour
One way of viewing costs is to understand how costs change with respect to changes in the
activities (eg. sales). This is referred to commonly as the cost behaviour.
eg. How would food costs change when you produce more hamburgers?
How would rental costs change when you produce more hamburgers?

Knowing how costs behave with respect to a relevant activity measure is

essential for  planning  decision making
 control  accurate product costing.

The four major patterns of Cost Behaviour are:

1. Variable Costs 3. Mixed Costs

2. Fixed Costs 4. Step Costs

Variable Costs
Variable Costs are defined as costs that, in total, change in ____________________ with the
change in activity (eg. volume of business).

Exhibit 1 - Variable Cost

Cost
Food Cost
One meal - $
10,000 0.50

5,000

10,000 20,000 Activity Level

eg. Food Costs, ____________________________________

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Fixed Costs
Fixed Costs are costs that, in total, _______________________even when the level of the
activity changes.

Exhibit 2 - Fixed Cost

Cost Rent expense
Sell 1,000 meals -
?

15,000

1,000 10,000 Activity level

eg. ________________, __________________, Insurance expenses

Mixed Costs
Mixed Costs or semi-variable costs are costs that have both a fixed and variable component.
eg.
Elements
Mixed Cost
Fixed Variable
…………………….. Cost of system/rental of system Cost of calls

……………………… Basic Pay Bonuses based on sales

Exhibit 3 - Mixed Cost

Cost

Variable
Component

Fixed
Component

Activity Level

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Step Costs
Step costs are constant within a range of activity but _____________ among
ranges of activity.
eg. If a housekeeping supervisor is able to oversee no more than 15 room attendants, then
the operation must add another supervisor upon adding the 16 th room attendant. This
new supervisor would be able to supervise an additional 14 room attendants.

Exhibit 4 - Step Costs

Labour Cost ($)

9,000

6,000

3,000

15 30 No of Room Attendants

Looking at the above examples:

Will food cost be $0.50 per meal all the time ?
Will rental expense remain at $ 15,000 all the time?

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Cost Classifications for Decision Making

In making decisions, it is essential to have a firm grasp of the concepts of relevant costs,
differential costs, sunk costs and opportunity costs.

Relevant Costs
A relevant cost is one that affects a decision. To be relevant, a cost must be:
 _______________ (ie. a cost must differ between alternatives)
 _______________ (ie. cost must not have already occurred but must be incurred
only after the decision is made) and
 _______________

By focusing on relevant costs, decision-makers can narrow the set of costs considerations to
those that make a difference between alternatives. Comparison must be over same period.

Sunk Costs
A sunk cost is a ___________ cost ie. a cost already incurred and about which nothing can
be done.
It cannot make any difference to a decision. The decision to be made will also not change the
sunk cost.
Illustration

Assuming we are faced with the following alternatives:

(1) To keep the old machine for one more year or
(2) To lease a new one for a year?
Which of the following costs / items will we consider in our decision-making?

Keep Old Lease New

Cost of old machine $ 10,000
Salvage value (of old machine) - current $ 500
Salvage value (of old machine) - one year later nil
Rent per year $ 5,000
Repairs per year $ 3,000 $ 1,000
$ 4,000 $ 2,000
Electricity per year
Labour cost per year $ 7,000 $ 7,000

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Solution:
Keep Old
Lease New
Relevant costs to consider: $ $

7,000 7,500

Answer: ______________________________as it costs less.

The below costs were ignored in our analysis. Why?

 Cost of the old machine ( _________________ cost )
 Labour cost ( _________________ cost)

Opportunity Costs
Opportunity cost is the potential benefit that is given up when one alternative is selected over
another.
Opportunity costs are among the ____________ cost considerations in decision-making
situations.

eg. You are currently employed with a company that pays you a salary of $12,000 a year.
You are thinking of leaving the company to take up a diploma course at Temasek
Polytechnic (TP). Assume the fee per year is $2,000. What would be the costs of your
3 year education at TP?

Relevant costs $
School fees
Salary forgone ( _____________ cost) _________
42,000

Other Cost Concepts

Standard Costs
Standard costs are forecast of what actual costs should be under projected conditions. These
standards serve as comparisons for control purposes and as evaluations of productivity.
Generally, standard costs are established on a unit basis.

