Contrary to some traditional pricing models where the party bringing in the traffic invoices initial traffic at a high price, decreasing as the volume mounts, hospitality pricing models have found an equilibrium in that they succeed in balancing the pressure to sell by the hotel chain – bringing in the traffic – with the pressure to maintain the infrastructure over the longer time by the owner of the infrastructure, by using a model which increases the price as traffic increases. In this, infrastructure is of course the goose, and the results are the golden eggs. As I believe this pricing model to be relevant for other industries as well, it it worth giving the broad strokes of this balance.
Context
As a young auditor, one of my main sectors was hospitality. I travelled in most of Eastern and Western Europe with stints to other continents as well, auditing hotel chains. One of the things I found fascinating was how almost all of the larger hotel chains managed to maintain the relationship between the two actors working together in this very specific revenue model and this in a highly competitive market.
On the one hand, you have the infrastructure owner. This is the owner of the property where the hotel is located. For those unfamiliar with the hospitality industry, most hotel buildings are not property of the hotel chains using them, but of individuals or investment organisations which aim to extract value out of them over a longer period of time.
On the other hand we have the hotel chain, the actual exploitation partner. They want to maximise use in order to extract as much revenue out of the property as possible. The exploitation partner drives traffic as well as performing the actual management of the hotel, employing the staff etc.
What is interesting in this relationship is that the traditional pricing model in these structures may be a bit different than what you would expect. Let’s explore the model and its actors.
The stage and its actors
We all know hotels: the are the places you go to sleep at night when you are away from home, for work or for leisure. But a hotel is not just a simple building with some staff. There are often at least two main actors active in such an endeavour:
The infrastructure owner
The infrastructure owner, as his title implies, owns the infrastructure and puts it contractually at the disposition of the exploitation partner, over a set period of time. His objective is to gain revenue from this infrastructure. The infrastructure owner is often a silent partner, with little to no hand in the actual running of the hotel, with the possible exception of fixed infrastructure maintenance.
The exploitation partner
The exploitation partner is the active partner in the daily functioning of the hotel. In effect, he manages the day-to-day operations of the hotel. When the exploitation partner represents a brand, this brand often comes with a group of customers that choose to preferentially stay in this brand of hotels when on a trip. There are many reasons for this, such as familiarity, convenience, standing, points gained … but the brand, if it is a good brand, is usually capable of passively or actively driving traffic to the property.
The underlying revenue split model
Let’s look at how the revenue is usually split between the actors in this model.
Infrastructure owner
The owner of the infrastructure usually takes the lion’s share of the revenue from the first clients. This could be considered as the payment – by the exploitation partner – for the access to the infrastructure. In essence, the hotel chain pays to gain access to the goose, to be able to get some of its golden eggs. As usage during a fixed time period – usually a year – mounts, the share of revenue the infrastructure owner has the right to decreases. Once the right to access to the goose has been paid, the infrastructure partner profits less from traffic increases, although he will still profit.
Or, to put it differently, the infrastructure owner has no direct advantage in overburdening his own infrastructure, as what he makes from it is decreasing with the mounting occupancy volumes. That is, unless he is strapped for cash, which is often likely resulting in his selling of the goose to another interested infrastructure owner. Sometimes hotel property changes hands without the exploitation partner changing.
Exploitation partner
The exploitation partner, the one actively managing the hotel, has a low initial part of the revenue, but as occupancy rates and rate per night per room increase he gets a larger share of the revenues. Contrary to the infrastructure owner, the exploitation partner wants to drive traffic to the hotel and wants to raise the occupancy rates as high as possible at an as high as possible rate per room per day. Key performance indicators monitored in most hotels are occupancy rates, difference from rack rates (the standard rates) and average yields per type of room.
The exploitation partner wants to load the infrastructure to capacity, as he makes his revenue from the higher occupancy rates and yields.
Rational decision taking by the actors
But what is driving these actors?
Infrastructure owner
The infrastructure owner wants to find the balance between his – usually longer term – revenue objectives and the cost of infrastructure maintenance, a cost which he usually carries for everything which is fixed infrastructure. He will therefore aim for optimal capacity and negotiate a high enough maintenance provision, which is a participation in the fixed infrastructure costs by the exploitation partner.
The infrastructure owner will push back against too high a usage of the infrastructure, in effect, against killing the goose with the golden eggs.
Exploitation partner
The exploitation partner wants to maximise his revenue and therefore drives traffic to the infrastructure. He wants to maximise his revenue, which he earns from a certain level of revenue (a function of occupancy and yields). But he has no advantage in squeezing too much out of the infrastructure, as over-using an infrastructure is likely to degrade it to the point where the customers are no longer willing to pay the premium for being able to benefit from the infrastructure.
The exploitation partner will therefore usually negotiate limited to no exclusivity, meaning he can also establish relationships with other properties in popular areas, and thus is able to balance traffic over the properties. He will also be quite picky in terms of the choice of infrastructure. His brand name and brand popularity depends on it. I’ve seen models in which customer evaluations of the total experience, including their appreciation of the property amenities and location actually influenced share of revenue for the different parties.
A balancing act
And this model results in a finely balanced equilibrium between two partners, in the best of circumstances really acting as partners. On the one hand, we find …
… pressure on the infrastructure owner from the exploitation partner
The exploitation partner wants to put as much traffic as possible in a popular infrastructure but without pushing it to the breaking point. He challenges the infrastructure owner to develop as much quality capacity as possible, which can take the form of fixed infrastructure investments such as room upgrades, more rooms in existing infrastructure etc. But all this needs to be done without degrading the perceived value of the property. And in all this, the exploitation partner will want to avoid exclusivity as this would no longer allow him to drive traffic to other properties if need be, in effect answering the requests from his network. But we also see …
… pressure on the exploitation partner from the infrastructure owner
The infrastructure owner wants to keep his goose at the lowest possible cost, or optimal revenue point, to him. Once he is happy with the traffic and the revenue generated, he will start to push back on higher capacity usage. This can be either initially negotiated at the contractual level but also be a part of a negotiation on for example infrastructure upgrades and cost allocations for that. And this eventually leads to …
… an optimisation point for each of the partners
Once the infrastructure owner is at his optimum capacity, he will aim at slowing down the exploitation partner. And, this is the most important part, at no point in time will the infrastructure owner feel he pays to much for the traffic the exploitation partner is driving to his property. At the balance point, both parties win, but even at any reasonable, profitable point on the revenue continuum neither party should feel disadvantaged.
Wider application
I’m convinced that such an equitable model could be applied in other industries as well and I am surprised that industries which could benefit from a long term relationship between two partners working together to serve a customer don’t use this model more often. It is fundamentally a longer term relationship model. This is a more complex model than basic revenue sharing models, but it ensures an equitable treatment of all partners.
Exploring The Black Box 