Key Performance Indicators 1

 

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[edit] 1 Summary

[edit] 2 Why should you use it?

The purpose of key performance indicators is to provide to decision makers in the organisation a measurable indicators for measuring or judging the organisational performance and for measuring the achievements of organisational objectives. KPI’s are the tool for internal business analysis and for controlling the strategy outcome. KPI’s are critically important for a host of hospitality decision making situations and they can help hospitality managers in their efforts to ensure efficient and effective management of resources and to achieve the main objective of any organisation – maximisation of the profit. Nevertheless the KPI’s, as they are uniform for all organisations, assure the managers a tool for benchmarking with other organisations in order to improve their own performance.

[edit] 3 Why has it been developed and who developed it?

[edit] 4 When should you use it?

Whenever the manager has to make a decision the KPI’s are the right tool for him. The managers make decisions on a daily basis. Most often they make decisions on organizations performance on monthly and quarter of the year basis. The main decisions are made on the yearly basis.


[edit] 5 How does it work?

Most of KPI’s are financial measures. Why? This is because financial measures are based primarily on the most fundamental common denominator in business, i.e. money. The critics argue that financial measures are not perfect to direct and control the business. They argue that financial measures focus on symptoms rather than causes (example: profit may decline because of declining customer service, therefore it would be more appropriate for managers to focus on monitoring a quality of customer service) and that financial measures tend to be oriented to the short-term performance of the past, which can hinder forward- looking, long term initiatives. Therefore also some non-financial performance indicator (i.e. Balance Scorecard, rooms-related performance measures) become more and more important for measuring a comprehensive organisational performance.

The main source for financial measures is accounting information system and within the main “products” of the accounting system i.e. financial statements – Profit & Loss Account, Balance Scheet, Cash flow statement - and cost information system.

The main groups of KPI’s are:

  • Financial statement analysis
  • Operational measures
  • Cost – volume – profit analysis


[edit] 5.1 Financial statement analysis

Financial statement analysis is used to analyse the financial performance and stability of organisation. Much of the analysis can be conducted through the use of ratios, so it is frequently named also Ratio Analysis. Within the financial statement analysis two distinct perspectives of organisational performance are conducted and observed. First, the profit performance and second the financial stability. Operational measures, which are also mostly conducted through the use of ratios (operational ratios) are used to measure day to day operating issues. Many of operational ratios do not involve financial measures, but they represent important performance indicators too. Cost – volume – profit analysis primary focus on projecting future levels of profitability. It is a tool for managers to understand how much cost and profits will fluctuate following a change in sales volume. The key performance indicators are presented in following Exhibit 1.

Exhibit 1: Key performance indicators

GROUP OF PERFORMANCE INDICATOR PERFORMANCE INDICATOR FORMULA PERFORMANCE INDICATOR WHAT DOES IT SHOW?
FINANCIAL STATEMENT ANALYSIS
a) PROFIT PERFORMANCE
Return on investment (ROI) ROI = EBIT / Total Assets How much return (profit) from the assets available has been generated by the company management’s performance in the certain period of time.row 2, cell 3
Gross profit margin GPM = Gross profit / Revenue The percentage of sales available to cover general and administrative expenses and other operating costs.
Profit margin PM = EBIT / Revenue How much profit has been earned on sales.
Assets Turnover AT = Revenue / average balance of total assets How much profit has been earned on total assets or employed assets.
Accounts receivable turnover (ART) ART = Credit sales / average balance of accounts receivable The percentage of credit sales on average balance of accounts receivable.
Average number of days to collect accounts receivable Average number of days to collect accounts receivable = 365 days / ART How many days we need to collect the accounts receivable.
Inventory turnover (IT) IT = Cost of sales / average balance of inventory The percentage of cost of sales on average balance of inventory.
Average number of days inventory held Average number of days inventory held = 365 days / IT How many days the inventory is held in the company.
Fixed asset turnover Fixed asset turnover = Revenue / Average balance of fixed assets The percentage of revenue on fixed assets.
b) FINANCIAL STABILITY
Current assets ratio CAR = Current assets / Current Liabilities Whether the company’s assets will cover its liabilities that will fall due for payment in the next 12 month
Financial leverage or Debt to assets Debt to assets = Total debt / Total assets The level of debts of the company.
Times interest earned Times interest earned = EBIT / annual interest payment An extend to which interests charges are covered by the company’s level of profit.

