Royalty Hotels
A Forecasting and Capacity Management Case

Joseph S. Martinich
University of Missouri - St. Louis

a case to supplement
Production and Operations Management: An Applied Modern Approach

This case is intended to be the basis for a business analysis and class discussion rather than to illustrate either effective or ineffective handling of a business situation. Companies and characters are fictitious and are not intended to represent actual companies or people.

Copyright 1997 by Joseph Martinich. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the permission of Joseph Martinich or the distributor, John Wiley & Sons, 605 Third Ave., New York, NY 10158. Printed in the U.S.A.

The Background

Royalty Hotels is a chain of approximately 20 hotels located throughout the U.S. and Canada. Royalty's target market is the high-end business, convention/conference, and vacation traveler, with most of its sites rated in the 4-star (out of five) category. Royalty has always had a reputation for good quality rooms and services, so it has typically priced its rooms slightly above those of comparable hotels (based on comparing listed rack rates and occasional phone surveys of competing hotels), yet it has consistently maintained occupancy rates slightly above the industry average (as compared to published industry data for comparable hotels). In spite of this the company has been less profitable than its major competitors.

Alexandra Shephard, the President of Royalty, was greatly concerned about this, and so she decided to form a team of her top managers to study the problem. Because Royalty had above average room prices and above average occupancy rates, the team members assumed revenues were not the problem, so they initially focused on the company's costs. They studied staffing, advertising, supplies, training, taxes, and every other major cost component. Although they were able to identify some cost-reducing improvements, they found that Royalty's staffing and other costs were generally in line with its competitors. This caused the team to look at revenues more carefully.

Differential Pricing and Yield Management

The same situation and considerations apply to hotels. They have a fixed number of rooms each night. They want to earn as much revenue as possible from the rooms, but filling a room at a low price is better than leaving it empty. The key question is how do you fill all the rooms at the highest prices possible? There are many conflicting forces that must be considered, and all of the pricing and reservation decisions are made within an environment of uncertainty - we don't know how many customers there will be and how the customers will behave.

Hotels have always used differential pricing, charging higher prices (at or near the posted rack rate) during times of high demand (e.g. mid-week and when major conventions or other special events are in town), and lower prices during periods of low demand (e.g., weekends and holidays). The hotel also typically charged lower rates to those who reserved their rooms several weeks or months in advance. This pricing strategy has been used in the airline and car-rental industries as well. In recent years these two industries have made pricing strategies more scientific by adjusting prices for future flights or car rentals on a continuous basis according to how many seats or cars had been reserved and the predicted future demand. This approach is called yield management because it attempts to maximize the revenue yield from a given inventory of airline seats and cars. The Royalty management team had read and heard quite a bit about the effectiveness of yield management in the airline and auto rental industries, and they had even heard that some hotel chains were considering it. Royalty itself had even instituted a yield management approach in an informal way by suggesting to individual hotel managers that they review the reservation status of their sites regularly and adjust the number of rooms available at different prices accordingly. Royalty, however, did not provide specific guidelines for adjusting prices, nor did it provide any special computer software to assist with this effort. Hotel managers were expected to use data provided by the current reservation information system to make their decisions.

Considerations and Tradeoffs in Yield Management

In industries with fixed service inventories (airlines, auto rental, hotels) most companies try to use what is called discriminatory pricing, whereby they charge different prices to different customers and try to obtain as high a price from each customer as possible. For example, airlines charge very high prices for unrestricted tickets purchased close to the time or day of departure. The reason is that the type of person buying such a ticket at the last minute is likely to have a compelling need to make the trip (typically a business trip), and may require speed or flexibility in travel times (e.g., he/she cannot to stay over a Saturday night). Therefore, this customer is often willing to pay a high price for this convenience, especially if alternative flights are full. Likewise, people making reservations for discretionary travel many weeks or months in advance are able to search for the best prices and are flexible in their travel plans, so they tend to be very price sensitive, and will choose the airline that provides the lowest price. To fill the seats of the airplane, the airlines must set the prices for these passengers low. As the day of the flight approaches, if the flight is heavily booked (and if the airline perceives that competing flights are heavily booked), the customers' options are more limited and the airline is in a stronger pricing position. Therefore, the airline can increase the prices it charges (or not discount seat prices as much) to additional customers. Similarly, if the flight is not heavily booked, the airline can benefit by reducing prices further or making available more discounted tickets in order to fill the plane. (Filling a seat at almost any price is better than flying with it empty.)

Based on the experiences of the airline, car rental, and hotel industries, the following observations and factors have been identified as important in developing good yield management tactics for hotels.

  1. Customers who make reservations do not always show up. So a certain amount of overbooking is necessary to have a high chance of filling all the rooms.

  2. If a hotel overbooks too much, there will be customers with reservations who cannot be served. This creates bad will, which will ultimately cost the hotel money. (It may cost the hotel money in the short term as well if the hotel must find a room for the customer at an alternative hotel at a higher price.)

  3. A hotel may not want to fill all its rooms early (e.g. weeks before the target date) with customers receiving discounted prices. By holding some rooms available, even until the target date itself, the hotel may be able to earn more money by selling rooms to "walk-ups" (people who arrive at the hotel with no reservations) at full rack rates if alternative hotels are full. Of course this increases the risk of not filling all the available rooms, or having to offer the rooms to walk-ups at very low prices, if there are many available rooms at alternative hotels .

  4. The prices customers are willing to pay at the time of reservation (including last-minute walk-ups) is affected by the availability of alternative rooms and the relative prices of the alternatives.

  5. There are typically two or more "classes" of rooms, with more desirable rooms (larger, better views) commanding a higher price. If all lower-priced rooms are occupied, customers with reservations for these lower priced rooms can be upgraded to higher-priced rooms at the lower price; the opposite is generally not as possible. Customers with reservations for higher-priced rooms will often not accept lower-priced rooms, even at the lower price; an additional price reduction or complementary service is often required to satisfy the customer.

    The Problem

    After studying the yield management issue, the team concluded that the company's problem was a poor pricing and reservation strategy. Royalty was filling its rooms well, and its list prices were high, but its average actual room rate was too low. The rooms were often filled with people receiving discounted rates. Royalty's management believed that it could increase its average room rate by 2-5% with a better yield management strategy. (This would double or triple profits because the additional revenues would go straight to the bottom line, and its current profit margin was approximately 2.5% of revenues.) After discussing this with hotel site managers, the managers agreed that better pricing was possible, but they felt that they needed a computerized system that would adjust the prices of rooms, and the number of rooms offered at various prices automatically, just as the airlines do. Managers would have the ability to enter special events information into the computer system (such as a conference is booked and 90% of the rooms can be priced at the contracted price), and override the system if desired.

    Discussion Questions

    1. Yield management systems are very dependent on accurate forecasts of future demands and customer behavior. For Royalty to develop a good yield management system:
    (a) What specific forecasts need to be made? How frequently should they be updated?
    (b) What factors are likely to affect the demand for rooms at Royalty? How should these be incorporated (if at all) into the forecasting procedure (i.e., describe the general type of forecasting model or rules Royalty should use to forecast demand)?
    (c) Describe precisely what data should be collected and how they should be organized? How often should the data be collected? How should the data be used in the forecasting models?

    2. Even if demand forecasts are accurate, yield management won't be productive unless good pricing rules are used.
    (a) How should Royalty use the forecasts to make pricing decisions? Describe the pricing decision rules you would recommend.
    (b) How often should Royalty update its prices and room availabilities?


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Last Updated: May 22, 1998

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