Welsh hotel: Cost-volume-profit analysis and uncertainty

Phillips, Paul A
International Journal of Contemporary Hospitality Management; 1994; 6, 3; ABI/INFORM Global
pg. 31

WELSH HOTEL: (OST-VOLUME·PROFIT ANALYSIS AND UNCERTAINTY lED

The basic cost-volume-profit analysis is widely and profit. This makes it a useful managerial tool in a
used for short-term planning, but may not be variety of situations, including performing break-even
analysis, evaluating pricing strategy, determining special
adequate unless uncertainty is included. order/booking acceptance or choice of sales mix. The
basic equation can be written as:
NP = Px - (a+bx)
where:

Welsh Hotel: NP = Net profit

P
x
=Selling price per unit
= Units sold

Cost-Volume- a
b
= Fixed costs
=Variable costs per unit.
While the model has several shortcomings owing to its

Profit Analysis inherent assumptions, which are summarized in Table I, it

also assumes that all variable costs are known with
certainty. This latter assumption seems peculiar as
managers are not making decisions within a vacuum but in

and Uncertainty an environment that is subject to much turbulence. Thus

the overall merits of the model have to be questioned.

The inclusion of uncertainty within the basic CVP model

is not a novel idea, as several writers[1-4] have written
about the topic. (The term "uncertainty" will be used in a
non-mathematical sense as, in practice, the words "risk"
and "uncertainty" are often used synonymously.)
Jaedicke and Robichek's[2] influential paper specified
International Journal of Contemporary Hospitality Management, how the normal probability distribution can be used to
Vol. 6 No.3. 1994. !Jp. 31-36 <[ MCB llmvennty Press Llmltf'd, og;:'9-n119
show how one variable (price) affects another variable
(variable expense), with both being normally distributed,
and subject to a known uncertainty in advance. However,
Introdudion there is scant use of probability estimates in decision
Hotels tend to have a high level of fixed costs owing to the making. This has been borne out empirically by Drury et
levels of investment required. This should result in above al.[5, p. 331], who reported, after a study of 300 UK firms,
normal profits in good times, as variable costs remaining that:
will form a smaller proportion of additional revenue.
• 49 per cent never used statistical probability
However, while high profits can be achieved above the
analysis for decision making;
break·even point, high losses will result if revenue is
significantly reduced. • 24 per cent rarely used statistical probability
analysis;
Thus much attention is given to the traditional CVP
model (which ignores uncertainty), as failure to cover
fixed costs in the long term can result in the demise of any Table I. CVP Assumptions
organization. Is the basic CVP model adequate, bearing in
mind that certainty does not always exist during the • Semi·variable costs can be separated into their fixed
decision·making process? This article examines the basic and variable elements
CVP model and describes how to include uncertainty • Fixed costs will remain unchanged, and variable costs
during the decision· making process. Prior to any will vary proportionately with sales volume
discussion about uncertainty, a review of traditional CVP • Single product/service, or constant sales mix
analysis will be performed.
• Sales vulume is the unly factor that affects custs and
revenues within the relevant range
• Revenue items vary in direct proportion with volume
Traditional CVP Analysis • No changes in stock levels or profits are determined on a
CVP analysis is an important technique which is widely marginal costing basis
used for short· term planning purposes. It seeks to • Efficiency levels remain unchanged
examine the relationship between costs, volume, sales,

