Introduction
Profit-making organizations such as Devonshire seeks to maximize the value of their shareholders by increasing revenues and profit margins as well as minimizing the costs without compromising the quality of services provided. The hospitality industry is a highly competitive one, and running a hotel successfully requires strategic decision making in all departments, including finance, marketing, production as well as adequate supply chain management. The following report analyzes the reasons behind an adverse or rather unfavorable variance in the actual and budgeted profit margins in the Devonshire Hotel. It also advices on the plausibility of a proposed project to invest in a hotel extension. Third, the report analyzes the effects of proposed price changes in the hotel’s menu as well as the proposed promotion program to boost Devon’s revenues.
Unfavorable Variance in Profit Margins
Devon has reported a lag in actual bar and restaurant performance over the past few months by 6%. That means there is an unfavorable variance, and the actual performance resulted in lower profit margins than the projected ones. In other words, the company recorded less revenues or more expenses it had anticipated. The difference in occupancy rates, supply costs, and labor costs are the significant causes of variance in the hotel business (Park & Jang, 2014). Devon needs to understand where the variance came from by conducting a variance analysis. The variance analysis will help in identifying if the decline in profitability resulted in less revenues or increased costs than the budgeted. Also, the management should consider if the variance constitutes a trend.
Possible Causes of the Variance
Devon is likely to find a difference in the cost of food, which may be caused by high prices paid to the suppliers, pilferage, poor customer services, and wastage in the kitchen, free meals, and increase in the portion of food offered to customers or an error in accounting. If the actual cost of raw materials or rather ingredients used in the preparation of food in the hotel increased than the standard rate that the company anticipated, the company would record high cost of production, resulting in less gross profit (Park & Jang, 2014). Also, employees may engage in pilferage, which results in the need to purchase additional items, thus increasing the expenses in the hotel. Poor customer services that result in customer returns and complaints reduces the total revenues. In the era of social media, poor rating causes the hotel to lose existing and potential customers.
Additionally, the employees at Devon may be wasting resources in the kitchen by either ordering too many raw materials, throwing the raw materials away, or even cooking too much food increases the cost of production, thus reducing the profit margins for the company. Free meals to members of staff or customers, whether as a promotion program or favors, can be an unsustainable cost to Devon, resulting in decreased profitability (Guilding, 2014). Lastly, increasing the portions served to the customers reduces the number of portions sold in a day, which in turn decreases the profit margins. Devon should investigate and identify the exact causes of the profitability variance.
Action Plan to Remedy the Variance
Although it may be tedious for Devon to track each and every ingredient it uses in food production, there are four ways in which it can control food costs variance. Firstly, the company should improve its supply chain management by working closely with its suppliers. A strategic partnership with suppliers can benefit the company significantly (Guilding, 2014). The partnerships can give Devon access to trade discounts and favorable credit terms that will effectively reduce the cost of production. Secondly, the company needs to be consistent in compliance with the preparation of the recipes, production, presentation, as well as plating (Dopson & Hayes, 2015). Consistency will ensure that standard portions are offered to consumers and no wastage in food production, thus putting the costs under control.
Third, Devon needs to have an effective inventory management system. The economic order quantity model can help in establishing the appropriate reorder level, as well as the lead period. That means the company orders the optimal quantity, thus reducing wastage and stock-outs. Also, the company should ensure that it adopts the best inventory valuation method (Dopson & Hayes, 2015). The last way to control food cost variance is by tracking the market prices for the ingredients used in food production. This will ensure that Devon gets the best deal while purchasing the ingredients/
Viability of Proposed Project
The proposed project to extend the hotel will cost the Devon an initial cash outlay of £130,000. The discounting rate or the minimum required rate of return for the company is 15%, and the company expects cash flow of £33,500 every year for five years. The expected return is calculated by discounting the expected cash flow. Net Present Value (NPV) and Internal Rate of Return (IRR) is the most appropriate capital budgeting technique to evaluate the project because it considers the concept of the time value of money (Kengatharan, 2016). The only disadvantage of NPV and IRR is that the methods only consider the quantitative data of the project and ignores the qualitative data that may influence the success of the project.
The expected cash flows before discounting are £167,500. However, due to the concept of the time value of money which suggests that money held today is worth more than money held tomorrow, it is important to discount the values using the 15% discounting rate. The discounted expected cash flows are £112,297.36. The NPV is calculated by subtracting the initial cash outlay from the discounted expected cash flows. The rule for NPV is for the company to reject the project if the NPV is negative and accept the project if the NPV is positive. The NPV for the extension of the hotel project is -£17,702.64, which means that Devon should reject the project.
The last capital budgeting project that will be used to evaluate the plausibility of the proposed extension project is the payback period. Its disadvantage is that it is a traditional method that does not apply the concept of the time value of money. It is an advantage that the method is simple to calculate and interpret results (Kengatharan, 2016). The payback period measures the period it will take for the company to recoup its initial cash outlay. The company should not accept a project with a long payback period. From the calculations, it will take Devon 3.88 years to recoup the initial cash flow. This is a long payback period, and it should not invest in the project.
Given the sales mix, Devon will understand the units of each dish that should be sold to attain the desired profit margins. For instance, the company should consider providing customers with Chocolate Fondant as desserts, Chicken Provencal as a main meal, and Chicken Parfait as starters. On the other hand, Devon should avoid Selection of Sorbents as desserts, Vegetarian Risotto, and Seafood Cocktail as dishes for mains and starters, respectively.
Contribution Analysis
The contribution is calculated by subtracting the variable cost per unit from the selling price unit (Guilding, 2014). The company proposes a worst-case scenario in which it will sell only 100 packages at the price of £175 and a best-case scenario where 200 packages are sold at the same price of $175 per package. With a variable cost of 25%, the contribution per unit for the best and worst-case scenario will be £131.25. After conducting a market analysis, it was established that the ideal packages that the company can sell to remain open throughout the year are 180 for $200. This translates to a contribution per unit of £150. On the other hand, the total revenues under the worst-case scenario are £17,500, and after subtracting the 25% variable costs, the total contribution is £31,125. After subtracting the fixed overheads of £15,000, the net contribution is a loss of £1,875.
The total revenues under the best-case scenario are £35,000, which translates to a total contribution of £26,250 and a net contribution of £11,250. Lastly, if the company engages in a promotion that will cost it £2,500, Devon will realize a net contribution margin of £9,500. Although the best-case scenario has the highest net contribution margin, the ideal scenario is more realistic, and Devon should consider opening the hotel throughout the year. Aside from the positive contribution margin, the hotel will not risk losing customers to competition as it stays closed.
Conclusion
Based on the above analysis, it is evident that the variance in profit margins by 6% is attributed to the food cost variance. Devon should consider building a strategic relationship with its customers, be consistence in its food production and accounting procedures as well as adopting effective inventory management to ensure it has optimum raw materials and finished products. The NPV for investing in the proposed project, the IRR is 9.09% while the payback period is 3.9 years, and all suggests that Devon should reject the proposed project. Also, the company should consider the sales mix to increase profitability. Lastly, the company should open the hotel throughout the year and sell the packages at $200. This will ensure a positive net contribution margin and create awareness to the consumers about the hotel through advertising.
