The Sovereign Lodge is an old, but well maintained property that has changed ownership several times over the years. It has no restaurant or bar. It is positioned as a mid-price, good quality "destination" resort lodge.
The Sovereign Lodge is open during the skiing season. It opens on December 2 and closes the last day of March. The ski mountain it serves operates on a permit from the state which allows only 120 days of operation per year. Each of the 50 rooms in the east wing rents for $15 for single occupancy or $20 for double occupancy. The west wing of the lodge has 30 rooms, all of which have spectacular views of the skiing slopes, the mountains, and the village. Rooms in this wing rent for $20 and $25 for single or double occupancy, respectively. The average occupancy rate during the season is about 80% (typically, the Lodge is full on weekends and averages 50 to 60 rooms occupied on week nights.) The ratio of single versus double occupancy is 2:8, on average.
Operating results for the last fiscal year are shown in Exhibit 1. Mr. Kacheck, the manager of the lodge, is concerned about the off-season months, which show losses each month and reduce the high profits reported during the season. He has suggested to the owners, who acquired the lodge only at the end of the 2006 season, that to reduce the off-season losses, they should agree to keep the west wing of the lodge operating year-round. He estimates the average occupancy rate for the off-season to be between 20% and 40% for the next few years. Kacheck estimates that with careful attention to the off-season clientele a 40% occupancy rate for the 30 rooms during the off-season would be much more likely if the owners would commit $4,000 for advertising each year ($500 for each of 8 months). There is no evidence to indicate that the 2:8 ratio of single vs. doubles would be different during the remainder of the year or in the future. Rates, however, would have to be drastically reduced. Present plans are to reduce them to $10 and $15 for singles and doubles.
The manager's salary is paid over 12 months. He acts as a caretaker of the facilities during the off season and also contracts most of the repair and maintenance work during that time. Using the west wing would not interfere with this work, but would cause an estimated additional $2,000 per year for repair and maintenance.
Mrs. Kacheck is paid $20 a day for supervising the maids and helping with check-in. During the season, she works 7 days a week. The regular desk clerk and each maid are paid on a daily basis at the rate of $24 and $15 respectively. The payroll taxes and other fringe benefits are about 20% of the payroll. Although depreciation and property taxes would not be affected by the decision to keep the west wing open, insurance would increase by $500 for the year. During the off-season, it is estimated that Mr. and Mrs. Kacheck could handle the front desk without an additional person. Mrs. Kacheck would, however, be paid for 5 days a week.
The cleaning supplies and half of the miscellaneous expenses (room supplies) are considered a direct function of the number of rooms occupied. The other half of the miscellaneous expenses are fixed and would not change with 12 month operation. Linen is rented from a supply house and the cost also depends on the number of rooms occupied, but is twice as much, on average, for double occupancy as for single occupancy. The utilities include two items: telephone and electricity. There is no electricity expense with the lodge closed. With the lodge operating, electricity expense is a function of the number of rooms available to the public. Rooms must either be heated or air-conditioned. The telephone bills for each of the four seasonal months were as follows:
80 Telephones @ $3.00/month $240
Telephone Basic Service Charge 50
$290
During the off-season, only the basic service charge is paid. The monthly charge of $3 is applicable only to active telephones.
An additional aspect of Mr. Kacheck's proposal is that a covered and heated swimming pool be added to the lodge. Mr.Kacheck believes that this would increase the probability that the off-season occupancy rate would be above 30%. Precise estimates are impossible. It is felt that although the winter occupancy rate will not be greatly affected by adding an indoor pool, eventually such a pool will have to be built to stay even with the competition. The cost of such a pool is estimated to be $40,000. This amount could be depreciated over 5 years with no salvage value ($15,000 of the $40,000 is for a plastic bubble and the heating units, which would be used nine months of the year). The only other costs associated with the swimming pool are $400 per month for a lifeguard, required by law during the busy hours, additional insurance and taxes, estimated to be $1,200; heating cost of $1,000; and a yearly maintenance cost of $1,800. If the pool were covered, a guard would be needed for 12 months. If it is not covered, a guard would be needed only for 3 summer months (from 15 June to 15 September, the warmest period of the year), and there would be no heating expense.
EXHIBIT 1 Sovereign Lodge
Operating Statement, For the Fiscal Year ended 3/31/09
Revenues $160,800
Expenses
Salaries
Manager $15,000 Manager's Wife 2,400 Desk Clerk 2,880
Maids (four) 7,200
$27,480
Payroll Taxes and Fringe Benefits 5,496
Depreciation (15 year life) 30,000
Property Taxes 4,000
Insurance 3,000
Repairs and Maintenance 17,204
Cleaning Supplies 1,920
Utilities 6,360
Linen Service 13.920
Interest on Mortgage (5% interest rate) 21,716
Miscellaneous Expenses 7,314
Total Expenses 138,410
Profit before Federal Income Taxes $22,390
Federal Income Taxes (48%) 10,747
Net Profit $11,643
The six alternatives are Opening in the summer, with and without advertising, for each of no pool, pool without bubble, pool with bubble.
