SOLUTIONS MANUAL for Accounting Essentials for Hospitality Managers 4th Edition by Guilding Chris an

CHAPTER 1 Introduction Problem 1.1: Solution a) Functional interdependency exists when the performance of one functional area is affected by the performance of a separate functional area. For example, in a hotel complex that is dominated by a casino, the success of the rooms and food and beverage departments will be affected by the success of the casino operations in attracting clients to the complex. b) Functional interdependency is an important issue for the designers of a hotel’s system of accountability because care should be taken to hold a manager accountable for only those aspects of the hotel’s performance that he or she can influence. For example, the heads of rooms and food and beverage departments should not be held accountable for a decrease in their room sales if it is caused by reduced casino activity.

Problem 1.2: Solution a) The four main dimensions of sales volatility in the hotel industry are: 1. economic cycle induced sales volatility, 2. seasonal sales volatility, 3. weekly sales volatility, 4. intra-day sales volatility. b) The implications that these dimensions of sales volatility carry for hotel accounting systems are as follows: 1. Economic cycle induced volatility: Hotel sales’ high susceptibility to general economic conditions highlights the importance of hotels carefully forecasting economic cycles as part of the annual budgeting process.

2. Seasonal sales volatility: Three accounting implications arise: • Seasonal sales volatility can be so severe to warrant temporary closure for some resort properties. This possibility of having to make a closure decision signifies that

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cost and revenue data should be recorded in a manner that will enable a well informed financial analysis of the pros and cons of closing.

• Seasonal sales volatility can also pose particular cash management issues. During the middle and tail-end of the busy seasons, surplus cash balances are likely to result, while in the off-season and the build up to the busy season, deficit cash balances are likely to result. Careful cash budgeting will therefore need to be conducted.

• Seasonal sales volatility will also affect price discounting decisions. To ensure such decisions are well informed, careful forecasting as part of the annual budgetary process, will have to be conducted.

3. Weekly sales volatility: Accurate forecasting of weekly sales volatility will inform management’s decision making with respect to the amount and timing of room rate discounting, staffing needs as well as restaurant purchasing needs.

4. Intra-day sales volatility: Intra-day demand volatility has led to widely-used pricing strategies such as “early bird specials” in restaurants and “happy hours” in bars. Records concerning demand at different times of the day will have to be maintained in order to inform such hotel pricing issues.

Problem 1.3: Solution Examples of business decisions requiring the use of financial accounting data include: (a) A bank manager deciding whether to lend money to a company. (b) A shareholder deciding whether to sell her shares due to a fear that the company she has invested in might go bankrupt. (c) A potential shareholder thinking about purchasing shares in a company and interested in determining if the company is profitable.

Examples of business decisions requiring the use of management accounting data include: (a) Determining whether accounts are being collected on time. (b) Determining whether the business will have sufficient cash over the next year to avoid the need to arrange a line of credit. (c) Determining whether a drinks vending machine or a confectionary vending machine should be installed in a hotel’s foyer area. (d) Determining what room rate to charge to achieve a target level of profit. (e) Determining whether a seasonal hotel should be closed down during the quiet season. (f) Determining whether a restaurant manager is performing well.

Problem 1.4: Solution a) High product perishability signifies that an item cannot be held in inventory for sale at a later time. Food items have a limited life in inventory because of their rapid physical deterioration. Room nights and conference facilities cannot be placed in inventory because they relate to a particular time period that expires.

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b) The absolute perishability of rooms, conference and banquet facilities and the relative perishability of food underlines the importance of accurate hotel demand forecasting as part of the budgeting process. Generally, the most important aspect of forecasting is room occupancy, as room sales drive sales levels of other hotel services. Accurate restaurant forecasting provides the basis for maintaining a full menu of options while also minimising the cost of food wastage.

Problem 1.5: Solution Fixed costs are costs that do not vary as a function of sales activity levels. Hotels involve considerable investment in fixed assets such as buildings on prime land as well as extensive furnishings, fittings and equipment. This investment generates high rent and depreciation costs, which together with significant salary costs, result in a high fixed cost structure for hotels.

Problem 1.6: Solution a) Major hotel activities include room housekeeping, restaurant food preparation and service as well as bar service. Despite the advent of the machine and computer age, the physical aspect of all of these activities has changed little over the last fifty years, as they continue to have a high labour component. b) High labour intensive activities in hotels signifies the importance of performance measures that focus on labour productivity. Such performance indices include restaurant covers per employee hour worked and restaurant sales per employee hour worked.

Monitoring differences between actual labour cost and budgeted labour cost represents another dimension of labour cost management. An appropriate analysis of the difference between budgeted and actual labour cost enables a distinction to be drawn between labour rate and labour efficiency factors.

Problem 1.7: Solution Financial accounting concerns the preparation of financial reports for external users such as shareholders, banks and government authorities. In order for these financial reports to be meaningful, it is important that they are produced in a standardised way and are seen to be reliable. Management accounting concerns the provision of financial information to internal management. This information is designed to help managers in their decision making and control of businesses. Financial information sought by hotel managers includes determining the cost of providing a meal to inform the menu pricing decision, determining how many delegates need to attend a conference in order to achieve break even, and determining what level of profit is made by each selling unit of a hotel to inform any rationalisation decision to drop a unit. The provision of all these types of financial information falls within the scope of management accounting.

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Problem 1.8: Solution The main accounting information users are: • Managers within the company being accounted for. Managers use accounting information in planning and controlling business activities.

• Outside parties such as shareholders, potential shareholders, creditors and government agencies. These parties use accounting information to make investing, lending, taxing and regulatory decisions.

Problem 1.9: Solution Accounting reports represent the main source of information that the investing community uses when attempting to make wise equity investments. A lack of confidence in accounting systems is bound to translate into a reluctance to invest in companies. This will inhibit the ability of economically viable companies to expand, which in turn will carry negative implications for employment, availability of goods and services, and our standard of living.

It is critically important that a reliable financial accounting system that engenders trust and encourages corporate development is established, otherwise economic activity suffers.

Problem 1.10: Solution Any of the elements referred to in Box 1.3 could be used as an answer to this question.

Problem 1.11: Solution Amongst the advantages deriving from the USALI are the following: • it can save on accounting system design costs as it represents a “blueprint” accounting system that can be adopted by any business in the hotel industry, • the system can be viewed as “state of the art” as it benefits from the accumulated experience of the parties that have contributed to the system’s development over many years, • by promoting consistent account classification schemes as well as formatting of reports, it facilitates comparison across hotels, • it represents a common point of reference for hotels within the same hotel group.

Problem 1.12: Solution 3 main organizational forms and their main differences Characteristics Number of owners

Sole proprietorship One

Partnership Two or more 4

Company Generally many

Business size

Small

Generally small

Key decision makers

Owner

Partners

Larger and can be very large Board of directors

Owner liability

Unlimited

Unlimited

Limited

Organisation life

Limited

Limited

On-going

Problem 1.13: Solution At the outset of a business, ‘capital raised’ refers to the long term funds invested in the business.

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CHAPTER 2 Analysing transactions and preparing year-end financial statements Problem 2.1: Solution a) Simply defined, assets are things that are owned by a business. Typical hotel assets include: cash, accounts receivable, prepayments, inventory, cars, china, silver, glass, linen, uniforms, equipment, land and buildings. b) Simply defined, liabilities comprise financial obligations of the organisation. Typical liabilities include: wages & salaries payable, accounts payable and bank loans. c) Simply defined, owners’ equity represents the residual claim that owners have on the assets of an organisation subsequent to the acquittal of all liabilities. Owners equity increases when owners introduce more funds to the organisation and when the organisation makes profit.

Problem 2.2: Solution The balance sheet equation relates to the fact that assets minus liabilities equals owners’ equity. The equation can also be stated as assets equal liabilities plus owners’ equity.

Underlying the first equation is the notion that the value of the owners’ equity in a business equals the surplus assets that would remain following acquittal of all liabilities. Sense can also be made of the second equation as a business raises money and then invests the money in various assets.

Problem 2.3: Solution Analysis of SerenitySleep Hotel’s financial transactions in first 10 days of June Assets June 1 2 3 4 5 6 7 8 9

Cash at Bank +20,000 -3,000 -900

Accounts Receivable

=

Inventory

Office equipment

Liabilities Accounts Loan Payable Payable

+

Owner’s Equity Profit or Capital Loss +20,000

+3,000 +900 +1,400

-1,500

+1,400 +6,000

+4,500

+1,000

+1,000

-800 +1,300

-800 +1,300 -400

-400

7

10

-240 14,860

1,000

1,900

9,000

1,400

$26,760

=

$5,900

4,500

19,200 +

-240 1,660

$20,860

Problem 2.4: Solution A business balance sheet summarises the assets, liabilities and owners’ equity pertaining to the business. It can thus be seen to be one representation of the wealth of the organisation.

It relates to a particular moment in time.

In the income statement sales revenue and expenses (i.e., resources consumed) for a period of time are summarised. The deduction of total expenses from total revenue provides profit (or loss if expenses are greater than revenue).

Problem 2.5: Solution An expense records the idea of something consumed or used up in connection with generating revenue. Expense items are included in the computation of profit – they have a negative impact on profit. Owners drawings do not affect profit. They represent an allocation of a portion of the computed profit to owners.

Problem 2.6: Solution The income statement always relates to a time period. For example, it may report revenue earned and expenses incurred during the last financial year. Note that revenue and expenses only make sense when talking about a period of time. A balance sheet, however, relates to a moment in time, not a period of time. As a balance sheet reports assets, liabilities and owners equity, these are things that will always be changing in a large company. Therefore a particular moment in time has to be selected for reporting these items.

Problem 2.7 Buildings : ASSET Wages : EXPENSE Drawings : OWNERS EQUITY Sales : REVENUE Loan owed : LIABILITY Cash: ASSET

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Accounts payable : LIABILITY Loan interest paid : EXPENSE Inventory used : EXPENSE Inventory on hand : ASSET Bank account interest earned : REVENUE

Problem 2.8: Solution Analysis of LusciouslyLong restaurant’s financial transactions in first 10 days of May Assets May 1 2 3 4 5 6 7 8 9 10

Cash at Bank

Accounts Receivable

+1,200 -750 +660 -2,400 -330 -350 +4,200 +1,500

+800

3,730

= Furniture

Inventory +350

Liabilities Accounts Loan Payable Payable +350

+

Owner’s Equity Profit or Capital Loss +2,000 -750

-660 -2,400 -330 -350 +4,200 +1,300

+2,800

1,440

350

3,160 3,160

3,160 3,160

$8,680

=

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$7,360

4,200

-2,400 +

$1,320

3,720

Problem 2.9: Solution a) Johnson Hotel Income Statement for the month ending 31 December 20X1 $ $ Sales revenue 38,000 less Stock used 6,500 Miscellaneous expenses 3,000 9,500 Profit $28,500 b) Johnson Hotel Statement of Owner’s Equity for the month ending 31 December 20X1 $ Opening owner’s equity 148,000 Net profit 28,500 176,500 Less: Drawings 4,000 Closing owner’s equity $172,500 c) Johnson Hotel Balance Sheet as at 31 December 20X1 Assets Cash Accounts receivable Linen Uniforms Buildings

$ 5,000 12,000 8,000 7,500 250,000 $282,500

Liabilities Accounts payable Loan payable

$ 10,000 100,000

$

110,000 Owner’s equity Capital

10

172,500 $282,500

Problem 2.10: Solution MacNoodle Restaurant’s Balance Sheet Equation Assets Cash at Bank April 1 + £10,000 - £400 2 - £100 4 5 + £350 7 - £450 8 - £100 14 - £300 18 27 + £460 28 - £280 29 30 30 £9,180

Accounts Receivable

=

Inventory

Liabilities Accounts Payable

Equipment

+

Loan Payable

Owners’ Equity

Capital + £10,000

Profit or Loss

+ £400 + £1,000

+ £900

+ £500

+ £500 + £350 - £450 - £100 - £300

- £250

- £60 + £340 £340 £11,110

£590

£1,000

£200 =

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£900 £1,100

£10,000 +

- £250 + £460 - £280 - £60 + £340 £10

£10,010

Problem 2.11: Solution a) MacNoodle Restaurant Income Statement for April 20X1 £ Sales revenue less Expenses Cost of sales Wages Rent

£ 1,150

310 380 450 1,140 £ 10

Profit

b) MacNoodle Restaurant Statement of Owner’s Equity for April 20X1 £ 10,000 10 10,010 0 £10,010

Owner’s equity contribution plus Net profit less Drawings Owner’s equity at end of period

c) In the interest of consistency, in this solution the balance sheet format used is the same as that used in Exhibit 2.2. As the question draws on a setting in the UK, however, one could justifiably present the balance sheet using the format presented in Exhibit 2.3.

MacNoodle Restaurant Balance Sheet as at 30 April 20X1 Assets Cash Accounts receivable Inventory Equipment

£ 9,180 340 590 1,000

Liabilities Accounts payable Loan payable

£ 200 900

£

1,100 Owners’ equity Capital

£11,110

12

10,010 £11,110

Problem 2.12 Solution a) Paul Eastwell Hotel Income Statement for the year ending 30 June 20X1 $ $ 115,000

Sales revenue less Food & Beverage used Wages Miscellaneous expenses

23,000 41,700 4,200 68,900 $46,100

Profit b)

Paul Eastwell Hotel Statement of Owner’s Equity for the year ending 30 June 20X1 $ 199,900 46,100 246,000 6,000 $240,000

Opening owner’s equity Net profit Less: Drawings Closing owner’s equity c)

Paul Eastwell Hotel Balance Sheet as at 30 June 20X1 Assets Accounts receivable Food inventory Beverage inventory Cleaning supplies Tennis ball stock Furniture Buildings Land

$ 12,000 3,800 2,400 1,100 800 13,000 125,000 230,000

Liabilities Bank overdraft Accounts payable Wages owing Tax payable Loan payable

$ 7,300 22,000 4,600 14,200 100,000

$

148,100 Owner’s equity

$388,100

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240,000 $388,100

CHAPTER 3 Double entry accounting Problem 3.1: Solution No, it is inappropriate and misleading to suggest a debit to an account represents a good or a bad thing. It is true that a debit to the cash or bank account may be seen as beneficial as it signifies that an inflow of money has occurred, however, a debit to an expense account signifies an increase in the expense account and not many businesses would regard an increase in an expense as beneficial. We can conclude that we can only say that a debit to an account is a good thing if we know what type of account we are talking about.

Problem 3.2: Solution No, in double entry accounting we cannot say that a debit represents a plus and a credit represents a minus.

Debiting an asset account will usually represent a plus as asset accounts generally have a debit balance (the bank account can be an exception, however, if it is overdrawn). Liability accounts (e.g., accounts payable), however, generally have a credit balance, therefore a debit entry will have the effect of reducing the account’s credit balance.

Problem 3.3: Solution a)

Owners’ Equity

Bank 4,000

b)

4,000

Beer inventory

Accounts Payable

5,000

c)

5,000

Bar snacks inventory

Cash

450

d)

450

Equipment

Accounts Payable

1,000

e)

1,000

Bank

Revenue

14

350

f)

350

Cost of sales

Beer inventory

150

150

Problem 3.4: Solution “Fixed assets” is the term given to all physical assets that will be held by the owning company for more than a year. Fixed assets are acquired for use in operations rather than for resale to customers. “Current assets” include cash and other assets that through the business’s operating cycle will be converted into cash, sold or consumed within one year of the balance sheet date. The main current assets are: cash, prepayments (discussed in Chapter 4) accounts receivable and inventory.

Problem 3.5: Solution Because of banking terminology, many managers are confused by the workings of the cash account. This confusion arises because the bank is using terminology from its perspective and not the account holder’s perspective. When funds are deposited in an account, the bank records a credit to the account. Imagine that Jo Blow deposits $500 in his savings account held with the Trusty bank. The double entry that the Trusty bank would record in its accounting system is as follows:

Cash

Jo Blow Account

500

500

Note that the cash account (which is an asset from the bank’s perspective) has been debited. Note also that the bank’s record of the Jo Blow account has been credited. This account represents a liability from the perspective of the bank (i.e., it records what the bank owes to Jo Blow). As the bank’s liability to Jo Blow has increased, the account has been credited. When Jo Blow receives a statement from his bank, he will find that the $500 deposit has been recorded as a credit to his account.

Problem 3.6: Solution Journals are maintained in order to: 1. Provide a chronological record of all transactions. If a business was to experience a problem with its accounting system during a particular time period, the journal could be turned to as a record of transactions occurring during that time period.

2. Provide a complete record of each transaction. Note that in the general ledger, transactions are recorded in more than one place, eg., a $300 cash sale is recorded in the “cash account” record and the “sales account” record. Recording all information relating to a transaction in a journal helps in the avoidance and detection of errors.

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Problem 3.7: Solution Typical assets that an individual will list include: ‘money at bank’, clothes, furniture, car, house, etc.

Typical liabilities that an individual will list include: bank overdraft or loan, student loan, loan on car, mortgage on house, etc.

By deducting the total of an individual’s liabilities from the total of their assets we can compute the individual’s ‘net worth’.

Problem 3.8: Solution Usual balance

If increasing the account

If decreasing the account

Asset

Debit

Debit

Credit

Liability

Credit

Credit

Debit

Owners’ equity

Credit

Credit

Debit

Revenue

Credit

Credit

Debit

Expense

Debit

Debit

Credit

Debit balances 120,000

Credit balances

Type of account

Problem 3.9 Buildings Wages payable Bank overdraft Trade Creditors Soft drink inventory Office supplies Drawings Owners equity

1,300 2,240 3,300 880 540 3,600 78,450 16

Bank loan Accounts receivable Sales Bank interest revenue Total

18,420 4,500 24,600 1,210 129,520

129,520

Problem 3.10: Solution a)

Cash

Revenue

500

b)

500

Cash

Wages 400

c)

400

Accounts receivable

Revenue

600

d)

600

Cash

Drawings 1,000

e)

1,000

Inventory

Accounts Payable

700

700

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Problem 3.11: Solution a)

a d e

g

Cash 30,000 12,000 20,000 2,000 30,000 12,000 2,100 10,800 4,000 1,500 80,000 44,400 35,600

c f g h i j k

Accounts payable 12,000 10,000 b 8,000 c 9,000 f 12,000 27,000 15,000

b

Food inventory 4,000

b

Beverage inventory 6,000

e

Accounts receivable 10,000

c

Furniture & Equipment 20,000

h Revenue 40,000 e

f

Food purchase expense 9,000

i

Wage expense 10,800

k

Bank l oan 2,000 20,000 18,000 Owners’ equity 30,000

a

f

Beverage purchase expense 2,000

j

Supplies expense 4,000

h

Interest expense 100

Rent expense 1,500

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d

b) T. Francis Restaurant Income Statement for January 20X1 $ Revenue Cost of sales Food Beverage

$ 40,000

9,000 2,000 11,000 29,000

Gross Profit Other expenses Rent Supplies Wages Interest

1,500 4,000 10,800 100 16,400 $12,600

Net Profit

T. Francis Restaurant Balance Sheet as at 31 January 20X1 $

$

Current assets Cash

35,600

Food inventory

4,000

Beverage inventory

6,000

Accounts receivable

10,000 55,600

Fixed assets Furniture & equipment

20,000

Total assets

$75,600

Current liabilities Accounts payable

15,000

Long-term liabilities Bank loan

18,000

Owners’ Equity Capital invested

30,000

Retained earnings

12,600 42,600

Total liabilities & owners’ equity $75,600

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Problem 3.12 (a): Solution a b f

j

Cash 80,000 99,500 40,000 8,000 12,000 1,500 300 1,200 6,000 1,500 1,800 2,000 132,000 121,800 10,200

c d g h i j k l m

Linen & uniforms 5,800

c

Land & Buildings 99,500

d

Kitchen equipment 20,000

Accounts payable 6,000 12,000 d 5,800 e 17,800 11,800

Revenue 12,000

Bank loan 40,000

b

Share capital 80,000

a

f

l

Cost of sales food 1,800

k

Beverage inventory 1,500 500 k

i

e

g

Wage expense 1,500

h

Interest expense 300

i

Insurance prepaid 1,100

m

Dividends paid 2,000

Insurance expense 100

Cost of sales - beverage k 500

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Problem 3.12 (b) Solution Oz Hinterland Ltd Income Statement for first month of business $ Revenue Cost of sales Food Beverage

$ 12,000

1,800 500 2,300 9,700

Gross Profit Other expenses Wages Interest Insurance

1,500 300 100 1,900 7,800

Net Profit Retained earnings = Net Profit – dividends = $7,800 - $2,000 = $5,800

Oz Hinterland Ltd Balance Sheet as at the end of first month of business $ $ Current assets Cash Insurance prepaid Beverage inventory

10,200 1,100 1,000 12,300

Other assets Linen and uniforms Kitchen equipment Land and buildings

5,800 20,000 99,500 125,300 $137,600

Total assets Current liabilities Accounts payable Long-term liabilities Bank loan Total liabilities

11,800 40,000 51,800

Owners’ Equity Capital Retained earnings

80,000 5,800 85,800

Total liabilities & owners’ equity $137,600

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CHAPTER 4 Adjusting and Closing Entries Problem 4.1: Solution “Adjusting entries” is the term used to describe the set of bookkeeping entries that need to be made in order to update some accounts prior to the preparation of the accounting year-end income statement and balance sheet.

This “tidying up” of accounts, which is really what the adjusting entries represent, has to be completed prior to closing entries. In many cases, the need for adjusting entries arises because the timing of cash flows (either receipts or disbursements) does not coincide with the period in which it is appropriate to recognise the revenue or expense. This distinction between the timing of a cash flow and the timing of the recognition of a revenue or an expense item stems from the accrual concept of accounting which holds that: • revenue is recognised when it is earned and certain, rather than simply when cash is received, • an expense is recognised in the period when the benefit derived from the associated expenditure arises.

Closing entries involve rolling all the accounts that feed into the income statement (plus the drawings account) back to zero at the end of the accounting year. For this reason, these accounts are sometimes referred to as temporary accounts. Accounts that feed directly into the balance sheet are sometimes referred to as permanent accounts as they are not rolled back to zero at the end of the accounting year. The revenue, expense and drawings accounts have to be wound back to zero at the end of the accounting year, otherwise they would carry amounts that relate to the business since its inception, rather than the current accounting year.

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Problem 4.23: Solution a)

Telephone expense

Telephone payable

500 b)

500 Rent expense

Rent accrued

2,400 c)

2,400

Depreciation expense

Accumulated depreciation

1,000 d)

1,000

Salary & wage expense

Salaries & wages accrued

70,000 e)

70,000

Unearned revenue

Revenue

1,200 f)

1,200

Rental revenue

Unearned revenue

400

400

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Problem 4.24: Solution a) 1.

Cash

Accounts receivable

92,000

O.B. 141,500 92,000

2.

