Fixed vs. Variable Costs

Hotel Finance Course

A Comprehensive USALI-Compliant Guide

Module 4:

Fixed vs. Variable Costs

Understanding Cost Behavior and Operational Leverage

Module 4: Fixed vs. Variable Costs

Welcome to Module 4! You've learned how hotels generate revenue and how income statements show profitability. Now we'll explore one of the most critical concepts in hotel finance: cost behavior. Understanding how costs behave in relation to business volume is absolutely essential for budgeting, forecasting, pricing decisions, profitability analysis, and effective cost control.

This module reveals why hotels are so sensitive to occupancy changes and why a small revenue increase can create a large profit increase (and vice versa). This is operational leverage in action---one of the most important concepts you'll master in this course.

Learning Objectives

By the end of this module, you will be able to:

• Distinguish between fixed, variable, and semi-variable costs

• Explain why hotels have high operational leverage

• Analyze cost behavior by hotel department

• Calculate and interpret contribution margin

• Understand the difference between direct and indirect costs

• Develop cost management strategies based on cost behavior

Understanding Cost Behavior

Not all costs behave the same way when business volume changes. Understanding cost behavior patterns is fundamental to effective hotel financial management.

CRITICAL CONCEPT: The relationship between costs and volume determines your profit sensitivity. Hotels with more fixed costs (relative to variable costs) experience more dramatic profit swings when revenue changes---both up and down.

The Three Types of Costs

1. Variable Costs

Variable costs change in direct proportion to business volume. Double your volume, double your variable costs. Cut volume in half, cut variable costs in half.

Key Characteristics:

• Change directly with volume

• Controllable in the short term

• Zero at zero volume

• Constant per unit

Examples in Hotels:

• Guest room supplies: Shampoo, soap, amenities---increase with each room sold

• Food cost: Ingredients increase with covers served

• Housekeeping linen: More occupied rooms need more linen

• Credit card fees: Percentage of revenue

• OTA commissions: Based on bookings

Variable Cost Example:

Guest supplies cost $8 per occupied room

100 rooms occupied = $800 cost

200 rooms occupied = $1,600 cost (doubled)

50 rooms occupied = $400 cost (halved)

2. Fixed Costs

Fixed costs remain constant regardless of business volume (within a relevant range). Whether you sell 10 rooms or 100 rooms, fixed costs don't change.

Key Characteristics:

• Remain constant regardless of volume

• Not easily controllable in short term

• Exist even at zero volume

• Decrease per unit as volume increases

Examples in Hotels:

• Property taxes: Set annually regardless of performance

• Insurance: Premiums based on coverage, not occupancy

• Management salaries: GM, department heads paid regardless

• Rent/ground lease: Contractual obligation

• Depreciation: Accounting allocation, not volume-dependent

• Property management system fees: Often flat monthly fee

Fixed Cost Example:

Property tax: $20,000 per month

100 rooms occupied = $20,000 (cost per room: $200)

200 rooms occupied = $20,000 (cost per room: $100)

50 rooms occupied = $20,000 (cost per room: $400)

Notice how the total cost stays constant at $20,000, but the cost PER ROOM changes dramatically based on volume. This is why hotels with high occupancy are more profitable---fixed costs are spread over more units.

3. Semi-Variable (Mixed) Costs

Semi-variable costs have both fixed and variable components. They exist at zero volume (fixed component) but increase with volume (variable component). These are the most common type of cost in hotels.

Key Characteristics:

• Part fixed, part variable

• Step up at certain volume levels

• Require analysis to separate components

• Most common type in hotels

Examples in Hotels:

• Labor: Minimum staffing required + additional staff for volume

• Utilities: Base load (lights, systems) + usage-based (A/C in occupied rooms)

• Telephone: Line charges + call charges

• Maintenance: Routine preventive + reactive repairs

Semi-Variable Cost Example - Housekeeping Labor:

Fixed component: 2 supervisors at $4,000/month = $8,000

Variable component: $12 per occupied room

At 100 rooms: $8,000 + (100 × $12) = $9,200

At 200 rooms: $8,000 + (200 × $12) = $10,400

At 50 rooms: $8,000 + (50 × $12) = $8,600

IMPORTANT INSIGHT: Because most hotel costs are either fixed or semi-variable (not purely variable), hotels have HIGH OPERATIONAL LEVERAGE. This means small revenue changes create large profit changes. This is both an opportunity and a risk.