The Alternatives are:
Stay open, no advertisement, and no pool.
Stay open, advertisement, no pool.
Stay open, no advertisement, and pool only.
Stay open, advertisement, and pool only.
Stay open, no advertisement, pool and bubble.
Stay open, advertisement, pool and bubble.
A matrix showing incremental fixed costs for each of the six alternatives and categories of cost covering, repairs, insurance, Mrs. K, advertising, the pool, the bubble, pool expenses (quite a few categories here), telephone, electricity, and maids (if you think necessary).
Each number in this matrix should be carefully explained as if to a non-finance person.
Fixed costs for the off season which is also known as Incremental fixed cost:
Manager's wife: she is paid only 5 days a week therefore, number of days for which she is paid
Total days in the 8 month period = (365-120) = 245 days
Therefore, number of weeks in that period 245/7 = 35 weeks
35 x 5 days = 175 days (Mrs. Kacheck is paid only for 5 days a week)
175 x $20 = $3500 (amount spent on Mrs. Kacheck's salary)
Maid's salary
At least one maid is considered in the off peak season and the alternatives in which advertising is done 2 maids are taken.
Maid is paid $15 per day and for 245 days during the off peak season
15 x 245 = $3675 per maid
Considering 1 maid for 8 months results in the $3675
While for 2 maids, 2 x $3675 = $7350
Repair and maintenance
$2000 for 8 months (mentioned in the case study)
Additional $1800 for the alternatives in which pool is considered.
Utilities: (Telephone + Electricity)
Utilities expense = telephone + electricity + heating (in alternative 5 and 6 only)
The telephone and the electricity is the direct function of number of rooms available to the public it is considered for 30 rooms.
Telephone for 1 month 290
Therefore telephone for 4 months = 290 * 4 = 1160 + 400 (basic service charge for 8 months when all the line were closed assuming that the lodge was closed for 8 months) = $1560
Expenses on telephone for 8 months assuming that the 30 rooms are available to the public = 30 x 3 = 90 + 50 (basic service charge for east wing which is closed) = $140 per month
Therefore, for 8 months = 140 x 8 = $1120
Electricity:
Hence by here we can calculate the electricity expense i.e. = 6360 - 1560 = $4800
Electricity expense for 80 rooms for 120 days = 4800
Therefore electricity expense of per room per day = 4800 / (80*120) =0.5 per room per day
Therefore for 30 rooms for 245 days = 0.5 x 30 x 245 = $3675
And heating expense will cost $1000 (wherever pool and bubble is included i.e. in alternative 5 and 6)
Then compute the incremental contribution (in $) per occupied room/day during the off-season?
Incremental Contribution = Revenue - Variable expense
Stay open, no advertisement, and no pool.
Incremental Contribution Margin: Total Revenue - Total Variable Expenses
=20580-3524
= 17056
17056 = 2842.66 per room
6 Rooms
2842.66 = 11.60 contribution margin per room per day
245 days
Incremental Contribution Margin: Total Revenue - Total Variable Expenses
=41,160 - 7,291
=33869
33869 = 2822.41 per room
12 Rooms
2822.41 = 11.52 Contribution Margin per room per day
245 days
Incremental Contribution Margin: Total Revenue - Total Variable Expenses
=30870 - 5529
= 25341 Contribution Margin
25341 = 2815 .66 per room
9 Rooms
2815.66 = 11.49 Contribution Margin per room per day
245 days
Variable Expenses
=41,160 - 7,291
= 33,869 Contribution Margin
33869 = 2822.41 per room
12 Rooms
2822.41 = 11.52 Contribution Margin per room per day
245 days
Incremental Contribution Margin: Total Revenue - Total Variable Expenses
=30,870 - 5,529
= 25,341 Contribution Margin
25341 = 2815.67 per room
9 Rooms
2815.67 = 11.49 Contribution Margin per room per day
245 days
Incremental Contribution Margin: Total Revenue - Total Variable Expenses
=41,160 - 7,291
= 33,869 Contribution Margin
33869 = 2822.41 per room
12 Rooms
2822.41 = 11.52 Contribution Margin per room per day
245 days
Note: All the calculations are for calculating the revenue is done considering the ratio of 2:8 for single : double as mentioned in the case study.
Incremental Variable expenses -
Linen services:
For expenses of 4 months = 13920 (given in the case study)
With respect to 80 % of 80 rooms assuming the ratio of Single: double as 2:8
Therefore linen supplies =
13920/ (13 single rooms x 1 + 51double rooms x 2) = 13920/115 = 121.05 for 4 months
Therefore linen expense for 1 day 121.05 / 120 = 1.01
Therefore in 245 days we have 6 rooms occupied in the ratio of 2:8 as single: double (4 double rooms cost $8 and 2 single rooms cost $2 per day giving a total of $10 per day for the linen services) 245 x 10 = $2450
Similarly when the occupancy rate is double i.e. 40 % at that time the number of rooms changes from 6 to 12 and considering 3 singles and 9 double rooms the linen comes $5145
Cleaning supplies
Expenses on cleaning supplies in 4 months = 1920
No. of rooms occupied in that period = 80 % of 80 = 64 rooms
Therefore, cleaning supplies per room per day = (1920)/ (64*120) = $0.25
Hence, for 6 rooms for 245 days = 0.25 x 6 x 245 = $368
Similarly, when the number of rooms taken is 9 for the case of 30% and for 12 for 40% occupancy.
