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Guilding The University of Queensland, Australia and Griffith University, Australia Abstract
A review of the findings of prior empirical research concerning hotel management contracts between owners and operators is undertaken. It is noted that management contracts have become increasingly commonplace in the international hotel sector and that gross revenue and gross operating profit are the most extensively used determinants of operator incentive fee remuneration. These findings present a platform for examining how revenue and gross operating profit are deficient in promoting owner-operator goal congruency. In light of this, return on investment (ROI) and residual income (RI) are examined as potential alternative determinants of operator reimbursement. While it is appears that both ROI and RI as determinants of hotel operator fees would represent an advance in promoting owner-operator goal congruency, a rationale outlining how residual income is preferable to ROI is outlined. Keywords: hotel management contract, return on investment, residual income, capital expenditure
Collier and Gregory (1995) feel that capital budgeting research is particularly warranted in the hotel sector due to the sector’s dual role of property and management and that hotels have a high proportion of capital intensive assets. Further, hotels are vibrant organisations that are characterised by complex buildings that are costly to maintain (Chan, Lee et al., 2001). The importance of these assets underscores the view that the most important budget in a hotel is the capital budget (Condon, Blaney et al., 1996; Lynch, 2002). Guilding (2003; 2006) notes heightened capital budgeting complexity in hotels operating with a management contract, because the capital outlay decision must cross an organisational divide in satisfying the investment appraisal criteria of both owner and operator. Given the high number of hotels operating in the context of an owner-operator management contract and the governance challenges arising in this context, Field (1995) expresses surprise at the minimal amount of academic research directed towards furthering our appreciation of this idiosyncratic governance arrangement. While there is a large literature concerning capital budgeting practice in hotels (e.g. Eyster and Geller, 1981; Eder and Umbreit, 1987; Schmidgall and Ninemeier, 1987; Schmidgall and Damitio, 1990; Brander-Brown, 1995; Collier and Gregory, 1995; Collier and Gregory, 1995; Field, 1995; DeFranco, 1997; Jones, 1998; Damitio and Schmidgall, 2002; Guilding, 2003; e.g. Guilding and Hargreaves, 2003; Guilding, 2006; Guilding and Lamminmaki, 2007), few studies have investigated the particular capital budgeting issues that arise in hotels governed by a management contract (e.g. Field, 1995; Guilding, 2003; Guilding, 2006). This is 1
surprising as Beals and Denton (2005) contend that expectations concerning operators’ expenditure of owners’ money in the most appropriate manner have been severely undermined by observations in the field as well as law court judgements. This suggestion of sub-optimal expenditure of owners’ capital beckons a fundamental examination of this critical aspect of the owner-operator relationship. Dickson, Williams, and Lee (2008) feel that in order to improve goal alignment between owner and operator, the hotel industry needs to develop an operator incentive mechanism that embraces operating performance throughout the course of the management contract and also recognises hotel resale value. These factors provide the contextual motivation for this study. The study’s objective is twofold. Firstly, it seeks to provide an examination of management contract provisions pertaining to hotel operator remuneration and also metrics used in performance assessment and to explicate shortcomings of these provisions in promoting owner-operator capital expenditure goal congruency. Secondly, it examines the relative merits of alternative bases for determining a hotel operator’s fee level. The importance of remunerating a hotel operator in a manner that will promote owner-operator capital expenditure goal congruence becomes particularly evident when we recognise that it is generally the hotel operator that initiates capital expenditure proposals (Guilding, 2006). Should a lack of capital expenditure goal congruence exist between hotel owner and operator, situations are likely to arise where the operator fails to share with the owner a capital expenditure idea that serves the interest of the owner to a significant extent, but only serves the operator’s interest to a negligible degree. By exploring hotel owner-operator contractual relations, this study can be seen to be contributing to agency theory. Agency theory has served as a popular framework for the examination of exchanges where one party, the principal, assigns work to a second party, the agent. It focuses on exposing contractual problems arising when agents have the capacity to act in a self-interested manner that is inconsistent with the principal’s interests (Berle and Means, 1962; Jensen and Meckling, 1976). This problem is exacerbated in the presence of information asymmetry favouring the agent.1 The agency model has been employed in a wide variety of business settings concerned with a range of issues ((e.g., vertical integration (Walker and Weber, 1984), executive compensation (Baker, Jensen et al., 1988), tender offers (Cotter and Zenner, 1994). It has also been applied in a range of disciplinary contexts (e.g., accounting (Demski and Feltham, 1978), marketing (Basu, Lai et al., 1985) and organisational behaviour (Eisenhardt, 1988)). The focus of this study concerns the owner-manager agency relationship which has dominated agency theory based studies (Eisenhardt, 1989; Walsh and Seward, 1990); the hotel owner represents the principal and the hotel operator represents the agent. The remainder of the paper is structured as follows. The next section summarises the findings of prior research that suggests increasing use of hotel management contracts. This is followed by an examination of the widespread use of operator fee determinants and also termination clause performance measures that undermine owner-operator capital expenditure goal congruency. A consideration of the relative merits of return on investment and residual income as alternative operator fee incentive bases is then provided. The final section provides a concluding discussion and some suggestions for further research designed to extend insights concerning the dynamics of hotel capital expenditure provided herein.