Cost Behavior by Hotel Department

Understanding how costs behave in each department guides management strategies. Let's examine the cost structure of major departments:

Rooms Department Costs

Highly Variable:

• Guest supplies ($6-12 per room)

• Linen replacement (increases with usage)

• Commission/reservation fees

Moderately Variable:

• Housekeeping labor (can flex with occupancy)

Semi-Variable:

• Front desk labor (minimum coverage + peak staffing)

Fixed:

• Rooms manager salary

• Some systems costs

Result: Rooms department has HIGH operational leverage---revenue increases flow through at 75-85%. This is why rooms revenue is so valuable!

F&B Department Costs

Highly Variable:

• Food cost (28-35% of food revenue)

• Beverage cost (20-28% of beverage revenue)

Moderately Variable:

• Server/banquet labor (tied to volume)

Semi-Variable:

• Kitchen labor (minimum team + additional for volume)

Fixed:

• Restaurant manager salaries

• Some equipment depreciation

Result: F&B has MODERATE operational leverage---revenue increases flow through at 25-40%. Lower than rooms due to higher variable costs (food/beverage cost).

Undistributed Operating Expenses

These are primarily FIXED or semi-variable with large fixed components:

• A&G: Mostly fixed (management salaries, systems, office)

• Sales & Marketing: Mix of fixed (salaries) and variable (commissions, some advertising)

• POM: Mostly fixed (engineering staff, preventive maintenance)

• Utilities: Semi-variable (base load + usage)

These costs DON'T decrease much when occupancy drops---this is why low occupancy is so painful for profitability.

The Operational Leverage Concept

Operational leverage refers to how much profit changes when revenue changes. High operational leverage means small revenue changes create LARGE profit changes.

Why Hotels Have High Operational Leverage

1. Large Proportion of Fixed Costs

The building, systems, and core staff exist regardless of occupancy. These massive fixed costs create leverage.

2. Rooms is Highest Margin and Largest Revenue

Since rooms revenue is the largest source AND has the highest margin (75-85%), small occupancy changes have huge profit impact.

3. Incremental Cost of Selling One More Room is Low

Once the hotel exists, selling one additional room costs perhaps $15-25 in variable costs. At $150 ADR, that's $125-135 contribution margin (83-90%)!

Operational Leverage Example

Let's see operational leverage in action with a real example:

BASE SCENARIO:

Revenue: $1,000,000

Variable Costs (30%): $300,000

Fixed Costs: $500,000

Total Costs: $800,000

Profit: $200,000 (20% margin)

10% REVENUE INCREASE SCENARIO:

Revenue: $1,100,000 (+$100,000)

Variable Costs (30%): $330,000 (+$30,000)

Fixed Costs: $500,000 (no change)

Total Costs: $830,000

Profit: $270,000 (+$70,000 = 35% increase!)

CRITICAL INSIGHT: A 10% revenue increase created a 35% profit increase! That's operational leverage. The revenue increase of $100,000 minus only $30,000 in variable costs = $70,000 flowing to profit.

The Flip Side of Operational Leverage

Operational leverage works BOTH WAYS. Just as revenue increases create magnified profit gains, revenue decreases create magnified profit losses:

10% REVENUE DECREASE SCENARIO:

Revenue: $900,000 (-$100,000)

Variable Costs (30%): $270,000 (-$30,000)

Fixed Costs: $500,000 (no change)

Total Costs: $770,000

Profit: $130,000 (-$70,000 = 35% decrease!)