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COST APPROACHES TO PRICING

(A) Mark-Up Approach

A popular method of pricing food and beverages is marking up the cost of the goods sold.
The mark-up is designed to cover all non-product costs, such as labour, utilities, supplies,
interest expense, taxes and also to provide the desired profit.

eg. One bowl of laksa

Cost = $2.50
Desired Product Cost Percentage = 30%

Desired Product Cost percentage = ____________ = 30 %

Selling price = $ 8.33 or $ due to price rounding

The mark-up percentage should be enough to cover:

 all _______________ (eg. labour cost, use of the kitchen facilities, cleaning up
cost, etc), and
 give the desired level of ___________

(B) Bottom-Up Approach

This method can be used for pricing rooms (Hubbart Formula) or meals. It begins from
the bottom in the sense that it starts with the determination of the desired profit and
adding on relevant costs and taxes to arrive at a price for the product or service.

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Illustration A

The TP Hotel, a 200-room hotel, is projected to cost $14,900,000 inclusive of land,

building, equipment and furniture. An additional $100,000 is needed for working
capital. The hotel is financed with a loan of $7,000,000 at 12% annual interest with the
owners providing cash of $8,000,000. The owners desire a 15% annual return on their
investment.
A 75% occupancy is estimated; thus, 54,750 rooms will be sold during the year (200
x .75 x 365). The income tax rate is 20%.

Additional expenses are estimated as follows:

Fixed Charges: Undistributed Operating Expense:
Property Taxes $ 350,000 Administrative & General $ 800,000
Insurance 150,000 Human Resource 420,000
Depreciation 400,000 Sales & Marketing 500,000
$ 900,000 Property Operation & Maintenance 580,000
$2,300,000
Rooms department direct expenses are $20 per room sold.
The other operating department’s profit are estimated as follows:
Food and Beverage $150,000

Required: Determine Room Rate.

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Answer to Illustration A

Item Calculation $___

Net Profit after Tax Owners’ investment x ROI
( x %) 1,200,000

Net Profit before Tax Net Profit = __________ 1,500,000

1 – tax rate 1-
Add: Expenses
Interest expense Principal x interest rate x time + 840,000
= x % x yr
Estimated depreciation, property taxes and insurance + 900,000
Undistributed operating expense + ________
Required operated departments’ profit (Rooms + F&B) 5,540,000
Less: Departmental results excluding rooms
F & B profit - ________
Rooms department profit 5,390,000
Add: Rooms department direct expense ( x $ )+ 1,095,000
Room’s revenue 6,485,000
(divided by the no. of rooms) 
Required Room Rate $ 118.45

Note : The Hubbart Formula is most useful in setting target average prices as opposed to
actual average prices. A lodging establishment does not generally earn profits in its
first two or three years of operation. Thus, the average price determined using this
formula is a target price.

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Cost Approaches: Four Modifying Factors

Four modifying factors should be considered when pricing is based on a cost approach:

1. Historical Prices Need to consider prices charged in the __________;

avoid dramatic changes in prices.

2. Perceived Price Value Guests must perceive that price is ______________

Relationship in order to feel that they are getting good value.

3. Competition Match price charge by ____________.

4. Price Rounding Price _________________ eg. to nearest $ 0.25.

Industry Standards
For most five-star hotels that provide full range of services including F&B set-ups, the cost
percentages and the profit margin are as follow:

Cost % Profit Margin %

Departments (Cost / Revenue) (Net Profit/Revenue)
Food
30%
Beverage
Rooms 20% 80%

YIELD MANAGEMENT
The focus of yield management is selling rooms in a way that ________ total revenue, rather
than trying simply to sell all ______________ rooms. That is, before selling a room in
advance, the hotel considers the probability of being able to sell the room to other market
segments that are willing to pay higher rates.

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Illustration B
Corporate Group
Room Rate $80 $55
Average length of stay 2 nights 2 nights
Advance booking 1 week 3 weeks
Rooms already sold 40 rooms -
Average booking in group 20 rooms
Forecast sales for next 3 weeks 55 rooms
Hotel has 100 rooms
Should a group desiring 20 rooms for Apr 21 and Apr 22 be sold the rooms at $55 per
room on Apr 1?