Information asymmetry arises when one party can access information that is unavailable to the second party.
Slattery (1996) noted 75% of listed Asian hotels operating under a management contract. while Smith Travel Research (2003) noted an increase to 55%. note the recent emergence of ‘manchises’. The contract includes a description of the operator’s remuneration fee determination (Schlup. while the operator assumes responsibility for managing the hotel’s day-to-day business (Guilding. 2006. Kang et al. Ittner. Further. and A. G. Lababedi (2007). resembles a lease but has many of the commercial terms of a management contract Dickson. 1997). 2005). more recent evidence from Smith Travel Research (2003) indicates that management contract use in the U. This arrangement has been developed in the light of particular tax and legal regulations in certain jurisdictions such as Australia. Beals and Denton (2005). it is notable that a large proportion of a hotel company’s assets are made up of intangible assets in the form of goodwill associated with their brand name (Dev. 1988). This problem can lead agents to promote low net present value (NPV) projects that yield relatively high short-term accounting earnings at the expense of higher NPV projects that yield lower short-term accounting earnings (Baber.S. 1998). while the operator is only responsible for the operation of the hotel (Schlup. termed a ‘man-lease’.76% of US hotels had a management contract. from some drawbacks. 1995). 2004). which is an arrangement where hotel owners engage an operating company under a management contract for an initial period of three to five years. and for the account of the owner. A major reason accounting for the popularity of hotel management contracts stems from the benefit owners can derive from owning a hotel without the need to operate it (Horwath and Horwath.. Adler et al. Contractor and Kundu (1998) found 40. after which time the contract reverts to a franchise contract. 1995.. 2004). Morgan et al. Table 1 highlights the predominance of the management contract across North America. It is generally held that operators focus on short-term cash flows while owners have more of a long-term orientation (Guilding. The Bader and Lababedi Bader.. has further increased.. (2007) "Ten hot management agreement issues in Asia. Haast. however. The relationship signifies that the owner assumes full economic risk associated with ownership of the property. building.2 Gannon and Johnson (1997) note an increase in the relative popularity of the hotel management contract internationally. on behalf of. 1982. Lynch. Kennedy et al. 2005. The contract enables a hotel owner to retain legal ownership of the hotel site. Beals and Denton. furnishings and inventories." Journal of Retail & Leisure Property 6(2): 171-179. a management contract is essentially a written agreement between an owner and operator where the operator is appointed to operate and manage the hotel in the name of. plant and equipment. management contract. 2001.. Management contracts do suffer.Growing incidence of management contracts Although there is no standardised management contract." Hotels Resorts & Tourism Newsletter Volume. Dechow and Sloan. and Corgel (2007) have provided further recent testimony to the increasing popularity of management contracts. 2003). or franchising arrangement. Europe and Asia in the late 1990s. A fundamental problem concerns agency challenges. Larker et al. A second hybrid. 2002). 1987. 2 3 . Johnson. 1-11 DOI: . "Hotel management contracts in Europe. As cited by McCarthy and Raleigh (2004). This tension is widely referred to as the ‘horizon problem’ (Smith and Watts. Schiff. 1991. 2006). With regard to the brand value maximisation incentive. E. The three main options for operating a hotel are: owner-operator. Panvisavas and Taylor (2006). as the divorce of ownership and operation can create a volatile mix of economics and power that becomes manifested due to differing owner-operator time horizons (Beals. Operators also tend to focus on maximising their brand values and the longevity of their management contracts so that they can secure good opportunities from new contracts and increase the room stock under their management (Beals and Denton. E.