This is why hotels are so sensitive to occupancy changes and why maintaining revenue during downturns is critical. Fixed costs don't go away just because business slows.

Contribution Margin Analysis

Contribution margin is one of the most important concepts in hotel financial management. It tells you how much revenue contributes toward covering fixed costs and generating profit.

Contribution Margin = Revenue - Variable Costs

Contribution Margin % = (Revenue - Variable Costs) ÷ Revenue × 100

Understanding Contribution Margin

Every dollar of revenue first covers variable costs. What remains is contribution margin---money available to cover fixed costs. Once fixed costs are covered, contribution margin becomes profit.

Hotel Example:

Revenue: $750,000

Variable Costs: $169,300

Contribution Margin: $580,700

Contribution Margin %: 77.4%

This means every dollar of revenue contributes $0.774 toward fixed costs and profit. This high contribution margin explains why hotels can be very profitable when occupancy is strong.

Contribution Margin by Department

Different departments have vastly different contribution margins:

---

Department Revenue Variable Costs Contribution Margin %

---

Rooms $540,000 ~$55,000 (10%) 90%

F&B $180,000 ~$80,000 (44%) 56%

Spa $30,000 ~$9,000 (30%) 70%

STRATEGIC INSIGHT: This analysis shows WHY rooms revenue is so valuable---every rooms dollar contributes $0.90 toward fixed costs and profit. F&B contributes only $0.56. This is why hotels emphasize rooms revenue and why revenue mix matters so much.

Direct vs. Indirect Expenses

Another way to categorize costs is by traceability to departments:

Direct Expenses

Costs directly attributable to a specific department and controlled by that department head.

Examples by Department:

• Rooms: Housekeeping wages, guest amenities, front desk supplies, linen

• F&B: Food cost, kitchen labor, china/glassware, uniforms

• Spa: Therapist wages, spa products, treatment supplies

Why This Matters:

• Department heads CONTROL these expenses

• Should be held accountable for performance

• Clear cause-and-effect relationship

Indirect Expenses

Costs that benefit multiple departments or the entire property---cannot be directly attributed to one department.

Examples:

• Administrative & General (GM salary, accounting, HR)

• Sales & Marketing (benefits all departments)

• Property Operations & Maintenance (maintains entire building)

• Utilities (electricity, gas, water for whole property)

• Management fees

• Property taxes

Why This Matters:

• Department heads DON'T control these expenses

• Managed centrally (GM, CFO level)

• Performance evaluation should focus on what managers control

MANAGEMENT PRINCIPLE: When evaluating department head performance, focus on controllable costs (direct expenses). Don't penalize managers for items outside their control, though they should understand how indirect expenses affect total property profitability.

Controllable vs. Non-Controllable Costs

From a management perspective, some costs can be controlled in the short term while others cannot:

Controllable Costs (Short-term)

• Variable labor scheduling

• Overtime management

• Operating supplies

• Some marketing expenses

• Discretionary spending

Non-Controllable Costs (Short-term)

• Property taxes (set by government)

• Insurance premiums (contractual)

• Management contracts

• System contracts (PMS, reservation system)

• Rent/ground lease

Note: What's non-controllable in the short term may be controllable in the long term. Property managers can renegotiate contracts at renewal, challenge property tax assessments, or find more cost-effective systems. The distinction is about immediate vs. strategic control.

Managing Costs Strategically

Understanding cost behavior guides management strategies. Different cost types require different approaches:

Strategies for Variable Costs

4. Negotiate Volume Discounts

Leverage purchasing volume with suppliers for better pricing on guest supplies, linen, food & beverage.

5. Reduce Waste and Theft

Tight inventory controls, proper portioning (F&B), security measures prevent unnecessary variable cost increases.

6. Optimize Purchasing

Just-in-time ordering, seasonal menu planning, smart procurement reduce costs without sacrificing quality.

Strategies for Fixed Costs

7. Negotiate Better Contracts at Renewal

Insurance policies, system contracts, management agreements---everything is negotiable at renewal.

