10Operations Budgeting

Chapter 10 Outline

CompleteReview Questions 1-10 at the end of "HospitalityIndustry Managerial Accounting," Ch. 10

.Types of Budgets

Budgeting Horizons

Reasons for Budgeting

Personnel Responsible for Budget Preparation

The Budget Preparation Process

• Forecasting Revenue
• Estimating Expenses
• Projecting Fixed Charges and Interest Expense
• Budget Formulation Illustrated
• Flexible Budgets
• Budgeting for a New Lodging Property

Budgetary Control

Determination of Variances

Determination of Significant Variances

Variance Analysis

• Revenue Variance Analysis
• Cost of Goods Sold Analysis
• Variable Labor Variance Analysis
• Variance Analysis of Sands Motels Significant Variances

Determination of Problems and Management Action

Reforecasting

• Reforecasting at The Sheraton Corporation

Budgeting at Multi-Unit Hospitality Enterprises

Budgeting at Lodging Properties

Competencies

• 1.Describe the purposes of budgeting for operations and identify the roles and responsibilities of those involved in the budgeting process. (pp. 453456)
• 2.Explain the process of preparing an operations budget. (pp. 457469)
• 3.Describe the budgeting control process and explain how significant variances are determined. (pp. 469475)
• 4.Use information from budget reports to calculate and analyze several kinds of variances related to revenue, cost, volume, and labor. (pp. 475485)
• 5.Describe the proper management response to the results of variance analysis. (p. 486)

EveryRationalManagerplans for the future. Some plans are formal and others are informal. Budgets are formal plans reduced to dollars. Budgets provide answers to many questions, including the following:

• 1.What are the forecasted revenues for the month?
• 2.What is the budgeted labor for the year?
• 3.How many rooms are expected to be sold during any given month, and what is the expected average room rate?
• 4.What is the budgeted telecommunications department operating income for the month?
• 5.What is the estimated depreciation for the year?
• 6.How close were actual food and beverage revenues to the budgeted amounts for the month?
• 7.What is the projected net income for the year?

This chapter is divided into two major sections. The first section investigates reasons for budgeting, the process of preparing the operations budget, and the idea of budgeting horizons. The second section focuses on budgetary control and on how hospitality operations use budget reports in the budgetary control process. The Sands Motel, a hypothetical small lodging operation, is used to illustrate both budget preparation and control.

Types of Budgets

Hospitality operations prepare several types of budgets. Theoperations budget, the topic of this chapter, is also referred to as the revenue and expense budget, because it includes managements plans for generating revenues and incurring expenses for a given period. The operations budget includes not only operated department budgets (budgets for rooms, food, beverage, telecommunication, and other profit centers), but also budgets for service centers such as marketing, accounting, and human resources. In addition, the operations budget includes the planned expenses for depreciation, interest expense, and other fixed charges. Thus, the operations budget is a detailed operating plan by profit centers, cost centers within profit centers (such as the housekeeping department within the rooms department), and service centers.¹It includes all revenues and all expenses that appear on the income statement and related subsidiary schedules. Annual operating budgets are normally subdividedinto monthly periods. Certain information is reduced to a daily basis for managements use in controlling operations. The operations budget enables management to accomplish two of its major functions: planning and control.

Two other types of budgets are the cash budget and the capital budget. The cash budget is managements plan for cash receipts and disbursements. Capital budgeting pertains to planning for the acquisition of equipment, land, and buildings.

Budgeting Horizons

The annual operations budget must be subdivided into monthly plans in order for management to use it effectively as an aid in monitoring operations. The monthly plans allow management to measure the operations overall performance several times throughout the year. Certain elements of the monthly plan are then reduced to weekly and daily bases. For example, many lodging operations have daily revenue plans that differ by property, by day of the week, and by season. The daily revenue is compared to these daily revenue goals on the daily report of operations. Any significant differences (variances) require analysis, determination of causes, and, if necessary, corrective action. (Variance analysis will be discussed later in this chapter.) In addition, every month all revenue and expense amounts are compared to the budgeted amounts, and all significant variances are analyzed and explained.

Alternatives to the monthly breakdown of annual budgets are using thirteen 4-week segments or the 4-4-5 quarterly plan. The 4-4-5 plan consists of two 4-week plans followed by one 5-week, equaling the thirteen weeks in a quarter. Four of these quarterly plans serve as the annual operations budget.

Many hospitality organizations also prepare operations budgets on a long-range basis. A common long-range period is five years. A five-year plan consists of five annual plans. The annual plans for the second through fifth years are much less detailed than the current years annual plan. When long-range budgets are used, the next years budget serves as a starting point for preparing the operations budget. The long-range budget procedure is used to review and update the next four years and add the fifth year to the plan.

Long-range planning, also referred to asstrategic planning, is recognized as essential to the controlled growth of major hospitality organizations. It not only considers revenues and expenses (as do annual operating plans), but also evaluates and selects from among major alternatives those that provide long-range direction to the hospitality operation. Major directional considerations may include the following:

• Evaluating whether a proposed acquisition will have a positive effect on existing operations or whether it will hinder or detract from existing operations
• Determining whether the hospitality operation should expand into foreign markets
• Determining whether a quick-service restaurant chain should add breakfast to its existing lunch and dinner offerings
• Considering whether a single-property operation should add rooms or possibly expand to include another property

Recent research reveals about one-third of the private clubs in the United States prepare long-range operating budgets. The most common long-range plans cover four years in the future.