2007).. The combination of a base and incentive fee is the most common. 2002). While the base fee can be a fixed amount. Chen et al. 1993. It is notable that in other contexts. On the grounds of incremental hotel cash flow. Armitstead and Marusic (2006) note the imperative of designing management contracts that engender goal congruence and the need for hotel owners and operators to consider a wide variety of issues when negotiating a management contract in order to create a ‘win-win’ situation. These examples of conflicting interests underscore the fact that management contracts are frequently associated with owner-operator agency conflict (Dimou.g. Consider. such as the management of investment funds (see e. see e. 2003). 2006). greater weight is being attached to the use of higher incentive fees relative to the base fee (Barge and Jacobs. franchising (see e. and the organisation-supplier relationship (see e. Nikbakht et al. however. a proposed refurbishment of a hotel’s lobby. 2006).g. With respect to the combined base and incentive fee structure. the proposed lobby refurbishment may be highly desirable. Baucus and Baucus. Maxam. a base fee is taken to mean a fixed-dollar amount. This signifies that the term ‘base fee’ is something of a misnomer as it is a variable amount that might be better viewed as an ‘incentive fee’. 1997). Giroux and Jones. However. it has been conventional to view the base element as covering the management company’s operating expenses while the incentive fee contributes to the management company’s profit (Rushmore. it is most usually determined as a percentage of gross revenue. 2002). It can also lay the basis for stronger owner-operator goal alignment (Goddard and Standish-Wilkinson. Davanzo and Nesbitt. or (3) a base fee combined with an incentive fee (Goddard and StandishWilkinson.. Table 2 summarises the findings of prior studies concerned with ascertaining how base fees are determined in hotel management contracts. (2) an incentive fee only. Schlup. 2004). which can be a source of significant tension between the contracting parties. the refurbishment expenditure may not be viable. 2002. an owner’s choice of operating company and the exact terms of a contract are among the most critical factors determining a hotel’s long-term success (Horwath. 2002). 2002).importance of hotel brand value signifies that operators have an incentive to support capital expenditures that are consistent with projecting a favourable brand image even though the expenditure may provide limited equity value enhancement for the hotel owner. 4 .. in terms of improved brand alignment for the operating company. 2006).g. Rogers. the majority of management contract base fees are determined by gross revenue. 1987. Record and Tynan. Grinold and Rudd. Berger (1997) comments on the particular importance of the operator’s basis of remuneration. An operator’s remuneration is widely referred to as a ‘management fee’ (Rushmore. Management contracts and owner-operator capital expenditure goal congruency Due to the considerable agency issues arising in the hotel management contract context. Armitstead and Marusic.g.g. 1987. as it provides operators with an incentive to increase hotel revenue. 1987. for example. This development presents operators with greater risk together with the corollary of an increased earnings potential (Goddard and Standish-Wilkinson. 2005). auditing (see e. Three basic management fee structures are found in practice: (1) a base fee only. It is evident from this table that internationally. Increasingly. 2001. Baucus et al. Baucus.
where project A requires an initial investment of $1.000.000 per annum and project B which requires an initial investment of $500. project B provides a superior return on investment of 9% ($45. As the proportion of an operator’s total remuneration that is revenue based is increased. it will prefer project A as it generates the highest profit. Once the proportion reaches 100%. If an operator is remunerated according to an incentive fee that is based on profit. 1995) comment that they provide an incentive for operators to “blithely recommend expenditures that increase top-line revenues that never drop to the bottom line.000 X 100) compared to project A’s 5% ($50. the incentive to minimise costs and maximise profits is nil.” With respect to capital expenditure decision making. The emphasis attached to profit when determining an operator’s incentive fee would appear to have considerable potential to promote capital expenditure dysfunctionalism.000 ÷ $500. percentage above an owner’s priority return. promoting revenue maximising projects with no regard given to profit impact. However.000 and is projected to return $50. and no incentive to pursue cost cutting projects) will be mitigated where a hotel management contract also provides a separate profit based incentive. cash flow or cash flow minus specific charges. without necessarily positively impacting on profit. Prior to taking this investment appraisal methodological analysis further. Although this type of proposal may have the potential to carry a major positive impact on profit. reduced maintenance costs. two implications arise from remunerating operators based on hotel revenue: 1.000 per annum. GOP minus specific charges.000.000 and is projected to return $45. Consider the case of two mutually exclusive projects. the absence of any direct effect on revenue may result in operators with a revenue maximising inducement excluding it from any listing of recommended capital expenditure projects tendered to a hotel owner. a percentage of GOP that exceeds a base fee amount. operator remuneration based on revenue provides the operator with an incentive to promote capital expenditure proposals that maximise revenue. From this table it is apparent that most incentive fees are based on either a percentage of gross operating profit (GOP). so too will the extent of this bias. reduced laundry detergent costs. reduced water consumption and reduced wear and tear to laundered items. this simple analysis provides a clear indication that a hotel owner is likely to 3 These two implications (ie. even the presence of a small proportion of an operator’s fee being based exclusively on revenue will introduce a bias causing the operator to weight the importance of revenue maximisation more heavily than cost minimisation or profit maximisation. It signifies that an operator with a base fee incentive of maximising revenue might attempt to promote a capital expenditure proposal that will increase revenues by 20% and carry a negligible (or even negative) impact on profit at the expense of an alternative proposal that will increase revenue by 5% and profit by 10%.3 Table 3 summarises prior research findings concerned with the determination of operator incentive fees. Nevertheless. An example of a cost saving capital expenditure that carries no implication for revenue would be the option of upgrading a washing machine to a sophisticated washer that will result in less laundry labour hours worked. In line with the issue noted by Feldman.000 X 100) projected return on investment. 2.000 ÷ $1.The widespread popularity of revenue determined operator base fees appears somewhat surprising given Feldman’s (Feldman. 5 . An operator with a remuneration based on revenue would have no incentive to initiate cost saving hotel capital expenditure proposals. There is a small incidence of incentive fees based on GOP relative to gross revenue. appreciated value of property. a percentage of net operating profit (NOP) over a fixed amount or a percentage of the amount by which cumulative cash flow exceeds a cumulative set aside amount.