The ability of the company to serve its debts.

OPERATIONAL MEASURES – ROOMS RELATED PERFROMANCE MEASURES
Room occupancy Room occupancy = (No. of rooms let in hotel / Total rooms in hotel) x 100 The percentage of rooms let in hotel.
Paid occupancy Paid occupancy = (No. of rooms sold / Total rooms in hotel) x 100 The percentage of rooms sold in hotel.
Average room rate or average daily rate (APR) ADR = Day’s revenue from room letting / No. of rooms let in the day An average room rate, charged in the day.
Revenue per available room Revpar = Total daily room letting revenue / Total hotel rooms or

Revpar = Occupancy level x ADR

How much revenue has been earned by every room available in the hotel.
Room yield Room yield = Actual total room revenue / Potential total room revenue An actual revenue as a percentage of potential revenue.
Service cost per room Service cost per room = Total daily room servicing costs / No. of rooms serviced in the day The efficiency of room service expenditure.
COST – VOLUME - PROFIT ANALYSIS
Contribution margin CM = Revenue – Variable costs
Contribution margin ratio CM / Revenue x 100
Break Even Analysis

EBIT – Earnings before interests and tax

[edit] 5.2 Operational Measures - Rooms related performance measures

1.Summary

Performance ratios that have more an operational focus for measuring day to day operations and especially level of activity are so called operational measures. As in the hotel room represent the core business, most operational ratios are related to room. Most commonly used rooms related performance measures are room occupancy, average room rate, revenue per available room or room yield and service cost per room. However, revenue per available room – Revpar, is the most commonly used indicator for measuring sales performance in the hotel, as it gives the most complete picture of sales performance.

2.Why should you use it?

The purpose of using operational ratios is to measure the day to day activity level performance of the hotel. Hotels competing in the same geographical area frequently share information on each others’ occupancy level as a tool for measuring their performance. Comparing achieved operational ratios with planed operational ratios shows us, how successful we are implementing our strategy. As they are calculated on a daily or monthly basis, they are a useful tool for managers to promptly react, when these indicators are lower than planed and make decisions in a way that will improve their performance in order to achieve the strategic goals.

3.Why has it been developed and who developed it?

4.When should you use it?

Operational measures are mostly used on a day to day basis and they help managers by making day to day decision on operation performance. They are used also for benckmarking comparisons across hotels and they are useful tool for managers by creating pricing policy of the hotel.

5.How does it work?

The main rooms related performance indicators are:

  • Room occupancy
  • Average room rate
  • Revenue per available room - Revpar
  • Room yield
  • Service cost per room

As you will see below, the analysis of those indicators gives us a comprehensive picture of the hotel’s activity and sales performance if we analyse them together not separately.

Room occupancy

Room occupancy is widely quoted performance indicator in the hotel industry. It is calculated as follows:

Room occupancy = (Number of rooms let in hotel / Total rooms in hotel) x 100

It shows us the percentage of rooms let in a certain period of time (day, month, year). This activity level indicator could be a little misleading in those hotels that let out a significant number of complimentary rooms. It that case, computing room occupancy by dividing number of beds let by number of total beds in hotel, would be more appropriate. Or another option is to compute paid occupancy ratio as follows:

Paid occupancy = (Number of rooms sold / Total rooms in hotel) x 100

Further on, we have to have in mind, that a high paid occupancy percentage does not necessary signify a high revenue from rooms. This is because not all room sales are made at rack rate (the rack rate is defined as the maximum price that will be quoted for a room). According to that, a performance measure that indicates the average room rate charged needs to be computed. This can be achieved by using an average room rate (sometimes called average daily rate - ADR) performance indicator, which is calculated as follows:

Average room rate = Day’s revenue from room letting / Number of rooms let in the day

The room occupancy and the average room rate performance indicators, when considered independently, represent incomplete measures of sales performance. A higher level of total revue from rooms will not result from an increased occupancy level if the room rate has been disproportionately dropped. Similarly, a higher level of total revenue from rooms will not result if an increase in the average room rates coincides with a disproportionate decline in the occupancy level. For solving this incompleteness of both indicators, another indicator has been developed – revenue per available room (Revpar). It is calculated as follows:

Revpar = Total daily letting revenue / Total hotel rooms (both sold and unsold)

or

Revpar = Occupancy level x Average room rate

Revpar shows us room sales performance. It shows how much revenue has been earned by every room available in the hotel. By bringing occupancy level and average room rate together, it can give us more complete measure of performance. By using revpar managers concern to find an optimal balance between maximizing occupancy levels and average room rates charged. As a performance measure, revpar is preferred to total revenue as it facilitates benchmarking comparisons across hotels with different numbers of rooms.

