When calculating a business interruption or lost business income loss for a hotel or resort, it is very common to 1) calculate projected revenue 2) deduct actual revenue from projected revenue to calculate lost revenue and 3) deduct any saved (non-continuing) expenses to arrive at the loss amount. Please notice that it is saved expenses and not variable expenses.
The distinction between “saved” and “variable”expenses is especially significant to hotel and resort operations. In the wake of the BP oil spill, many hotels and resorts submitted claims related to lost room revenue. Some of the losses related to empty rooms. These losses will, of course, have associated saved expenses such as hourly housekeeping, room supplies, water, and electricity. However, the second type of room revenue loss is related to a decrease in room rates. In this case, there is no savings of the above items. The rooms are still occupied and the same expenses are incurred. The only thing that changes is the level of revenue and profitability. Applying saved expenses to these revenue losses would understate the loss to the resort. In this situation, perhaps a better application of these expenses would relate to occupancy. While these expenses are variable, they would most likely have a better correlation with occupancy rather than revenue.
For simplicity, let’s assume that a hotel has only two rooms and that each room usually rents for $100 per night. Let’s also assume that a normal operating expense is a housekeeper who makes $10/hour and that it takes an hour to clean each room. Therefore, under normal conditions, housekeeping is 10% of revenue. We will further assume that normally our rooms would be 100% occupied but because of an unanticipated disaster, which negatively affected tourist travel, one of the rooms is unoccupied and one is rented at a 50% discount. Instead of $200 in revenue for the night, the total revenue was $50 and therefore lost revenue is $150. Well, of course the hotel owner must account for saved housekeeping. The $150 in lost revenue less 10% ($15) means the hotel should recover $135 for the loss right? Not in this case.
Revenue does not drive housekeeping expense. Room occupancy drives housekeeping expense. One room was unoccupied and therefore did not need to be cleaned resulting in a savings of $10. The second room was still occupied and had to be cleaned. There is is no $5 savings in housekeeping due to a decrease in revenue. The actual amount to be paid is $140 and not $135.
This example is oversimplified in order to illustrate a point. When this issue is applied to hundreds of rooms, for several months, and dozens of related expenses, the numbers can be significant. In a large hotel or resort claim, understanding what drives expenses can mean the difference of thousands upon thousands of dollars.
John Hutson is fiercely committed to guiding clients through the process of quantifying a business interruption for litigation or an insurance claim. Please feel welcome to contact John to discuss your project.