Reasons for Budgeting

Many small organizations in the hospitality industry have not formalized their operations budgets. Often, the overall goals, sales objectives, expense projections, and the desired bottom line remain in the head of the owner/manager. However, there are many reasons every hospitality operation should use formalized budgeting. Several of these are briefly described below:

• 1.Budgeting requires management to examine alternatives before selecting a particular course of action. For example, there are pricing alternatives for each product and/or service sold. Also, there are many different marketing decisions that must be made, such as where to advertise, how much to advertise, how to promote, when to promote, and so on. There are also several approaches to staffing, each of which will affect the quality of service provided. In nearly every revenue and expense area, several courses of action are available to hospitality operations. Budgeting provides management with an effective means of evaluating these alternatives.
• 2.Budgeting provides a standard of comparison. At the end of the accounting period, management is able to compare actual operating results to a formal plan. Significant variances should be analyzed to suggest the probable cause(s) that require additional investigation and possibly corrective action. While the preparation of budgets is independent of budgetary control, it is inefficient not to use budgets for control purposes. The focus of the last part of this chapter is on the control process.
• 3.Budgeting enables management to look forward, especially when strategic planning is concerned. Too often, management is either solving current problems or reviewing the past. Budgeting requires management to anticipate the future. Future considerations may be both external and internal. External considerations include the economy, inflation, and major competition. Internal considerations are primarily the hospitality operations reactions to external considerations. Hospitality operations should aggressively attempt to shape their environment rather than merely reacting to it.
• 4.When participative budgeting is practiced, the budget process involves all levels of management. This involvement motivates the lower level managers because they have real input in the process rather than being forced to adhere to budget numbers that are imposed upon them. Too often, autocratic budgeting approaches result in unsuccessful managers who blame the budget preparers (higher level managers) instead of accepting responsibility for poor operating results.
• 5.The budget process provides a channel of communication whereby the operations objectives are communicated to the lowest managerial levels. In addition, lower level managers are able to react to these objectives and suggestoperational goals such as rooms sold, rooms revenues, rooms labor expense, and so on. When the budget is used as a standard of comparison, the operating results are also communicated to lower level managers. This allows for feedback to these managers. Further, lower level managers are required to explain significant varianceswhy they exist, what the causes are, and what action is to be taken.
• 6.Finally, to the degree that prices are a function of costs, the budget process (which provides estimates of future expenses) enables managers to set their prices in relation to their expenses. Price changes can be the result of planning, thereby allowing such changes to be properly implemented. Price changes made on the spur of the moment often result in unprofessional price execution, such as penciled changes on menus, poorly informed service staff who misquote prices, and other similar situations.

The majority of club managers (60 percent) in a recent survey indicated that the most important benefit of the operations budget is that it provides a standard of comparison. The most important benefit to 33 percent is the ability to examine alternatives necessary for selecting a particular course of action. The remaining 7 percent of club managers indicated other benefits of preparing an operations budget.

Personnel Responsible for Budget Preparation

The complete budget process includes both budget preparation and budgetary control. The major purpose of budgeting is to allow management to accomplish three of its functions: planning, execution, and control.

In most hospitality organizations, the board of directors approves the operating budget, the preparation of which has been delegated to the chief executive officer (CEO). The CEO generally enlists the controller to coordinate the budget preparation process. However, budgeting is not a financial function where bookkeepers, accountants, and the controller have the sole responsibility. The controller facilitates the budget preparation process by initially providing information to operating managers. The major input for the budget should come from operated department (profit center) managers working with their lower level managers and from service department managers.

The controller receives the department managers operating plans and formulates them into a comprehensive operating budget. This is then reviewed by the CEO and a budget committee (if one exists). If the comprehensive operating budget is satisfactory in meeting financial goals, the CEO presents it to the board of directors. The controller or cheif financial officer often accompanies the CEO to assist the CEO as needed. If the operating budget is not satisfactory, then the elements requiring change are returned to the appropriate department heads for review and change. This process may repeat several times until a satisfactory budget is prepared.

The final budget should ideally be the result of an overall team effort rather than a decree dictated by the CEO. This participative management approach should result in maximizing departmental managers motivation.

The Budget Preparation Process

The major elements in the budget preparation process are as follows:

• Financial objectives
• Revenue forecasts
• Expense forecasts
• Net income forecasts

The operations budget process begins with the board of directors establishing financial objectives. A major financial objective set by many organizations, both hospitality and business firms in general, is long-term profit maximization. Long-term profit maximization may mean that the operation does not maximize its profits for the next year. For example, in the next year, profits could be increased by reducing public relations efforts and major maintenance projects; however, in the long run, cuts in these programs may disturb the financial well-being of the hospitality establishment. An alternative objective set by institutional food service operations (for example, hospital food service) is cost containment. Since many of these operations generate limited food service revenues, cost containment is critical to enable these operators to break even.