Revenue O.B. 1,320,000

Accounts receivable 141,500 92,000 101,000

101,000

b) The first entry is to record the write down of the accounts receivable for the 180 days due balance: Allowance for doubtful accounts O.B. 2,400 4,500

Accounts receivable 141,500 92,000 101,000 4,500

Following the review of the accounts receivable ledger, it has been determined that the allowance for doubtful accounts should have a credit balance of $2,080 [($84,000 X 0.0075) + ($44,000 X 0.0125) + ($18,000 X 0.05)].

An inspection of the balance on the “allowance for doubtful accounts” account reveals that following the above debit entry of $4,500, it has a debit balance of $2,100. In order to achieve the requisite closing credit balance of $2,080, an adjusting credit entry of $4,180 has to be made to the “allowance for doubtful accounts”. This adjusting entry signifies that the allowance for doubtful accounts entries made throughout the year were insufficient to reflect the doubtful account reality at the year-end. It is presumed that through the year, when the monthly entry has been made to allow for doubtful accounts, the “bad debts expense” account has been debited. Accordingly, we need to increase the bad debts expense account at the year-end, i.e., make an adjusting debit entry of $4,180 to the “bad debts expense” account.

Bad debts expense O.B. 12,400

Allowance for doubtful accounts 4,500 2,400 4,180

4,180

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Problem 4.4: Solution Interest revenue : REVENUE Wages accrued: LIABILITY Depreciation expense : EXPENSE Insurance prepaid : ASSET Unearned revenue : LIABILITY Bad debts expense : EXPENSE Supplies inventory : ASSET Allowance for doubtful accounts : NEGATIVE ASSET Accumulated depreciation : NEGATIVE ASSET

Problem 4.5 Solution a) In the table below, developed to answer part (b), the accounts that need to be closed have entries in the two ‘closing entry’ columns. Those accounts with no entries in these two columns do not need to be closed at the end of the year. b) Closing entry required is shown in the last two columns of the following table: Closing entry Account Dr Cr Sales revenue

Sales revenue

Income statement

Interest revenue

Income statement

Income statement

Insurance expense

Depreciation expense

Income statement

Depreciation expense

Rent expense

Income statement

Rent expense

Inventory Interest revenue Wages accrued Prepaid insurance Insurance expense Accumulated depreciation

Prepaid rent Allowance for doubtful accounts

Problem 4.6: Solution

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Firstly, we can determine the cost of supplies used as follows: Opening balance Supplies purchased Less: returns Supplies made available Supplies used Closing balance

£ 3,400 36,000 39,400 1,020 38,380 ?

4,200

As we have determined that the cost of supplies made available is £38,380 and we know that we have ended the year with a stock of £4,200, we can conclude that £34,180 (£38,380 - £4,200) of supplies must have been used during the year.

The year-end adjusting and closing entries necessary in this situation can be managed in three stages. Firstly, the balances on the “cleaning supplies purchases” and the “cleaning supplies returns” accounts can be transferred to the cleaning supplies inventory account. This results in the “cleaning supplies purchases” and the “cleaning supplies returns” accounts commencing the new accounting year with zero balances.

Cleaning supplies purchases 36,000 36,000

Cleaning supplies returns 1,020 1,020

Cleaning supplies inventory 3,400 36,000

1,020

As an alternative to this approach, the “cleaning supplies purchases” and the “cleaning supplies returns” accounts could be closed directly to the income account.

Secondly, the cleaning supplies expense account can be debited with the £34,180 cost of cleaning supplies used that was calculated above. The corresponding credit entry is to the cleaning supplies inventory account.

These entries result in the recognition of an expense (the supplies expense account will be closed to the income statement). They also result in a £4,200 debit balance in the supplies inventory account, which reflects the result of the year-end stock-count. This inventory account balance will comprise part of the total assets recorded in the year-end balance sheet.

Cleaning supplies expense

Cleaning supplies inventory 3,400 1,020

34,180 36,000

34,180

Thirdly, as a closing entry, the cleaning supplies expense account must be closed to the income statement.

Cleaning supplies expense

Income statement

34,180

34,180 34,180

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Problem 4.7: Solution a) (1)

Sales revenue 2,500

(2)

Unearned revenue 420,000

2,500

Salaries & wage expense

Accrued salaries & wages 4,000

145,000 4,000 (3)

Depreciation expense

Accumulated depreciation

82,000

10,000

10,000 (4)

Rent expense

Prepaid rent

3,000

900

600

600 (5)

Interest revenue

Interest receivable 11,000

1,000

1,000 (6)

Insurance expense

Prepaid insurance

18,000

12,000

6,000

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6,000

b) TranquilStay Hotel Revised Income Statement for the year-ended 30 June 20X1

€ Sales Revenue Less: Cost of Sales Gross Profit Add: Interest revenue

€ 417,500 80,000 337,500 12,000 349,500

Less: Expenses Salaries and wages expense Depreciation expense Car park rental expense Insurance expense Sundry expense

149,000 92,000 3,600 24,000 14,000 282,600

€ 66,900

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Problem 4.29: Solution a) Unearned service revenue

Service revenue

1,000

b)

1,000

Insurance expense

Prepaid insurance

600

600

c) Interest receivable

Interest revenue

400

400

d) Supplies expense

Supplies

7,200

7,200

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Problem 4.30: a) Solution

Johnson Hotel Income Statement for the period ended 30th June 20X1 $ 26,500 16,000

Sales revenue Cost of sales Gross profit less Wage expense Depreciation expense General operating expenses

10,500 4,500 250 140 4,890 $5,610

Net profit

b)

$

[Add ($5,610 – $2,000) to retained profit] Johnson Hotel Balance Sheet as at 30th June 20X1 $ 2,200 1,500 400

Cash at bank Accounts receivable Inventory Current assets Plant and machinery at cost Less: Accumulated depreciation Fixed assets net book value Total assets

$

4,100 11,000 1,020 9.980 $14,080

Accrued wages Accounts payable Unearned revenue Current liabilities

100 2,200 200 2,500

Share capital Retained profits Total liabilities and equity

4,800 6,780 $14,080

30

Problem 4.10 Solution Year end adjustments 1. An expense has been incurred but not yet paid.

2. A $5,000 deposit for a conference to commence in two week’s time has been received. At the time the deposit was received, cash was debited and revenue was credited.

3. A bus insurance payment was expensed during the year, but at the end of the year there is still a period of insurance cover that has not been used up.

4. A car insurance payment was recorded by debiting insurance prepaid during the year, but at the end of the year there is still a period of insurance cover that has not been used up.

5. Some revenue appears to be unearned at the year end.

6. A new fixed asset purchased at the beginning of the year was accounted for by debiting the fixed asset accounting and crediting the cash account.

7. A portion of rent for a large land parcel was paid in advance three weeks before the year end, but has not been used up at the year end.

When the rent was paid by the hotel the accountant debited rent expense and credited cash.

8. Rent for a smaller land parcel has not been paid by the hotel and is owing at the year end.

Year end journal entries d. Debit expense, credit expense payable. a. Debit revenue, credit unearned revenue.

e. Debit prepaid insurance, credit insurance expense. h. Debit insurance expense, credit insurance prepaid. g. Debit revenue, credit unearned revenue. b. Debit depreciation expense, credit accumulated depreciation. f. Debit prepaid rent, credit rent expense.

c. Debit rent expense, credit rent payable.

Problem 4.11: Solution a)

KowloonKingdom Hotel Calculation of revised Income statement data Calculation of revised revenue Revenue in pre-adjustments Income Statement Add engineering conference revenue not recorded Less deposit received for accountants’ conference Revised revenue

$ 346,000 13,000 359,000 5,000 354,000

Calculation of revised operating expenses Operating expenses pre-adjustments Income Statement Accrued wages Elapse of insurance premium (.75 X $4,000) Kitchen cleaning supplies expense (1,100 + 5,400 – 800) Revised operating expenses

$ 102,000 3,200 3,000 5,700 113,900

31

b) KowloonKingdom Hotel Income statement for the year ending 31 December 20X1 Revenue Less: Operating expenses Depreciation expense Net profit

$ 354,000 113,900 42,000 198,100

Problem 4.12: Solution a) 1.

Wage expense

Wages accrued

340

2.

340

Prepaid rent

Rent expense

290

3.

290

Interest receivable

Interest revenue

212

4.

212

Insurance expense

Prepaid insurance

540

540

b)

Impact of adjusting entries on Kings Arms Pub Profit Reductions to profit Wage expense increase

340 32

Insurance expense increase

540 880

Increases to profit Rent expense decrease Interest revenue increase • •

290 212 502

Adjusting entries would reduce profit by £378 (880 – 512).

Therefore profit would be overstated by £378 if the adjusting entries were not made.

c) Impact of adjusting entries on Kings Arms year end assets balance Reductions to assets Prepaid insurance decrease

540

Increases to assets Prepaid rent increase Interest receivable increase • •

290 212 502

Adjusting entries would reduce assets by £38 (540 – 502).

Therefore assets would be overstated by £38 if the adjusting entries were not made.

Impact of adjusting entries on Kings Arms year end liabilities balance Increases to liabilities Wages accrued increase • •

340

Adjusting entries would increase liabilities by £340.

Therefore liabilities would be understated by £340 if the adjusting entries were not made.

Impact of adjusting entries on Kings Arms year end owners equity balance As adjusting entries would reduce profit by £378, they would also reduce owners equity by £378. Therefore owners equity would be overstated by £378 if the adjusting entries were not made.

33

CHAPTER 5 Financial Statement Analysis Problem 5.1: Solution a) Dupont (ROI)

EBIT T.A.

=

EBIT Revenue

X

Revenue T.A.

HoJo:

50 ÷ 250 0.2

= =

50 ÷ 500 0.1

X X

500 ÷ 250, 2

EasyRest

15 ÷ 75 0.2

= =

15 ÷ 300 0.05

X X

300 ÷ 75, 4

b) Both companies’ F&B activities have achieved a 20% return on total assets. However, their methods of achieving this return have been quite different. HoJo has earned a 10% profit margin and a 200% turnover of sales to total assets, whereas EasyRest has had a much higher sales turnover (4 or 400%) with a smaller profit margin (5%).

The companies appear to have different pricing policies. HoJo’s mark-up on cost of sales is 150% (300/200), whereas EastRest only marks up cost of sales by 36% (80/220).

34

Problem 5.35: Solution a) Cost of sales

=

0.6 X £28,750,000 = £17,250,000

Average inventory =

£400,000 + £800,000 + £900,000 + £200,000 4

= £575,000

Inventory turnover

=

30

Average age of inventory =

£17,250,000 £575,000 365

= 30

=

12.17 days

b) Enwad appears to have less liquid inventory than the average firm in the industry. Enwad’s inventory is converted into a sale after 12 days while the average firm in the industry is taking approximately 9 days (365 ÷ 40).

35

Problem 5.36: Solution a Year ending 20X1 working capital: ($10,800 + 27,000 + 7,500 + 10,400 + 1,500) - ($8,400 + 3,600 + 4,500 + 700 + 10,700) = $57,200 - $27,900 = $29,300 Year ending 20X2 working capital: ($14,300 + 26,000 + 7,500 + 12,000 + 1,600) - ($12,200 + 5,600 + 3,400 + 400 + 9,500) = $61,400 $31,100 = $30,300 b.

Year ending 20X1 current asset ratio: $57,200 ÷ $27,900 = 2.05 Year ending 20X2 current asset ratio: $61,400 ÷ $31,100 = 1.97

c.

Year ending 20X1 acid test ratio: ($57,200 -10,400 - 1,500) ÷ $27,900 = 1.62 Year ending 20X2 acid test ratio: ($61,400 - 12,000 - 1,600) ÷ $31,100 = 1.54

d.

The working capital shows a marginal increase, however both the current asset ratio and the acid test ratio have decreased marginally. It appears the increase in the working capital has largely been accounted for by an increase in the size of the business (all things being equal, as a business doubles in size, so its working capital needs to double in order to maintain the same level of liquidity).

Overall, we can conclude that there has been a marginal decrease in the restaurant’s level of liquidity.

e.

Accounts receivable turnover = Credit sales  average accounts receivable Credit sales = $500,000 X 0.55 = $275,000 Average accounts receivable = ($27,000 + $26,000)  2 = $26,500 Accounts receivable turnover = $275,000  $26,500 = 10.38

f.

Accounts receivable collection period = 365  A.R. turnover: 365  10.38 = 35.16 days

g.

Inventory turnover = Cost of sales  average inventory Cost of sales = $150,000 Average inventory = ($10,400 + $12,000)  2 = $11,200 Inventory turnover = $150,000  $11,200 = 13.39

h.

Inventory collection period = 365  inventory turnover: 365  13.39 = 27.25 days

36

Problem 5.4: Solution a

The accounts receivable turnover rate is declining therefore the restaurant is extending a longer period of credit (12.6 days in 20X1 [365 ÷ 29] and 19.2 days in 20X3 [365 ÷ 19]).

b.

Since sales, and presumably cost of sales, has remained fairly constant over the 3 years, and since the food inventory turnover rate has declined, more money is now tied up in inventory.

c.

Yes, the current asset ratio has improved (increased). The answers to parts a and b seem to indicate that a large part of the increasing current asset ratio stems from increases in accounts receivable and inventory.

d.

To provide a most informed answer to this question, we would like to know what returns on investment are being earned by other restaurants. ROE (return on shareholder’s equity) has declined from 10.56% to 9.02%. This suggests dissatisfaction on the part of the owners. If this downward trend has coincided with a major downturn in the economy, however, the owner’s may feel that management has run the restaurant relatively effectively.

e.

The debt to equity ratio has declined, this signifies a lower level of indebtedness and therefore a potential lender will perceive less risk in the restaurant as a potential borrower. Further, in light of the increasing current asset ratio, the potential lender will perceive the restaurant as representing less of a short-term risk as a borrower. Based on these two observations, it appears that it will be easier for the restaurant to borrow in 20X3.

37

Problem 5.5: Solution a

ROI = Profit margin X Total asset turnover (TATO) 14% = 40% X TATO TATO = 14 ÷ 40 = 0.35

b.

Following a 10% decline in selling price, assuming cost per cover remains constant, profit margin per average cover would fall from 40% (i.e., 8 ÷ 20) to 33% (i.e., 6 ÷ 18). TATO required to maintain ROI at 14% can be calculated as follows: 14% = 33% X TATO ; TATO = 14 ÷ 33; TATO = 0.42

c.

As old TATO = 0.35, and assets = $200,000; Old total revenue = 0.35 X 200,000 = $70,000 As old cover price is $20; number of meals served = $70,000 ÷ 20 = 3,500. $ Revenue needed at new price to maintain 14% ROI: 0.42 X $200,000 = $84,000 Unit sales needed = 84,000 ÷ 18 = 4,666.67 Increase in covers = 4,666.67 - 3,500 = 1,166.67

Problem 5.6: Solution Season

Occupancy

Recent summer season Previous year’s summer season

0.80 0.90

X

Average room rate £120

Revpar =

£96

X

£100

=

£90

Using revpar, we can see that hotel revenue per available room has increased. As a result, the decision to increase room rates appears justified. The decrease in occupancy is more than off-set by the increase in the average room rate.

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Problem 5.7: Solution A comparison of the two years’ sales performance can be achieved by calculating daily revenue yield per seat.

This could be done by combining the data for the lunch and dinner seatings, however a more informative analysis results from treating each seating separately.

In 20X2 lunch revenue is $789,950 (37% of $2,135,000), and dinner revenue is $1,345,050 (63% of $2,135,000).

Comparison of 20X1 and 20X2 lunch time sales performance Sitting / Period Lunch 20X1 Lunch 20X2 a

Average spend per head $15 $14.066 a

X X

Seat turnover 1.4 1.5 b

= =

Daily revenue yield per seat $21 $21.1

: $789,950  56,160 = $14.066 : 56,160  (120 X 312 days) = 1.5

b

Comparison of 20X1 and 20X2 dinner time sales performance Sitting / Period Dinner 20X1 Dinner 20X2 a

Average spend per head $28 $29.94 a

X X

Seat turnover 1.1 1.2 b

= =

Daily revenue yield per seat $30.80 $35.93

: $1,345,050  44,928 = $29.94 : 44,928  (120 X 312 days) = 1.2

b

In 20X2 the average lunch spend per head has declined from $15 to $14.066, however this decline has been compensated for by an increase in seat turnover from 1.4 to 1.5. Considered together, the impact of these two effects has resulted in a very slight increase in daily revenue yield per seat from $21 to $21.1.

With respect to dinners, the average spend per head has increased from $28 to $29.94. In addition there has been an increase in seat turnover from 1.1 to 1.2. Both these effects represent a positive impact on daily revenue yield per seat which has increased by $5.13 from $30.80 to $35.93.

The restaurant manager can be informed that the sales productivity of the restaurant’s seats has improved over the year. Lunch time performance is only slightly improved, however dinner performance has improved significantly with a 16.6% improvement in daily revenue yield per seat ($5.13  $30.8).

Problem 5.8 Solution a) ROI = EBIT ÷ Assets X 100 last year’s ROI = 2,000 ÷ 19,950 X 100 = 10.23% this year’s ROI = 1,290 ÷ 25,680 X 100 = 5.02% Note: the ROI for this year could also be calculated by using average assets across the two years as the denominator.

This analysis reveals that the hotel’s ROI has decreased from 10.23% to 5.02%. b)

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Last Year’s performance

This Year’s performance

Gross profit margin 4,000 ÷ 5,000 X 100 = 80% 4,170 ÷ 5,250 X 100 = 79.4% Operating profit margin 2,000 ÷ 5,000 X 100 = 40% 1,290 ÷ 5,250 X 100 = 24.6% (EBIT ÷ Sales) Accounts receivable turnover 5,000 ÷ 350 = 14.3 5,250 ÷ 360 = 14.6 Inventory turnover 1,000 ÷ 400 = 2.5 1,080 ÷ 440 = 2.45 Fixed Asset turnover 5,000 ÷ 18,600 = 0.27 5,250 ÷ 24,660 = 0.21 Comparing last year’s performance to this year’s performance, the two big changes revealed by the above ratio analyses are: 1. A 38.5% decline in the operating profit margin from 40% to 24.6%.

2. a 22% decline in the fixed asset turnover from .027 to 0.21.

Both of these changes would have the effect of bringing down the current year’s ROI. Note: the ROI for this year and also the turnover ratios could also be calculated by using the average value of the asset in question across the two years.

Problem 5.9: Solution a) Year i. Current asset ratio

20X1 (20,000 + 11,500 + 3,400 + 10,900) ÷ 32,000 = 1.43 (20,000 + 11,500) ÷ 32,000 = 0.98

ii. Acid test ratio

20X2 (24,000 + 13,500 + 4,200 + 12,000) ÷ 31,000 = 1.73 (24,000 + 13,500) ÷ 31,000 = 1.21

b) TulipTower had a concerning liquidity status in 20X1 with a current asset ratio of 1.43 and an acid test ratio of 0.98. The acid test ratio is particularly concerning as it was less than 1. The hotel’s liquidity has improved in 20X2 with a current asset ratio of 1.73 and an acid test ratio. While this suggests a positive trend, many analysts like to see the current ratio to be in excess of 2. c) Year i. Debt to assets ratio ii. Times interest earned

20X1 (32,000 + 250,000) ÷ 450,000 = 63% 285,000 ÷ 16,000 = 17.8

20X2 (31,000 + 232,000) ÷ 465,000 = 56% (321,000 ÷ 14,300) = 22

d) The debt to assets ratio has decreased from 63% in 20X1 to 56% in 20X2. This signifies that the hotel’s relative debt burden is decreasing. The hotel’s times interest earned ratio has also increased, signifying greater ease in meeting interest payments, although the 17.8 ratio for 20X1 would not be considered high.

Problem 5.10: Solution a) Note: the question provides year end data on assets for 20X1 and 20X2. When calculating asset turnover figures for 20X2, the average of the opening and closing asset balances are taken (as explained in the chapter, if average asset data for a year can be accessed, this provides a better basis for calculating the asset turnover ratio). With respect to the year 20X1, the only asset data available relates to the year end asset balances. Consequently, the 20X1 year end balance is the best indication of average assets for 20X1 and these figures have been used in the 20X1 asset turnover calculations provided below.

Year i. Accounts receivable

20X1 (0.8 X 750,000) ÷ 15,000 = 40 40

20X2 (0.8 X 785,000) ÷ 14,500 = 43.31

turnover Accounts receivable collection period ii. Inventory turnover

365 ÷ 40 = 9.1 days

365 ÷ 43.31 = 8.43 days

285,000 ÷ 23,500 = 12.13

321,000 ÷ 23,750 = 13.52

b) When 20X1 is compared to 20X2, the turnover of inventory and accounts receivable is increasing. This signifies more efficient asset utilisation as, relatively speaking, less assets are being held to generate sales. c) Year i. Gross profit margin ii. Net profit margin

20X1 20X2 (750,000 – 285,000) ÷ 750,000 = 62% (785,000 – 321,000) ÷ 785,000 = 59% 31,000 ÷ 750,000 = 4.13% 38,000 ÷ 785,000 = 4.8%

d) SmallIsle’s gross profit margin has decreased from 62% in 20X1 to 59% in 20X2. This signifies that its cost of sales is greater relative to sales. The hotel’s net profit margin has increased, however, from 4.13% to 4.8%. This signifies that, relative to sales, the hotel must be saving in some area of expenses other than cost of sales.

Problem 5.11 Solution a) The hotel’s profit performance has declined over the period, as ROI has gone down. This is despite the fact that both gross profit margin and net profit margin have improved. It must be that the total asset turnover has declined to such an extent that it has more than offset the increase in NPM. b) The hotel’s short term financial stability has improved. This is evident from the fact that the current asset ratio and the acid test ratio have both improved. c) The hotel’s long term financial stability has declined. This is evident from the fact that the times interest earned ratio has declined, while the debt to equity ratio has increased. d) The room’s department performance has declined. Although room occupancy has gone up, revenue per available room has declined. This signifies there must have been a drop in average room rates charged that more than off-set the increased occupancy level.

Problem 5.12 Solution a) Current year’s accounts receivable turnover = Credit sales ÷ Average accounts receivable €20,000 X 0.1 ÷ 25 = 80 Current year’s average age of accounts receivable = 365 ÷ 80 = 4.5625 days Note: cost of sales = 40% of €20,000 (as gross profit margin is 60%).

Current year’s inventory turnover = Cost of sales ÷ Average inventory €8,000 ÷ 550 = 14.54 Average days inventory held in stock = 365 ÷ 14.54 = 25.1 days

41

b) Current ratio = €770 ÷ €280 = 2.75 Acid test ratio = €65 ÷ €280 = 0.23 c) The current ratio appears very healthy, however the acid test ratio is well below 1, and therefore not at all healthy. This signifies that much of CurryinaHurry’s current assets are held in less liquid assets (the bulk of this is inventory). So long as the business is confident that it can quickly convert its inventory into cash, if a liquidity emergency situation were to arise, this issue should not be a problem for the business.

