For decades, industry participants have performed
simple cash flow projections
when examining lodging assets. Typically line item revenues and
expenses are projected based on
current value dollars and vary within a projection
only in concert with inflationary influences. While praised for
their simplicity and ease of
understanding, these financial models neglect an important
factor of cash flow projections; that being the influence of
efficiencies and inefficiencies that
hotel operations have on bottom line Net Operating
Income.
To accurately examine the future cash flow
potential of a lodging asset, we believe
that one must utilize a fixed and variable model to project both line
item revenues and expenses. This fixed
and variable approach is a long-standing
foundation of basic managerial accounting. Moreover, this kind
of analysis is the most appropriate
means by which to emulate the complex interrelationship
of utilization and profitability with a complex and dynamic
income producing vehicle such as a
hotel. The fixed and variable approach is considered
a more technical method of which to project both line item
revenues and expenses as it allows for
the forecasting of efficiencies and inefficiencies
in revenues and expenses as related to fluctuations relative
to a base, or index of variability.
It is widely accepted in the industry that
the majority of fluctuations beyond
the fixed portion of line item revenue, are occupancy dependent. In
the past, however, the industry has
indexed fluctuations in expense relative to
the corresponding departmental income or, in the case of Undistributed
Operating Expenses, to Total Revenue.
For example, the variable component of Food
and Beverage Expense would be calculated relative to changes in Food and
Beverage Income, whereas the variable
component of Administrative and General Expense
would be indexed to Total Revenue. This methodology dictates that
line item expenses vary solely with
fluctuations in corresponding Departmental
Revenues.
Pinnacle Advisory Group recently set forth to test
this method of calculating the
fixed and variable components of line item revenue and expense through
simple linear regression analysis. By
examining both Departmental Expenses and
Undistributed Operating Expenses on hundreds of actual financial
statements via a simple linear
regression analysis, we tested the viability of
utilizing occupancy as common base, or index of variability. Specifically,
we tested the statistical significance
of utilizing fluctuations in occupancy as
the basis of the variable component of all line item revenues and
expenses, rather than linking the
variable component of these costs to the corresponding
line item revenue.
Through a complex understanding of
statistics that is beyond the scope of the summary
discussion presented here, we have determined that there is, in fact,
statistical justification for utilizing
occupancy as a common base of variability
when employing the fixed and variable approach to cash flow projection.
It is important to note that our findings also support conventional
methods whereas each line item's variability is linked to the
corresponding Departmental Revenue and
Undistributed Operating Expenses are linked
to Total Revenue. In sum,
the most influential aspect affecting the variable portion of line
item expenses is fluctuation in
occupancy. As such, a fixed and variable model
of cash flow projection that takes occupancy differences into
consideration is the model that Pinnacle
Advisory Group employs. This does not
mean that there are not other influential factors. Therefore, we believe
that the comprehensive analysis behind
these findings warrants continued research.
Initial indicators validate our approach while simultaneously
inviting further research on the topic.
Substantial credit
for this analysis and editorial response goes to Daniel C. Hanrahan
II, CRE, MAI, principal, and Brian J. Tocci in the Philadelphia office
of Pinnacle Advisory Group. Rachel J.
Roginsky, member of the International Society of Hospitality Consultants
(ishc.com). is Principal of Pinnacle Advisory Group, a hospitality
consulting firm, based in the Boston, MA office.