Another objective may be to provide high quality service, even if it means incurring higher labor costs than allowable to maximize profits. Other objectives set by hospitality organizations have been to be the top establishment in one segment of the hospitality industry, to be the fastest growing establishment, and/or to be recognized as the hospitality operation with the best reputation. Many more objectives could be listed. The critical point is that the board must establish major objectives. These are then communicated to the CEO and are the basis for formulating the operations budget.

When a management company operates a hotel for independent owners, the owners expectations for both the long and short term must be fully considered. Generally, the owners reserve the right to approve the operating budget. Therefore, failure to consider their views will most likely result in their rejection of the plan, as well as damaged relationships and the need to redo the budget. Several of the major hotel chains, such as Hilton, Hyatt, and Marriott, manage many more hotels than they own. Thus, their management teams at the managed properties must work closely with the owners of each hotel.

Forecasting Revenue

Forecasting revenue is the next step in preparing the operations budget. In order for profit center managers (for example, rooms department managers) to be able to forecast revenue for their departments, they must be provided with information regarding the economic environment, marketing plans, capital budgeting, and detailed historical financial operating results of their departments.

Information regarding the economic environment includes such items as:

• Expected inflation for the next year.
• Ability of the operation to pass on cost increases to guests.
• Changes in competitive conditionsfor example, the emergence of new competitors, the closing of former competitors, and so on.
• Expected levels of guest spending for products/services offered by the hospitality operation.
• Business travel trends.
• Tourist travel trends.
• For international operations, other factors such as expected wage/price controls and the political environment may need to be considered.

In order for this information to be useful, it must be expressed in usable numbers. For example, regarding inflation and the ability of the operation to increase its prices, the information received by department heads may be phrased as follows: inflation is expected to be 4 percent for the next year and prices of all products and services may be increased by an average maximum of 5 percent, with a 2.5 percent increase effective January 1 and July 1.

Marketing plans include, but are not limited to, advertising and promotion plans. What advertising is planned for the upcoming year, and how does it compare with the past? What results are expected from the various advertising campaigns? What promotion will be used and when during the budget year? What results can be expected? Are reduced room prices and complimentary meals part of the weekend promotion? Answers to these questions and many others must be provided in order for managers to be able to prepare their budgets.

Capital budgeting information includes the time of the addition of property and equipment. For an existing property, the completion date of guestroom renovation must be projected in order to effectively estimate room sales. The renovation of a hotels restaurant, the addition of rooms, and so forth are areas that must be covered before projecting sales and expenses for the upcoming year.

Historical financial information should be detailed by department. The breakdown should be on at least a monthly basis, and in some cases, on a daily basis. Quantities and prices should both be provided. That is, the number of each type of room sold and the average selling price by market segmentbusiness, group, tourist, and contractshould be provided. Generally, financial information for at least the two prior years is provided. The controller should be prepared to provide additional prior information as requested.

Historical financial information often serves as the foundation on which managers build their revenue forecasts. This type of budgeting has been calledincremental budgeting. For example, rooms revenue of a hotel for 20X1 through 20X4 is shown inExhibit 1. From year 20X1 to 20X4, the amount of revenue increased 10 percent for each year. Therefore, if future conditions appear to be similar to what they were in prior years, the rooms revenue for 20X5 would be budgeted at $1,464,100, which is a 10 percent increase over 20X4.

An alternative approach to budgeting revenue based on increasing the current years revenue by a percentage is to base the revenue projection on unit sales and prices. This approach considers the two variables of unit sales and pricesseparately. For example, an analysis of the past financial information inExhibit 2shows that occupancy percentage increased 2 percent from 20X1 to 20X2, 1 percent from 20X2 to 20X3, and 2 percent from 20X3 to 20X4. The average room rates have increased by $2, $3, and $4 over the past three years, respectively. Therefore, assuming the future prospects appear similar, the forecaster may use a 1 percent increase in occupancy percentage and a $5 increase in average room rate as the basis for forecasting 20X5 rooms revenue. The formula for forecasting rooms revenue is as follows:

Exhibit 1Rooms Revenue Increase

Exhibit 2Rooms Revenue 20X120X4

Rooms Available		occupancy Percentage		Average Rate		Forecasted Rooms Revenue
36,500		.76		$54		$ 1,497,960

This simplistic approach to forecasting rooms revenue is meant only to illustrate the process. A more detailed (and proper) approach would include further considerations, such as different types of rooms available and their rates, different room rates charged to different guests (for example, convention groups, business travelers, and tourists), different rates charged on weeknights versus weekends, and different rates charged based on seasonality (especially for hotels subject to seasonal changes), and so on. In addition, managers of other profit centers, such as food, beverage, telecommunications, and the gift shop, must forecast their revenue for the year.

Although sales forecasting is often used for short-term forecasts, many of its concepts are relevant to forecasting revenue for the annual budget. In addition to relying on historical information, many hotels, especially convention hotels thathave major conventions booked a year or more in advance, are able to rely in part on room reservations in forecasting both room and food and beverage sales. Still, for activities not reserved so far in advance, forecasting must be done.