It is certainly something that the business manager needs to bare in mind, however.

42

CHAPTER 6 Internal Control Problem 6.1 Solution 1) Safeguard assets This objective concerns the protection of an organisation’s assets from theft, ensuring that fixed assets are maintained so that they can be used efficiently and safely (eg appropriate hotel lift maintenance), and ensuring inventory items are appropriately stored to avoid waste and spoilage.

2) Promote efficient operations In a labour intensive business such as a hotel, ensuring appropriate recruitment and training can go a long way towards promoting efficiency. Adoption of technological advancements, such as providing all banquet staff with ear piece communication devices can also greatly facilitate efficient operations. A system that monitors the adoption of technological advancements in the sector can ensure a hotel is at the forefront of reaping technology based operating efficiencies.

3) Maintain accurate and reliable accounting records This objective requires that procedures are established to ensure the production of reliable annual reports to outside parties such as shareholders. Users of external financial reports need assurance that the reports provide a fair reflection of the economic events that have affected an organisation. Managers also need reliable accounting information to assist their operational management decision making and control.

4) Promote the pursuit of business policies It is not worth having internal control procedures if they are not followed. Many organisations conduct internal audits that provide several internal control roles, including an appraisal of the extent to which document procedures are being correctly adhered to.

Other ways to ensure business policies are adhered to include appropriately training staff and video recording staff as they conduct their work (video recording is an extensively used internal control device in casinos).

Problem 6.2 Solution Examples of particular internal control challenges arising in hotels include: • Hotels have a high volume of cash transactions.

• Hotels experience high employee turnover, • Many activities within hotels are conducted as relatively small independent units.

For instance, if a bar is staffed by two individuals, economies of scale that can facilitate the development of segregated roles consistent with strengthening internal controls are absent.

• In hotels many employees work in close proximity to inventory items that can be easily pilfered.

43

These characteristics signify that hotel managers need to have a sound appreciation of internal control system design.

Problem 6.3 Solution HarbourView Hotel Bank Reconciliation as at 31 December 20X1 Balance as per bank statement Add: outstanding deposits

Cr

Less: unpresented cheques Balance as per cash at bank account

Dr

$ 34,290 1,240 35,530 2,170 $33,360 *

* Workings HarbourView’s double entry accounting system bank account record Cash at bank balance – 31 December 20X1 Less: Bank fees

Dr

Add: Bank account interest received Adjusted cash at bank balance - 31 December 20X1

Dr

$ 33,376 32 33,344 16 $33,360

Problem 6.4 Solution The ways that a bank account greatly facilitates internal control over cash include: a. Enabling a business to greatly reduce the amount of cash held on its premises; b. Minimising the need for cash transactions, as a result of electronic transfer and chequing facilities; c. Facilitating bank reconciliation statements, thereby enabling periodic checks to be made of the accuracy of the cash balance recorded in a business’s accounting system.

Problem 6.5 Solution With respect to the new cash management system, there is insufficient segregation of duties. The changes made signify that the individual who collects cash could take the money for his own use and attempt to cover his theft by not reporting the fact that the cash has been collected.

44

There is also insufficient segregation of duties with respect to the new purchases and payments system. The new system has made it easier for the individual who places the order to take the goods ordered for their own personal use.

Problem 6.6 Solution Several internal control shortcomings are evident in the Kenyan SafariCamp scenario. a) Sue Rodwell could be failing to record certain sales on the cash register and then putting in her pocket the cash taken for the non-recorded sales. Also, at the end of the day she could be recording some fictitious returns to customers on the cash register and pocketing the recorded return amount, as no return has really been made. As no perpetual record of the stock balance is maintained, either of these potential practices by Sue would be hard to detect. b) Steve Fitchett could be taking some of the daily takings, amending the cash receipts record and ensuring that his actions do not come to light when preparing the bank reconciliation statements. As Steve has been the shop manager for several years, if he has been slowly building up an embezzlement practice, the shop’s gross profit margin is unlikely to reveal any ‘spiked’ effect in a particular period. The shop may have been suffering a diminished gross profit margin over several years. c) As no up-to-date record of inventory is maintained, it would be hard to determine if there is a large volume of theft, by whatever party, occurring in the shop.

Problem 6.7 Solution a) The internal function can represent a valuable vehicle promoting internal control. In a large organisation such as the Extravagant hotel group, it can be a cost effective way to promote the efficient conduct of operations and to ensure internal control procedures are in place and being complied with. If a procedure, or a reporting form that represents a step in a procedure, becomes redundant, the internal audit can be an effective way to flag that the procedure should be up-dated. Closing the internal audit team in the Extravagant group raises the risk of opportunities to increase internal efficiencies being missed. Further, once management in hotels realise that the internal audit checks are at an end, there is a greater chance of them lapsing into poor internal control practices in an effort to save money. b) In a purchasing situation where the goods in question are readily transportable and can be taken for personal use, it is important that systems are in place to prevent fraudulent activity. The purchasing and payments system at the 8tillLate bar has insufficient segregation of duties. This signifies that the manager could be placing liquor orders and taking the liquor home for his personal use. As he approves invoices for payment and oversees the periodic stock counts, this behaviour could go on for many years without being detected. c) A waiter working at the SublimeSpice restaurant could have told friends that if they come to the restaurant and sit at one of his tables he will charge them a greatly discounted meal price. He might also tell them that in return, he will place a bottle 45

of wine at the table (also not charged for) which he would like them to give back to him later that night. Also, failure to assign customers to seats can result in some waiting staff being twice as busy as other waiting staff. This can engender two forms of resentment among staff. Those staff members wanting an easy time may resent staff who are not getting as many customers. Those staff members seeking high tips will likely resent the fact that the busy staff members have an opportunity to earn more tips. d) Dividing tips provides an incentive for staff to perform their functions well. It carries the problem of waiting staff not entering into the tip pool all the cash tips that they receive. In the MemorableMunch case, table cleaners are likely to be the first staff members to a dirty table, signifying they have first access to any cash tip left on the table. This signifies that the table cleaners may have an opportunity to pocket all of a cash tip placed on a table.

Problem 6.8 Solution Employing a new staff member appears to be a costly solution to addressing this internal control problem. Just as we should not spend more on management accounting systems than the value of the benefit that derives from the management accounting system, we should not pay more on an internal control procedure than the savings that will result from the new procedure’s implementation. While it appears appropriate to give a particular staff member control over the office supplies area, the job would not appear to be large enough to warrant a new staff member. The General Manager should seek to determine if there is a member of the current administration team who sits close to the office supplies cupboard and who could be given responsibility for handling issues of supplies from the cupboard. If this individual is frequently away from the cupboard or is unable to see it from their desk, they should keep the cupboard locked.

If it is felt that having a designated office supplies custodian responsible for issuing from the store still provides insufficient control, a voucher system could be introduced. Under this voucher system, each individual requesting office supplies would have to complete a voucher indicating what items they have taken from the office supplies and sign the voucher docket. Completed dockets should then be held in a file by the office supplies custodian. The voucher file will provide the General Manager with a way of inspecting whether any staff members are consuming inordinate amounts of office suppliers. The voucher file would also provide the office supplies custodian with information concerning what supplies need to be reordered. With many staff having desktop printers that use different sized print cartridges, it is often necessary to keep a back-up supply of each printer cartridge model. This signifies that having an accurate record of the exact printer cartridge model numbers used is important.

Problem 6.9 Solution (a) 46

Dr

Petty Cash Cr Cash at bank To establish a petty cash fund

300 300

(b) Dr

Stationery expenses Taxi fare Stamps Office supplies Miscellaneous expenses Office supplies Cr Cash at Bank To reimburse the petty cash fund

24.25 34.50 28.00 64.90 31.30 44.20 227.15

Problem 6.10 Solution a) QuaintCottage Bank Reconciliation As at 31 May 20X1 Balance as per bank statement Add: outstanding deposits Less: unpresented cheques

Cr

11,649 860 12,509

5422 899 5426 565 5428 3,950

Balance as per cash at bank account

Dr

5,414 £7,095

b) Extract of bank account record maintained in the double entry accounting system: Note: The £41 interest has been added to the cash receipts record for May (£9,840 + £41 = £9,881), and the £15 keeping fee has been added to the cash payments record for May (£9,695 + £15 = £9,710).

QuaintCottage’s cash at bank T-account Cash at Bank 1 May Balance 6,924 31 May Cash payments 31 May Cash receipts 9,881 31 May Balance 16,805 1 June Balance 7,095

47

9,710 7,095 16,805

Problem 6.11 Solution (a) Dr

Petty Cash Cr Cash at bank To establish a petty cash fund

400 400

(b) Dr

Recruitment expenses Staff cessation expenses Staff cessation expenses Office supplies Mail expenses Kitchen supplies Miscellaneous expenses Cr Cash at Bank To reimburse the petty cash fund

42.50 55.00 88.00 22.50 30.00 8.40 22.60 269.00

Problem 6.12 Solution Dr

Travel expenses Delivery expenses Kitchen supplies Cr Cash at Bank To reimburse the petty cash fund

70.00 60.00 90.00 220.00

Problem 6.13 Solution a) 30 November Balance Direct deposit Bank interest Updated balance

Cash at Bank $1,075 Bank fee 700 30 Updated balance 1,805 $1,800

b) Fellini’s Eco Retreat Bank Reconciliation As at 30th November 48

5 1,800 1,805

Cr

Balance as per bank statement Add: outstanding deposits

$2,000 400 2,400

Less: unpresented cheques Balance as per cash at bank account

Dr

49

600 $1,800

CHAPTER 7 Cost Management Issues Problem 7.1: Solution The range of cost classifications arise due to the wide diversity of management decision making and control situations that can arise. In the text of the chapter it was noted that the cost classifications that can arise include the following: a) outlay vs. opportunity costs, b) direct vs. indirect costs, c) variable vs. fixed costs, d) controllable vs. non-controllable costs, e) incremental vs. sunk costs.

An opportunity cost can be a significant issue if management is considering taking an action that will result in a lost opportunity. The issue of direct versus indirect costs is an issue when attempting to determine the profitability of revenue generating departments, as calculation of each departments’ net profit would necessitate the allocation of indirect costs. Many issues arise that necessitate a distinction between fixed and variable costs; one significant issue addressed in this chapter concerns the aggressive pricing strategy of setting prices over the short-term at a level designed to cover variable costs. In responsibility accounting it is important that managers are only held accountable for costs that they can control. Finally, sunk costs are irrelevant in decision making; the decision maker need only focus on costs that will be affected by whatever decision is at hand.

50

Problem 7.2: Solution a) Variable costs: Food and drink Conference materials Fixed costs (£360  80)

£ 7.0 6.0 4.5 £17.5

Variable costs: Food and drink Conference materials Fixed costs (£360 120)

£

b) 7 6 3 £16

c) The cost per attendee declines with more attendees because the fixed cost is spread across more attendees. d) If 120 people attend, the cost per attendee is £16.

If profit is to be 20% of revenue, then cost must be 80% of revenue.

As cost = £16 per person when 120 people attend, revenue per person must be £16  0.8 = £20. e) The lowest price that does not result in the conference adversely affecting this year’s profit is the variable cost, i.e., £13 (£7 + £6).

51

Problem 7.3: Solution a) Determination of variable cost function: When 20,000 kgs of laundry was processed (highest level of activity), cost = $22,000.

When 18,000 kgs of laundry was processed (lowest level of activity), cost = $20,400.

It therefore costs an extra $1,600 ($22,000 - $20,400), to process an extra 2,000 kgs of laundry (20,000 - 18,000).

Therefore, the variable cost per kg is $1,600 ÷ 2,000 = $0.80 per kg.

Determination of fixed cost function: Calculation based on July’s performance: HighFlyer’s laundry costs for July are $22,000, and their variable laundry costs are $16,000 ($0.80 X 20,000 kgs). Fixed laundry costs must therefore be $6,000 ($22,000 - $16,000). b) Total laundry costs if 25,000 kilograms of laundry are processed: (25,000 X $0.80) + $6,000 = $26,000

Problem 7.4 Solution Some costs change directly in line with levels of activity. For instance, if we double sales, some costs will double, e.g., food used in meals served. Such costs are termed "variable costs". Other variable costs include most housekeeping costs. When a hotel moves from a 50% occupancy period to a 100% occupancy period, twice as many rooms will need to be cleaned. As twice as much time will be spent cleaning rooms, housekeeping costs will double. This signifies that housekeeping costs are variable.

Other costs will be unaffected by the increased output (e.g., senior staff salaries, grounds maintenance, depreciation of fixed assets, etc.). Those costs that do not alter with changed levels of sales activity are termed "fixed costs". Insurance in a restaurant does not change with the number of people served, so it is referred to as a ‘fixed cost’. Similarly, if a restaurant is rented, rent will be charged on the basis of time elapsed, not on the basis of the number of customers served. This signifies that rent can also be classified as a fixed cost.

Problem 7.5 Solution Indirect costs do not lend themselves to being allocated to a particular product, service or revenue generating department. The problem of allocating indirect costs to a department (see Exhibit 7.1 in chapter 7) signifies that departmental performance reports are incomplete (if no effort is made to allocate the indirect costs to departments). As costs charged to departments are partial (they typically do not include indirect costs) a manager can be misled into thinking his department is making a profit, whereas if indirect costs were to be allocated to his department he would discover he is making a loss.

With respect to pricing a service, a manager needs to appreciate that the cost data for a service will be incomplete (assuming no attempt is made to allocate indirect costs to services). This signifies that when pricing a service, a manager will need to charge a price that is sufficient to cover not only costs that are

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assigned to the service (ie, direct costs), but also indirect costs. Indirect as well as direct costs must be covered by prices charged, otherwise a business will be making a loss. Managers therefore need to understand that cost data can be incomplete and decisions made accordingly.

Problem 7.6: Solution

Building rent expense Advertising expense Depreciation expense Personnel department expense

Computational schedule of indirect expense allocations Amount allocated to Amount allocated to Rooms Restaurants 350  500 X $90,000 = 100  500 X $90,000 = $63,000 $18,000 $1.15m  $1.5m X $250,000  $1.5m X $20,000 = $15,333 $20,000 = $3,333 $900,000  $1.2m X $200,000  $1.2m X $45,000 = $33,750 $45,000 = $7,500 $250,000  $500,000 X $210,000  $500,000 X $100,000 = $50,000 $100,000 = $42,000

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Amount allocated to Bars 50  500 X $90,000 = $9,000 $100,000  $1.5m X $20,000 = $1,333 $100,000  $1.2m X $45,000 = $3,750 $40,000  $500,000 X $100,000 = $8,000

Problem 7.54: Solution Lost gross profit Expenses saved 126,000 - 12,000 - 4,500 Net decline in hotel profit

Impact on hotel’s profitability resulting from shop closure $115,000 $109,500 $ 5,500

Santa Fe’s shop should not be closed as this would result in a decline of $5,500 in the hotel’s total profit.

Alternative way of looking at this problem Impact of closing 1) Negative implication:

Gross profit lost =

2) Positive implications:

Reduced electricity expenses Other reduced expenses $126,000 - $7,500 - $12,000 =

$115,000 $3,000 $106,500

Negative implication of $115,000 outweighs positive implications of $109,500 ($3,000 + $106,500) by $5,500.

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Problem 7.55: Solution

a) Firstly, the relative weightings associated with each basis used to allocate the indirect costs can be determined.

Relative sales levels Relative square metres of floor space Relative number of employees Relative book value of assets

Rooms 375  500 = 0.75 800 1,000 = 0.8

Restaurant / bar 100  500 = 0.2 120 1,000 = 0.12

Disco 25  500 = 0.05 80 1,000 = 0.08

25 50 = 0.5

20  50 = 0.4

5 50 = 0.1

8.5 10 = 0.85

1 10 = 0.1

$0.5  10 = 0.05

Secondly, by multiplying the appropriate weighting by the total indirect cost to be allocated, the total indirect cost to be allocated to each of the revenue centres can be determined.

Marketing ($34,000) Facility Maintenance ($21,000) General Administration ($40,000) Depreciation ($32,000) Insurance ($6,000)

Rooms 0.75 X $34,000 = $25,500 0.8 X $21,000 = $16,800 0.5 X $40,000 = $20,000 0.85 X $32,000 = $27,200 0.85 X $6,000 = $5,100

Restaurant / bar 0.2 X $34,000 = $6,800 0.12 X $21,000 = $2,520 0.4 X $40,000 = $16,000 0.1 X $32,000 = $3,200

Disco 0.05 X $34,000 = $1,700 0.08 X $21,000 = $1,680 0.1 X $40,000 = $4,000 0.05 X $32,000 = $1,600 0.05 X $6,000 = $300

0.1 X $6,000 = $600

Finally the amounts calculated in the above schedule can be introduced to the income statement to find each department’s profit or loss following the allocation of overheads.

Revenue Cost of sales Labour Other direct costs Departmental profit Indirect costs: Marketing Facility Maintenance General Administration Depreciation Insurance Total indirect costs Profit before tax Tax

HeavensAbove Allocated Income Statement for June 20X1 Rooms Restaurant / bar Disco $ 375,000 $ 100,000 $ 25,000 22,000 8,000 80,000 31,000 4,200 35,000 6,000 4,000 260,000 41,000 8,800

Total $ 500,000 30,000 115,200 45,000 309,800

25,500 16,800 20,000 27,200 5,100 94,600

6,800 2,520 16,000 3,200 600 29,120

1,700 1,680 4,000 1,600 300 9,280

34,000 21,000 40,000 32,000 6,000 133,000

165,400

11,880

(480)

176,800 40,000

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Net profit

$ 136,800

b) No, we cannot conclude that a department should be closed down if it shows a loss following the allocation of indirect costs. In the solution to part (a) it has been fund that the disco is making a small loss. Many of the indirect costs that are allocated to the disco are fixed and they will not disappear should the disco be closed, however. For example, if the facility maintenance costs relate to maintenance of the whole hotel structure, it is unlikely that they would decrease following closure of the disco. This signifies that the $1,680 currently allocated to the disco would have to be allocated to the other two revenue generating departments with the result that their reported level of profitability would decline. In this case, it appears that closure of the disco would result in reduced profit for the entire hotel complex.

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Problem 7.9: Solution This problem can be tackled by conducting an incremental analysis.

Factors affected if hotel closes for January & February Lost revenue Saving in: Cost of sales Wages ($6,800 - ($3,000 X 2)) Electricity ($340 - ($50 X 2)) Advertising Maintenance Depreciation (no change) Insurance

Impact on profit ($8,000) $2,000 $800 $240 $800 $200 $80 $3,880

The hotel should not close in January and February as this will reduce the hotel’s annual profit by $3,880.

Problem 7.10 Solution a)

Cost savings per tray if muffin production ceased Ingredients Direct labour Variable kitchen overhead Fixed kitchen overhead

Cost per tray of buying from Magic Muffins

$ 9 20 5 6 $40

$42

The GangesDelta would save $200,000 (5,000 X $40), in production costs if it ceased muffin production, but incur an additional expense of $210,000 (5,000 X $42) in purchases from Magic Muffins. It would therefore lose $10,000 if it purchased from Magic Muffins, therefore the Magic Muffins offer should not be accepted. b) If the DeltaGanges kitchen space currently used in the production of muffins could be used to produce breads that would contribute $50,000, then the Magic Muffins offer should be accepted. From the answer in part (a) it was found that if the space used to produce muffins could not be used for some other purpose, the net effect of purchasing outside is a loss of $10,000. If the space could be used for another purpose that would contribute $50,000 to profit there would be a net profit of $40,000 (50,000 – 10,000) resulting from the decision to buy from Magic Muffins.

Problem 7.11: Solution a)

Impact on profit if one day university conference is hosted: $ Increased revenue Delegate fees (400 X $26) 10,400 Venue hire 3,000 Incremental revenue

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$

13,400

Variable costs Food (400 X $15) Drink (400 X $12) Casual staff wages (400 X $6)

6,000 4,800 2,400 13,200 $ 200

Increase to profit

Hosting the university conference is justifiable on financial grounds, as it will increase profit by $200. b) Impact on profit if magician conference is hosted: $ Increased revenue Fee per delegate (200 X 3 X $12) Room sales contribution (200 X 3 X 30) Incremental revenue

$

7,200 18,000 25,200

Variable costs Food (200 X 3 X $15) Drink (200 X 3 X $12) Casual staff wages (200 X 3 X $6)

9,000 7,200 3,600 19,800 $ 5,400

Increase to profit

Hosting the magician conference can be justified on financial grounds, as it will increase profit by $5,400.

Problem 7.12 Solution a) Determination of variable cost function: When 3,600 room nights were sold (highest level of activity), cost = ¥410,000.

When 2,600 room nights were sold (lowest level of activity), cost = ¥310,000.

It therefore costs an extra ¥100,000 (¥410,000 - ¥310,000), to clean an extra 1,000 rooms (3,600 – 2,600).

Therefore, the variable cost per room cleaned is ¥100,000 ÷ 1,000 = ¥100 per room.

Determination of fixed cost function: Calculation based on January’s performance: SakuraStay’s housekeeping costs for January are ¥410,000, and their variable housekeeping costs are ¥360,000 (¥100 X 3,600 rooms). Fixed housekeeping costs must therefore be ¥50,000 (¥410,000 - ¥360,000). b) Total housekeeping costs if 4,000 room nights are sold: (4,000 X ¥100) + ¥50,000 = ¥450,000

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c) Room nights cleaned would probably be better than room nights sold. This is because some guests might request that their room is not cleaned for every night during their stay in the hotel. d) Several reasons can be identified: • Neither guest nights sold nor rooms cleaned are perfect indicators of housekeeping costs as although a hotel may experience 100% occupancy for two weeks, in the first week all the guests may be checking out after one nights stay and in the second week all the guests may check out after a week’s stay. This would signify lower housekeeping costs in the second week.

• Some guests make more mess than others.

• Some housekeeping staff will be quicker than others.

• During a high activity period, the hotel may have had to pay some staff at an overtime rate of pay. This would signify the costs in a busy period could be misleading if attempting to use them as indicative of costs during a quiet period.

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CHAPTER 8 Cost-Volume-Profit Analysis Problem 8.1: Solution The contribution margin format enables us to quickly answer questions such as “What will happen to profit if our hotel’s revenue increases by $100,000?”. If variable costs are 20% of revenue, then the contribution margin ratio is 80%. This signifies that a $100,000 increase in revenue will result in an $80,000 increase in profit (0.8 X $100,000).

The contribution margin format can also be seen as helpful to management’s understanding of cost structure as it places revenue alongside those costs that are affected by the level of revenue achieved.

Problem 8.2: Solution Cost-volume-profit analysis can be helpful if a manager is considering questions such as: 1. “How many units will we need to sell in order to breakeven?”