8. Challenge Expense Necessity

Does every fixed cost truly need to exist? Zero-based budgeting approach questions all fixed expenses.

9. Seek Efficiencies Through Technology

Automation, better systems, process improvements can reduce fixed labor needs over time.

Strategies for Semi-Variable Costs

10. Understand Fixed vs. Variable Components

Analyze which portion is truly fixed (minimum staffing) vs. variable (volume-based additions).

11. Optimize Staffing Models

Use part-time, on-call staff to add flexibility. Cross-train for multi-departmental coverage.

12. Monitor Step-Up Points

Understand at what volume you need to add staff or resources. Manage around these thresholds when possible.

Module 4 Practice Exercise

Let's apply cost behavior concepts to a real scenario:

Scenario:

The Seaside Resort has 210 rooms and forecasts:

• Expected occupancy: 70% (30 days)

• Expected ADR: $180

• Variable cost per occupied room: $25

• Total fixed costs: $350,000

• Semi-variable costs: $75,000 base + $10 per occupied room

Calculate:

13. Expected rooms revenue

14. Total variable costs

15. Total costs (variable + semi-variable + fixed)

16. Expected profit

17. Contribution margin percentage

18. If occupancy drops to 60% (ADR stays same), what would profit be?

Solutions

1. Expected Rooms Revenue

Available rooms = 210 × 30 = 6,300

Rooms sold = 6,300 × 70% = 4,410

Revenue = 4,410 × $180 = $793,800

2. Total Variable Costs

Variable costs = 4,410 rooms × $25 = $110,250

3. Total Costs

Variable: $110,250

Semi-variable = $75,000 + (4,410 × $10) = $119,100

Fixed: $350,000

Total Costs = $579,350

4. Expected Profit

Profit = $793,800 - $579,350 = $214,450

5. Contribution Margin %

Contribution Margin = $793,800 - $110,250 = $683,550

CM % = $683,550 ÷ $793,800 = 86.1%

6. At 60% Occupancy

Rooms sold = 6,300 × 60% = 3,780

Revenue = 3,780 × $180 = $680,400

Variable costs = 3,780 × $25 = $94,500

Semi-variable = $75,000 + (3,780 × $10) = $112,800

Fixed = $350,000 (no change)

Total costs = $557,300

Profit = $680,400 - $557,300 = $123,100

OPERATIONAL LEVERAGE DEMONSTRATED: A 10-point occupancy decrease (70% to 60%) equals 14.3% revenue decline ($793,800 to $680,400). But profit decreased 42.6% ($214,450 to $123,100)! This 3:1 ratio (42.6% ÷ 14.3% = 3.0) shows the power of operational leverage.

Module 4 Summary

Congratulations on completing Module 4! You now understand cost behavior and operational leverage---concepts that explain why hotels are so sensitive to occupancy changes and why profit can swing dramatically with small revenue changes.

Key Takeaways

19. Three cost types behave differently: variable (change with volume), fixed (constant), and semi-variable (mixed).

20. Hotels have high operational leverage due to large fixed costs relative to variable costs---small revenue changes create large profit changes.

21. Rooms department has very high contribution margin (90%) making it the profit engine. F&B has moderate contribution margin (56%).

22. Direct vs. indirect costs distinction matters for accountability---department heads control direct costs.

23. Cost management strategies differ by cost type---variable costs require waste reduction, fixed costs require long-term negotiation.

24. Operational leverage works both ways---revenue increases magnify profit gains, but revenue decreases magnify profit losses.

Looking Ahead

Now that you understand cost behavior and operational leverage, Module 5 will introduce the Key Performance Indicators (KPIs) that hotel managers use daily to measure and drive performance. You'll learn to calculate and interpret metrics like GOPPAR, flow-through, labor productivity measures, and market penetration indices. These KPIs are the vital signs of hotel financial health.

--- END OF MODULE 4 ---

Continue to Module 5: Key Performance Indicators (KPIs)