Estimating Expenses

The next step in the budget formulation process is estimating expenses. Since expenses are categorized both in relation to operated departments (direct/indirect) and how they react to changes in volume (fixed/variable), the forecasting of expenses is similar to the approach used in forecasting revenue. However, before department heads are able to estimate expenses, they must be provided with information regarding the following:

• Expected cost increases for supplies, food, beverages, and other expenses
• Labor cost increases, including the cost of benefits and payroll taxes

Department heads of profit centers estimate their variable expenses in relation to the projected revenues of their departments. For example, historically, the food department may have incurred food costs at 35 percent of food sales. For the next year, the food department manager decides to budget at 35 percent. Therefore, multiplying projected food sales by 35 percent results in the projected cost of food sales. Other variable expenses may be estimated similarly.

An alternate way to estimate expense is based on standard amounts. For example, a hotel may have a work standard that requires room attendants to clean two rooms per hour. Given this standard, if 800 rooms sales are budgeted during a month, 400 labor hours would be budgeted for room attendants labor. If the average hourly wage is $7.50 per hour, $3,000 in wages is budgeted for room attendants for the period. Employee benefits related to room attendants are additional costs that also must be considered.

Another example is guestroom amenities. If the typical amenity package includes soap, mouthwash, shampoo, and so forth and costs $2 per room, then when 800 rooms sales are forecasted, the guest amenities budget would be $1,600.

Fixed expenses are projected on the basis of experience and expected changes. For example, assume that supervisors in the food department were paid salaries of $85,000 for the past year. Further assume that the new salary level of the supervisors is $90,000 plus another half-time equivalent to be added at a cost of $15,000 for the next year. Thus, the fixed cost of supervisor salaries for the next year is set at $105,000. Other fixed expenses are similarly projected.

The service center department heads also estimate expenses for their departments. The service departments in a hotel comprise the general expense categories of administrative and general, marketing, property operation and maintenance, utility costs, human resources, information systems, security, and transportation. Service center department heads will estimate their expenses based on experience and expected changes. Generally, the historical amounts are adjusted to reflect higher costs. For example, assume that the accounting department salaries of a hotel for 20X1 were $150,000. Further assume that salary increases for 20X2 are limited to an average of 5 percent. Therefore, the 20X2 accounting department salaries budget is set at $157,500.

Exhibit 3Interest Expense Budget for 20X2

A different budgeting approach,zero-base budgeting (ZBB), is applicable in budgeting for service departments. ZBB, unlike the incremental approach, requires all expenses to be justified. In other words, the assumption is that each department starts with zero dollars (zero base) and must justify all budgeted amounts. Lets look at an example that illustrates the differences between the incremental and ZBB approaches to budgeting.

Assume that the marketing department of a hotel had a total departmental budget of $500,000 in 20X1. In 20X2, cost increases are expected to average 5 percent, and new advertising in the monthly city magazine is expected to cost $500 per month. Under the incremental approach, the marketing budget would be set at $531,000, determined as follows:

$500,000 + $500(12) + $500,000(.05) = $531,000

Under ZBB, the marketing department would have to justify every dollar budgeted. That is, documentation would be required showing that all budgeted amounts are cost-justified. This means all payroll costs, supplies, advertising, and so forth would have to be shown to yield greater benefits than their cost.

The ZBB approach to budgeting in hotels appears to be limited to the service departments. However, since the total cost of these departments is approximately 25 percent of the average hotels total revenue, the total amount can be considerable.

More detailed discussion of ZBB is beyond the scope of this chapter.²

Projecting Fixed Charges and Interest Expense

The next step in the budget formulation process is projecting fixed charges. Fixed charges include depreciation, insurance expense, property taxes, rent expense, and similar expenses. In addition, interest expense, if any, must be forecasted. These expenses are fixed and are projected on the basis of experience and expected changes for the next year.

Exhibit 3illustrates how the interest expense budget for 20X2 is determined by estimating interest expense based on current and projected borrowings. Based on calculations inExhibit 3, the interest expense budgeted for 20X2 is $107,000.

Even though the above mentioned expenses are considered to be fixed, management and/or the board may be able to affect the fixed amounts for the year. For example, property taxes are generally based on assessed valuation and a property tax rate. Generally, a reduction in the assessed valuation will result in a reductionin the hotels property taxes. Thus, if the property is over-assessed, management should pursue a reduction that, if successful, will lower the property tax expense. Some hotels have been successful in obtaining reductions in their assessments, thus reducing this fixed expense for the year.

The final step of the budget formulation process is for the controller to formulate the entire budget based on submissions from operated departments and service departments. The forecasted net income is a result of this process. If this bottom line is acceptable to the board of directors and/or the owners, then the budget formulation is complete. If the bottom line is not acceptable, then department heads are required to rework their budgets to provide a budget acceptable to the board and/or owners. Many changes may be proposed in this rework process, such as price changes, marketing changes, and cost reductions, to mention just a few. Often, the board or owner will provide a targeted bottom line number before the budget is prepared. More often than not, budgets must be reworked several times before an acceptable budget is produced.