However it should be noted, that maximizing revpar does not necessarily signify profit maximization. In a situation of major room rate discounting, the higher revpar associated with an increase in occupancy could result in lower level of overall profit if the increased total revenue does not outweigh the additional costs i.e. housekeeping, energy costs, associated with the hotel’s increased activity.

The Revpar dimension of room sales performance can be measured slightly differently by viewing actual revenue as a percentage of potential revenue. The ratio, measuring this dimension is so called room yield and is calculated as follows:

Room yield = Actual total room revenue / Potential total room revenue

Revpar and room yield indicators give the same results. A high revpar will signify a high room yield. Accordingly to that, there is no need to compute both performance indicators.

On the expense side of a hotel’s room sales activities, the efficiency of room service expenditure can be monitored by calculating the service cost per room indicator:

Service cost per room = Total daily room servicing costs / Number of rooms serviced in the day


6.Related topics/tools

  • Pricing policy
  • Yield management
  • Rack rate

7.links/sources

Guilding, Chris (2005): Financial Management for Hospitality Decision Makers, First published 2002, Burlington.

Owen, Gareth (1998): Accounting for Hospitality, Tourism & Leisure, 2.edition, Edinburgh.

[edit] 5.3 Cost-volume profit analysis (CVP)

1.Summary

Cost – Volume – Profit Analysis is a valuable technique or tool for manager’s decision making, when considering a decision to enter a new commercial activity or when considering the decision on improving existing performance. The primary focus in CVP analysis concerns projecting future levels of profitability.

2.Why should you use it?

It is a tool for analytical approach that can enable managers to answer the questions about how to achieve or maintain the target level of profitability.

3.Why has it been developed and who developed it?

4.When should you use it?

The CVP analysis is used when we have to answer to following questions:

a) When entering new business or commercial activity within an existing business:

  • How many units will we need to sell in order to break even?
  • How much will we need to sell in order to achieve our target profit level?

b) With existing business:

  • What will happen to profit if we manage to increase sales volume by 10%?
  • If we increase advertising by 10%, how much more would we have to sell in order to maintain our current level of profit.

5.How does it work?

The primary focus in CVP analysis concerns projecting future levels of profitability. Projecting profit requires an understanding of how much costs and profits will fluctuate following change on sales volume. An understanding a fixed and variable costs comes into account. Total revenue minus total variable costs is generally referred to as contribution margin. The contribution margin highlights what proportion of revenue is consumed by variable costs. It is important to recognize that because variable costs move in line with revenue, this relationship is constant. For example: If 25% of sales revenue is consumed by variable costs, 75% of sales revenue remains as contribution for covering fixed costs. Once revenue achieves a level that is sufficient to cover all fixed costs, additional sales will contribute to the earning of profit. As the contribution is 75% of revenue, once fixed costs are covered, profit will accumulate at the rate of 75% of every additional euro of sales. Further on contribution margin ratio refers to the percentage of sales that is not consumed by variable costs. The formula is as follows:

Contribution margin ratio = (Contribution margin / Revenue) x 100

Or

Contribution margin ratio = ((Revenue – Variable Costs) / Revenue) x 100

The contribution margin format is useful as it enables us to quickly answer questions such as what will happen to our profit, if revenue increases by certain amount. For example: If we take the contribution profit margin as above 75% and if we want to find out what will happen with our profit if we increase the revenue by 200.000 EUR, we know that increased revenue by 200.000 EUR will add 150.000 EUR (0,75 x 200.000 EUR) to profit.

Break even analysis

Breakeven analysis shows us, how many units need to be sold to achieve target level of profit. Breakeven analysis can be applied in different scenarios that signify varying degrees of complexity. In basic situation of calculating breakeven it is presumed that only one service is sold.