2. “How much will we need to sell in order to achieve our target profit level?”

3. “What will happen to profit if we manage to increase sales volume by 10%?”

4. “By what volume of sales are we currently surpassing our breakeven point?”

5. “If fixed costs increase by $20,000, how much more would we have to sell in order to maintain our current level of profit?”

Problem 8.3: Solution a) The Hulsey Restaurant Income statement for the year ending 31 December 20X1 (Contribution margin layout) $ Percentage Sales revenue 500,000 100.0 Variable costs Variable cost of sales 100,000 20.0 Variable operating expenses 16,000 3.2 Contribution margin 384,000 76.8 Fixed costs Salaries and wages 144,000 28.8 Marketing 10,000 2.0 Rent 48,000 9.6 Maintenance 5,000 1.0 Other 10,000 2.0 217,000 43.4 Net Profit $ 167,000 33.4 b) Breakeven point = Fixed costs  Contribution per cover = $217,000  (25 - [5 + 0.8]) = $217,000  $19.2 = 11,302 meals per annum.

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c) From the income statement prepared using the contribution margin layout, it is evident that the contribution margin is 76.8%.

An increase in sales of 10%, represents a $50,000 sales increase ($500,000 X 0.1). As the contribution margin ratio is 76.8% a 10% increase in sales will result in a $38,400 increase in profit ($50,000 X 0.768).

d) Profit = Contribution margin - Fixed costs. ($600,000 X 0.768) - $217,000 = 460,800 - 217,000 = $243,800.

e) A 10% increase in revenue would signify that profit would increase by $50,000 ($500,000 X 0.1).

Alternately stated, profit would increase by $2.5 for each cover served. As there are 20,000 covers sold, profit would increase by $50,000 ($2.5 X 20,000).

Problem 8.4: Solution a = $30 b = $1,200,000 c = $60 d = $46,000 e = 8,000 f = $400,000 g = $25 h = $26,500

Problem 8.5: Solution a) Room nights to be sold to breakeven = Fixed costs  Contribution per room night £360,000  (£68 - £8) = 6,000 room nights.

Room nights available per annum = 365 X 60 = 21,900  Percentage occupancy necessary to breakeven = 6,000  21,900 X 100 = 27.4%

b) Room nights to be sold to achieve a before tax profit of £60,000 = (Fixed costs + target profit)  Contribution per room night = (£360,000 + £60,000)  (£68 - £8) = 7,000 room nights.

c) Room nights to be sold to achieve an after tax profit of £72,000 = [Fixed costs + (After tax target profit  “1 - tax rate”)]  Contribution per room night = [£360,000 + (£72,000  0.6)]  (£68 - £8) = (360,000 + 120,000)  60 = 8,000 room nights.

Problem 8.6: Solution

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a) Breakeven = Fixed costs  Contribution per unit, ($112,000 - $1,200)  ($30 - $8) = $110,800  $22 = 5,036.4 covers per annum This represents $151,091 in sales revenue. b) After tax profit target = 0.2 X $325,000 = $65,000.

Before tax equivalent of $65,000 after tax = $65,000  (1 - 0.35) = $100,000.

Sales needed to generate required rate of return = (Fixed costs + Required rate of return)  contribution per cover ($110,800 + $100,000)  $22 = 9,581.8 covers per annum.

Problem 8.7: Solution a) Contribution earned for each single room night sold = ($56 - $6) + (0.9 X $8) + (0.5 X $20) = $50 + $7.2 + $10 = $67.2 Contribution earned for each double room night sold = ($88 - $8) + (2 X 0.7 X $8) + (2 X 0.3 X $20) = $80 + $11.2 + $12 = $103.2 As rooms are sold in the proportion of 3 doubles for every 2 singles, we can refer to the contribution earned by selling “packages”, whereby a package comprises 3 double room nights and 2 double room nights.

Contribution earned by sale of a package = (2 X $67.2) + (3 X $103.2) = $134.4 + $309.6 = $444 Number of packages to be sold to breakeven = Fixed costs  contribution per package = $1,998,000  $444 = 4,500.

As each package comprises 3 double room and 2 single rooms, 4,500 packages comprise 9,000 single rooms (4,500 X 2) and 13,500 double rooms (4,500 X 3). Need to sell 9,000 singles and 13,500 doubles in order to breakeven.

Check to see if solution is correct: Contribution from double room sales Contribution from single room sales Contribution from dinners sold to double room guests Contribution from breakfasts sold to double room guests Contribution from dinners sold to single room guests Contribution from breakfasts sold to single room guests Total contribution Less Fixed costs Profit

13,500 X ($88 - $8) 9,000 X ($56 - $6) 13,500 X 2 X 0.3 X $20

$ 1,080,000 450,000 162,000

13,500 X 2 X 0.7 X $8 151,200 9,000 X 0.5 X $20 90,000 9,000 X 0.9 X $8 64,800 1,998,000 1,998,000 $0

As profit is $0 when 9,000 single and 13,500 double rooms are sold, this level of sales represents breakeven for the hotel.

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b) At an occupancy of 70% the following number of rooms are sold per annum: Double rooms: 0.7 X 90 X 365 = 22,995 Single rooms: 0.7 X 60 X 365 = 15,330 Contribution from double room sales Contribution from single room sales Contribution from dinners sold to double room guests Contribution from breakfasts sold to double room guests Contribution from dinners sold to single room guests Contribution from breakfasts sold to single room guests Total contribution Less Fixed costs Profit

22,995 X ($88 - $8) 15,330 X ($56 - $6) 22,995 X 2 X 0.3 X $20

$ 1,839,600 766,500 275,940

22,995 X 2 X 0.7 X $8

257,544

15,330 X 0.5 X $20

153,300

15,330 X 0.9 X $8

110,376 3,403,260 1,998,000 $ 1,405,260

Problem 8.8: Solution a) From a short-run cost perspective, so long as rooms are priced at a level that covers variable cost, they will be contributing something towards profit. From this perspective, therefore, the lowest conceivable weekly rate for a room is $180. A marketing director might argue, with some justification, that setting room rates this low could damage reputation over the long term. b) During a week’s stay, the average guest will contribute $71 ([2 X $25] + [3 X $7]) to the profit of the hotel’s restaurants (or $142 per double room booked for a week). Extending the logic developed in part (a) above, in the short run we only need to secure a contribution to profit from the incremental pair of hotel guests. In this situation we could drop the accommodation rate below the room’s variable cost because the two guests will contribute in other ways to the hotel’s total profitability. The lowest we could conceivably set the room rate under this situation is $38 (180 - 142). This strategy would mean we are using the accommodation division as a “loss leader” to subsidise the restaurant division’s profits. If we were to charge $39 for the room for the week, the net impact on profit from selling one more double room is: Revenue from room: $ 39 Add: Contribution from restaurants 142 Minus: Variable cost of servicing room 180 Net positive impact on profit $1 If we were to apply this very aggressive pricing strategy with respect to the Japanese tour operator, we would add $400 (400 x 1) to profit during the off season. c) If we want the accommodation department to act as a loss leader, we would need to change the incentive structure applied in this department. One mechanism designed to achieve this would be to attach greater importance to occupancy levels. A second approach could involve crediting a portion of the restaurant revenue received from hotel guests to the accommodation department. Such an incentive scheme might appear a little administratively cumbersome to manage. Such schemes have been widely applied in Japan with considerable success, however. This scheme could result in the accommodation manager filling more unoccupied rooms and considering ways that he can get a greater proportion of guests eating at one of the hotel’s restaurants.

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Problem 8.9: Solution a) As fixed cost changes if guests per week moves above 10, two breakeven analyses have to be conducted, one for an activity level of 6 to 10 guests, and one for an activity level of 11 to 15 guests.

For 6 to 10 guests: Contribution per guest per week = $200 - $86 = $114 Breakeven (in guest weeks) =

In each of the 30 weeks would therefore need to sell:

$22,000 + $12,000 = 298.25 $114

298.25 30

=

9.94 rooms

For 11 to 15 guests: Contribution per guest per week = $200 - $86 = $114 Breakeven (in guest weeks) = In each of the 30 weeks would therefore need to sell:

$34,000 + $12,000 = 403.5 $114 403.5 = 13.45 rooms 30

b) Increased profit = 10 ($200 - $86) X 30 - 34,000 = $200 c) Increased profit = 12 ($200 - $86) X 30 - 46,000 = ($4,960) i.e., a loss.

Problem 8.10: Solution a) Contribution per room sold = Selling price – Commission – Cost of cleaning room Contribution per room sold = $20 - $2 - $4 = $14 Breakeven point = Fixed costs  Contribution per room sold Breakeven point = $112,000  $14 = 8,000 room sales b) Profit = Contribution – Fixed costs Profit = (25,000 X $14) - $112,000 = $238,000 c) •

• •

A 10% decrease in the selling price would signify that revenue per room sold would decline by $2 ($20 X 10%), but this reduced selling price would also result in a saving in sales commission paid per room night sold of $0.2 ($2 X 10%). Considered together, this means contribution per room night sold would decline by $1.80 ($2 - $0.20). This means total profit would decline by 25,000 X $1.80 = $45,000.

A 10% increase in cost per room cleaned would signify that profit would decrease by 25,000 X $4 X 0.1 = $10,000.

A 10% increase in fixed costs would signify that profit would decrease by $112,000 X 0.1 = $11,200.

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•

A 10% decline in rooms sold would signify that profit would decrease by 25,000 X $14 X 0.1 = $35,000.

• A 10% increase in commission rate charged by the Backpackers Association would signify that profit would decrease by 25,000 X $2 X 0.1 = $5,000.

Therefore, a 10% decrease in the selling price would cause the greatest decline in profit.

Problem 8.11: Solution First determine the total of fixed and variable costs:

Cost of sales Salaries and wages Marketing Rent Other Totals

Total costs Rs 120,000 175,000 40,000 300,000 60,000 695,000

Total variable costs Rs 120,000 105,000 12,000

Total fixed costs Rs

15,000 252,000

70,000 28,000 300,000 45,000 443,000

As total variable costs are Rs252,000 and revenue is Rs900,000 the total contribution is Rs648,000.

Therefore the contribution margin ratio = Rs648,000 ÷ Rs900,000 = 72% Breakeven in revenue = Fixed costs ÷ contribution margin ratio Breakeven in revenue = Rs443,000 ÷ 0.72 = Rs615,277.77

Note, breakeven in room numbers can also be calculated as follows: Total contribution = Rs900,000 - Rs252,000 = Rs648,000 Room nights sold = 35,040 (120 rooms X 0.8 X 365) Therefore contribution per room night sold = Rs648,000 ÷ 35,040 = 18.49315 Therefore room nights to be sold in a year to breakeven = Rs443,000 ÷ 18.49315 = 23,955 (rounded).

This equates to 65.62 rooms per night.

Problem 8.12: Solution Several shortcomings are evident in breakeven analysis. These include: a) Selling price is treated as being constant. In reality it may be necessary to drop the price in order to sell more. b) Fixed costs are treated as constant. This assumption is reasonable if the analysis is restricted to a range of sales activity levels that could be supported by the current level of fixed costs. This signifies that CVP analysis should be used in the context of short-term analysis, i.e., the period of time in which fixed costs will not alter. c) Total variable costs are treated as varying in direct proportion to sales volume. This relationship will breakdown if higher levels of sales activity results in the hotel securing volume discounts on purchases, or any economies of scale.

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CHAPTER 9 Budgeting and Responsibility Accounting Problem 9.1: Solution Responsibility accounting involves sub-dividing an organisation into units of accountability. It is fundamental to control as it involves holding managers accountable for the performance of their respective units.

Budgeting is closely associated with responsibility accounting because budgeting involves allocating resources to an organisation’s sub-units. In addition, the budget highlights benchmarks that are used when appraising a unit manager’s performance. As the budgeting system sets targets for all of an organisation’s subunits, it is difficult to conceive of any meaningful budgeting occurring in the absence of a responsibility accounting system.

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Problem 9.67: Solution

There is no single “easy” answer to this question.

Issues that might be addressed in a well-reasoned answer include: • So long as Bromwich provided the requisition to Joe in reasonable time (i.e., sufficient purchasing lead time), it would be inappropriate to hold the head of banqueting and conferences responsible for the part not arriving. Despite this issue, it would appear that the head of banqueting and conferences was responsible for the refund decision and therefore justification could be given for charging at least a portion of the lost revenue to her department. One could also argue that given the importance of the part, Maxine should have followed up with Joe more times.

• The following rationale could be developed for charging all of the lost revenue to the purchasing department: 1. In the whole organisation, the purchasing manager is the one who is most closely associated with the role of ensuring timely delivery.

2. Joe could be criticised for not getting another staff member or Maxine to follow up on the order while he was away on holiday.

3. Joe could have requested that a copy of the consignment be faxed when told that the delivery was underway.

4. Joe should have informed Maxine earlier of the potential problem with the delivery.

5. By requiring Joe’s department to carry the loss, he may take greater care when ordering one-off special parts in the future.

• It could also be argued to be inappropriate to attach blame to Joe (it was really the supplier’s fault), as it appears he may well have made reasonable efforts to ensure timely delivery.

• Joe and Maxine could attempt to recoup some of the loss from the supplier. At the very least, this would inform the supplier of the cost of their mistake.

• This case appears to be a situation highlighting how it can be very inappropriate to use the responsibility accounting system as an apportioning blame system rather than a “determining who should have the opportunity to explain” system.

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Problem 9.68: Solution

1) The first thing to note is that the responsibility accounting system appears to be perceived as an “apportioning blame” system. This is highly undesirable as it is likely to give rise to ill-feeling that is more damaging than helpful. A properly used responsibility system emphasises information rather than blame. If managers feel they are beaten around the head when unfavourable variances occur, they are likely to view the system as a tool of bureaucracy and start conjuring up ways to undermine the system. When the numbers are used in a manner that emphasises the informational role of the responsibility system, managers are more likely to be open to discussion with colleagues in a quest for gaining improved performance. Scheduling an inter-departmental management meeting following the receipt of monthly performance reports may be one way of focusing on the information aspect of the responsibility accounting system.

2) The accountant could agree that in the future “pastry cutters” wages will be charged to Maintenance at the rate of $9 per hour and that a correction will be made for last month’s entry. The $4.50 premium could be charged to a “Loss from unused capacity” account which is charged back to the F&B department because it was the F&B director who elected to retain these staff. The Maintenance manager should be told that it is up to him to get $9 of work per hour out of the staff placed under his direction. The fact that these are nonpreferred personnel could be recognised in a note to the monthly report.

3) Theoretically, the accountant could argue that the $4.50 (or even the whole $13.50) represents investment in an asset as: a) It is an investment today that will yield a benefit in the future (i.e., retention of preferred kitchen staff), b) It is an investment today that will result in a saving in the future (i.e., no need to expend resources recruiting and training new skilled kitchen staff).

Due to conservatism, accountants would not tend to take this view, however. The distinction is nevertheless important. An “expense” tends to be viewed in a negative light, while an “investment” tends to be viewed in a positive light.

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Problem 9.69: Solution

The consultant should first attempt to determine to what extent bus repairs have become a significant expense.

This is important because: 1. The consultant must ensure that he or she is not being used by one cost centre to unjustifiably criticise the management of another cost centre.

2. The consultant must determine whether the extent of the problem is sufficient to warrant changes in the existing lines of accountability.

If the consultant feels that the cost of conducting bus repairs is indeed significant, he or she would need to weigh up the relative merits of the following three alternative recommendations: 1.

2.

3.

The first alternative would be to charge the cost of bus repairs to the personnel cost centre and not the facility maintenance cost centre. The advantage of this approach is that it does not disrupt the established line of command that involves bus drivers reporting to the personnel department. Avoiding this disruption would be desirable if it is felt that co-operation between the bus drivers and the personnel department is critical to the bus drivers gaining access to information necessary to prepare their pick up schedules. There is a disadvantage associated with this approach, however. Much of the incentive for the facility maintenance department ensuring that the bus repairs are conducted effectively and at minimum cost would be removed.

The second alternative would be to change the lines of authority by requiring the bus drivers to report to the head of facilities maintenance. The advantage of this approach is that there would be a greater incentive for a senior manager to actively manage the issue of staff bus accidents.

The disadvantage of this approach is that there would be a dislocation between the bus drivers and the personnel department that maintains records necessary for preparation of the bus drivers’ pick up schedules. This dislocation may result in the personnel department failing to provide the information required to the bus drivers in a timely and accurate fashion.

If the shortcomings of the above two alternatives are considered to be too great by the hotel’s senior management, the hotel may feel it best to not change the existing arrangements. If this alternative were to be selected, the head of the facilities maintenance department should be informed that he should indicate to senior management whenever the incidence of bus repair work surpasses reasonable levels.

Problem 9.5: Solution

Required closing inventory Sales Less opening inventory Hat purchases

Required closing inventory Sales

Quarterly purchases budget for hats 1 2 160 120 1,200 800 1,360 920 240 160 1,120 760

3 280 600 880 120 760

4 300 1,400 1,700 280 1,420

Quarterly purchases budget for scarves 1 2 120 90 600 400 720 490

3 210 300 510

4 225 700 925

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Less opening inventory Hat purchases

180 540

120 420

90 420

210 715

Problem 9.6 Solution a.

Hong Kong Hotel: Last year’s ROI = $900,000 ÷ 6,000,000 X 100 = 15% New ROI if asset sales is made = ($900,000 - $48,000) ÷ ($6,000,000 - $400,000) X 100 = $852,000 ÷ $5,600,000 X 100 = 15.21% Yes, ROI for the HK hotel will increase from 15% to 15.21% if the asset sale is made.

Singapore Hotel: Last year’s ROI = $300,000 ÷ 6,000,000 X 100 = 5% New ROI if asset sales is made = ($300,000 + $40,000) ÷ ($6,000,000 + $500,000) X 100 = $340,000 ÷ $6,500,000 X 100 = 5.23% Yes, ROI for the Singapore hotel will increase from 5% to 5.23% if the asset sale is made. b.

Residual Income earned on asset that HK hotel is proposing to sell: $48,000 – (0.1 X $400,000) = $8,000 As the asset is generating a positive residual income, it should not be sold.

Residual Income that will be earned on asset that Singapore hotel is proposing to purchase: $40,000 – (0.1 X $500,000) = -$10,000 As the asset will generate a negative residual income, it should not be purchased.

Problem 9.7: Solution In the April, May and June quarter there are 91 days (30 + 31+ 30).

The average number of guests staying per day is 350 (200 X 0.7 X 2.5).

The total number of guest days in the quarter = 31,850 (91 X 350).

Sea Breeze calculation of 2nd quarter expected restaurant contribution Source of contribution Calculation Breakfasts 31,850 X 0.9 X £4 = Lunches 31,850 X 0.3 X £8 = Dinners 31,850 X 0.6 X £12 = Total contribution

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Contribution £114,660 £76,440 £229,320 £420,420

Problem 9.71: Solution Purchasing budget for Eiffel Tower replicas June July Replica demand 600 700 Add: required ending inventory 280 320 Need to make available 880 1,020 Less: opening inventory 240 280 Replicas to be purchased 640 740 Purchases in €

€ 3,840

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€ 4,440

August 800 200 1,000 320 680 € 4,080

Problem 9.72: Solution a)

Ritzy Rooms Budgeted Income Statement for the year ended 31 December 20X1 $ Revenue from single rooms: 126,000 (360 X 10 X 0.7 X $50) Revenue from double rooms: 302,400 (360 X 30 X 0.4 X $70) Total revenue Less: Single room variable costs: 18,900 (126,000 X 0.15) Double room variable costs: 30,240 (302,400 X 0.10) Fixed costs 180,000

$

428,400

229,140 199,260 9,000 190,260 76,104 $114,156

Operating profit Less loan interest Before tax profit Tax (at 40%) Net profit b) Times interest earned = EBIT  Annual interest payment $199,260  $9,000

=

22.14

This times interest earned ratio of 22.14 is well in excess of what is required by the bank manager. On this particular criterion, it appears the bank would be willing to make the $90,000 loan.

Problem 9.10: Solution Lucky Dip jam - Budgeted production schedule (in jars)

Lucky dip demand Add: ending inventory Need to make available Less: opening inventory Production of jars

October 1,100 88 1,188 120

November 880 132 1,012 88

1,068

924

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December 1,320 77 1,397 132 1,265

Lucky Dip jam - Budgeted fruit purchases

Production of lucky dip

October 1,068

November 924

X 0.5 to convert to kgs Add: ending inventory Need to make available Less: opening inventory Fruit purchases (in kgs)

534 23 557 20 537

462 32 494 23 471

Cost of purchases (X $2)

$1,074

$942

December 1,265 632

Problem 9.11: Solution a)

ReggaeRegal’s ROI without acquiring BrownBean: $500,000 ÷ $2,500,000 = 20% ReggaeRegal’s ROI if BrownBean had been acquired: New profit = $500,000 + $50,000 = $550,000 New asset base = $2,500,000 + $300,000 = $2,800,000 New ROI = $550,000 ÷ $2,800,000 = 19.64% There would have been a drop in ROI from 20% to 19.64% if BrownBean had been acquired. b) Residual income if BrownBean is not acquired Profit $500,000 minus Capital charge ($2.5m X .14) $350,000 Residual income $150,000 Residual income if BrownBean is acquired Profit $550,000 minus Capital charge ($2.8m X .14) $392,000 Residual income $158,000 ReggaeRegal’s residual income would have increased by $8,000 if the BrownBean had been acquired. c) From a corporate standpoint, ReggaeRegal should have acquired the BlackBean as it would have provided an ROI that exceeds the threshold ROI established by the chain. From

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a self interest viewpoint, however, the GM made the rational move in not investing in the BalckBean, as it would have reduced his hotel’s ROI, and therefore his bonus.

A hotel General Manager that is motivated by a desire to maximise ROI may act in a manner that is contrary to corporate interests. This is because the GM may reject an investment opportunity if the opportunity provides an ROI that is less than the hotel’s existing ROI, regardless of whether the investment’s ROI is greater than what corporate head office requires as an investment return.

The hotel’s ROI incentive scheme will not always motivate managers to make the right decisions. Accordingly, the chain should also hold the General Managers accountable for residual income.

