Hospitality & Tourism Management 370
Cost Approaches to Pricing
Prices influence the profitability of a firm. Four main factors are essential for price
Demand sets the upper limit or ceiling of price. It determines what
customers are willing to pay.
Elasticity of demand to changes in price is an important issue in setting
The price elasticity of demand is measured as the change in quantity
demanded per unit change in price. In numerical terms,
Price elasticity of demand =(% change in Quantity Demanded)/ (%
change in Price)
For instance, a budget hotel increases its room price from 20$ to 22$ per room
night (10%). Consequent to this price increase, the demand declined from 100 to
950 rooms (5%). The price elasticity of demand for this motel would be
(5%/10%) or 0.5. The airline and lodging industry recognize seasonal fluctuations
in demand and price their products accordingly. Such demand-based approach to
pricing is called yield management.
Another important factor to consider in pricing is cost. Costs set the lower limit or
floor of price.
Business objectives or goals of a firm constitute the third price setting factor.
Objectives or goals provide the overall environment for setting prices. A 10% profit
objective annually, for instance, provides a price-setting environment for a business
firm. Such environment differs significantly if a firm happens to be a non-profit
4. Competition Competition provides the fourth important price-setting factor. A firm’s
competition sets the benchmark for comparing its various pricing alternatives.
Skimming and penetrating price policies are examples substantiating this fact.
Two other modifying factors must also be remembered in setting prices. First is the
historical trend of prices. Dramatic price changes should be avoided if possible as they
affect demand adversely. Second, the final price must be set after incorporating policies
such as odd and even pricing (e.g., $9.99 instead of 10$ to create an illusion that price is
in the lower range) or price rounding (e.g., price rounded up to the nearest $25).
II. Mark-Up Approach to Pricing
This is a traditional pricing approach in the Food and Beverage industry. The ingredient
markup approach considers all product costs. For instance, as shown in exhibit 2, the
ingredient costs total to $1.63 per portion. If the desired food cost percentage for this
restaurant is 40%, then the chicken dinner is priced at ($1.63/0.4) = $6.52.
The prime ingredient mark-up approach differs only in that the cost of prime ingredients
(for instance, the $0.69cost of chicken in a chicken dinner, exhibit 2) is marked up, rather
than the total cost of all ingredients. The multiple used here is based in experience, and is
greater than the multiple used for the ingredient mark-up approach.
III. Pricing or Rooms
1. $1 per $1000 Approach
This is a traditional experience based approach for pricing rooms in hotels.
According to this rule, the price of a room should be $1 for each $1,000 of project
cost per room. For instance, if the average project cost for each room in a motel
was $45,000, the price of each room should be set at $45 per night. This approach
fails to consider all essential factors in price setting other than project costs.
2. Hubbart Formula
This is a more comprehensive approach to room pricing that considers three of the
four essential price setting factors – namely, desired profits (objective), costs, and
expected rooms sold (demand). It is also called the bottom up approach to room
pricing. It starts with desired profits or net income, adds income taxes, and then
adds fixed costs and management fee, followed by operating overhead costs and