John Blodgett is the managing partner of a business that has just finished build

Question

John Blodgett is the managing partner of a business that has just finished building a 60 room hotel. Blodgett anticipates that he will rent these rooms for 15,000 nights next year (or 15,000 room nights). All rooms are similar and will rent for the same price. Blodgett estimates the following opearting costs for next year.
Variable opearting costs $5 per room night
Fixed costs
Salaries and wages $173,000
Maintenance of building and pool 52,000
Other maintanace and administration costs 150,000
Total fixed costs $375,000
The capital invested in the motel is $900,000. The partnership's target return on investment is 25%. Blodgett expects demand for rooms to be uniform throughout the year. He plans to price the rooms at full cost plus a markup on full cost to earn the target return on investment.




1. what price should Blodgett charge for a room night? What is the markup as a percentage of the full cost of a room night?
2. Blodgetts market research indicates that if the price of a room night determined in requirement 1 is reduced by 10%, the expected number of room nights to rent would increase by 10%. Should Blodgett reduce prices by 10%? Show your calculations.

Explanation / Answer

John Blodgett is the managing partner of a business that has just finished building a 60 room hotel. Blodgett anticipates that he will rent these rooms for 15,000 nights next year (or 15,000 room nights). All rooms are similar and will rent for the same price. Blodgett estimates the following opearting costs for next year.
Variable opearting costs $5 per room night
Fixed costs
Salaries and wages $173,000
Maintenance of building and pool 52,000
Other maintanace and administration costs 150,000
Total fixed costs $375,000
The capital invested in the motel is $900,000. The partnership's target return on investment is 25%. Blodgett expects demand for rooms to be uniform throughout the year. He plans to price the rooms at full cost plus a markup on full cost to earn the target return on investment.

1. what price should Blodgett charge for a room night? What is the markup as a percentage of the full cost of a room night?
2. Blodgetts market research indicates that if the price of a room night determined in requirement 1 is reduced by 10%, the expected number of room nights to rent would increase by 10%. Should Blodgett reduce prices by 10%? Show your calculations.

1.
Let P be the Total rent revenue
          VC                 FC                  Return
P = ($5 x 15,000) + $375,000 + ($900,000 x 25%)
P = $450,000 + $225,000 = $675,000

Chargeable price per night = $675,000 / 15,000 = $45
Markup = $225,000 / $450,000 = 50%
2.
Revised price per night = $45 x 90% = $40.50
Expected room nights = 15,000 x 110% = 16,500

Rent revenue      16,500 x $40.50         $668,250
Variable costs      16,500 x $5              -$82,500
Contribution margin                             $585,750
Less : Fixed costs                               -$375,000
Operating Income                                $210,750
Rate of return on investment $210,750 / $900,000 = $23.42%

The revised rate of return(23.42%) after price reduction is less than expected retun of 25% on investment. As such Blodgett should not reduce its price.

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