Problem 9.12: Solution a. A bar would most likely be a profit centre. Although care would have to be taken in holding the manager profit accountable, as profits would likely be heavily dependent on the hotel’s accommodation occupancy level and the bar manager would have no influence over the hotel’s room occupancy. b. A laundry department would be a cost centre as there would be no revenue generated by this operating unit. c. A maintenance division would be a cost centre as there would be no revenue generated by this operating unit. d. A restaurant would most likely be a profit centre. Although care would have to be taken in holding the restaurant manager profit accountable, as profits would likely be heavily dependent on the hotel’s accommodation occupancy level and the restaurant manager would have no influence over the hotel’s room occupancy. e. A shop would very likely be a profit centre. Depending on the nature of the shop, its location in the hotel complex and its accessibility to passing pedestrians, it would have to be recognised that the shop’s sales are affected by the hotel’s accommodation occupancy level. f. A local tours booking agent would have the opportunity to drive tour booking revenue and these sales would give rise to minimal cost. It could therefore be appropriate to treat this operating unit as a revenue centre. g. A human resource management department would be a cost centre as there would be no revenue generated by this operating unit. h. A kitchen would most likely be a cost centre. However, kitchen staff may benefit from being treated as a profit centre because it would strengthen the perceived importance of quality, provide an incentive to give fast service and to expand the menu. It would be particularly appropriate to treat the kitchen as a profit centre if the chef has a well established reputation amongst diners. i. The General Manager oversees the whole hotel. He would have influence over costs, revenues and the investment in the hotel. The whole hotel can therefore be regarded as an investment centre with the General Manager held accountable for a measure such as ROI or residual income.

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CHAPTER 10 Flexible Budgeting and Variance Analysis Problem 10.1: Solution In a static budgeting system, a budget is rigid in the sense that it is not modified once the actual volume of sales is known. While this approach is used extensively, some managers find it helpful to flex budgets up or down in line with the actual volume of sales achieved. Failure to accurately predict the volume of sales is a major factor causing many significant differences between the static budget and actual performance. Under flexible budgeting, however, the effect of a hotel selling more or less than was originally projected is eliminated from differences between the actual and budgeted performance. Elimination of this factor is significant because, by definition, managers in cost centres exert little influence on sales volumes.

A shortcoming of isolating variances between actual performance and the static budget is that much of a variance may be attributable to the fact that it is practically impossible to correctly estimate the volume of sales that will occur in a forthcoming accounting period. Variances occurring as a result of an organisation being busier or quieter than expected are not really reflective of the performance of many managers. If we were to take static budget variances to the extreme, we can see that very favourable variable cost variances can be achieved if we have no one staying at our hotel! To remove the effect of actual volume of sales being different to the budgeted volume of sales, we can produce a flexible budget. In a flexible budget, the static budget figures are restated as if the actual volume of sales achieved had been known at the time the budget was set.

Problem 10.2 Solution The $1,200 unfavourable materials price variance signifies that the materials used in the kitchen in the previous month cost $1,200 more than what budget data indicates they should have cost.

The $800 favourable materials efficiency variance signifies in the previous month, kitchen materials were used more efficiently than was budgeted for. For instance a reduction in food scrapped due to poor quality, or a reduction in food thrown away as a result of staleness would be two factors contributing to a favourable materials efficiency variance. Such efficiencies achieved in the previous month have caused the kitchen to beat the budget by $800 in terms of materials efficiency.

The unfavourable materials flexible budget variance is simply the net of the materials price variance and the materials efficiency variance. The fact that we have a $400 unfavourable efficiency variance in the previous month signifies that for the volume of sales that we actually achieved in the kitchen, materials used cost $400 more than they should have done as per budgeted data.

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Problem 10.3: Solution a) As the lodge has made 15% more room sales than was budgeted for ([12,420 - 10,800]  10,800 X 100), we can produce a flexible budget by increasing the revenue and variable cost figures stated in the static budget by 15%. A simple way to achieve this is to multiply them by a factor of 1.15.

The Curbside Motor Lodge Flexible Budget Performance Report For the Quarter Ended 30 September, 20X1

Room nights sold Revenue (sales) Variable Costs: Labour Room amenities Contribution Margin Fixed Costs Operating Profit

Actual 12,420 £ 1,179,900

Budget 10,800 £ 1,080,000

Flexible Budget 12,420 £ 1,242,000

84,456 5,216 1,090,228 241,000 £ 849,228

75,600 5,400 999,000 235,000 £ 764,000

86,940 6,210 1,148,850 235,000 £ 913,850

Flexible Budget Variances £ 62,100 (U) 2,484 (F) 994 (F) 58,622 (U) 6,000 (U) £ 64,622 (U)

b) A shortcoming of isolating variances between actual performance and the static budget is that much of a variance may be attributable to the fact that it is practically impossible to correctly estimate the volume of sales that will occur in a forthcoming accounting period.

Variances occurring as a result of an organisation being busier or quieter than expected are not really reflective of the performance of many managers. If we were to take static budget variances to the extreme, we can see that very favourable variable cost variances can be achieved if we have no one staying at our hotel! To remove the effect of actual volume of sales being different to the budgeted volume of sales, we can produce a flexible budget. In a flexible budget, the static budget figures are restated as if the actual volume of sales achieved had been known at the time the budget was set.

The flexible budget performance report provides very different management insights to those provided by the static budget variances computed by Curbside’s conventional performance report. The extent of these differences is highlighted by the following table.

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Curbside: Comparison of static budget and flexible budget variances Static budget Flexible budget variances variances Revenue (sales) (F) (U) Variable Costs: Labour (U) (F) Room amenities (F) (F) Contribution Margin (F) (U) Fixed Costs (U) (U) Operating Profit (F) (U) • The unfavourable flexible budget variance for revenue signifies that rooms must have been sold below the rate budgeted for. This fact was not evident from the static budget variance.

• The favourable flexible budget variance for labour signifies that labour worked efficiently or the labour rate was below the rate budgeted for. This fact was not evident from the static budget variance.

• The size of the unfavourable revenue flexible budget variance is sufficient to have turned the favourable static budget contribution margin variance into an unfavourable flexible budget variance. This impact is also apparent at the operating profit level.

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Problem 10.4: Solution 10.2 a)

Curbside: room cleaning labour rate and efficiency variances for quarter ending 30/9/X1 Actual labour hours X Actual rate 5,630.4 X £15 £84,456

Actual labour hours X Budgeted rate 5,630.4 X £14.00 £78,825.6

£5,630.4 Unfavourable labour rate variance

Budgeted labour hours X Budgeted rate 6,210 X £14.00 £86,940

£8,114.4 Favourable labour efficiency variance

£2,484 Labour favourable flexible budget variance

10.2 b)

Curbside: room amenities price and efficiency variances for quarter ending 30/9/X1 Actual packs X Actual price 13,040 X £0.40 £5,216

Actual packs X Budgeted price 13,040 X £0.50 £6,520

£1,304 Amenities favourable price variance

£310 Amenities unfavourable efficiency (or usage) variance

£994 Amenities favourable flexible budget variance

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Budgeted packs X Budgeted price 12,420 X £0.50 £6,210

10.2 c)

Curbside: selling price and sales volume variances for quarter ending 30/9/X1 Actual volume of sales X Actual selling price 12,420 room nights X £95* £1,179,900

Actual volume of sales X Budgeted selling price 12,420 room nights X £100** £1,242,000

£62,100 Unfavourable selling price variance

£162,000 Favourable sales volume variance

£99,900 Favourable revenue variance *

: £1,179,900 12,420 = £95 £1,080,000  10,800 = £100

**:

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Budgeted volume of sales X Budgeted selling price 10,800 room nights X £100 £1,080,000

Problem 10.80: a) Solution

Tiff’s Restaurant Flexible Budget Performance Report For the Month Ended 30 June

Actual

€

Flexible Budget

Flexible Budget Variance

Flexible Budget Variance % *

€

€

Breakfasts (actual served: 110) Revenue (sales) Variable costs Breakfast contribution margin

759 242 517

770 275 495

11(U) 33 (F) 22 (F)

1.4% 12.0% 4.4%

Lunches (actual served: 100) Revenue (sales) Variable costs Lunch contribution margin

1,700 540 1,160

1,400 500 900

300 (F) 40 (U) 260 (F)

21.4% 8.0% 28.9%

Dinners (actual served: 300) Revenue (sales) Variable costs Dinners contribution margin

6,600 2,850 3,750

7,500 3,000 4,500

900 (U) 150 (F) 750 (U)

12.0% 5.0% 16.7%

Total restaurant contribution Less: Fixed costs Net profit

5,427 740 4,687

5,895 800 5,095

468 (U) 60 (F) 408 (U)

7.9% 7.5% 8.0%

*: Flexible budget variance as a percentage of the flexible budget. b) From the above table’s final column, it is evident that there is a large lunch revenue flexible budget variance that is 21.4% of the flexible budget amount. This variance has resulted from the average lunch revenue being €17, i.e., €3 more than the budgeted average lunch revenue. If this higher average revenue stems from higher than anticipated menu prices, the higher prices may have resulted in the below budget volume of lunch sales achieved (the restaurant has sold 50 lunches less than was budgeted for). Management may need to consider whether the higher prices have resulted in a reduced volume of sales.

A second factor that might be worthy of further investigation is the €900 unfavourable variance that has resulted from dinner average revenue being below budget. Average dinner revenue was budgeted at €25, however actual average dinner revenue is €22. Management might review what has caused the failure to meet budgeted average dinner revenue and whether dinner menu prices need to be increased.

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Problem 10.81: Solution a)

Litres of water will be treated “in thousands” as the cost of water quoted in question is based on “per 1,000 litres”.

Niagra Falls: water price and efficiency variances Actual litres X Actual price 90 X $9.50 $855

Actual litres X Budgeted price 90 X $10 $900

$45 Favourable price variance

Budgeted litres X Budgeted price 66 X $10 $660

$240 unfavourable efficiency variance

$195 unfavourable flexible budget variance b)

The restaurant manager should be held accountable for the water efficiency variance. It is the restaurant manager who can affect the efficiency with which water is used in the restaurant.

No manager at the hotel can be held accountable for the water price variance as no manager can affect the water rates set. If a premium rate is levied once a certain threshold of litres consumed is surpassed, and if the restaurant consumption surpasses this threshold in a month when the flexible budget is at a point below the threshold, then the restaurant should be held accountable for the price variance resulting.

The premium water rates levied will have been incurred because of inefficient use of water.

This problem is significant as it highlights two important accountability issues: * Actual variable costs should be compared to flexible budget and not “raw” budget.

The restaurant manager would be justified in claiming that some of the adverse water expense variance arose because actual level of restaurant activity was above budgeted activity. The flexible budget eliminates this issue. * The restaurant manager has no influence over the per litre water charges (unless premium rates for high consumption arise). By distinguishing between water price and water efficiency variances, we are able to hold the restaurant manager accountable for that part of the water expense variance that they can influence, i.e., water efficiency.

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Problem 10.82: a) Solution

Ambience Hotel: pastry preparation labour rate and efficiency variances for January Actual labour hours X Actual rate 120 X $12 $1,440

Actual labour hours X Budgeted rate 120 X $14 $1,680

$240 Favourable labour rate variance

Budgeted labour hours X Budgeted rate 110 X $14 $1,540

$140 Unfavourable labour efficiency variance

$100 Labour favourable flexible budget variance

b) Too much emphasis on attaining favourable labour rate variances might well result in the hiring of poorly qualified and low quality labour. This might then result in unfavourable efficiency variances and also low quality output.

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Problem 10.83: a) Solution

Deluxe Hotels: meat price and efficiency variances for June

Actual kgs.

X Actual price 1,400 X $2.85 $3,990

Actual kgs.

X Budgeted price 1,400 X $3.00 $4,200

$210 Meat favourable price variance

Budgeted kgs.

X Budgeted price 1,300 X $3.00 $3,900

$300 Meat unfavourable efficiency variance

$90 Meat unfavourable flexible budget variance b)

Deluxe Hotels: pastry price and efficiency variances for June Actual kgs.

X Actual price 270 X

Actual kgs.

X Budgeted price 270 X

Budgeted kgs.

X Budgeted price 260 X

$1.11 $300

$1.00 $270

$1.00 $260

$30 Pastry unfavourable price variance

$10 Pastry unfavourable efficiency variance

$40 Pastry unfavourable flexible budget variance

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c)

Deluxe Hotels: meat pie preparation labour rate and efficiency variances for June Actual labour hours X Actual rate 280 X $14.5 $4,060

Actual labour hours X Budgeted rate 280 X $12 $3,360

$700 Unfavourable labour rate variance

Budgeted labour hours X Budgeted rate 260 X $12 $3,120

$240 Unfavourable labour efficiency variance

$940 Labour unfavourable flexible budget variance

d) If the purchasing function falls under a unit of accountability that is separate from the area responsible for meat pie preparation (e.g., a purchasing manager might be responsible for meat purchasing while a chef is responsible for meat pie preparation), then problems can arise. If the purchasing manager tries to buy meat very cheaply, there is likely to be a compromise on quality. Lower quality signifies that the chef will have to throw a greater proportion of meat away. This will result in an unfavourable meat efficiency variance and damage the working relationship between the chef and the purchasing manager. This problem can be managed by either placing the purchasing function under the control of the chef or requiring all purchases to meet welldefined quality standards.

A second problem that can occur if the quality of meat declines is that sales may suffer due to reduced quality of pies. If pies represent a large enough proportion of the kitchen’s sales, lower quality pies could also tarnish the reputation of the hotel’s restaurant.

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Problem 10.9: Solution a) Ways the budget-setting could have been improved: • The new administrator failed to gain the participation of the laundry manager when setting the budget. This appears particularly inappropriate given the administrator is relatively new to the job.

• Rather than calculating the quarterly budget as one fourth of the annual budget, the varying levels of activity associated with each quarter should have been taken into account.

• It is not appropriate to set next year’s budget by simply making a percentage adjustment to last year’s performance. This is highly arbitrary and signifies that no real planning has taken place.

If the new administrator wants to see improvement, it would be better to have a planning meeting with the laundry manager so that the possibility of implementing specific improvements can be discussed. The budget can then be developed in light of this continuous improvement plan.

• The control system implemented by the new administrator appears to have been developed in a highly authoritarian manner. As a result, there is a high possibility that it will meet with resistance from the laundry manager as well as other department heads. b) The report does not effectively communicate the efficiency of the laundry department. As actual laundry throughput was more than what was budgeted for, and several of the expenses are variable, it is not surprising that actual expenses are high relative to the static budget. This situation could be rectified by producing a flexible budget. c) The following two modifications have been made in producing the revised performance report provided below: 1. Variances reported are based on the flexible budget and not the static budget.

2. As the report is being used as the basis for monitoring the laundry supervisor’s performance, a distinction is made between those expenses that are relatively controllable by the laundry manager and those that are not.

The flexible budget has been based on kilograms of laundry processed and not room occupancy. This is because laundry processed appears to be the best indicator of the laundry department’s level of activity. Room occupancy is not a perfect indicator of the laundry department’s activity because of factors such as some guests using more towels than others. In addition, the laundry department may well be cleaning restaurant linen, staff uniforms, etc. As the volume of laundry processed is 25% above the amount stated in the static budget, the flexible budget has been calculated by increasing all variable costs stated in the static budget by 25% (i.e., by multiplying the static budget amounts by 1.25).

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Val Dizzy Air Hotel Laundry Department Revised Quarterly Performance Report 3 Months to 30 September, 20X3

Room occupancy days Kilograms of laundry processed Controllable expenses: Cleaning products Laundry equipment electricity Labour Salaried supervision Uncontrollable expenses: Laundry equipment depreciation Facility maintenance Allocation of central administration overheads

Actual 9,600 100,000 $

Static budget 8,000 80,000 $

Flexible budget

Flexible budget variance

100,000 $

$

944 605 9,200 2,995

800 500 8,000 3,000

1,000 625 10,000 3,000

56 20 800 5

5.6% 3.2% 8% 0.2%

425 1,650

425 1,500

425 1,500

0 (150)

0% (10%)

896 $16,715

800 $15,025

800 $17,350

(96) $635

(12%)

% Variance

In the above analysis, cleaning products, laundry equipment depreciation and labour are all assumed to be variable costs. It has been assumed that facility maintenance is contracted for, therefore variation with activity is not expected.

By calculating flexible budget variances, it appears that the laundry manager has performed well in containing costs. This is a very different finding to that made when the variances are based on the static budget.

Problem 10.10: Solution a) CornishChef: meat price and efficiency variances Actual kgs.

Actual kgs.

Standard kgs.

X X X Actual price Budgeted price Budgeted price 924 924 880 X X X £2.75 £3.00 £3.00 £2,541 £2,772 £2,640 $231 Meat favourable price variance

$132 Meat unfavourable efficiency variance

$99 Meat favourable flexible budget variance b)

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CornishChef: labour rate and efficiency variances Actual hours Actual hours Standard hours X X X Actual rate Budgeted rate Budgeted rate 682 660 X X £10 £6,820

£10 £6,600

$220 unfavourable labour efficiency variance

c) Good buying involves purchasing materials: • at the right price, • right quality • and right amount at the right time.

Giving the purchasing manager a bonus based on the first bullet point might result in him taking his eye off the second two bullet points.

The purchasing manager may start to buy lower quality meats at a lower price. This would result in tension with the chef, as the chef would have to throw out more fat and poor quality steak, resulting in an unfavourable material variance and a negative impact on his bonus prospects. The purchasing office may also attempt to buy large quantities of meat on days that the price is low or in order to get bulk discounts. This could provide a meat storage problem for the chef. Further, the chef is likely to be resistant to using meat that has been frozen in a kitchen freezer.

Problem 10.11: Solution a)

Revenue Cost of Sales Groff Profit

DecadentDaiquiri budget compared to actual performance for August Actual Budget Variance $ $ $ 81,000 63,000 18,000 (F) 9,785 8,100 1,685 (U) 71,215 54,900 16,315 (F)

b) To compute flexible budget, multiply budget by 1.2.

DecadentDaiquiri flexible budget compared to actual performance for August Actual Flexible Budget Variance $ $ $ Revenue 81,000 75,600 5,400 (F) Cost of Sales 9,785 9,720 65 (U) Groff Profit 71,215 65,880 5,335 (F) c) The flexible budget appears to be a better basis to use when monitoring performance. The bar sold 20% more drinks that were budgeted for, therefore cost of sales compared to fixed budget is relatively

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meaningless. It is only when cost of sales is compared to the flexed budget for cost of sales that we find the variance is relatively small. d)

DecadentDaiquiri: rum material price and efficiency variances for August Actual litres X Actual price 515 X $19 $9,785

Actual litres X Budgeted price 515 X $18 $9,270

$515 Rum unfavourable price variance

Standard litres X Budgeted price 540 X $18 $9,720

$450 Rum favourable efficiency variance

$65 Rum unfavourable flexible budget variance

Problem 10.12: Solution Benchmarking involves gauging actual performance against some other performance indicator. The term is frequently used in the sense of gauging against best practice. Frequently used benchmarks include the results of best performing units within a large hotel group and also industry averages.

By comparing against best practice, managers are alerted to areas where there is scope for improvement.

When benchmarking against the best performing units within a group, information can be shared with respect to how the best practice was achieved.

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CHAPTER 11 Performance Measurement Problem 11.1: Solution There appears to be considerable validity in the adage that “what gets measured is what gets managed”.

Consideration of students approach to studies supports this view. Students tend to put much more effort preparing assignments that carry a mark relative to homework problems that do not carry a mark. It appears people have a great tendency to attach more importance to those things that are measured. This close association between what gets measured and what gets managed highlights the importance of carefully thinking through what should be measured in a hotel’s performance measurement system.

Problem 11.2: Solution 1. Many hotels engage the services of a specialist hotel operating company. Many large hotels operate in this manner, with a management contract struck between the hotel owner and hotel operator. The tension that can arise between the focus of a hotel’s operating company and its owner highlights an additional complexity factor heightening the importance of careful performance measurement system design.

2. The underlying diversity of the activities conducted in a hotel that were described in chapter 1 (ie, the service orientation evident in the provision of accommodation, the retail orientation evident in bar sales and the production orientation evident in restaurant kitchens) requires the development and application of a range of performance measures that move well beyond traditional financial performance measures.

Other challenges arising include the fact that hotel groups have to manage highly geographically dispersed operating units (ie, hotels) and operate in a sector where very high turnover rates prevail for operating staff.

Problem 11.3: Solution (a) Financial performance measures focus on results not causes. If a hotel’s financial performance measurement system indicates a declining level of sales, we know that all is not well. We would not know, however, what factors account for this bad financial result. We would have no sense of what corrective action should be taken because the sales account represents a highly aggregated performance indicator and there are many factors that could account for a changed level of sales. A broader based performance measurement system will have a greater capacity to highlight factors that lie behind a declining level of sales. (b) Financial performance measures suffer from a backward-looking orientation. Financial performance measures tend to focus on performance in a specific period of time that has past. A more valuable performance measurement system is one that can provide pointers towards likely future performance. For instance, increasing levels of customer satisfaction suggests future strong performance due to an increase in return guests and positive word of mouth promotion. Similarly, improved employee morale points towards a likely reduction in future staff turnover and an increase in the care and quality of service provided. (c) Financial performance measures focus on a limited performance dimension. Financial performance measures are obviously limited to measuring those things that can be measured in money terms. Marketing managers in hotels recognise that customer loyalty is an exceedingly important factor contributing to a hotel’s overall performance. Human resource managers recognise that employee morale is very important, particularly as hotel customers come into contact with many hotel employees. Computers and information systems are key integral components contributing to the effective operation of any large hotel (just consider 89

the drastic implications of a one week failure in a hotel’s computerised reservation system). Despite the undoubted importance of factors such as customer loyalty, staff morale and information system support, none of these aspects of a hotel’s operation can be monitored using a financial measure. (d) Financial performance measures can promote short-term focused behaviour. If managers focus too much on the short term, they may be taking steps that can damage a hotel’s long-term success. This issue is a particularly apparent problem in the hotel industry because of the frequency with which General Managers (GMs) experience relocation within a chain of hotels. In many chains, it is not unusual for a GM to average around three years at each property. If a hotel chain operates such a management policy and attaches major emphasis on financial performance indicators, there is an incentive for managers to take steps that will result in increasing reported profit for the three years they are with a hotel, with limited concern given to the hotel’s longer term performance. This could mean that the GM cuts back on those financial outlays where no immediate downside is apparent. For example, a GM could reduce property preventative maintenance expenditure, cut back on staff development and training, and reduce expenditure associated with the hotel’s local customer loyalty programme that was established by the preceding GM. All of these steps can be expected to result in an immediate cost saving. The negative implications of these expenditure reductions may not begin to be felt until three years after they have been implemented. This signifies that the GM initiating the expenditure can appear to have performed well, due to the increased reported profit associated with the time he was GM. He could well look even better once he is replaced and the deferred negative implications of the steps he has taken start to be realised following his departure.

Problem 11.4 Solution Factors highlighting the importance of monitoring financial performance measures include: • Financial performance measures are objective, ie the amount of sales revenue generated by an organisation can be objectively verified, however, considerable subjectivity is involved with non-financial measures such as gauging customer satisfaction.

• The external community (shareholders, etc) attach considerable importance to the financial performance of organisations, as reflected in their published income statements and balance sheets. It is important that the criteria used by the external community to gauge an organisation’s performance are closely monitored by an organisation’s management.