Budget Formulation Illustrated

A very simplified lodging example will be used to illustrate the preparation of an operations budget. The Sands Motel is a 20-room, limited-service lodging facilitythat is, it does not sell food and beverages. Each room is equipped with a telephone. Thus, the Sands Motel has two profit centers, the rooms department and telecommunications department. The Sands Motel also has two service centers, administration, and a combined maintenance and utility cost department.

The board of directors has established the major financial goal of generating a minimum net income of 15 percent of sales. The income statements for the past three years are presented inExhibit 4. An analysis of this financial information appears inExhibit 5. Economic environment information relevant to the Sands Motel in 20X4 is summarized as follows:

• No new firms are expected to compete with the Sands Motel.
• Overall consumer demand for motel rooms is expected to remain relatively constant.
• Inflation is expected to be about 5 percent in the next year.

The major findings and projections for 20X4 are as follows:

Item	Analytical Findings	Projection for 20X4
1. Rooms Revenue Paid Occupancy	There is no new competition for next year, and the Sands has increased its paid occupancy one percentage point each year for the last three years. Assume a 1% increase in 20X4. Projection for 20X4	71%

Exhibit 4Income StatementsSands Motel

Item	Analytical Findings	Projection for 20X4
Average Room Rate	This has increased by $2 each year, and the Sands Motel has still increased its occupancy percentage. An additional $2 increase appears to be reasonable for 20X4. Note: The $2 increase is 6% of the $33.50 average price for 20X3 and exceeds the expected inflation of 5%.	$35.50

Exhibit 5Analysis of Income StatementsSands Motel

Item	Analytical Findings	Projection for 20X4
2.Telecommunications Revenue	This has increased from 2% to 2.5%. A .2% increase appears reasonable for 20X4.	2.7%
3.Rooms Expenses Payroll	This has fluctuated significantly due to labor unrest. Major pay increases this past year appear to be satisfying the two room attendants and part-time front office personnel. Keep the payroll percentage for 20X4 at 20X3 levels.	16%
Laundry	This has remained constant at 1% of rooms revenue for three years.	1%
Linen	A .5% increase was experienced in 20X3 due to major purchases. The prior 2% appears adequate for 20X4.	2%
Commissions	The average for the past three years has been 1%. Continue to use 1% as an estimate for 20X4.	1%
All Other Expenses	These have stabilized for the past two years at 1.5%. This appears reasonable.	1.5%
4.Telecommunications Expense	This has nearly equaled telecommunications revenue each year. A breakeven situation is reasonable for 20X4.	100% of telecommunications revenue
5.Administration Payroll	The fixed portion has increased approximately $2,000 per year from 20X120X3. A $3,000 increase is scheduled for 20X4 to reward the general manager. Variable labor (as a percentage of total revenue) is expected to be 3% for 20X4.	$27,000 and 3%
other	Although this increased to 2.5% in 20X3, it is expected to return to the previous level of 2% in 20X4.	2%
6.Maintenance and Utility Costs
Maintenance	The fixed portion of part-time workers pay has increased $500 each year over three years. An increase of $1,000 is scheduled for 20X4. Variable maintenance of 3% appears adequate for 20X4.	$6,000 and 3%
Utility Costs	The fixed portion has increased approximately $500 each year since 20X1. Therefore, the estimated fixed portion should be increased accordingly for 20X4. The variable portion has increased .2% from 20X120X3. Utility costs are expected to be moderate in 20X4 and 5.4% appears reasonable.	$2,500 and 5.4%
7.Fixed Charges
Depreciation	The accountants calculation of depreciation for 20X4 is $15,000 for existing fixed assets and an additional $700 for a new microcomputer to be purchased in 20X4.	$15,700
Property Taxes	This assessed valuation is expected to increase by 10% for 20X4. The tax rate is not expected to change; therefore, increase property taxes for 20X4 to $6,600.	$6,600
Insurance	The current three-year insurance policy expires on December 31. The new three-year policy requires a $6,000 premium each year.	$6,000
Interest Expense	The flexible interest rate presently at 15% is expected to average 14.5% for 20X4. The average debt outstanding for 20X4 will be $90,000. $90,000 .145 = $13,050.	$13,050
Income Taxes	Income taxes for 20X120X3 were 30% of the income before income taxes. Due to reduced rates, the tax rate for 20X4 will be 25%.	25% of pre-tax income

The operations budget for 20X4 is shown inExhibit 6. The projected 20X4 net income for the Sands Motel of $29,586 is 15.6 percent of sales, which exceeds the minimum requirement of 15 percent.

Flexible Budgets

The budgets we have discussed so far have been fixed (sometimes called static) in that only one level of activity was planned. However, no matter how sophisticated the budget process, it is improbable that the level of activity budgeted will be realized exactly. Therefore, when a fixed budget is used, variances from several budget line items, specifically for revenues and variable expenses, can almost always be expected. An alternative approach is to budget for several different levels of activity. For example, a hotel may budget at three paid occupancy levels, such as 69 percent, 71 percent, and 73 percent, even though it believes that the level of activity is likeliest to be at the 71 percent level. With flexible budgeting, revenues and variable expenses change with each level of activity, while fixed expenses remain constant.

