Question

Amy Richardson had been a well-paid sales manager of a major hotel chain for 15 years. Due to a hotel owner's illness, Amy was offered the opportunity to purchase a hotel near a seaside vacation area she had often visited. After obtaining a lawyer and a financial accountant to assist her, Amy did an analysis of the most recent financial statements of the hotel. Since the hotel had consistently shown a profit during the past few years, Amy thought that the price of the hotel was reasonable, so she decided to purchase the hotel. She resigned her position, obtained a loan, and purchased the hotel.

During the first year as a hotel manager, Amy received an offer from a tour operator who proposed to guarantee a considerable number of room reservations, including during the off-season. However, she turned down the offer because the tour operator asked for a 20% price reduction compared to the regular room rate. A few weeks later, she decided to shut down the restaurant, located in the main building of the hotel, in order to save expenses. With regard to general expenses, she was particularly concerned with the high room cleaning and service costs. On the sales side, although the reservations for the cheaper standard rooms were a bit sluggish, the more expensive large-size superior rooms had a very good occupancy rate of over 90%.

The following year, there was a severe economic downturn and also a very bad weather season that reduced the number of guests and also caused a resulting mold situation in the hotel building that required expensive repair work. Amy ran short of cash, became emotionally distraught, and eventually had to sell the hotel at a significant loss.

Question: Using Relevant Costs To Make Short-Term Decisions explain potential management errors that Amy had made and could have helped her to improve decision-making and the financial results of the business.

Answer 1

The probable management failures are discussed as follows-

1. Turning down the offer of tour operator
If the reduction in price (opportunity cost) is lower than the estimated increase in income due to higher turnover of guests (opportunity income), then Amy should have accepted such an offer. Also, during the sluggish season, the guarantee provided by the tour operator would have benefitted Amy.

2. Closing the main hotel building when it has high occupancy rate
The shut down decision making shall be made where there is no/low occupancy and the fixed expenses are higher. In the case of Amy, even though the shutdown would have saved some the fixed costs, the hotel would have also lost the contribution margin, which might have provided profits sufficient to set off such expenses.

3. Poor estimation of market
Amy has failed miserably in predicting the future market of hotel industry and should not have invested any amount in such industry where the market is expected to be sluggish.