Exclusive Feature: Are your Top-Line dollars flowing through to Your Bottom-Line dollars? Quite often, a crucial misconception for hotels is to focus on department profit instead of profit flow through.
What do I mean by that, you ask?
I am getting right to that.
Let us define both terms to get a better understanding.
Department Profit is:
Department Revenue LESS Department Expenses
Profit Flow Through is:
Incremental Profit Over Incremental Revenue X 100
[expressed as a percentage]
So, what’s the big deal about profit flow through?
Coming right up.
It is a huge deal.
Let me explain.
Relationship between Revenue & Profit
Department Profit is an absolute measure.
It reduces department expenses from department revenue.
It does not however tell you a key story about the relationship between revenue and profit.
What do I mean by that?
I mean that revenue and profit do not operate in isolation.
They have a relationship.
You look puzzled.
Hang on, I will clear the air.
Again, let us define what revenue is and what profit is.
Revenue is considered the Top Line.
It is what the hotel business (like any other business) earns from operating.
You could say:
Revenue is What the Business Earns.
Profit on the other hand is considered the Bottom Line.
It is what the hotel business ends up having from operating.
In other words:
Profit is What the Business Retains.
Now comes the most important part.
What the business retains is closely related to what the business earns.
Or, Revenue and Profit are closely related.
Often, they are related through expenses.
Expenses can be defined as the cost of doing business.
Or,
Expenses are What the Business Incurs.
And what the business incurs is for the purpose of earning revenue.
Revenue & Expenses both influence Profit
In this triangle of revenue, expenses and profit, lies a powerful phenomenon.
The phenomenon of cause and effect.
Businesses exist because they continue to earn revenue.
As an extreme example, during covid-19, businesses stopped existing literally.
Why, you ask?
Because they stopped earning revenue.
They stopped because there were no customers.
So, earning revenue is a foundational concept.
You could say that earning revenue is one cause for the business.
Or, simply revenue is a cause.
So, what is the effect, you want to know?
Coming right up.
Effect is generally regarded as anything that is a result.
And so, the result in a revenue, expenses, profit triangle is the profit.
Now, we are closer to knowing why measuring department profit alone is not good enough.
Department Profit as said earlier only tells you the result.
It is Department Revenue Less Department Expenses.
However, would you not want to know whether the result (profit) is:
In other words, are you not interested in knowing whether your profit is acceptable.
Hotel owners would want to know why the profit is not good enough.
They are the ones who have pumped in millions of dollars into the hotel project.
They have a right to know.
But the hotel management also would want to know.
Because they are answerable to the hotel owners.
So, what is that measure that will tell you the efficiency of profit retention.
This is considering that department profit cannot tell us that.
To the rescue comes the powerful principle of profit flow through.
What is Profit Flow Through?
The principle of Profit Flow Through is a powerful one.
How does it tell you how efficient your hotel has been in retaining profit?
Well, it uses a simple formula between revenue and profit.
Remember, what we said about revenue and profit being closely related.
So, the principle uses this relationship to measure efficiency.
Let me explain.
Profit Flow Through basically says that any profit growth needs to trace back to the revenue management stage itself.
How, you ask?
By relating a change in revenue to a change in profit.
In other words, what is the relationship in numbers between:
- What the Business Earned and
- What the Business Retained
We can restate that as any increase in revenue must result in increase in profit.
However, that is not the entire story.
We also must find out how much was the increase in profit compared to the increase in revenue.
In essence, that is what profit flow through is all about.
Of course, it will all make sense when you see revenue, expenses and profit in number terms.
Let us do that with a simple illustration.
Say, you are the General Manager of your hotel.
In a particular month or year (in this illustration we have used year), you look at the department profit in dollars as well as percentage terms.
Let us see what department profit looks like.
Below is provided a table which shows:
- Revenue, Expenses and Profit for This and Last Year
- There are 3 scenarios shown in this table.
- Each row of the table is a different scenario.
- Each scenario has different revenue, expenses, and profit for this as well as last year.
Remember what I said about department profit being an absolute number.
In the above table, you see Profit for this and last year.
You can only say that each scenario produces different profit for this as well as last year.
That is not very helpful.
How will you be able to improve it or whether you need to improve it?
Let us add one additional measure – department profit increase %.
See table below with that addition.
Your department profit increase % will tell you by what proportion the profit has increased.
For example, in the table above Scenario 2 (row 2) has the highest increase % of 15% than say, Scenario 1 (8%) and Scenario 3 (12%).
This is better than just the department profit in dollars.
However, if we go back to our earlier discussion on profit flow through, we still do not know much about the efficiency of the profit increase %.
In other words, we do not know if our profit increase has been efficient or not.