Exhibit 7contains three condensed operations budgets for the Sands Motel. The flexible budgeting reflects occupancy at 69 percent, 71 percent, and 73 percent. The static budget for the Sands Motel (Exhibit 6) was based on 71 percent occupancy. The kinds of observations that should be made in relation to flexible budgeting reflected inExhibit 7include the following:

Exhibit 6Sample Operations Budget Worksheet

• Revenues increase/decrease with occupancy.
• Departmental expenses increase/decrease with occupancy.
• Undistributed operating expenses increase/decrease only slightly, since a major portion of these expenses is fixed.
• Fixed expenses remain constant as expected.
• Net income changes with activity, but not as much as revenue.
• Net income as a percentage of total revenue for the three levels of activity is as follows:

Exhibit 7Flexible Operations Budget SandsMotel

At 69% occupancy:		=		=	14.8%
At 71% occupancy:		=		=	15.7%
At 73% occupancy:		=		=	16.4%

Therefore, the minimum required profit margin percentage of 15 percent can only be realized at the budgeted occupancy levels of 71 percent and 73 percent. Since 69 percent yields less than the targeted 15 percent profit margin, managementmay be requested to review the budget at 69 percent in an attempt to achieve the desired net income.

The flexible budget is relatively easy to prepare using computers. The relationship between revenues and expenses is expressed in formulas, and the computer, with minor human assistance, is able to do the rest. The major benefit of the flexible budget is to provide management and owners with bottom-line results for alternative levels of activity. Many activity levels can be projected.

As a note of caution, however, forecasters should realize that different levels of activity will most likely affect prices and possibly related expenses. For example, a room rate of $35.50 was used across the three occupancy levels used in the Sands Motels flexible operations budget. However, in order to increase occupancy above 73 percent, an average price reduction may be necessary, and a still greater price reduction may be required beyond 80 percent or some other higher number.

Budgeting for a New Lodging Property

The preceding discussion covers budgeting for an existing lodging property. However, a hotel in its first year lacks a historical base. How can it prepare its budget?

Certainly one source for budgeting for a hotels first year is the lodging feasibility study (LFS) that is generally prepared to secure the financing for the property. This study provides a summary of operations including sales, direct expenses of the profit centers, and operating overhead expenses. However, forecasters should not rely totally on these numbers for two major reasons. First, the study is prepared to secure financing, and the figures are not detailed by month, type of market, and so forth. Second, the LFS is prepared before the construction of the hotel, which is probably two years before the opening of the hotel; thus, the figures are somewhat dated. Nonetheless, it is a set of figures with which to start. These numbers should be updated on the basis of current room rates, labor costs, and other expenses.³

If a new hotel is part of a chain, cost information of similar properties can be obtained. When used cautiously, this information will be reasonably useful.

Finally, few if any new hotels or restaurants make a bottom line profit their first year. Unexpected expenses arise until the bugs are worked out and the market realizes the property exists. Therefore, the initial budget should allow for these higher than normal costs and possibly lower revenues than desired. A critical need is to have sufficient cash to carry the new property to the point of cash breakeven, which often is delayed until the second or third year of operation.

Budgetary Control

In order for budgets to be used effectively for control purposes, budget reports must be prepared periodically (generally on a monthly basis) for each level of financial responsibility. In a hotel, this would normally require budget reports for profit, cost, and service centers.

Budget reports may take many forms.Exhibit 8, a summary income statement used by The Sheraton Corporation, is prepared monthly and is the summary of the entire hotel operations. It is used by the hotel top management and is also made available to corporate executives and financial analysts. In addition to variances from budget, variances from last years actual are also shown in order to put the budget in perspective and to provide management with trend information.

Exhibit 8Monthly Summary Income Statement

Exhibit 9is a departmental budget report for the rooms department. It provides a further breakdown of the elements that make up revenues, wages, benefits, and other expenses. This report, which is available to corporate management, also goes to the next level of management below the general manager and controller.

In order for the reports to be useful, they must be timely and relevant. Budget reports issued weeks after the end of the accounting period are too late to allow managers to investigate variances, determine causes, and take timely action. Relevant financial information includes only the revenues and expenses for which the individual department head is held responsible. For example, including allocated overhead expenses such as administrative and general salaries on a rooms department budget report is rather meaningless from a control viewpoint, because the rooms department manager is unable to affect these costs. Further, they detract from the expenses that the rooms department manager can take action to control.

Relevant reporting also requires sufficient detail to allow reasonable judgments regarding budget variances. Of course, information overload (which generally results in managements failure to act properly) should be avoided.

There are five steps in the budgetary control process:

• 1.Determination of variances
• 2.Determination of significant variances
• 3.Analysis of significant variances
• 4.Determination of problems
• 5.Action to correct problems

Determination of Variances

Variances are determined by using the budget report to compare actual results to the budget. The budget report should disclose both monthly variances and year-to-date variances. Variance analysis generally focuses on monthly variances, because the year-to-date variances are essentially the sum of monthly variances.

Exhibit 10is the January 20X4 summary budget report for the Sands Motel. This budget report contains only monthly financial information and not separate year-to-date numbers, as January is the first month of the fiscal year for the Sands Motel.