• Bankruptcy occurs when an organisation does not have sufficient cash to pay off its liabilities. The fundamental importance of ensuring an organisation is not approaching bankruptcy underscores the importance of monitoring key current asset and liability accounts.

Problem 11.5: Solution Choose any six from the following: 1) Ensure appropriate balance in the system A performance measurement system should be well balanced by employing a mix of financial and non-financial, lag and lead, internal and external, and objective and subjective measures.

2) Avoid performance measurement information overload Too many performance indicators can distract a manager from monitoring information that is key to guiding hotel success. No manager should be held accountable for more than five measures.

3) Performance measures must be linked to mission and strategy

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Performance measurement indicators should be chosen to ensure that managers focus their attention on facets of the business that are key to achieving a hotel’s mission and strategy.

4) Report performance measures in a timely manner To enable prompt action by management, performance indicators should be reported as soon as possible.

5) Be careful of performance measures that might trigger undesirable behaviour If emphasis is to be attached to a room cleaning time measure, it will be important to also monitor quality of room cleaning to avoid staff taking undesirable short cuts to reduce room cleaning times.

6) Keep performance measures simple If staff do not understand how a performance measure is calculated, they will not know what steps to take in order to improve the dimension of performance captured by the measure.

7) Managers should only be held accountable for things they can affect It is pointless to hold a manager accountable for a dimension of performance if the manager has limited ability to change what is being measured.

8) Emphasise positive dimensions of a performance measure It is better to use performance measures to motivate, rather than demotivate, staff. As a result, it is better to talk of 80% occupancy than 20% vacancy.

9) Involve managers in any decision to change performance measures Such involvement can lead to better designed performance measures and increase the probability of a manager striving to achieve a high level of performance for the business dimension appraised.

10) Provide performance measure benchmark data To raise awareness of where performance can be improved, use benchmark data to highlight the achievements of the best performers in the sector.

11) Provide rewards for achieving performance measurement targets To motivate staff, when a performance measure is met or surpassed, many companies provide a reward such as a cash bonus or a share allocation.

Problem 11.6: Solution A well designed performance measurement system will have achieved an appropriate mix of performance measures that exhibit balance across the following dimensions: 1. Financial vs Non-financial Financial measures monitor aspects of hotel performance in monetary terms.

Non-financial performance measures monitor aspects of hotel performance in non monetary terms. It is unlikely that all of a hotel’s key dimensions of performance can be measured in monetary terms (eg., occupancy levels and staff turnover rates represent two important factors that are monitored extensively in the hotel sector).

2. Lag vs Lead measures Lag measures monitor aspects of hotel performance that represent the outcome of actions already taken. Lead measures focus on measuring the actions or factors that drive outcomes. For example, occupancy and room cleaning injuries can be viewed as lag indicators. What drives these outcomes?

Occupancy may be driven by customer loyalty and cleaning injuries may be driven by hours spent training staff. This signifies that customer loyalty and hours spent training staff are lead indicators. A focus on lead indicators can also help managers modify business activities to take advantage of evolving opportunities.

3. Internal vs External Internal measures focus on people and factors within a hotel organisation such as employees and internal hotel systems and procedures. External measures focus on people and factors outside the hotel organisation such as customers, shareholders, competitors and hotel quality rating agencies.

4. Objective vs Subjective Objective measures monitor aspects of hotel performance that can be measured with certainty. Subjective performance measures monitor aspects of hotel performance that cannot be gauged with certainty, e.g., if three consulting firms were asked to independently provide a percentage score reflecting the status of a hotel staff’s morale, they would most likely each come up with a different score. We tend to feel more comfortable with objective performance indicators, as they are independently verifiable and there is no room for a dispute to arise over measurement accuracy. This preference for accurate and verifiable

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measurement can result in organisations placing undue emphasis on aspects of performance that can be objectively measured. This tendency has to be resisted, however, as it is unlikely that all of a hotel’s key dimensions of performance can be measured objectively.

Problem 11.7: Solution The key features of a balance scorecard system are: 1. It is structured around 4 key performance dimensions: • Financial • Customer • Internal Processes • Learning and Growth 2. It is a strategy based framework. The balance scorecard system engineers: • clarification of strategy; • articulation of strategic objectives for each of the 4 key performance dimensions; • strategy implementation by focussing staff on performance measures that are linked to strategic objectives 3. It constitutes a cause-effect integrated framework of performance measures. Each BSC performance measure sits within a cause-effect network that flows from learning and growth performance measurement through to financial outcomes.

4. It translates performance measures used at senior levels into performance measures to be used at lower organisational levels. The strategic performance measures need to be translated into more narrowly defined performance measures that tend to be stated in non-financial operational terms for lower level staff (eg, cleaning material inventory turnover).

Problem 11.8: Solution Four major steps taken in developing a balanced scorecard are: • Step 1: Develop the unit’s mission / vision • Step 2: Develop a strategy to achieve mission / vision • Step 3: For each of the four key performance dimensions (Financial, Customer, Internal Processes, and Learning & Growth) develop strategic objectives consistent with pursuit of mission / vision • Step 4: For each of the four key performance dimensions (Financial, Customer, Internal Processes, and Learning & Growth) develop performance measures that will drive the business toward achieving its strategic objectives and also monitor the extent that these objectives are being achieved.

Problem 11.9: Solution The balanced scorecard’s four key performance dimensions are as follows: a) Financial perspective The financial perspective comprises strategic objectives that are developed from a shareholder’s perspective.

Kaplan and Norton suggest these objectives can be developed by responding to the question: To succeed financially, how should we appear to our shareholders? Once these objectives have been developed, a set of financial measures can be generated. Possible financial measures include: departmental cost, cost of a providing a room night, hotel profit, profit of a market segment, revenue per available room, ROI, share price, etc. b) Customer perspective

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The customer perspective comprises strategic objectives that are developed from a customer’s perspective. Kaplan and Norton suggest these objectives can be developed by responding to the question: To achieve our vision, how should we appear to our customers? Once these objectives have been developed, a set of customer related performance measures can be generated. Possible customer related performance measures include: customer loyalty, proportion of returning customers, customer complaints, customer profitability, etc. c) Internal process perspective The internal process perspective concerns the development of process related objectives that are consistent with achieving financial and customer objectives. Kaplan and Norton suggest these objectives can be developed by responding to the question: To satisfy our shareholders and customers, what business processes must we excel at?

Once these objectives have been developed, a set of internal process related performance measures can be generated. Possible internal process related performance measures include: customer billing errors, time to process check ins, restaurant service errors, workplace safety compliance, community involvement, customer database availability, etc. d) Learning and growth perspective The learning and growth perspective concerns the development of organisational capability goals that are consistent with achieving the financial and customer objectives. Kaplan and Norton suggest these objectives can be developed by responding to the question: To achieve our vision, how will we sustain our ability to change and improve? Once these objectives have been developed (which can focus on the short or long term), a set of learning and growth related performance measures can be generated. Possible learning and growth performance measures include: training investment per employee, absenteeism, motivation index, employee satisfaction, proportion of staff with access to desk top computers, etc.

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Problem 11.94: Solution Examples of performance measures, appropriate to a hotel setting, are presented under each of the balanced scorecard’s four key performance dimensions in the table below.

Financial

• Operating profit • Return on investment • Revenue growth • Revenue compared to budget • Sales mix • Pricing effectiveness • Operating profit compared to prior year • Operating profit compared to budget • Operating profit compared to comparable properties • Cost controls on individual line items

Customer

• Customer satisfaction • Customer retention • New customer acquisition • Market segmentation • Market share • Customer profitability • Responsiveness • Service levels • Mystery-guest assessments

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Internal Process

• Service errors • Physical asset maintenance • Capital expenditure efficiency • Internal control practices • Safety compliance • Time required to complete processes (eg, check in, room service, breakfast seating and serving, etc) • Market segment information

Learning & Growth

• Personal growth of staff • Internal promotion levels • Staff satisfaction • Staff retention • Staff empowerment • Strategic skills of staff • Training levels • Frequency of training • Training of staff for range of positions • Staff computer access • Community participation and knowledge exhibited by general managers

Problem 11.95: Solution ConferenceCha Strategic Objectives and Performance Measures Solution part a

Solution part b

Strategic Objectives Financial • Increase conference revenue • Increase conference profits

Lag indicators • Conference revenue • Conference profit

Customer • High customer satisfaction • High professional conference organiser satisfaction

Internal processes • Maintenance of strong relationships with professional conference organising companies.

• Maintenance of high quality audio visual systems • Maintaining high quality banquet catering

Learning and Growth • Staff happy to be involved in conference activities • Staff well trained in the provision of conference support activities

Lead indicators Financial • Trend in average number of delegates attending conferences • Trend in number of conferences hosted • Trend in profit per conference

• Customer satisfaction • Professional conference organiser satisfaction

• • •

• • • •

Customer • Provision of high quality food and beverage • Provision of well maintained conference and room facilities

Internal processes Professional conference • Procedures established to organisers completion of maintain liaison with awareness indicators professional conference organising companies Random checks of audio visual system performance • Procedures established to standards inspect quality of audio visual systems Random checks of banquet catering standards • Procedures established to promote the delivery of high quality banquet catering

Staff satisfaction Staff training levels Staff retention levels Absenteeism

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Learning and Growth • Staff empowerment • Staff ability to multi-task • Training hours per employee • Staff motivation

Problem 11.12 ClubEscape Strategic Objectives and Performance Measures Solution part a Strategic Objectives Financial • Increase resort revenue in new destinations • Increase resort revenue internationally • Increase resort profits internationally

Customer • High customer satisfaction with food.

• High customer satisfaction with range and quality of activities.

• High customer satisfaction with ‘family experience’.

Internal processes • Maintenance of a large range of activities.

• Maintenance of high quality activities.

• Maintenance of family oriented activities.

• Maintenance of high quality food provision.

• A range of high potential new locations are identified.

• New properties constructed on schedule.

Solution part b Lag indicators

Lead indicators Financial • Resort revenue in new • Number of new properties destinations under construction • Resort revenue internationally • Time to complete new property construction • Resort profit internationally • Trend in revenue per available room • International advertising expenditure.

• Public image of resort as ‘upmarket’ and ‘exotic’.

• Resort image amongst travel agents as ‘up-market’ and ‘exotic’.

• Customer satisfaction with food.

• Customer satisfaction with range of activities.

• Customer satisfaction with quality of activities.

• Customer satisfaction with ‘family experience’

• • • • • • •

Customer • Provision of high quality food.

• Customers well-informed about range of activities.

• Frequency with which customer satisfaction with activity quality and range is appraised.

• Frequency with which customer satisfaction with ‘family experience’ is appraised.

Internal processes Average number of activities • Procedures in place to support offered at one time. the offering of a range of varied activities in a week.

Percentage variation in activities offered in a week.

• Procedures established to ensure the maintenance of high Assessed quality of activities quality in activities offered. on offer.

• Proportion of family oriented Number of families involved activities offered. in activities together.

• Frequency with which quality Quality of food provided. and number of activities are Proportion of new property appraised proposals that receive • Food quality procedures approval. established.

Proportion of new properties • Well-developed procedures to completed on schedule. inform the identification of high potential new resort sites.

• Procedures established to expedite on-time completion of new site developments.

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Learning and Growth • Staff focused on providing a • range of high quality activities.

• • Staff focused on providing high quality food.

• Staff focused on providing quality family experiences.

• • Retention of staff well • trained in new resort location identification.

•

Learning and Growth Staff awareness of the • Extent of staff training on the importance of the range and importance of the quality and quality of activities offered. range of activities offered.

Staff motivated to provide a • Presence of procedures range of high quality designed to motivate staff who activities. oversee resort activities.

Staff well trained in quality • Training hours per kitchen food provision. employee.

Staff motivated and trained to • Emphasis placed on working provide quality family with families in staff experiences. recruitment and training.

Staff retention levels.

• Staff satisfaction levels.

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CHAPTER 12 Cost information and pricing Problem 12.1: Solution Contribution pricing is concerned with covering variable costs to ensure a positive contribution results. It is particularly appropriate with perishable stock such as rooms. If a room is not sold for a particular night and the night in question elapses, that particular room night can never be sold in the future. The contribution pricing philosophy holds that it is better to receive some contribution to profit rather than no contribution, before an unsold room night elapses. As a result, contribution pricing can be seen as a ‘last minute’ mentality that can come into play as the time for a room night elapsing approaches. Viewed in this way, contribution pricing represents an attempt to secure a contribution from stock that is about to be sacrificed (either because of the passage of time or, in the case of food, if the stock is becoming too old to sell).

Yield management is not a ‘last minute’ room pricing philosophy. Yield management involves sales and marketing management developing pricing plans that recognise factors such as whether a reservation pertains to a quiet or busy season, weekday or weekend and also the nature of a customer’s market segment (e.g., group booking vs a single transient guest). Unlike contribution pricing that focuses on generating a price that covers variable cost, yield management focuses on maximising revenue per available room. Questions addressed in yield management include whether a discounted tour booking should be made for a future period, when most of a hotel’s stock of rooms has already been sold for the period in question.

Problem 12.2 Solution a. If a car manufacturer’s sales are slow on a particular day, there is no particular need for the manufacturer to drop the prices of its cars in an effort to sell more on that day. Cars not sold today can simply remain in the car manufacturer’s finished goods inventory in readiness to be sold tomorrow or at some other time in the future. This is because cars represent a non-perishable inventory item.

This is not the situation for a hotel’s room inventory, however. If tonight’s right of occupancy in a particular hotel room is not sold today, the opportunity to sell that occupancy right will be lost forever, as an unsold room night today cannot be placed into inventory for sale at a later date. This heightens the incentive for hotels to consider a strategy of discounting room rates as the time of an unsold block of room nights approaches. As an unsold room night cannot be sold at a future date, it is described as being highly ‘perishable’. b. Pricing strategies should take into account the degree to which a product or service is perishable.

To illustrate, let us compare a bottle of wine and a fresh cream cake that are available for purchase from a café that adjoins a hotel’s foyer. Due to differences in the perishability of the two products, a manager would be justified in implementing very different pricing strategies for the two products.

Let us assume that the unit variable cost of making the cakes is $1.20, and that immediately following production, the cakes are priced at $4 each. Let us also assume that if a cake is not sold by the end of the day following its production, it will have to be discarded as waste (ie, the cake is highly perishable). On the day following the cake’s production, if the cake is not sold by the time the café closes, its revenue earning potential will be lost forever. Accordingly, a manager might be justified in dropping the retail price of the cakes to $0.5 one hour before the café is due to close.

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The bottle of wine does not suffer from the same perishability as the cream cake. The closing of the café on a particular day does not signify that the future revenue potential of the bottle of wine is lost. Accordingly, the rationale for dropping the price of cream cakes to a point that is below their variable cost does not apply to the bottle of wine.

Problem 12.3: Solution Total costs: £ 22,500 40,000 65,000 85,000 £212,500

Bank loan (£250,000 @ 9%) Depreciation Other fixed costs Operating expenses Total costs

After tax profit sought by owners = £450,000 X 0.15 = £67,500.

Before tax profit needed to provide after tax profit of £67,500 = £135,000 (tax is 50%).

Total revenue needed to provide before tax profit of £135,000 = Total costs + desired before tax profit, i.e., £212,500 + £135,000 = £347,500.

Room rate = Total revenue ÷ Room nights sold in a year Room nights sold in a year = 40 X 0.55 X 365 = 8,030 Room rate = £347,500 ÷ 8,030 = £43.27

Problem 12.4: Solution a) Total investment in rooms = $12,600,000 (70% of $18m).

Average room investment = $140,000 ($12.6m  90).

Average room rate = $140 ($140,000  1,000). b) Revenue required per day = $3,066,000  365 = $8,400 Let “M” represent price charged per square meter.

(21 X 60M) + (21 X 80M) + (21 X 110M) = $8,400 1,260M + 1,680M + 2,310M = $8,400 5,250M = $8,400 M = $1.6 For the economy rooms the rate should be: $1.6 X 60 = $96.

For the double rooms the rate should be: $1.6 X 80 = $128.

For the deluxe rooms the rate should be: $1.6 X 110 = $176.

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Problem 12.5: Solution a) Profit = Revenue - Variable costs - Fixed costs Contribution = Revenue - Variable costs In this problem Variable costs are 75% of Revenue, Contribution = 25% of Revenue We can say: Target profit = 0.25 of Revenue - Fixed costs, or: 50% of $120,000 = 0.25R - ($55,000 + $8,000 + $30,000 + $5,000 + $6,000 + $4,000 + $28,000), $60,000 + $136,000 = .25R, $196,000 ÷ 0.25 = R, R = $784,000 Answer: total revenue of $784,000 will provide a 50% before tax return on the owners’ investment of $120,000. b) Total number of weekdays restaurant is open = 49 X 4 = 196.

Total number of weekday covers sold = 196 X 50 X 2 = 19,600.

Total number of Saturdays and Sundays restaurant is open = 49 X 2 = 98.

Total number of weekend covers sold per annum = 98 X 50 X 3 = 14,700 Total number of covers sold per annum = 19,600 + 14,700 = 34,300 average selling price per cover to provide target profit = $784,000 ÷ 34,300 = $22.86

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Problem 12.101: Solution

The “cost mark up” approach Imagine that an item to be priced costs $8. If a 25% mark up is applied, the resulting price can be computed as follows: $ Cost 8 + 25% of cost 2 Price 10 The “gross profit margin” approach Gross profit margin = Gross profit ÷ Selling price X 100 If the selling price is $10, a gross profit margin of 20% signifies a profit of $2, (i.e., 0.2 X $10).

Answer: A 25% cost mark up provides the same level of profit as a 20% gross profit margin.

This distinction between mark up and gross profit margin can be baffling for some students. Note that mark up is based on cost and gross profit margin is based on price. A 20% gross profit margin signifies a greater level of profit than a 20% mark up.

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Problem 12.102: Solution Price elasticity is determined by the formula: % change in quantity demanded % change in price % change in quantity demanded = 0.5 ÷ 5 X 100 = 10% % change in price = 5 ÷ 40 X 100 = 12.5% Price elasticity = 10 ÷ 12.5 = 0.8 As the price elasticity index is less than 1, we can conclude that the “all you can eat roast” Sunday special is price inelastic.

Problem 12.8: Solution a) Price = Cost of meal ingredients X Cost plus multiple £2.52 X 8 = £20.16 b) The new multiple must be: Existing selling price  cost of main ingredient £20.16  £1.68 = 12.

Problem 12.9: Solution Daily revenue if reservation is made for party of 40: Party of 40 revenue (40 x $90) Revenue from business clients (160 x $120) Total

$3,600 $19,200 $22,800

Daily revenue if reservation is not made for party of 40: Existing business client reservations (80 x $120) Further business client reservations (108 x $120) Total

$9,600 $12,960 $22,560

Total revenue is maximised by extending a reservation for the party of 40. Therefore, on the basis of revenue maximisation, the reservation should be made. Alternately stated, extending the reservation results in a higher revpar of $114 ($22,800  200) than the $112.80 ($22,560  200) if the reservation is not made.

It should be noted, however, that revenue maximisation is not necessarily the same as profit maximisation. Of the two options, the revenue maximising option results in the sale of an extra 12 rooms. These extra rooms will signify extra housekeeping and energy costs. As it is highly unlikely that variable cost per room sold would exceed the $90 rate received if the group booking is taken, we can conclude that the option with the higher revpar is preferred.

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Problem 12.10: Solution a) Target profit = 0.3 X £1,920,000 = £576,000 Target contribution = Target profit + Fixed costs = £576,000 + £704,000 = £1,280,000 Target contribution per room sold = £1,280,000 ÷ 32,000 = £40 Price per room = Target contribution per room sold + unit variable cost = £40 + £6 = £46. b) Breakeven = £704,000 ÷ (£50 – £6) = 16,000 room nights sold.

Problem 12.11 Solution After tax profit sought by owners: $2,000,000 X 15% = $300,000 Before tax profit needed to provide $300,000 after tax: $300,000 ÷ (1- 0.4) = $500,000 Add interest expense: (.12 X $6,000,000) + $500,000 = $1,220,000 Add fixed costs: $1,020,000 + $1,220,000 = $2,240,000 Less F&B profit: $2,240,000 - $150,000 = $2,090,000 Rooms department profit goal: $2,090,000 Room nights sold in a year: 365 X 0.7 X 200 = 51,100 Variable expenses arising from room sales: 51,100 X $12 = $613,200 Room revenue required: $2,090,000 + $613,200 = $2,703,200 Room rate to charge: Target revenue ÷ room nights sold per year = $2,703,200 ÷ 51,100 = $52.90

Problem 12.12: Solution Price elasticity refers to the percentage change in demand for a given percentage change in price. If the percentage change in demand is greater than a percentage change in price, demand is referred to as ‘price elastic’. If the percentage change in demand is less than a percentage change in price, demand is referred to as ‘price inelastic’. During the high season we can expend the demand for hotel rooms to be relatively price inelastic. In tourist areas, during summer school holidays, because demand is buoyant, hotel guests have limited hotel choice and little opportunity to shop around for lower prices. This signifies that during the high season, hotel rooms are relatively price inelastic. The reverse is the case during the low season.

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CHAPTER 13 Working Capital Management Problem 13.1 Solution A significant factor contributing to the difference between profit and cash flow is the way accountants account for fixed assets. If we pay $500,000 for a fixed asset, cash will immediately decline at the time we pay for the fixed asset, however the reported profit in the year the asset is purchased will not be affected by nearly as much. If it is determined that the cost of the asset is to be depreciated over 10 years, in the year that the asset is purchased, reported profit will only be reduced by the $50,000 annual depreciation charge for the asset (assuming the asset was purchased at the beginning of the year), not the $500,000 asset cost. This signifies that in the year the asset is purchased, a $450,000 discrepancy arises between reported profit (affected by a $50,000 depreciation charge) and actual cash flow (affected by a $500,000 payment to the fixed asset supplier).

Other factors accounting for a difference between profit and cash flow include: • We recognise revenue at the time a service is provided, not when cash is received.

• If supplies are paid for on credit, there will be a lag between purchases and payments.

• Employees are paid following the completion of work or a working period.

• In many countries, electricity accounts are settled on a quarterly basis. This signifies at least a three month discrepancy between some of the electricity expense incurred and payment for electricity.

• Insurance and rent are paid in advance of charging the associated expense to the income statement.

• In the case of insurance, payment is made a year in advance of a portion of the expense.

• When a company arranges a loan or increases its share capital there is an immediate large positive impact on cash flow. The only income statement impact concerns the loan’s annual interest expense, however.

Problem 13.2 Solution The following issues should be appraised when considering whether to extend trade credit to a customer: 1. Character: does the customer have a predisposition towards timely payment of accounts?

2. Capacity: does the customer have the capacity to run a successful business?

3. Capital: does the customer have sufficient working and long-term capital to honour the account when it is due for payment?