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 INTERNATIONAL JOURNAL OF CONTEMPORARY HOSPITALITY MANAGEMENT 6,3

• 20 per cent sometimes used statistical probability The Z-value of 1.5 is shown diagrammatically in Figure 1,
analysis; and since the total area under the normal distribution curve
• 7 per cent often used statistical probability analysis. is equal to one, the shaded portion is equal to the probability
of obtaining a value from the original distribution more
While the above study suggests a certain amount of than 1.5a from the mean. To convert the Z-value of 1.5 into
reluctance to use statistical probability estimates, the the actual probability estimate, it is necessary to use normal
analysis is not difficult to apply. It is the purpose of this distribution tables. The probability estimate can be derived
article to show how to apply this methodology to the from Drury's Appendix q5] by moving down the left-hand
basic CVP model. Moreover, as most hotels have long- column to "1.5", and moving horizontally to the column
term objectives in terms of return on capital employed headed "0.00". The figure of 0.0668 is equal to the proba-
(ROCE), emphasis will be placed on sales volume (e.g. bility of obtaining a value from the original distribution
rooms sold) and "bottom line" variables. For the purpose more than 1.5a from the mean. Conversely, the probability
of this example, sales price, variable, and fixed costs will of obtaining a value less than 1.5a from the mean is 1-
be assumed to be certain, while volume is assumed to be 0.0668, i.e. 0.9332. Finally, Figure 2 reveals that
uncertain with a normal distribution. This means that the approximately, 99.7 per cent, 95.4 per cent and 68.3 per cent
probability distribution for profit can also be assumed to of total observations lie within 3, 2 and 1 standard
be normal. deviations respectively.

11Ie Normal Distribution The Welsh Hotel

Table II shows the 1992 income statement for a
The normal distribution is bell-shaped and symmetrical
hypothetical 125-room hotel in Wales, the data being
with equal mean and median. To confirm whether a
distribution is normal it is usually necessary to ascertain
the mean (;.1) and the standard deviation (~. (It ought to be
pointed out at this juncture that, even if the precise
Figure 1. Z-value of l.5 Shown Diagrammatically
distribution is not known, the probability can still be
determined. Wanhill[6] has shown how the Camp-Meidell
inequality can be used to establish the probability of an
outcome by using the equation 114 x 2. However, the
equation suffers if the standard deviation is less than one,
and interpolation needs to be performed.) If there is no
dispersion, i.e. all observed values are the same, the mean,
in this instance, would then be the same as the observed
values. Moreover, as dispersions can deviate either side of
the mean, it is usually necessary to quantify the amount.
To compare two distributions it is necessary to translate
the observations of both distributions into Z-values.
Basically, Z-values convert each distribution into a
standard normal form with a mean of zero, and a
standard deviation of one. The formula used being:
Figure 2. Observations to Be Found under the Normal
X-fl Distribution Curve
Z= - -
a
where X = Value of variable
fl =Mean value
a = Standard deviation.
For example, if a variable, X, that has a normal
distribution with a fl of 200, and a a of 20, has an actual
observation of 230, the Z-value, when calculated, can be
I
used to establish the probability of this occurrence. Using 95.4% I
the above equation, Z can be calculated as follows:
99.7% I

30' 1(1 Mean 1a 30'

Z = 230-200
1.5
20

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 WELSH HOTEL: COST-VOLUME-PROFIT ANALYSIS AND UNCERTAINTY

Table II. 1992 Welsh Holel Income Statement

Cost of Payroll and Total dept Dept

Sales sales expenses expenses profit
Department (£) (£) (£) (£) (£)

Rooms 881,5UO 282,125 282,125 599,375

Food and
beverage 1,025,375 345,375 351,125 696,500 321\,875
Minor operating depts 95,584 24,827 11,507 36,334 59,250
2,002,459 370,202 644,757 1,014,959 987,500

Less: undistributed operation expenses

Admin. and general 109,285

Marketing 55,159
Energy 77,325
Property operation 57,T16 515,500
Fixed charges 215,995
Net income before tax 172,000