Variances shown on this report include both dollar variances and percentage variances. The dollar variances result from subtracting the actual results from the budget figures. For example, rooms revenue for the Sands Motel was $14,940, while the budgeted rooms revenue was $15,620, resulting in a difference of $680. The difference is set in parentheses to reflect an unfavorable variance. Dollar variances are considered either favorable or unfavorable based on situations presented inExhibit 11.

Exhibit 9Monthly Income StatementRooms Department

Exhibit 10Summary Budget ReportSands Motel

Percentage variances are determined by dividing the dollar variance by the budgeted amount. For rooms revenue (Exhibit 10), the (4.35 percent) is the result of dividing $(680) by $15,620.

Variances should be determined for all line items on budget reports along with an indication of whether the variance is favorable or unfavorable. The kind of variance can be indicated by marking it + for favorable and for unfavorable, F for favorable and U for unfavorable, or placing parentheses aroundunfavorable variances and showing favorable variances without parentheses as shown inExhibit 10. Some enterprises simply asterisk unfavorable variances.

Exhibit 11Evaluating Dollar Variance Situations

Determination of Significant Variances

Virtually all budgeted revenue and expense items on a budget report will differ from the actual amounts, with the possible exception of fixed expenses. This is only to be expected, because no budgeting process, however sophisticated, is perfect. However, simply because a variance exists does not mean that management should analyze the variance and follow through with appropriate corrective actions. Only significant variances require this kind of management analysis and action.

Criteria used to determine which variances are significant are calledsignificance criteria. They are generally expressed in terms of both dollar and percentage differences. Dollar and percentage differences should be used jointly due to the weakness of each when used separately. Dollar differences fail to recognize the magnitude of the base. For example, a large hotel may have a $1,000 difference in rooms revenue from the budgeted amount. Yet the $1,000 difference based on a budget of $1,000,000 results in a percentage difference of only .1 percent. Most managers would agree this is insignificant. However, if the rooms revenue budget for the period was $10,000, a $1,000 difference would result in a percentage difference of 10 percent, which most managers would consider significant. This seems to suggest that variances should be considered significant based on the percentage difference. However, the percentage difference also fails at times. For example, assume that the budget for an expense is $10. A dollar difference of $2 results in a 20 percent percentage difference. The percentage difference appears significant, but generally, little (if any) managerial time should be spent analyzing and investigating a $2 difference.

Therefore, the dollar and percentage differences should be used jointly in determining which variances are significant. The size of the significance criteria will differ among hospitality properties in relation to the size of the operation and the controllability of certain revenue or expense items. In general, the larger the operation, the larger the dollar difference criteria. Also, the greater the control exercised over the item, the smaller the criteria.

For example, a large hospitality operation may set significance criteria as follows:

Revenue	$1,000 and 4 percent
Variable expense	$500 and 2 percent
Fixed expense	$50 and 1 percent

A smaller hospitality operation may set significance criteria as follows:

Revenue	$200 and 4 percent
Variable expense	$100 and 2 percent
Fixed expense	$50 and 1 percent

Notice that the change in criteria, based on size of operation, is generally the dollar difference. Both significance criteria decrease as the item becomes more controllable.

To illustrate the determination of significant variances, the significance criteria above for a small hospitality operation will be applied to the Sands Motels January 20X4 budget report (seeExhibit 10). The following revenue and expense items have significant variances:

• 1.The unfavorable $680 difference between the budgeted rooms revenue and the actual rooms revenue exceeds the dollar difference criterion of $200, and the unfavorable 4.35 percent percentage difference exceeds the percentage difference criterion of 4 percent.
• 2.The favorable $257 difference between the budgeted rooms payroll expense and the actual rooms payroll expense exceeds the dollar difference criterion of $100, and the favorable 10.28 percent difference exceeds the percentage difference criterion of 2 percent.
• 3.Several rooms expense variances such as laundry, linen, and commissions exceed the percentage difference criterion, but do not exceed the dollar difference criterion, so they are not considered significant; therefore, they will not be subjected to variance analysis.

Variance Analysis

Variance analysisis the process of analyzing variances in order to give management more information about variances. With this additional information, management is better prepared to identify the causes of any variances.

We will look at variance analysis for three general areasrevenue, cost of goods sold, and variable labor. The basic models presented in these areas can be applied to other similar areas. For each area, formulas, a graph, and an example will be provided. In addition, the two significant variances of the Sands Motel, rooms revenue and rooms payroll expense, will be analyzed.

Revenue Variance Analysis

Revenue variancesoccur because of price and volume differences. Thus, the variances relating to revenue are calledprice variance(PV) andvolume variance(VV). The formulas for these variances are as follows:

Exhibit 12Rooms Revenue: Budget and ActualSample Motel

A minor variance due to the interrelationship of the price and volume variance is theprice-volume variance(P-VV), calculated as follows:

These formulas are illustrated by using the Sample Motel, whose budget and actual monthly results for rooms revenue appear inExhibit 12.

The budget variance of $500 is favorable. Variance analysis will be conducted to determine the general cause(s) of this variancethat is, price, volume, or the interrelationship of the two. The price variance for the Sample Motel is determined as follows:

The price variance of $4,000 is unfavorable because the average price charged per room night of $90 was $10 less than the budgeted average price of $100.