Hence, for 9 rooms for 245 days = 0.25 x 9 x 245 = $551
Hence, for 12 rooms for 245 days = 0.25 x 12 x 245 = $735
Miscellaneous expense
50 % of 7314 is variable i.e. 3657 for 120 days considering 64 rooms
Therefore misc. expense per room per day = 3657/ (64 x 120) = 0.48 per room per day
Hence for 6 rooms for 245 days = 0.48 x 6 x 245 = $706
Similarly when the occupancy rate is 30 % the number of rooms taken is 9 and when it is 40 % the number of rooms taken is 12.
Hence for 6 rooms for 245 days = 0.48 x 9 x 245 = $1058
Hence for 6 rooms for 245 days = 0.48 x 12 x 245 = $1411
By dividing each of the six incremental fixed costs by the incremental contribution per unit, and comparing this figure with the number of room/days available outside of the skiing season, you should derive break even occupancy percentages in the range 18% - 44%. For each decision alternative calculate the occupancy rate necessary to break even on the incremental annual expenses.
Break even volume = Incremental fixed cost / contribution margin per unit (room)
Stay open, no advertisement, and no pool.
Break Even Volume:
= 14470
2842.66
=5.09
Stay open, advertisement, no pool.
Break Even Volume:
= 22145
2822.41
=7.84
Stay open, no advertisement, and pool only.
Break Even Volume:
= 27270
2815.66
= 9.68
Stay open, advertisement, and pool only.
Break Even Volume:
= 34945
2822.41
= 12.38
Stay open, no advertisement, pool and bubble.
Break Even Volume:
= 31270
2815.67
= 11.10
Stay open, advertisement, pool and bubble.
Break Even Volume:
= 38945
2822.41
= 13.79
The occupancy percentage comes out to be nearly equal to 40% considering all the options i.e. stay open, advertisement, pool and bubble. The number of rooms required to be filled is approximately equal to 12 out of 30.
By comparing these breakeven figures with Mr Kachek's expectations (as indicated in the text) you should draw conclusions about which of the alternatives is the best.
The recommend alternative on the basis of breakeven calculations:
Ans. The best alternative should be the first one i.e. just to stay open because only 5.5% more occupancy is needed to meet the break even condition which is quite less as compared to the other values. This decision alternative can also be considered because of the revenue.
Mr. Kacheck also thinks that if the advertising is done then the occupancy percentage will be at least 40% and by comparing the percentage of the contribution margin to the incremental fixed cost gives the Break even volume which is good for the first alternative.
Alternative 1: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 5.09 %. All the calculations are done considering the occupancy rate as 20% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 14.01 %
Alternative 2: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 7.8 %. All the calculations are done considering the occupancy rate as 40% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 42.2 %
Alternative 3: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 9.68%. All the calculations are done considering the occupancy rate as 30% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 21.4 %
Alternative 4: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 12.4%. All the calculations are done considering the occupancy rate as 40% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 27.6 %
Alternative 5: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 11.10%. All the calculations are done considering the occupancy rate as 30% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 19.9 %
Alternative 6: The breakeven volume the rate of percentage which is required to be increased in the occupancy comes to be 13.8%. All the calculations are done considering the occupancy rate as 40% in that decision alternative. To meet a condition where total revenue is equal to the total expense the most favorable rate of occupancy for this case should be 26.2 %
7 Using the original profit statement for the skiing season, and the best alternative for the non skiing season you should derive an overall annual profit figure for Sovereign Lodge.
After analyzing the income statement of the peak season i.e. skiing season along with all the six alternatives, the second alternative is the best one in which the lodge stay opens along with the advertisement.
Note: In this option the net profit comes to be highest which is the reason to select this alternative in order to carry forward the lodge to stay open for the rest of the off peak season.
8 You should write a conclusion which incorporates your comments in Note 5, and your opinion from Note 6, and any other views about the future of this Lodge in order to make a final recommendation to the owners. This conclusion should be at least half a page long.
Ans. The financial statements say that second alternative in which the lodge is to stay open with the advertisement but no pool is the best alternative because the net profit for that alternative is the highest and to be more profitable is the best thing.
As Mr. Kacheck's expectation if the advertising is done keeping the lodge open, the assumed percentage is 40 which enables the overall revenue for the year to be the highest. The net profit for this decision alternative is highest amongst all i.e. $16819. Because there are no additional expenses the overall revenue is high and there are more profit margins.
Mr. Kacheck expects that the profit margin will be higher for the alternatives in which the advertising is done. Initially the basic condition is to keep the lodge open during the off peak season and in that period if no additional expense is done then the net profit comes to be the higher as in the second alternative. Advertising can improve the occupancy percentage as more people will come to know about the lodge. The advertising money can be utilized in to the website of the lodge so that people can find out the information about the lodge online.