derived from the Welsh section of the 1992 Horwath for determining the proportions of fixed and variable
Consulting UK hotel report[7], and prepared using the expenses. Such methods include: high-low, least squares,
American Uniform System of Accounts for Hotels as a and regression analysis[S, pp. 31-5].
basis. The Welsh hotel's occupancy percentage for 1992
was 57 per cent, which equates to 26,006 rooms being sold It should be noted that the Welsh hotel is a high fixed cost
for the period. To perform CVP analysis from an income operation. If we consider sales volume, variable costs
statement it is necessary to prepare a contribution income amount to 24.9 per cent and fixed costs 51.5 per cent. With
statement[S, pp. 92-113]. regards to total cost, variable cost represents 32.6 per cent,
and fixed costs 67.4 per cent. This high percentage of fixed
Contribution is equal to sales minus variable costs. In costs results in a high degree of profit instability for the
order to determine variable costs it is necessary to Welsh hotel.
separate total costs into their fixed and variable cost
components. Obviously, cost of sales, direct wages, and Now that we have separated fixed from variable costs, it
direct expenses are intimately related to sales volume, is possible to calculate the contribution per room sold:
and are assumed to be variable in nature. However, costs Using: Contribution
such as managerial salaries and departmental expenses No. of rooms sold
(including energy, telephone, training and marketing
costs) will be neither wholly fixed nor variable, and are _ £1 ,503,306
£57.S1.
known as semi-variable costs. Powers[9] stated that, if an - 26,006
expense is to be considered semi-variable, it must pass Once this has been calculated the break-even point can be
the following three tests: established. This can be seen graphically in Figure 3, and
(1) It must have a base level of expense. Regardless of calculated:
sales volume this expense level will occur. Using: Fixed costs
(2) Beyond this base level, the level of expenses will Contribution per room
increase with an increase in sales. _ £1,031,306
17,S40 rooms sold.
(3) The level of increase with changes in sales volume - £57.81
is less than that for variable expense in the same Having previously stated that the number of rooms sold
problem situation. follow a normal distribution, the general manager (GM),
Table III shows the contribution income statement, which in collaboration with his head of department (HOD) for
for illustrative purposes was prepared after separating the rooms division has to decide on a figure for the
semi-variable costs into their fixed and variable elements number of rooms sold (the mean), so that there is a 50/50
by apportioning them SO/20 respectively. Naturally, it is chance of the actual number of rooms sold being above or
up to the individual to obtain the actual split for their below this mean figure. Suppose that, after the preparation
operation, by making use of one of the various techniques of the annual budget, the figure of 26,006 rooms is chosen.

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 Ell INTERNATIONAL JOURNAL OF CONTEMPORARY HOSPITALITY MANAGEMENT 6,3

Table III. 1992 WeM Hotel Contribution Income Statement

Variable
Sales cost Contribution
Department (£) (%) (£) (%) (£) (%)

Rooms 881,500 100 56,425 6.4 825,075 93.6

Food and beverage 1,025,375 100 415,600 40.5 609,775 59.5
MOD 95,584 100 27,128 28.4 68,456 71.6

2,002,459 100 499,153 24.9 1,503,306 75.1

Less:

Undistributed operation expenses 515,500

80 per cent of departmental expenses 515,806 1,031,306 51.5

Net income before tax 472,000 23.6

In this example, it happens to be the number of rooms sold The break-even point therefore lies -2.720" from the
the previous year (again, it is up to the reader to determine mean of our standard normal distribution. As the
the appropriate figure). Once the mean has been distribution is symmetrical, the areas for the
established the standard deviation can be considered. negative and positive values are the same. The
probability estimate can be derived from Drury's
To establish the standard deviation in terms of rooms sold it Appendix[5], by moving down the left-hand column
is necessary to apply more probability theory. Based on past to 2.7, and then moving to the column headed 0.02.
experience, the GM and his HOD for rooms decide that there The figure of 0.00326 represents the probability of
is a 50/50 chance that the final number of rooms sold will not achieving the break-even point. In other words,
vary by 2,000 either side of the mean (see Figure 4). Since the probability of "at least breaking even" is
approximately 50 per cent of the area under a normally (1 - 0.00326) 0.997, i.e. 99.7 per cent.
distributed curve lies within +/- 0.670" from the mean (see (2) The probability of at least making £500K.
Figure 2), then 10" must be equal to 3,000 rooms. Now that
we have satisfied the requirements for a normal distribution, The number of rooms that need to be sold to earn
we are in a position to establish the probabilities of different a contribution that would produce a net profit of
profit levels. Suppose that the GM of the Welsh hotel in £500Kis:
collaboration with his assistant manager wants to ascertain . Fixed costs + Profit requirement
the probability of breaking even and making £500,000, Usmg: --::------:-,-----,------~
Contribution per room
£600,000, or £700,000 next year.
(1) The probability of at least breaking even. £1,031,306 + £500,000 = 26489
£57.81 '
· Z I 17,840 - 26,006
Usmg: -va ue = -2.72
3,000 Figure 4. Normal Distribution for Welsh Hotel Rooms Sold
Figure 3. Break-even Chart of the Welsh Hotel
3.000,-------------------,

