In both economics and business decision-making, “sunk cost” refers to costs that have already happened and cannot be recovered. These are different than ongoing costs that are spent on salaries, subscriptions, insurance, etc. The concept is important because sunk costs will stay the same regardless of the outcome of any action or decision you make in the future.
In the area of hotels, the cost of construction (and/or hotel purchase) falls into the category of sunk cost. Let’s think of a hotel from the owner’s perspective. They want to maximize the value of the real estate they have purchased – every inch of it. Every day, the goal is to turn the invested dollars into something of greater value. And the potential revenue that space in the hotel might earn is gone forever once the day that it is empty. You only have one chance to rent a hotel room for the 4th of July. After the end of the day, the product instantly goes bad. You have to take it off the shelf and display a new one – called “July 5th.”
The problem occurs when hoteliers fall in love with their Room Types and forget that every day, the goal is to sell as much of the space as possible to put against the sunk cost of the purchase of the hotel. Any extra dollar that you can make on the hotel’s space – regardless of what name you have given it – ensures that you will not lose the opportunity to make money.
The concept of Room Types is really just something created to help with pricing. The cost of a hotel room is more or less fixed. Revenue Management sets room rates to cover all fixed costs and then thereafter generate additional profit. In acquisition strategy, tiered pricing help maximize exposure to a wider audience of potential buyers. However, once the guest reservation is acquired, the difference in room types is essentially meaningless. (Note: with accurate Forecasting, there is a point where a hotelier can predict which rooms may have a potential providing zero revenue against the hotel’s sunk cost for a given night. At that point, room type distinctions are also meaningless.) Once booked you simply have a set of guests who are paying various amounts to stay in various spaces in the hotel’s real estate. The goal is then to increase the total dollars earned for that night.
Traditionally, operators have been conditioned to sell ancillary services like dining, spa, golf, entertainment in the hope of generating extra revenue. While these services can make for a great experience, they are notoriously low margin offers. Hotels need to think like hotel owners – what asset makes the largest profit? For most hotels, the answer is space! And if you don’t sell that space it’s lost money. The easiest way to upsell and generate extra revenue is to provide room upgrades. The rooms are present, need no additional arrangements, and have the highest margin. “When you sit down to do the math on the potential additional revenue to be generated (even for hotels with minimal upsell opportunities), it becomes instantly clear that the effort can easily generate a significant ROI,” says Doug Kennedy, President of the Kennedy Training Network.
But it’s not simply about upgrading. It needs to be offered at the right price. “Upgraded accommodations, if offered at all, are at rack rates. The end result is that the additional cost to upgrade does not justify the value received,” continues Kennedy. In times of low occupancy, hotels have the potential to sell their premium rooms below the rack rate. For example, suppose a hotel has calculated that their average room rate for a Standard room to be $200 per night, of which $25 covers fixed costs such as cleaning, utilities etc. and the average room rate for a Suite was $300, of which cleaning, etc. costs $30. Selling a guest an upgrade to a suite for an additional $25 would give the hotel a margin of $195 – taking into account the $30 for cleaning the suite. Refusing to offer the suite or simply not offering it equates to a lower margin of $175. In times of low occupancy, where premium hotel rooms are unlikely to get sold for the length of stay (LOS) of the arriving guest, the hotel should ignore the normal premium room rate, ignore the fact that it represents more value and instead recognize that premium hotel rooms are hotel space that you can get revenue from. Every additional dollar made through an upsell or upgrade is an almost 100% addition to the margin and contribution of the hotel.
All hotels need to make money. For a guest, a room could mean privacy, comfort, cleanliness, convenience, and security. But for a hotelier, it’s a source of revenue, like any other product offering. Pre-pandemic, most hotel operators struggled to find effective ways to stimulate revenue when room occupancy was low. With the onslaught of Covid-19, the constant decrease in occupancy and revenue per available room has imposed unprecedented challenges to hotel owners and operators. Putting successful strategies in place, like upselling, can be a great resource to increase your revenue per booking, and mitigate losses.