4. Conditions: are there any particular economic conditions that might affect the potential customer’s ability to pay? In addition, there might be particular circumstances such as low

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occupancy in the off season that might cause a hotel to consider extending credit to less creditworthy customers.

5. Collateral: does the customer have assets that could be liquidated relatively easily in the event of a liquidity crisis that threatened timely reimbursement of the account due.

Problem 13.3: Solution Schedule of projected cash receipts for CrownJewel in ($ thousands)

Room sales 10% cash sales.

50% received from previous month’s sales 35% received from sales 2 months ago 5% received from sales 3 months ago Total room receipts Restaurant & bar sales 30% cash sales 70% received from previous month’s sales Total restaurant & bar receipts Total all receipts

October $ 540 $ 54

November $ 500 $ 50

December $ 600 $ 60

Total $ 164

300

270

250

820

231

210

189

630

31.5 $ 616.5

33 $ 563

30 $ 529

94.5 $ 1,708.5

$ 70 $ 21

$ 60 $ 18

$ 80 $ 24

$ 63

56

49

42

147

77 $ 693.5

67 $ 630

66 $ 595

210 $ 1,918.5

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Problem 13.4: Solution Schedule of projected cash disbursements for CrownJewel Hotel (in $ thousands)

Room variable costs – 60% of current month’s cost (Room revenue X .2 X .6).

Room variable costs – 40% of previous month’s cost (Room revenue X .2 X .4).

Restaurant & bar wages (Restaurant revenue X .1).

Food & drink costs – 40% of current month’s cost (Rest. & bar revenue X .15 X .4) Food & drink costs – 60% of previous month’s cost (R&B. revenue X .15 X .6) Fixed costs Electricity and insurance.

Total disbursements

October

November

December

$ 64.8

$ 60.0

$ 72.0

$ 196.8

48.0

43.2

40.0

131.2

7.0

6.0

8.0

21.0

4.2

3.6

4.8

12.6

7.2

6.3

5.4

18.9

15.0

15.0 3.0 $ 137.1

15.0 7.5 $ 152.7

45.0 10.5 $ 436.0

$ 146.2

Total

Problem 13.5: Solution Cash budget for CrownJewel Total cash receipts a Less Total cash disbursements b Net cash flow Add Opening cash balance Ending cash

October

November

December

Total

$ 693.5 146.2

$ 630.0 137.1

$ 595.0 152.7

$ 1,918.5 436.0

547.3 12.0

492.9 559.3

442.3 1,052.2

1,482.5 12.0

$ 559.3

$ 1,052.2

$ 1,494.5

$ 1,494.5

a: From solution to Problem 13.1. b: From solution to Problem 13.2.

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Problem 13.107: Solution Receipts: 10% of next month’s sales 50% of current month’s sales 40% of previous month’s sales Total receipts Payments: Variable cost payments made in advance of sale (next month’s sales X 0.15 X 0.1) Variable cost paid in month of sale (current month’s sales X 0.15 X 0.9) Salaries Ground maintenance Insurance ($420 X 12  2) Total payments Net cash flow Opening cash balance Closing cash balance

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January £ 1,200 5,000 3,200 9,400

February £ 1,300 6,000 4,000 11,300

March £ 1,400 6,500 4,800 12,700

180

195

210

1,350 4,000 500 2,520 8,550 850 4,200 £ 5,050

1,620 4,000 500

1,755 4,000 500

6,315 4,985 5,050 £ 10,035

6,465 6,235 10,035 £ 16,270

Problem 13.108: Solution

a) Credit sales per annum = 40% of $6,000,000 = $2,400,000 Accounts receivable turnover = Credit sales  Accounts receivable balance $2,400,000  $263,014 = 9.125 Average number of days to collect accounts receivable = Days in the year  Accounts receivable turnover 365  9.125 = 40 days The hotel is extending 30 day credit terms, yet the analysis of the year end account balance indicates that the average period that credit customers are taking to settle their accounts is 40 days. The extent to which this represents a matter for significant concern should be considered in the context of the additional days credit that have been taken by the average customer in the past. A more detailed review of the accounts receivable balance may reveal that several large and loyal customers are taking more than 40 days to settle their accounts. Before management decides to more aggressively pursue the collection of these overdue accounts, it should appraise whether goodwill with the customers may be damaged. b) This significantly alters the interpretation that should be attached to the accounts receivable turnover calculated in part (a). As November and December represent relatively busy months, it is to be expected that an above average accounts receivable balance will result at the end of December. It is to be expected that a relatively low “accounts receivable turnover” figure (and, as a consequence, a relatively high “number of days to collect accounts receivable” figure) will be calculated, if it is based on the accounts receivable balance pertaining at the end of a busy period.

In this situation, the low accounts receivable turnover figure can not be interpreted as signifying poor accounts receivable management. In order to gain a fairer reflection of the average accounts receivable turnover over the course of the year, we would need to take an average of the accounts receivable balance across the entire year (i.e., sum the 12 balances at the end of each month and divide by 12). The year end information provided is not sufficient to enable the interested manager to compute a true average accounts receivable turnover that is reflective of the performance across the whole year. The onus is therefore on the interested manager to ask the accounting department to provide the additional information required.

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c) CreatureComforts Aging of Accounts Receivable Schedule as at 31st December Days overdue Month Accounts receivable % of total (rounded)

Current

0-30

31-60

61-90

91-120

121-150

Dec. $210,000

Nov. $26,300

Oct. $7,890

Sep. $2,782

Aug. $13,448

July $2,594

Total $263,014

80%

10%

3%

1%

5%

1%

100%

The aging of accounts receivable schedule reveals a fairly typical time distribution of the accounts receivable balance, as most of the year end accounts receivable balance pertains to credit sales made in the current month (i.e., accounts receivable that are not yet overdue). The schedule also reveals, however, that there appears to be a problem with those accounts that are overdue by between 91 and 120 days. These accounts constitute 5% of the total amounts owing at the end of the year. 120 days represents a long time for accounts to be overdue.

It may well be the case that a single large account comprises most of the amount falling into the 91 to 120 days overdue category. If this is the case, further analysis should be made of the cause for the late payment and steps implemented to collect the outstanding amounts as soon as possible.

Problem 13.8: Solution Per annum usage of detergent = 25 X 12 = 300 boxes.

EOQ

=

 (2 X U X O ÷ C)

=

 (2 X 300 X 20 ÷ 2)

=

 6,000

=

77.46 (as 0.46 of a box cannot be ordered, TartanDays should place orders in lot sizes of 77 or 78).

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Problem 13.9: Solution a)

Usage per annum = 500 X 26 = 13,000 cheese blocks Carrying cost for one cheese block per annum = $20 X 0.05 = $1 EOQ

=

 (2 X U X O ÷ C)

=

 (2 X 13,000 X 30 ÷ 1)

=

 780,000

= 883.18, as 0.18 of a cheese block cannot be ordered, Roma should order its cheese in lot sizes of 883 blocks. b) To calculate Roma’s current carrying cost, two preliminary steps are necessary: • Roma’s lowest inventory level is 40 blocks (i.e., just before the new shipment arrives) and its highest inventory level is 540 blocks (i.e., just after a shipment arrives). Therefore its average inventory of cheese is 290 which is the midpoint between 40 and 540 (i.e., [40 + 540] ÷ 2). This signifies that half the time the cheese inventory will be above 290 and half the time it will be below 290.

• As money invested in cheese has an opportunity cost of 5% per annum, holding a $20 block of cheese for a year would cost Roma $1 (5% of $20).

Roma’s current annual carrying cost for cheese = Average inventory level X Cost of holding 1 block of cheese per annum: 290 X $1 = $290.

To calculate ordering cost, one preliminary step is necessary: • Roma’s number of orders placed per year = 26 (divide 52 weeks in year by 2 as orders are placed every 2 weeks).

Roma’s current annual ordering cost for cheese = Number of orders per annum X Cost to process each order: 26 X $30 = $780.

Roma’s current cheese carrying and ordering costs = $290 + $780 = $1,070. c)

EOQ signifies buying in lot sizes of 883.

Carrying cost if ordering at EOQ: Assuming minimum inventory level is 40 blocks, average inventory of cheese is: 481.5 ([923 + 40] ÷ 2).

Carrying cost of cheese per annum = 481.5 X $1 = $481.5 Ordering cost of cheese per annum: Average number of orders placed per annum = 13,000 ÷ 883 = 14.72 (in approximately 3 out of 4 years 15 orders would be placed, and in 1 out of 4 years 14 orders would be placed).

Average ordering cost per annum = Number or orders X Cost to process each order = 14.72 X $30 = $441.60 Total carrying costs + ordering cost = $481.50 + $441.60 = $923.10 Total carrying cost and ordering cost saved if using EOQ is $146.9 ($1,070 - $923.1).

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Problem 13.10 Solution MouthWatering’s effective annual rate of return gained by taking the discount can be determined by applying the following formula: % discount offered 100 - % discount offered

X

Days in a year Days difference in final due date and discount date

i.e., (1 ÷ 99) X (365 ÷ 20) = 0.184 (or 18.4%).

As the 18.4% rate of return earned from taking the trade discount offered is greater than the 8% currently earned from investments in marketable securities, MouthWatering should take advantage of the trade discount offered.

Problem 13.11: Solution In this situation it appears that Feast’N’Run is not considering between paying on the 10th and 40th days of the credit period, but between the 10th and 50th days of the credit period. Accordingly, the basic formula has been adapted in the following way: % discount offered 100 - % discount offered

X

Days in a year Difference between 10th and 50th days

i.e., (1 ÷ 99) X (365 ÷ 40) = 0.92 (or 9.2%).

As Feast’N’Run would have to borrow at 9.5% interest in order to take a trade discount that provides an effective rate of return of 9.2%, it is not in Feast’N’Run’s interest to take the trade discount offered.

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Problem 13.12: Solution a) 1) When long-term financing is €1,000,000, short-term borrowing can be calculated following the method outlined in the following table’s column 4.

1 Current assets

2 Total assets

January

€ 60,000

€ 1,060,000

€ 36,000

€ 24,000

February March April May June July August September October November December

60,000 60,000 40,000 6,000 2,000 2,000 2,000 2,000 6,000 40,000 60,000

1,060,000 1,060,000 1,040,000 1,006,000 1,002,000 1,002,000 1,002,000 1,002,000 1,006,000 1,040,000 1,060,000

36,000 36,000 24,000 3,600 1,200 1,200 1,200 1,200 3,600 24,000 36,000

24,000 24,000 16,000 2,400 800 800 800 800 2,400 16,000 24,000

Month

3 Accounts payable & accrued wages (60% of 1)

4 Short-term loan (2 - 3 - €1,000,000)

2) Cost of long-term funds = €1,000,000 X 10% = €100,000.

Cost of short-term loan = (24,000 + 24,000 + 24,000 + 16,000 + 2,400 + 800 + 800 + 800 + 800 + 2,400 + 16,000 + 24,000) ÷ 12 X 6% = 136,000 ÷ 12 X 6% = €680.

Total cost of financing = €100,000 + €680 = €100,680

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b) 1) When long-term financing is €1,020,000, short-term borrowing can be calculated following the method outlined in the following table’s column 4.

1 Current assets

2 Total assets

January

€ 60,000

€ 1,060,000

€ 36,000

€ 4,000

February March April May June July August September October November December

60,000 60,000 40,000 6,000 2,000 2,000 2,000 2,000 6,000 40,000 60,000

1,060,000 1,060,000 1,040,000 1,006,000 1,002,000 1,002,000 1,002,000 1,002,000 1,006,000 1,040,000 1,060,000

36,000 36,000 24,000 3,600 1,200 1,200 1,200 1,200 3,600 24,000 36,000

4,000 4,000 0 0 0 0 0 0 0 0 4,000

Month

3 Accounts payable & accrued wages (60% of 1)

4 Short term loan (2 - 3 - € 1,020,000)

2.

Cost of long term funds = €1,020,000 X 10% = €102,000.

Cost of current liabilities = (4,000 + 4,000 + 4,000 + 4,000) ÷ 12 X 6% = 16,000 ÷ 12 X 6% = €80.

Total cost of financing = €102,000 + €80 = €102,080

c) From the solutions provided above, it can be seen that the higher level of long term financing results in higher financing costs, and therefore lower profitability. The higher level of long term financing option signifies a lower level of current liability financing. Lower current liability financing will increase the net working capital signifying greater liquidity and therefore lower risk.

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CHAPTER 14 Investment Decision Making Problem 14.1: Solution The payback method is intuitively appealing and is relatively simple to understand.

Payback can be used as an initial screening mechanism prior to the use of more sophisticated investment appraisal techniques, particularly if a hotel is considering an investment in a high risk country that is subject to high exchange rate volatility. Such volatility can motivate a manager saying “If we don’t get our money back in three years” I don’t want to make this investment.

The payback technique has several shortcomings. Two major shortcomings of the payback approach are: 1. It fails to consider any cash flows occurring after the payback period. The second of the two examples presented in Box 14.2 has the faster payback, however the first example generates the most lifetime cash inflows. In the first payback example, if the projected operating cash inflows had been $100,000 in each of the last four years of the investment’s life, the payback would still be 4 years.

2. It fails to recognise the time value of money, i.e., $1 today does not have the same value as $1 in a year’s time. Payback treats cash flows occurring in different time periods as if they have the same value.

Problem 14.2: Solution a) The theoretically preferred investment appraisal technique is the Net Present Value approach. b) The Net Present Value technique does not suffer from any obvious shortcomings. If a company commits itself to a project with an NPV of $5m, and the share market is working efficiently, the company’s value should increase by $5m. This is because today’s value of all the company’s future cash flows has been increased by $5m.

The ARR’s shortcomings include: 1. It fails to consider the period of the investment. Suppose a hotel is deciding whether to take a 40% ARR investment option with a 3 year life or an $8,000 investment option that has a 10 year life and an ARR of 38%. The ARR approach would say take the 3 year project as it has the highest ARR. By investing in the 10 year asset that provides a 38% ARR, however, the investor would be able to increase its average return on assets for seven years longer than if it invests in the 3 year asset that provides a 40% ARR. Accordingly, it appears the 10 year 38% ARR investment option is preferable to the 3 year 40% ARR option.

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2. The ARR is based on accounting profits. These figures involve some apportioning of cash flows to different accounting periods (e.g., depreciation). As a result, profits are not “real” in a tangible sense. They represent nothing more than the accountant’s “account” of performance. Cash flows, however, are real, and it is the commercial reality of the timing of money entering and exiting the organisation, and not the accountant’s account, that we need to incorporate in the decision model.

Two major shortcomings of the payback approach are: 1. It fails to consider any cash flows occurring after the payback period. The second of the two examples presented in the book’s Box 14.2 has the faster payback, however the first example generates the most lifetime cash inflows. In the first payback example, if the projected operating cash inflows had been $100,000 in each of the last four years of the investment’s life, the payback would still be 4 years.

2. It fails to recognise the time value of money, i.e., $1 today does not have the same value as $1 in a year’s time. Payback treats cash flows occurring in different time periods as if they have the same value.

The IRR approach to investment appraisal has the following shortcomings: 1. In some cases, where a project’s cash flows include future cash outflows, two different discount rates can result in an NPV of zero (i.e., two IRRs for one project).

2. In a single project, accept or reject situation, NPV and IRR will give the same indication (i.e., if IRR > required rate of return, NPV will be > 0). When ranking projects, however, NPV and IRR can give conflicting signals, i.e., the highest NPV project will not necessarily be the highest IRR project. If this situation arises, preference should be given to the NPV indication as it is the theoretically preferred technique.

Problem 14.3: Solution Present value = $600 (PV8, 5yr) = $600 X 0.681 = $408.60

Problem 14.4: Solution a) Present value = $500 (PVA10,8yr) = $500 X 5.335 = $2,667.50 b) In this problem, as the PVA table is compiled on the basis that the first cash flow occurs in one year’s time, we need to isolate the first cash flow as it is due to occur today. As this cash flow is occurring today, it is already stated in terms of today’s $, therefore there is no need to discount it.

The present value of this stream of cash flows will be calculated on the following basis: Present value = Today’s cash flow + The present value of the annuity to be received at the end of the next seven years Present value = $500 + $500 (PVA10,7yr) = $500 + ($500 X 4.868) = $500 + $2,434 = $2,934

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Problem 14.116: Solution

In this problem, each cash stream comprises two annuities (cash stream A comprises a $3,000 annuity occurring at the end of year’s 1 and 2 and a cash flow annuity occurring at the end of years 4 - 8). We will find the present value of each cash stream by treating them as comprising two separate annuities.

Cash stream A Present value of cash flows occurring in years 1 and 2 = $3,000 (PVA12,2yr) = $3,000 X 1.690 = $5,070 Finding the present value of the cash flows occurring in years 4 - 8 is slightly challenging and will be calculated in two stages. Firstly, the annuity table will be used as normal to find the present value of the five annual cash flows. However, as the annuity table has been compiled on the basis that the first cash flow occurs in one year’s time, the answer provided will represent the value of the cash flows one year before the first cash flow occurs, i.e., at year 3. Consequently we will then have to discount the amount back over a three year period using the PV table (we use the PV table as, at this point, we will be dealing with a $ value stated at one point in time).

Present value of cash flows occurring in years 4 - 8 = $3,000 (PVA12,5yr) (PV12,3yr) = $3,000 X 3.605 X 0.712 = $7,700.28 We now add together the present value of the cash flows occurring in years 1 and 2 to the present value of the cash flows occurring in years 4 - 8 to find the total present value of cash stream A. Present value cash stream A = $5,070 + $7,700.28 = $12,770.28 Cash stream B There is another method for dealing with an interruption in an annuity. While the present value of cash stream B could be calculated using the same approach as that used for cash stream A we will use the alternative approach in order to illustrate how it can be applied.

In this approach we will initially assume that the $3,500 cash flow is present in the years 1 - 8 (i.e., we will use (PVA12,8yr). From the answer computed through this first step we will then deduct the present value of the two cash flows that are actually missing from the 8 year annuity (years 5 and 6).

PV cash stream B = $3,500 (PVA12,8yr) - $3,500 (PV12,5yr) - $3,500 (PV12,6yr) = $3,500 (4.968) - $3,500 (0.567) - $3,500 (0.507) = $17,388 - 1,984.5 - 1,774.5 = $13,629 From the above, it can be seen that the present value of cash stream A ($12,770.28) is $858.72 less than the present value of cash stream B ($13,629).

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Problem 14.117: Solution a)

Investment A’s accounting rate of return.

ARR =

Average annual profit generated by the investment Average investment

Investment A’s average annual profit generated by the investment = (£6,400 + £4,900 + £3,400 + £1,900 + £2,400)  5 = £3,800 Investment A’s average investment = (£36,000 + £3,000)  2 = £19,500 Investment A’s ARR = £3,800  £19,500 X 100 = 19.5% Investment B’s accounting rate of return.

Investment B’s average annual profit generated by the investment = (£0 + £800 + £8,400 + £10,400 + £5,400)  5 = £5,000 Investment B’s average investment = (£36,000 + £7,000)  2 = £21,500 Investment B’s ARR = £5,000  £21,500 X 100 = 23.3%

b)

Note that the payback method is based on cash flows and not profit.

Investment A’s payback. £36,000 is initially invested.

After 1 year, £14,000 has been recouped.

After 2 years, £26,000 has been recouped (£14,000 + £12,000).

After 3 years, £36,000 has been recouped (£14,000 + £12,000 + £10,000).

The payback is therefore 3 years.

Investment B’s payback. £36,000 is initially invested.

After 1 year, £5,000 has been recouped.

After 2 years, £12,000 has been recouped (£5,000 + £7,000).

After 3 years, £27,000 has been recouped (£5,000 + £7,000 + £15,000), at this time there is still £9,000 of the £36,000 initial investment to be recouped.

As £18,000 is recouped in year 4, we will assume that the final £9,000 needed was recouped half way through the project’s fourth year.

The payback is therefore 3.5 years.

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Calculation of investment A’s and investment B’s NPV

c)

In the following table “year 0” refers to cash flows occurring today Investment A

Year

PV Discount Net cash flows factor @ 12% (£)

0 1 1 0.893 2 0.797 3 0.712 4 0.636 5 0.567 Net present value

- 36,000 14,000 12,000 10,000 8,000 11,000*

Investment B

Present value of cash flows (£) - 36,000 12,502 9,564 7,120 5,088 6,237 £4,511

Net cash flows (£)

Present value of cash flows (£)

- 36,000 5,000 7,000 15,000 18,000 20,000*

- 36,000 4,465 5,579 10,680 11,448 11,340 £7,512

*: Included in these cash flows is the inflow relating to the estimated salvage of the investment.

Conclusion: Investment B is preferable as it has the higher NPV. d) The following table summarises the findings made when analysing the two investments using ARR, payback and net present value. As commentaries on investment appraisal techniques concur that NPV should be preferred to ARR and payback, investment B should be selected as the preferred investment. It provides the higher NPV.

Accounting rate of return Payback Net present value

Investment A

Investment B

19.5% 3 year £4,511

23.3% 3.5 years £7,512

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Preferred investment B A B

Problem 14.7: Solution a) The IRR is that discount rate that causes NPV to be equal to zero.

0 = -$200,000 + ($50,000 (PVAIRR,5yr). $200,000  50,000 = PVAIRR,5yr.

4 = PVAIRR,5yr.

Looking along the 5 year row of the “PVA” table, we find that a factor of “4” lies between the discount rates of 7% and 8%, therefore the IRR is between 7% and 8%. b) The hotel should not invest in the laundry equipment as the investment’s IRR is below its 10% cost of capital.

Problem 14.8: Solution a) If 12% results in a positive discount rate, the IRR will be above 12%. If a higher discount rate is tried as part of the trial and error approach of seeking the IRR, the lower discounting factors associated with a higher discount rate (if you’re not sure of this, check the PV and PVA tables and see) will cause the present values of the project’s future cash inflows to have a lower present value.

This, in turn, will reduce the NPV. b) In a single project, accept / reject, situation the NPV and the IRR will not conflict, i.e., a positive NPV signifies that the IRR will be greater than the required rate of return. When ranking investment projects, such as in the choice of the Italian restaurant or the British pub, the highest NPV project will not necessarily be the highest IRR project. In this situation, the Italian restaurant should be selected as it has the higher NPV. Commentaries on investment appraisal techniques concur that NPV should be preferred over the IRR, ARR and payback investment appraisal techniques when ranking more than one investment proposal.

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Problem 14.120: Solution

It would appear that the General Managers at the Birmingham and Manchester hotels have not acted in the best interests of the company. The Birmingham hotel has earned extra profits of £84,000 (£144,000 - £60,000) by investing in assets that cost £900,000 (£2,400,000 - £1,500,000).