2,500 -

2,000

Soo 25.14% 25.'4%

o 0.!<"----;:-s,-::00=0---:,:::c
0 ,-::00=0-----:c'5::-:,QOO==--2==0-=,00==0,-----:2-=-5,0==0-=-0--:::30:-:,0::-:00:--:3:-:-:'5,000 -0.67 Mean ·0.67

Rooms sold Values observed

24.006 26.006 28.006
- Fixed expenses _ Total expenses -+---- Sales rooms rooms rooms

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..... -

WELSH HOTEL: COST-VOLUME-PROFIT ANALYSIS AND UNCERTAINTY

(3) Sales mix: Hotels like most other businesses suffer

Z-vaIue -- 26,489 - 26,006 -
- 0.161 0:
from seasonality, and the profit/volume (PfV) ratio
3,000 '
would fluctuate from one sales mix to another.
which is equal to a probability of 0.4364, i.e. 43.6 Hence the more varied the sales mix, the greater
per cent. the problem for the manager.
(3) The probability of at least making £600K. (4) Multi-product: Perhaps one of the most critical
The number of rooms sold: issues when considering the operational difficulties
£1,031,306 + £600,000 = 28218 of the basic CVP model, is the fact that there is the
assumption that a single product/service is sold. In
£57.81 '
the case of the Welsh hotel, which has more than
Z-va Iue -- 28,218 - 26,006 -
- 0737
. (j one revenue-generating department, the user might
3,000 ' need critically to assess the contribution of each
which is a probability of 0.2296, i.e. 23 per cent. unit of the hotel. In this instance the user could
perform break-even analysis making use of a PN
(4) The probability of at least making £700K. graph, as illustrated in Figure 5, on a departmental
The number of rooms sold being: basis.
£1,031,306 + £700,000 = 29 948 However, while the Welsh hotel consists of double
£57.81 ' and twin rooms, which are similarly priced for
double or single occupancy. For the hotel which
Z-value = 29,948 - 26,006 - 1.3140: consists of suites, double and single rooms, the
3,000 ' hotelier may prefer to perform more detailed room
which is equal to a probability of 0.0951, i.e. 9.51 analysis. For illustrative purposes, Table IV shows
per cent. the potential daily and annual room revenue for
Hotel X. The rack rate for the suite (£140), double
From the above results for the Welsh Hotel, it might be (£105), and single (£70) rooms, are in the propor-
prudent for the GM to forget about making £600,000 or tions of 2, 1.5 and 1 respectively. Thus, if the rooms
more; the hotel has never previously achieved a profit sold each night were converted into equivalent
with an associated probability of less than 30 per cent. units (Eq. Units) of £70, with weightings of 2, 1.5,
and 1, for the suite, double, and single rooms, the
This article has shown the hotelier how to incorporate daily and year-to-date room revenue can be
uncertainty into the basic CVP model. The author is of compared with the daily and year-to-date break-
the opinion that any risk-averse GM would benefit from even points.
using probability theory during short-term decision
making. However, the user should not treat the model as a It is also necessary to ascertain fixed costs
panacea, as the results themselves will be as good only as (e.g., building depreciation, heating, and air-
the data and assumptions used. conditioning), and variable costs (e.g. linen and
cleaning) for each type of room sold within Hotel X.
It seems therefore necessary to enumerate some of the Let us assume that fixed and variable costs totalled
inherent operational difficulties of the basic CVP model: £2 million for the rooms department. As total cost
(1) Cost structure: Since separating semi-variable equals total revenue at the break-even point, £2
costs into their fixed and variable elements is at million of rooms revenue has to be generated
the heart of CVP analysis, all decision makers
ought to be fully aware of, and understand, the
cost structure of their operation; otherwise CVP Figure 5. Profit- Volume Chart of the Welsh Hotel
analysis will provide meaningless information.
1,500
(2) Cost behaviour: The basic model presumes that
fixed costs remain fixed and that variable costs per 1,000

unit remain constant. Nevertheless, costs do not 500

i!l
always behave in the usually assumed manner. 0
0

e'"-"
Fixed costs should not automatically be drawn as
a horizontal line, as in reality they may be more -SO~

"step-shaped", with each ledge of the step

-1,000
representing the range of activity where fixed
costs remain constant. This range is also known as ·l,SOO
0 5,000 10,000 15,000 20,000 25,000 30,000 35,000
the relevant range. In addition, it must be borne in
Rooms sold
mind that variable costs might be more curvi-
_ Profit/loss
linear, than linear.

