The profit flow through paradigm

One of the key financial performance indicators in the hospitality industry has been the profit flow through analysis (called “flow through” hereafter).

The flow through index is derived by dividing incremental profit by incremental revenues and expressing it as a percentage. So, the formula is:

Gross Operating Profit This Year minus Gross Operating Profit Last Year 
Gross Operating Revenue This Year minus Gross Operating Revenue Last Year

Simply stated, for every extra dollar earned, how much did we take to the bottom line.

Why is this index so critical?

It is basically because businesses are looking to get a bang for their buck so to speak. The most tragic example of wasted opportunity would be when you were able to earn significant incremental revenues but because you managed your costs badly your flow through was all but wiped out. This is not mere theory. Too many hotels are so gung ho about boosting the top line that they let revenues come in through the front door but fritter the gains away by leaving the back door open through bad cost management.

On a gross margin (gross operating profit) basis what are we talking about here?

Assuming that rooms department profitability is in the high eighties on a percentage basis and food and beverage in the forties, a healthy flow through percentage (on gross margin) would be between 70% and 90%. Whether it would be closer to 70% or 90% would be dependent on factors like the average rate, RevPAR, extent of fixed costs compared to total costs and so forth.

Directly impacting the flow through is the single most important revenue performance index – the RevPAR. In times of dynamic growth, say, in a developing economy, the RevPAR sees robust positive performance. A developing economy carries with it a burgeoning population (particularly, a middle class with a propensity to spend) and as such domestic demand fuels this growth. Double-digit increase in RevPAR performance annually is common fare. However, after some years of this spiraling growth phenomenon, the honeymoon is over when the supply demand factors undergo diametrically opposite situations from the times when growth was prevalent.

China and India as two of the major developing economies are classic case studies depicting different stages of the supply demand seesaw mechanics.

China went through more than a decade (or even two) of runaway growth fueled by the opening up of the economy and a population with great disposable income on their hands. Demand was unable to keep up with the supply then. But with the slowing down of the growth and supply not only catching up but also outstripping demand, the tables have been turned. Many key markets are witnessing depressed RevPARs, which is impacting bottom line significantly.

India, on the other hand, is actually in the same situation that China found itself a decade or more back. Supply is not able to meet rampant demand and this is sending RevPARs shooting up. Profitability is up consequently.

Whether it be the upswing or downswing of the growth, making sure the RevPAR delivers sustained flow through is paramount.

The flow through is impacted a great deal on how the mix in the RevPAR contribution pans out. Whether it is the volume delivering the major part of the RevPAR growth or the rate that is driving that will determine what the flow through will be like.

Let us illustrate with an example:

If the major percentage of increase in RevPAR has been contributed by occupancy, this occupancy increase will bring with it variable costs associated with occupancy increase (increased guest room supplies, cleaning supplies, reservation expenses and so forth) thereby diluting the take home to the bottom line (Scenario 1 above).

Contrast this with a RevPAR increase, which has been primarily, rate driven; such increase will go straight to the bottom line (Scenario 2 above). So, it is quite clear that a rate driven RevPAR increase is preferred. But obviously, this cannot happen all the time. Most times, it will be a mix of occupancy and rate driven RevPARs (Scenario 3). Hospitality industry being a seasonal one has its peak, shoulder, lean seasons where rates may vary and may not be the drivers always. So, what is the solution for sustaining profitability?

Enter, flow through analysis as a deliberate strategy to avoid dilution in incremental profits from incremental revenues. So, what does that entail?

Primarily, it is by identifying a hotel’s variable and fixed costs and keeping a tight leash on them to ensure that variable costs are indeed moving in tandem with Business volumes. This is also known as the break even analysis or the contribution margin analysis. The concept is that after a business meets its fixed costs, additional revenue increases will only bring with it variable costs and this helps to enhance bottom line. In a manner of speaking, it is a twin pronged attack of keeping down fixed costs and controlling variable costs in tandem with business volume movements. This is a very powerful method of sustaining profitability.

Unfortunately, flow through analysis has not earned the place it deserves in bottom line management in many hotel chains. However, there is no denying its delivery of results and profit sustenance. Hence, those who have harnessed its potential have seen enough results to include it as a mandatory long-term strategy in profit management.

Contributed by S Lakshmi Narasimhan, Ignite Insight, New York City