Efficiency of Profit Improvement
So, you might ask whether, based on the table, is our profit increase % efficient?
Any measure of efficiency is effective only when it makes the comparison clear.
Or, to state it differently:
Is our profit increase the best, say, compared to revenue increase?
Why compared to revenue you ask?
Because of three good reasons based on what we noted earlier:
- That revenue and profit are closely related.
- That revenue is what we earn and profit what we retain and
- That revenue is the cause and profit the effect
If we take these reasons into account, the principle of profit flow through emerges.
Profit Flow Through basically says:
If your revenue increased by x dollars, how much did your profit increase in dollars?
Stated as a percentage, the Profit Flow Through formula is:
Profit This Year Less Profit Last Year
------------------------------------------------------- X 100
Revenue This Year Less Revenue Last Year
Let us see the table this time with profit flow through % calculated.
You will immediately notice one fact from the above table.
That the profit flow through of 57% for Scenario 2 (2nd row) is the best.
If you remember, the profit increase % also showed this to be the best.
However, there is a huge difference between a profit increase % and profit flow through %.
Profit increase % is simply the increase in the profit dollars expressed as a %.
It does not consider revenue dollars at all.
This is where the profit flow through % shines and is a better measure.
The profit flow through % shows you how much profit % increased compared to revenue increase %.
So, a profit flow through of 57% (Scenario 2 – row 2) means:
For every dollar of revenue increase, 57% of profit was retained.
This now is an indication of the efficiency of our profit achievement.
How to Use Profit Flow Through as a Key Performance Indicator (KPI)
At this point, you might have a logical question.
What is the practical use of the profit flow through KPI?
Great question.
Well, it has a number of uses.
However, before that, let us understand a few facts about profit flow through:
- Profit Flow Through is different for Rooms, Food and Beverage departments in a hotel
- Profit Flow Through will be different based on the balance between occupancy and average daily rate (say, by RevPAR which takes both into account as we saw earlier)
- Profit Flow Through is effective only when measured between actuals (like we did in the table – This Year actuals Vs Last Year actuals)
- Profit Flow Through is not the last step in the process – rather, it is the first step and further analysis needs to follow.
Having said the above, the single most practical use of the profit flow through measure is this.
Regular profit flow through % calculations can be used for powerful benchmarking.
Benchmarking as in, compared to industry norms, the hotel’s past performance and so on.
Ironically, this benchmarking is to improve the profit flow through % itself.
I will close this post on profit flow through with one important clarification.
Remember, earlier we said profit flow through is the first step and needs further analysis.
What could be that analysis?
For example, that analysis could be by bringing in occupancy and average daily rate increases also and see which impact
revenue more.
As a rule, generally, if revenue increased due to average rate only, profit flow through will be higher (compared to occupancy increase).
Measuring efficiency, the secret sauce of Profit Flow Through
In closing, we could say that there is a secret sauce for the power of profit flow through.
This we saw from our illustration earlier.
Other KPIs like department profit focus on absolute differences.
That is not helpful as a tool for improvement.
If your hotel really wants to improve its profitability, it needs to attack the source.
And by focusing on efficiency of retaining profit, profit flow through delivers that tool.
Indeed, the secret sauce for profit flow through is measuring efficiency.
Ensure that you are leveraging it in your own hotel operation.
Lakshmi Narasimhan Soundararajan is the founder of Financial Skills Academy a New York city based enterprise focused on hotel finance training, coaching and consultancy. Lakshmi has been teaching undergraduate and graduate courses for a decade at New York University, Jonathan M Tisch Center of Hospitality as an Adjunct Assistant Professor during Spring and Fall semesters. He teaches hospitality finance, business development among other courses.
Right from the time he was in school, Lakshmi had a head for numbers. In fact, he says, numbers talk to him and tell him stories. At the same time, as he fashioned his career in the hospitality industry, he worked closely with colleagues who did not have a financial background. He saw them struggle with numbers and fear them.
Lakshmi made up his mind there and then to commit his career to hotel finance training by simplifying numbers for the benefit of his non-financial background colleagues.
He is currently working on Financial Skills Academy Membership with the philosophy of assisting hotel middle managers, small business owners and students to Build Financial Skills, Knowledge and Ability in themselves.
His vision is for Financial Skills Academy Membership to be the Ultimate Learning Hub for Hotel Finance Training.
Lakshmi 's all-time favorite historical figure is Leonard Da Vinci and in particular Da Vinci's love for simplicity. While developing his membership site, Lakshmi based the value proposition for his hotel finance training courses on three foundational principles: SIMPLE. NON-TECHNICAL. USABLE.
Blog and eLearning Portal: www.profitsmasterclassblog.com
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