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 INTERNATIONAL JOURNAL OF CONTEMPORARY HOSPITALITY MANAGEMENT 6,3

Table IV. Potential Annual Room Revenue for Hotel X assuming normal distribution remains valid, to a range of
business and operational issues in any hospitality
organization. For example, various services and
Rack Potential Potential departments could be assessed to determine the optimum
Type of No. of rate daily revenue annual revenue solution for achieving a certain minimum profit.
room rooms (£) (£) (£)

Suite 5 140 700 255,500 While the inclusion of uncertainty with the basic CVP
model is not contemporary, it would appear that its
Double 80 105 8,400 3,066,000
diffusion rate is at best modest. It is hoped, therefore, that
Single 40 70 2,800 1,022,000 the approach outlined in this article will be tested in other
125 11,900 4,343,500 areas of the hospitality industry, especially where the
term "uncertainty" can be interpreted and quantified.
annually for the department to break even. In other
words, the break-even occupancy percentage is References
£2/£4.3 million, i.e. 46 per cent. Thus, if we refer 1. Bierman, H. Jr, TOPics in Cost Accounting and Decisions,
back to Table IV; the daily room revenue rteeds to be McGraw-Hill, New York, NY, 1963, pp. 36-40, 40-46.
at least 46 per cent of £11,900, i.e. £5,474, or 2. Jaedicke, R.K. and Robichek, A.A., "Cost-Volume-Profit
approximately 79 Eq. Units. Analysis under Conditions of Uncertainty", The
The HOD for rooms now knows that, if the hotel Accounting Review, October 1964, pp. 917-26.
sells rooms at the rack rate, it needs to sell at least 3. Johnson, G.L. and Simik, S.S., "Multiproduct C-V-P
79 Eq. Units to break even. It can therefore sell in Analysis under Uncertainty",]ournal of Accounting
any permutation, as long as it sells a minimum of Research, Vol. 9 No.2, Autumn 1971, pp. 278-86.
79 Eq. Units. In other words, it could sell 53 double 4. Dickinson, JP., "Cost-Volume-Profit Analysis under
rooms (53*1.5) = 79.5 Eq. Units, or one suite, 25 Uncertainty",]ournal of Accounting Research, Vol. 12
double rooms, and 40 single rooms . No.1, Spring 1974, pp. 182-7.
(1 *2)+(25*1.5)+(40*1) = 79.5 Eq. Units. A similar 5. Drury, c., Braund, S. and Tayles, M., "A Survey of
methodology can also be used for the food and Management Accounting Practices in UK Manufacturing
beverage, and minor operating departments. Companies", ACCA Research Occasional Paper,
Chartered Association of Certified Accountants, UK.
As noted earlier, the user should seek advice as to the 6. Wanhill, S.R.C., "Which Investment Incentives for
suitability of the CVP model application prior to making Tourism?", Tourism Management, Vol. 7 No.1, March 1986,
important operational decisions, as problems will present pp.2-7.
themselves differently for each class of hotel. 7. Horwath Consulting, United Kingdom Hotel Industry
1992, pp. 38-9.
8. Kotas, R., Management Accounting for Hotels and
Conclusion Restaurants, 2nd edition, Chapman & Hall, 1986, pp. 92-113.
This article has concentrated on assessing the probability 9. Powers, T.L., "Break-even Analysis with Semi-fixed
of achieving certain profit levels for the Welsh hotel. Costs", Industrial Marketing Management, Vol. 16, 1987,
However, the methodology could also be applied, pp.35-41.

Paul A. Phillips is Lecturer in Financial Management at the School of Consumer Studies, Tourism and Hospitality
Management in the University of Wales College of Cardiff, Cardiff, UK.

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