This represents a return of 9.3%, i.e., the hotel has invested in assets that provide a return that is less than the company’s cost of capital. The Manchester hotel has experienced a £60,000 reduction in profits by selling off £400,000 in assets. This signifies that the assets sold had been earning 15%, i.e., more than the company’s cost of capital.

It makes no sense for a company to sell assets that are providing a return of 15% and, at the same time, to buy assets that will provide a return of 9.3%. In effect, what has happened is both hotels have used their existing return on capital employed as the threshold for deciding whether to invest in, or sell, an asset. In 20X1, if the Birmingham hotel could find an investment opportunity that provides a return greater than 4%, then it would be able to increase its average return on capital employed. Likewise, in 20X1 if the Manchester hotel could sell any of its assets that are providing a return less than 18%, it also would be able to increase its average return on capital employed.

This problem highlights a particular danger of using the accounting rate of return as an investment appraisal technique. Although a hotel company’s corporate office might use NPV as its primary investment appraisal technique, where a general manager is held accountable for a hotel’s ROI, there is a significant chance that the G.M. will only support investment projects that provide a return above the hotel’s existing return on investment. As many investment projects are initiated at the hotel level, the G.M. is in a powerful position to decide which proposals should be submitted to head office for consideration. Consider the Manchester hotel. In 20X1, if the G.M.’s performance is appraised through ROI, he may be reluctant to pass a 16% accounting rate of return project to head office, even if the project has a positive NPV. This is because acceptance of the project will reduce his hotel’s ROI.

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Problem 14.121: Solution a)

Payback

Net initial investment Annual cash saving

=

Note that investment in assets comprises the investment in any fixed asset associated with capital expenditure and also any necessary investment in working capital (current assets - current liabilities). In this case, the investment proposed will result in a decreased investment in stock held (i.e., a portion of funds locked up in assets will be liquidated).

Investment: Computer hardware Reduction in stock held Net investment

$40,000 (10,000) $30,000

Net annual cash saving: Wages saved License fee Net annual saving Payback =

$30,000 $10,000

$15,000 (5,000) $10,000 = 3 years

b) NPV: In order to calculate the extra taxation cash outflow, we need to determine annual depreciation (depreciation is a tax deductible expense). In the calculations below, it is assumed that the license fee is paid at the end of each year of the project’s 5 year life.

Changed annual tax cashflow: Savings in wages Increased depreciation License fee Increased taxable profit Tax @ 40%

$ 15,000 (8,000) (5,000) 2,000 800

NPV: PV of annual tax flow: 800 (PVA 10,5yr) = 800 X 3.791 =

$ PV (3,033)

PV of annual license fee: 5,000 (PVA 10,5yr) = 5,000 X 3.791 =

(18,955)

PV of wage savings: 15,000 (PVA 10,5yr) = 15,000 X 3.791 = PV of net initial investment (40,000 - 10,000) Net Present Value

56,865

Conclusion: The investment is financially justified as the NPV is positive.

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(30,000) $ 4,877

Problem 14.122: Solution a)

Payback Alternative 1 = 4 and a half years Payback Alternative 2 = 3 years Based on the payback method, alternative 2 is preferred as it provides the fastest payback.

b) Year Initial investment 1 2 3 4 5 6 Total

Alternative 1 Cash flows

Alternative 2 Cash flows

$40,000

$40,000

2,000 8,000 10,000 12,000 16,000 24,000

16,000 13,000 11,000 8,000 6,000 4,000

10% discount factor

.909 .826 .751 .683 .621 .564

PV Alternative 1

PV Alternative 2

($40,000)

($40,000)

1,818 6,608 7,510 8,196 9,936 13,536 $7,604

14,544 10,738 8,261 5,464 3,726 2,256 $4,989

c) Alternative 1 should be taken as it provides the higher net present value. Net present value is preferred to payback when selecting investment projects.

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Problem 14.12: Solution (The Stellar Views’ Chapel Case Study) a) In the following calculations, the contribution levels referred to in the case are assumed to represent a reasonable indication of cash flows. $ Cash flows generated by local market ceremonies Annual cash flow received from ceremonies 115 X ($550 - $100) Annual cash flow received from receptions 115 X 0.2 X $5,000 Annual cash flow received from accommodation 115 X 15 X $100

51,750 115,000 172,500

Cash flows generated by Japanese market ceremonies Annual cash flow received from ceremonies 80 X ($550 - $100) Annual cash flow received from receptions 80 X 0.9 X $2,000 Annual cash flow received from accommodation 80 X 0.9 X $1,000

36,000 144,000 72,000

Less: Annual fixed costs

10,000

Total annual cash flows generated by chapel weddings

$581,250

Present value of Chapel investment = -Initial Investment + Present value of future cash inflows.

-$1,000,000 + $581,250 (PVA 14,5yr) = -$1,000,000 + $581,250 (3.433) = -$1,000,000 + $1,995,431.2 = $995,431.2 As the NPV is positive, the chapel project should be supported. b) The chapel investment is risky in the sense that it is taking the hotel outside its core areas of expertise, i.e., conventional activities associated with hotel management. The hotel has no previous experience in wedding ceremony marketing and management. As the activity is completely new, the estimated demand figures provided by the consulting company are bound to have involved a high degree of subjectivity (i.e., a degree of “guesstimation”). The case provides no information on whether in-house staff will maintain the facility or whether maintenance of the chapel will be outsourced. Again, the hotel’s lack of experience with respect to this activity raises the risk profile of the investment.

In light of the relatively high risk associated with the investment, it would be appropriate for Stellar Views to use a discount rate higher than its cost of capital to calculate the NPV. c) Stellar Views should seek quotations from building companies that specialise in the particular type of building work required in a chapel (e.g., polished timbered seating, etc.). For a large building contract such as this, most hotels require at least three tenders from prospective builders.

The issue of gaining tenders was actually noted to be a problem in the hotel that provided the basic information for the case. The Financial Controller indicated that the hotel had sought quotes on so many jobs that had not been pursued that building companies were becoming reluctant to take the time necessary to prepare a well-considered quote.

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CHAPTER 15 Other Managerial Finance Issues Problem 15.1: Solution Three reasons accounting for EPS being a deficient financial goal for companies are: • The issue of EPS timing (early high EPS returns are preferable to late high EPS returns).

• The failure of EPS to capture cash flows. A period of high EPS may be a period of low company cash flow.

• EPS fails to recognize risk. A company may take on a risky project that increases its EPS, however the resulting increased risk profile for the company may well cause a decline it its share price.

Problem 15.2: Solution a. The residual dividend theory holds that a company should use all its available long term capital investing in positive net present value (NPV) projects, until no further positive NPV project opportunities remain. Following this line of thinking, once a company has invested in all available positive NPV projects, any remaining excess long term capital (ie, residual funds) should be distributed as a dividend to its shareholders. Applying this approach will result in considerable volatility in the dividends paid to shareholders. The information effect dividend theory holds that a decision to pay dividends to shareholders carries a positive impact on share price.

This is because the decision to pay a dividend can be seen as a signal that flags a company’s intent to pay higher dividends in years to come. Conversely, a decrease in dividends is believed to provide a negative signal, as it suggests that dividends might decrease in years to come. This thinking results in many companies pursuing a policy of only raising dividends levels if they are confident that the increased dividend level can be maintained in years to come. b. The findings of empirical research suggest that in practice companies tend to adhere to the information effect theory when setting their dividend policy c. The clientele effect tell us that whatever policy a company is adopting with respect to paying dividends, it should continue to apply this policy. This is because investors who have bought shares in a company must have been attracted to it, based on the dividend payment policy it is pursuing.

Problem 15.3: Solution Triple bottom line reporting focuses on:

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• • •

financial performance reporting, social performance reporting, and environmental performance reporting.

Problem 15.4: Solution Relationship number 1 2 3 4 5

Principal Company’s shareholders Food & Beverage Manager Patient Share investor Voters in electorate

Agent Board of directors Restaurant Manager Doctor Stock broker Member of Parliament

Problem 15.5: Solution BlissfullEscape Share value = D1 (PVIF10%, 1yr) + D2 (PVIF10%, 2yr) + Share sale price (PVIF10%, 3yr) = $2 (PVIF10%, 1yr) + $2 (PVIF10%, 2yr) + $25 (PVIF10%, 3yr) = $2 (0.905) + $2 (0.820) + $25 (0.744) = $1.81 + $1.64 + $18.60 = $22.05 As you own 100 shares, today’s total investment value = $2,205

Problem 15.6: Solution Share value = $6 ÷ 0.12 = $50.

Problem 15.7: Solution a) Project A Hotel operator incentive fee = .03 X $250,000 = $7,500 Hotel operator base fee = .10 X $100,000 = $10,000 Total operator fee = $7,500 + $10,000 = $17,500 Project B Hotel operator incentive fee = .03 X $400,000 = $12,000 Hotel operator base fee = .10 X $160,000 = $16,000 Total operator fee = $12,000 + $16,000 = $28,000 The hotel operator would prefer project B as it provides $10,500 more in fees.

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b) Project A Annual ROI = $100,000 ÷ $500,000 X 100 = 20% Project B Annual ROI = $160,000 ÷ $2,000,000 X 100 = 8% Based on ROI analysis, the owner would prefer project A as it provides the higher ROI.

Problem 15.8: Solution While 25% appears to represent a good share price return over two years, we would need to examine how similar companies have performed in the same time period. We would not say it’s a good return if Utopia’s competitors have achieved a 40% return over the same time period.

From the data provided, we can determine that Utopia has a price earnings ratio of 20 (€40 ÷ 2). This is high compared to Utopia’s competitors. A high price earnings ratio can be due to: • The investing community expecting an increase in Utopia’s EPS in the future. This would result in increased demand for the share which, in turn, would increase the share price (past earnings are only of interest to the investor to the extent that they provide an indication of expected future earnings), • The investing community perceiving relatively low risk in the Utopia company. As investors are averse to risk, reduced levels of risk will result in increasing demand for the share which, in turn, results in an increased share price.

Problem 15.9: Solution a. As Hotel A has a DOL of 2, if its room nights sold doubled (increase of 100%) we would expect its EBIT to increase by twice as much, ie by 200%. b. Hotel B has the higher risk with respect to its operating cost structure as it has the higher DOL. c. To reduce its DOL, management in hotel B will need to replace some of its fixed operating costs with variable costs. Possible options include, if its has a restaurant with a high amount of associated fixed costs it could lease out the restaurant to a specialist restaurateur company. If doing this to reduce DOL it would need to ensure that the responsibility of paying fixed costs associated with the restaurant are transferred to the restaurateur. The hotel could also to replace any equipment (fixed cost intensive) with labour hours provided by casual staff (variable costs).

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Problem 15.10: Solution a) Swanky Hotel DOL = 45,000 (160 – 15) ÷ 45,000 (160 – 15) – 540,000 = 6,525,000 ÷ 6,525,000 – 540,000 = 6,525,000 ÷ 5,985,000 = 1.09 DFL = 5,985,000 ÷ 5,985,000 – 280,000 = 5,985,000 ÷ 5,705,000 = 1.05 DTL = 1.09 X 1.05 = 1.1445 Swish Hotel DOL = 40,000 (155 – 10) ÷ 40,000 (155 – 10) – 1,040,000 = 5,800,000 ÷ 5,800,000 – 1,040,000 = 5,800,000 ÷ 4,670,000 = 1.24 DFL = 4,670,000 ÷ 4,670,000 – 400,000 = 4,670,000 ÷ 4,270,000 = 1.094 DTL = 1.24 X 1.094 = 1.36 b) Both the DOL and DFL indices in the Swish Hotel are greater. Combined, these signify that DTL is also greater in the Swish Hotel. At all levels of this leverage analysis, the Swish Hotel has greater risk.

Problem 15.11: Solution a.

DTL = DOL X DFL. The two hotels have the same DTL index of 10. b.

It is generally held that it is easier to retire debt that it is to substitute variable operating costs for fixed operating costs. As the Tiger hotel has a relatively low DFL of 1.25 and the Lion hotel has a comparatively high DFL at 4, it appears it will be easier for the Lion hotel to take steps to halve its DTL. Further, the Lion hotel can achieve the target of reducing DTL by 50% by reducing its DFL from 4 to 2. Even if the Tiger hotel removed all of its debt and reduced its DFL from 1.25 to 1, it still would not have achieved the 50% reduction in DTL that is sought.

Problem 15.12: Solution a) Financing option 1 (debt) £

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Financing option 2 (equity) £

Projected return on assets: 20% of $3.5 m.

Less interest on debt a Profit before Tax Less 40% Tax Profit after Tax

700,000 98,000 602,000 240,800 361,200

700,000 63,000 637,000 254,800 382,200

% Return on owners investment b

17.2%

14.7%

a: For financing option 1: 7% of $1,400,000; for financing option 2: 7% of $900,000. b: For financing option 1: $361,200  $2,100,000 X 100; for financing option 2: $382,200  $2,600,000 X 100. b) FrozenIce should take the debt funding option as it results in a higher return on equity (17.2%) that the equity funding option (14.7%).

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CHAPTER 16 Revenue Management Problem 16.1 Solution A low variable cost for a product or service signifies a high price setting discretionary range. A high price setting discretionary range signifies there is considerable scope to modify price in light of information provided by a revenue management system.

Problem 16.2 Solution Five business characteristics making an industry conducive to the application of revenue management are: • Fixed capacity • Ability to segment markets • Perishable inventory • Product sold in advance • Fluctuating demand • Low variable costs

Problem 16.3 Solution Three approaches that a hotel can take to gauge it’s revenue management performance are: a) Internal analysis of lost revenue. b) Analysing Revpar performance relative to other hotels operating within the same competitive set. c) Gauging Revpar performance by purchasing market data concerning hotels with a similar profile.

Problem 16.4 Solution a) Market occupancy % = Market room nights sold ÷ Room nights available X 100 = 13,590 ÷ (640 X 30) X 100 = 70.78% Market ADR

= Market room nights sold revenue ÷ Room nights sold = $1,971,300 ÷ 13,590 = $145.05

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Market Revpar

= Market room nights sold revenue ÷ Room nights available = $1,971,300 ÷ (640 X 30) = $102.67

Classic Hotel’s occupancy = 3,840 ÷ (160 X 30) = 80% Classic Hotel’s occupancy penetration = 80% ÷ 70.78% = 1.13 Classic Hotel’s ADR = $460,800 ÷ 3,840 = $120 Classic Hotel’s ADR penetration = $120 ÷ 145.05 = 0.827 Classic Hotel’s Revpar = $460,800 ÷ (160 X 30) = $96 Classic Hotel’s Revpar penetration = $96 ÷ 102.67 = 0.935 b) As the Revpar penetration index is well below 1, it does not appear that Classic Hotel’s revenue management function is performing well compared to its competitors. c) Classic Hotel’s occupancy penetration is well above 1 (1.13), but its ADR penetration is well below 1 (0.827). This suggests there will be more scope for minimising the loss of revenue resulting from selling rooms at prices that are below the price that they could have sold for than there is scope to reduce losses resulting from rooms not being sold.

Problem 16.5 Solution a) Regal Hotel’s Revpar = .68 X $140 = $95.2 Market Revpar = .72 X $124 = $89.26 Regal Hotel’s occupancy penetration = 68% ÷ 72% = 0.94 Regal Hotel’s ADR penetration = $140 ÷ 124 = 1.13 Regal Hotel’s Revpar penetration = $95.2 ÷ 89.26 = 1.07 b) As the Revpar penetration index is well below 1, it appears that the Regal Hotel’s revenue management function is performing well relative to its competitors. c) Regal Hotel’s occupancy penetration is well below 1 (0.94), but its ADR penetration is well above 1 (1.13). This suggests there may be more scope for minimising the loss of revenue resulting from rooms not being sold than selling rooms at prices that are below the price that they could have sold for. Regal Hotel’s management should be careful, however as it currently appears to have a strong Revpar, and a drop in room rates in an attempt to achieve higher occupancy could result in a lower Revpar as a result of a lower ADR.

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Problem 16.6 Solution Incremental daily room night revenue if no room rate discounting is introduced: (32 X €120) + (20 X €120) = €3,840+ €2,400 = €6,240 If 30% discount is introduced for the business traveller market: Room sales to the business traveller market segment will increase by 75% (2.5 X 30%) as the price elasticity of demand is 2.5. This signifies that projected rooms purchased by the business traveller market will increase from 32 to 56.

Therefore, incremental daily room night revenue if the 30% business traveller market room rate discount is introduced = (56 X €84) + (20 X €120) = €4,704 + €2,400 = €7,104 As the incremental nightly revenue increases by €864 (€7,104 - €6,240) if the 30% discount is introduced for the business traveller market, the Revenue Manager’s recommendation is justified.

Problem 16.7 Solution Incremental revenue from selling a ‘three room nights at $120 per night’ package versus a stand-alone $250 room night = (3 X $120) - $250 = $110 Incremental profit from selling a ‘three room nights at $120 per night’ package versus a stand-alone $250 room night = $110 - (2 X $25) = $60 Based on this analysis, the LeafyLodge should take the ‘three room nights at $120 per night’ package option as it will generate $60 more in profit.

Problem 16.8 Solution ON THE EARLIER DATE Revenue without the group booking: 360 rooms X $120 = $43,200 Revenue with the group booking: Revenue from non-group bookings = 320 rooms X $120 = $38,400 Revenue from group booking = 80 rooms X $75 = $6,000 Total revenue for the night with the group booking = $44,400 Group booking incremental impact on hotel revenue = $1,200 ($44,400 - $43,200) ON THE LATER DATE Revenue without the group booking (70% occupancy): 280 rooms X $120 = $33,600

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Revenue with the group booking: Revenue from non-group bookings = 280 rooms X $120 = $33,600 Revenue from group booking = 80 rooms X $70 = $5,600 Total revenue for the night with the group booking = $39,200 Group booking incremental impact on hotel revenue = $5,600 ($39,200 - $33,600) Conclusion: As the incremental impact on hotel revenue is $4,400 more ($5,600 - $1,200) if the later booking is made, the hotel would be justified in offering the tour operator the $5 room rate discount to encourage him to move the booking to the 70% occupancy period.

ALTERNATIVE (QUICK) APPROACH TO DETERMINING THE ANSWER: Incremental revenue if group booking is made on the earlier date: Additional revenue from group bookings: ($75 X 80) = $6,000 Lost revenue from displaced premium room rate guests = ($120 X 40) = $4,800 Net incremental revenue impact from early group booking = $1,200 ($6,000 - $4,800) The incremental revenue if the later booking is made is $5,600 ($70 X 80) which is $4,400 more than the incremental revenue resulting if the early booking is made ($5,600 - $1,200).

Problem 16.9 Solution Incremental impact on revenue if the booking is made on the earlier date: Additional revenue from group bookings: (Y300 X 70) = $21,000 Lost revenue from displaced premium room rate guests = (Y450 X 30) = Y13,500 Net incremental revenue impact from early group booking = Y7,500 (Y21,000 – Y13,500).

So long as the net incremental revenue impact resulting from the group booking being made later exceeds Y7,500, the later group booking will be preferable. In analysing the later group booking situation, no displacement of premium rate paying guests needs to be quantified, as the group booking will not bring the hotel up to full occupancy (ie no premium rate paying guest displacement will occur).

Room rate for the later night that will leave the revenue manager indifferent between the group booking made earlier or later = Y7,500 ÷ 70 = Y107.14.

From a short-term revenue maximization perspective, so long as the discounted room rate charged to the tour operator if making the block booking during the 70% occupancy period is greater than Y107.14, greater net incremental revenue will result if the booking is made during the low occupancy period.

Problem 16.10 Solution Total room revenue if the 30 room group booking is made:

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Revenue from non-group bookings: 80 rooms X ¥100,000 = ¥8,000,000 Revenue from group booking: 30 rooms X ¥70,000 = ¥2,100,000 Total revenue for the night = ¥10,100,000 (¥8,000,000 + ¥2,100,000).

Total room revenue if the 15 room discounted group rate booking is made: Revenue from non-group bookings: 88 rooms X ¥100,000 = ¥8,800,000 Revenue from group booking: 22 rooms X ¥60,000 = ¥1,320,000 Total revenue for the night = ¥10,120,000 (¥8,800,000 + ¥1,320,000).

This analysis demonstrates that ¥20,000 more revenue results if the cheaper 22 room group booking is made relative to the 30 room group booking. The higher net incremental revenue resulting from the 22 room group booking financially justifies PowderSkis’ Revenue Manager’s decision to offer the ¥10,000 per room rate discount as an incentive for the tour operator to reduce the number of rooms booked. It should be noted that the net revenue impact is only small, however and the Revenue Manager might like to consider reducing the amount of the room rate discount offered.

Problem 16.11 Solution a) Total nightly room revenue if the 50 room group booking is made: Revenue from non-group bookings: 150 rooms X $150 = $22,500 Revenue from group booking: 50 rooms X $100 = $5,000 Total nightly revenue = $27,500 ($22,500 + $5,000).

Total nightly room revenue if the 40 room discounted group rate booking is made: Revenue from non-group bookings: 160 rooms X $150 = $24,000 Revenue from group booking: 40 rooms X $95 = $3,800 Total revenue for the night = $27,800 ($24,000 + $3,800).

Total nightly room revenue if the 25 room discounted group rate booking is made: Revenue from non-group bookings: 175 rooms X $150 = $26,250 Revenue from group booking: 25 rooms X $90 = $2,250 Total revenue for the night = $28,500 ($26,250 + $2,250).

Offering either of the room rate discounts is justifiable, as both result in greater total revenue compared to if the 50 room group booking is made. b) The analysis conducted for part (a) reveals that $700 more nightly revenue results if the 25 room discounted to $90 option is taken.

Problem 16.12 Solution a)

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Total room revenue on the early night if 50 room group booking is not made: Revenue from non-group bookings: 225 rooms X R$250 = R$56,250 Total room revenue if the 50 room group booking is made: Revenue from non-group bookings: 200 rooms X R$250 = R$50,000 Revenue from group booking: 50 rooms X R$200 = R$10,000 Total revenue = R$60,000 (R$50,000 + R$10,000).

This signifies that net incremental revenue is R$3,750 (R$60,000 – RS56,250) with this option.

Incremental room revenue if the deferred group booking is made: Additional revenue from group bookings: 50 rooms X R$170 = R$8,500 This signifies that net incremental revenue is R$8,500 with this option.

Total nightly room revenue if the 25 room discounted group rate booking is made: Revenue from non-group bookings: 225 rooms X R$250 = R$56,250 Revenue from group booking: 25 rooms X R$190 = $4,750 Total revenue for the night = R$61,000 (R$56,250 + R$4,750).

This signifies that net incremental revenue is R$4,750 (R$61,000 – RS56,250) with this option.

This analysis indicates that both of the room rate discounting options are justifiable as they result in higher levels of net incremental revenue. b) The analysis conducted for part (a) reveals that the deferred group booking option is preferred, as this results in the highest net incremental revenue (R$8,500).

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