By distinguishing between fixed and variable cost, we can determine the volume of sales necessary to achieve breakeven. Breakeven is the level of sales where profit is 0. To conduct a breakeven analysis, we need to consider contribution at the unit level. In the context of hotel, by unit is usually meant room. As contribution margin refers to total revenue minus total variable cost, it follows that contribution margin per unit is calculated as follows:

Contribution per unit = Unit sales price – Unit variable cost

For better understanding let’s see the following example for calculating breakeven point for Hotel X.

The main question for hotel manager is what level of occupancy must be achieved in order to avoid recording a loss next year. The manager knows that the annual fixed costs are 2.190.000 EUR. The hotel has 200 rooms and the average room rate charged is 67 EUR. The variable cost associating with providing one night’s accommodation is 7 EUR. Form this data we can calculate the contribution margin per room night sold, which is 60 EUR (67 EUR – 7 EUR).

At the beginning of the year, the hotel can be described as 2.190.000 EUR “in the hole”, due to the 2.190.000 EUR fixed costs, that will be incurred regardless of the number of room nights sold. Following the sale of the first room night, the degree to which the hotel is “in the hole” will have declined by 60 EUR, as 60 EUR will have been contributed to covering the 2.190.000 EUR fixed costs. The question is now, how many room nights with a contribution of 60 EUR have to be sold to cover all the hotel’s annual fixed costs? As 36.500 contributions of 60 EUR provide 2.190.000 EUR (2.190.000 / 60), we can conclude that once hotel sell 36.500 rooms, it will have achieved breakeven. This line of logic has taken us through the following widely quoted formula for determining breakeven:

Breakeven number of units to be sold = Fixed costs / Contribution per unit

This breakeven point at 36.500 room sold per annum can also be stated in terms of the occupancy level, required to achieve breakeven. If the hotel is opened for 365 days per annum, it would have 73.000 room nights available per annum (365 x 200 rooms). 36.500 rooms represent 50% of hotel’s annual available room nights (36.500 / 73.000 x 100). We can therefore conclude that an occupancy rate of 50% will result in hotel achieving breakeven. The occupancy breakeven formula is as follows:

Occupancy breakeven = (Number of room sales necessary for breakeven / Room nights available) x 100

From this calculations we can quickly find out in which cases the breakeven level of room sales would be lowered. These are: Increase the average room rate above the actual one (67 EUR in our case) Reduce the variable costs per room night sold below the actual one (7 EUR in our case) Reduce the level of fixed costs below the actual one (2.190.000 EUR in our case).

Following exhibit presents a graphical representation of breakeven.















In this graph, sales activity is shown on the horizontal axis with euros in the vertical axis. If we draw in the total sales revenue line and also the total cost line for all levels of activity, we can determine the breakeven level of sales. A breakeven occurs at the activity level where total costs equal to total sales, breakeven is represented by the point where the sales and total cost lines intersect. In the graph this breakeven point is highlighted by the vertical dotted line. Any level of sales to the right of the dotted line will result in a profit. Any level of sales to the left of the line will result in a loss.

On the basis of breakeven analysis we can answer also the following questions that can assure us more safety performance:

  • By how many sales are we surpassing the breakeven?
  • How much would our occupancy level decline before we would record a loss?

For answering those questions we use so called Safety margin, using the following formulas:

Margin of safety in EUR sales = Current EUR sales – EUR sales required to break even

Or

Margin of safety in units sales = Current unit sales – Unit sales required to break even

Or

% occupancy safety margin = Current occupancy % - Occupancy % required to break even


Some managers are interested in determining the level of sales necessary to achieve a profit target. A profit target can be stated in terms of a before-tax or after-tax amount. If you are able to grasp the rationale for the approach taken in the basic breakeven situation, understanding how to determine the level of sales necessary to achieve a target profit will be relatively straightforward. The most simply way is just to add an amount of target profit to the fixed costs in the breakeven formula. Accordingly the target profit formula is:

Rooms sales to achieve target profit = (Fixed costs + Target profit) / Contribution per unit

At the end it should be noted that several assumptions are made when applying CVP. The main assumptions are:

  • Selling price is constant
  • Fixed costs are constant.
  • Total variable cost varies directly in proportion with sales volume.


[edit] 6 Related topics/tools

  • Balance Scorecard
  • Accounting information system
  • Financial statements
  • Cost management
  • Fixed and variable costs

[edit] 7 links/sources

Guilding, Chris (2005): Financial Management for Hospitality Decision Makers, First published 2002, Oxford.