Answer to Illustration B
Alternative 1 - Sell to Group

Group Sales 20 rooms x $ _____ = $ 1,100

Corporate Sales 80 rooms * x $ _____ = $ 6,400
$ 7,500

* 80 rooms is from 40 already sold + remaining 40 rooms to meet corporate sales forecast
(100 rooms available – 20 group sales – 40 past corporate sale = 40 remaining rooms)

Alternative 2 - Do not sell to Group

Corporate Sales 95 rooms x $ ____ = $ 7,600

The difference of $100 per night favours Alternative 2.

Instead of focusing on a high occupancy or a high average rate, management’s objective is to

maximize revenue (or yield) from the rooms available. Yield is defined as:

Actual revenue x 100

Potential revenue

Potential revenue = 100% occupancy at highest room rates.

Eg. A hotel has 150 rooms, each of which has a maximum rack rate of $ 200. Actual sales
on a particular night is $ 20,000. Calculate yield.

Yield = ________________ x 100 = 66.7%

Other factors that should be considered

 income from other services
 guaranteed booking from group reservations

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Limitations to Cost Approaches to Pricing

1. Any cost percentages should be interpreted with the absolute dollar in mind. As
percentages are expressed as part of the whole, we should never ignore the elements
that make up this whole, ie. the absolute dollar amount involved. Even though our
calculations may show that the cost percentages for certain items are quite high, the
_______________ dollar contribution could be significant enough not to eliminate this
product or service.

eg. TV Radio
Cost % 95% 60%
Profit Earned Per Unit $100 $5

One TV sold is equivalent to selling 20 radios.

2. Prices for all departments should be established such that they optimize the
operation’s net profit. This will generally result in some profit centres not maximizing their
revenues and thus their departmental profits. This ______________________ approach is
essential and can only be accomplished by the general manager and profit centre
managers coordinating their pricing.

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Appendix A
Introduction to Menu Engineering
This method considers both the profitability and popularity of competing menu items.

The profitability of an item is grouped into high or low based on its gross margin in dollars.

If the average gross margin is $4, an item with gross margin of $3 would be low in profitability.
Items with gross margins above $4 would be high in profitability.

Menu engineering requires the manager to know each menu item’s food cost percentage,
selling price and quantity sold over a specific period of time. Menu items are classified by
popularity (high or low) and profitability (high or low) into a four box grid. Each of these grid
boxes has been a classification which best describes its character.

High
Plow Horses Stars
Popularity

Dogs Puzzles
Low
Low High
Profitability (Gross Margin)

The benefits of using this form of analysis is that it enables us to make a decision (or strategy)
on a particular item. In general,

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Stars should be sustained

 must maintain rigid specifications for quality,
quantity and presentation
 locate them in a highly visible position on the menu

Plow Horses should be repriced carefully

 important reason for a restaurant’s popularity
 make any price increase in stages
 merchandise the Plow Horse by packaging it with
side items to increase its contribution margin

Puzzles should be repositioned

 reposition a Puzzle by featuring it in a more popular
location
 rename it as a Puzzle’s popularity can be affected
by what it is called
 should be removed if requires costly or additional
inventory
 decrease the Puzzle’s price as it may be facing
price resistance due to its high contribution margin

Dogs should be removed from the menu

 if dog remains because of special request from
influential guests, carry the dog item in inventory
but not on the menu. Furthermore, charge extra for
this service.

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Appendix B

Pricing with GST

Room Rate $100++ means the base room rate is :
$100 plus 10% Service Charge
plus 7% GST

I It is calculated as follows:

Base Room Rate $ 100.00

plus 10% Service Charge 10.00 (10% of base rate)
Subtotal $ 110.00
plus 5% GST 7,70 ( 7% of $110 )
Final Total $ 117.70

This means that the guest will be charged $ 117.70 on his room folio when he is quoted a
room rate of $ 100++.

$117.70 is considered to be the nett price which means that it has taken into consideration all
the charges and taxes. In the above example, we may quote the room rate as $ 117.70 nett
or $ 100 ++.

[When the GST was increased from 5% to 7% in 1 July 2007, the 1% cess was removed.
1% cess was previously charged on the base rate together with 10% service charge,
but before 5% GST. ]
Rebates with GST
Any rebates (or allowance) for the above will have to take into consideration the respective
charges and taxes as calculated above.

Example
The guest is given a $10 rebate (allowance) because the noises from the hotel
renovation has affected his stay. The amount to be rebated (taken out) from the folio:
Base Rate $ 10.00

Service Charge (10%) $ 1.00

GST (7%) $ 0.77
To rebate $ 11.77

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