The volume variance is computed as follows:

The volume variance of $5,000 is favorable, because 50 more rooms per night were sold than planned.

The price-volume variance is determined as follows:

The price-volume variance is due to the interrelationship of the volume and price variances. Ten dollars per room less than budgeted multiplied by the 50 excess rooms results in an unfavorable $500 price-volume variance.

The sum of the three variances equals the budget variance of $500 for room revenue as follows:

The price-volume variance in the analysis of revenue variances will be unfavorable when the price and volume variances are differentthat is, when one is favorable and the other is unfavorable. When the price and volume variances are the samethat is, either both are favorable or both are unfavorablethen the price-volume variance will be favorable.

Exhibit 13is a graphic depiction of the revenue variance analysis for the Sample Motel. The rectangle 0EFD represents the budgeted amount. The rectangle 0AHI represents the actual amount of rooms revenue. The price variance is the rectangle AEFB. The volume variance is the rectangle DFGI. The price-volume variance is the rectangle BFGH.

Cost of Goods Sold Analysis

Thecost of goods sold varianceoccurs because of differences due to cost and volume. That is, the amount paid for the goods sold (food and/or beverage) differs from the budget, and the total amount sold differs from the budgeted sales. The detailed variances related to the cost of goods are called thecost variance(CV), thevolume variance(VV), and thecost-volume variance(C-VV). The formulas for these variances are as follows:

Exhibit 13Revenue Variance AnalysisSample Motel

The cost-volume variance results from the interrelationship of the cost and volume variances.

The analysis of the cost of goods sold variance formulas is illustrated by using a food service example. The Sample Restaurant, open for dinner only, had cost of food sold results and budgeted amounts for January as shown inExhibit 14. The budget variance of $1,120 is analyzed using variance analysis as follows:

Exhibit 14Cost of Food Sold: Budget and ActualSample Restaurant

The cost variance of $300 is unfavorable because the cost per cover of 3,000 covers exceeded budget by $.10.

The volume variance is determined as follows:

The volume variance of $800 is also unfavorable because excessive volume results in greater costs than budgeted. Remember that this is from an expense perspective. Excessive volume from a revenue perspective is favorable.

The cost-volume variance is determined as follows:

The cost-volume variance of $20 is also unfavorable, even though the mathematical sign of the result is positive. The cost-volume variance will be unfavorable when the other two variances (cost and volume) are the samethat is, when both are favorable or unfavorable. When the cost and volume variances differthat is, when one is favorable and the other unfavorablethen the cost-volume variance will be favorable.

The sum of the three variances is $1,120:

This sum equals the $1,120 budget variance shown inExhibit 14. These results show that of the total $1,120, only $300 was due to cost overruns. Further investigation should be undertaken to determine why there were excessive food costs of $300. The volume variance of $800 should be more than offset by the favorable volume variance for the Sample Restaurant food revenue. The cost-volume variance of $20 is due to the interrelationship of cost and volume. It is insignificant and requires no additional management attention.

Exhibit 15Cost of Food Sold Variance AnalysisSample Restaurant

Exhibit 15is a graphic depiction of the cost of food sold variance analysis. The original budget of $12,000 for cost of food sold is represented by the rectangle 0ABC, while the actual food cost for the period is the rectangle 0DFH. Therefore, the difference between these two rectangles is the budget variance. The budget variance is divided among the three variances of cost, volume, and cost-volume. The cost variance is represented by the rectangle ADEB. The volume variance is represented by the rectangle BGHC. The cost-volume variance is represented by the rectangle BEFG.

Variable Labor Variance Analysis

Variable labor expense is labor expense that varies directly with activity. Variable labor increases as sales increase and decreases as sales decrease. In a lodging operation, the use of room attendants to clean rooms is a clear example of variable labor. Everything else being the same, the more rooms to be cleaned, the more room attendants hours are necessary to clean the rooms; therefore, the greater the room attendants wages. In a food service situation, servers wages are generally treated as variable labor expense. Again, the greater the number of guests to be served food, the greater the number of servers; therefore, the greater the serverexpense. The remainder of the discussion of labor in this section will pertain to variable labor, which we will simply call labor expense.

Labor expense variances result from three general causesvolume, rate, and efficiency. All budget variances for labor expense may be divided among these three areas.Volume variances(VV) result when there is a different volume of work than forecasted.Rate variances(RV) result when the average wage rate is different than planned.Efficiency variances(EV) result when the amount of work performed by the labor force on an hourly basis differs from the forecast. Of course, as with revenue variance analysis and with cost of goods sold variance analysis, there is a variance (called therate-time variance) due to the interrelationship of the major elements of the labor budget variance. The formulas for these variances are:

VV	=	BR (BT ATAO)
RV	=	BT (BR AR)
EV	=	BR (ATAO AT)
R-TV	=	(BT AT)(BR AR)

where the elements within these formulas are defined as follows:

• BR (Budgeted Rate)the average wage rates budgeted per hour for labor services.
• BT (Budgeted Time)hours requi