Reichardt and Lennhoff. making a charge for debt service and return on equity both appear to lay the basis for greater owner-operator capital expenditure goal congruency relative to an FF&E reserve allocation linked deduction. 2007).000) will be allocated to the FF&E reserve and deducted from the profit basis used for determining the incentive payment. it is noted by Schlup (2004) that because the adequate maintenance of a hotel is also in the best interest of the operator. then an additional $30 (3% of $1.5 Of the asset related deductions from GOP that are noted in Table 3. At the root of the problem is the reward given to the operator for increasing absolute profit without any need to limit the investment involved. Ransley and Ingram. however. Consider the case of a hotel operator evaluating a capital expenditure opportunity that will provide a $1. 1997. and debt service. This is In the interests of parsimony. 2003.000 increase in revenue). 4 6 . Charges against profit or cash flow noted in Table 3 that give recognition to the involvement of assets in generating profit include: property taxes. Eyster. 2007). Further. If the operator is paid a 3% of gross revenue base fee.. 1988.prefer project B. FF&E (furniture. 1999. This is because they are algorithms that incorporate a recognition given to asset involvement in generating profit. To appreciate this we need to recognise that the FF&E reserve allocation is generally set at around 3% of gross revenue (Ransley and Ingram. while an operator remunerated on a basis linked to profit can be expected to prefer project A. 2003. as it is widely noted that FF&E reserve contributions fall some way short of the average annual capital expenditure required to maintain FF&E (Ferguson and Selling. With respect to the operator’s incentive fee.4 This worked example highlights the extent to which deducting FF&E reserve allocations from GOP used as the basis for providing incentive fee payments to operators actually contributes minimally to greater owner-operator capital expenditure goal congruency.000 X 3% X 10%). Mellen. fittings and equipment) reserve allocation. Eyster. they stand to benefit by $30 (3% of the $1. 1985. This simplifying assumption does not affect the rationale outlined. Brooke and Denton. Understanding the implication for an operator when FF&E reserve allocations are deducted from the profit figure used as the basis for making incentive fee payments is complicated.000 increased revenue on the incentive fee paid is a reduction of only $3 ($1. 5 It is notable that widely deployed long-term loan restrictive covenants impose FF&E reserve contribution requirements on hotel owners as a means of protecting lender interests. Barge and Jacobs. Haast. As already noted.000 increase in revenue. we have assumed that the $1. the result of the $1. 2001. it is notable that the amount allocated to FF&E reserve does not represent a good proxy for FF&E capital expenditure. 2001.. Brooke and Denton.000 increase in revenue has not resulted in a change in profit. Table 3 highlights that some hotel operators’ remuneration is based on GOP or cash flow minus one or more charges relating to asset investment. Johnson. Remuneration bases that involve these types of deduction would appear to provide a better basis for promoting owner-operator capital expenditure goal alignment. 2000. Phillips. 2005. This shortcoming is also present if cash flow is substituted for profit in the scenario outlined. if the fee is based on profit minus a charge for FF&E reserve allocation and if the allocation is set at 3% of gross revenue. Say that 10% of the adjusted profit is being provided to the operator as their incentive fee. 2001. it appears fair that contributions to the FF&E reserve be treated as operating expenses. With respect to making a charge for the FF&E reserve allocation. signifying a reduced fee paid to operators remunerated on a profit basis. Dickson et al. Nylen et al. insurance.
Harris and Mongiello. Some contracts also include stand-aside provisions that require the operator to forego incentive fees until a predetermined level of GOP is achieved (Goddard and Standish-Wilkinson 2002). 1993) has observed some hotel operators remunerated according to a hybrid approach providing them with the option of receiving a base fee or an incentive fee. Discussions with a specialist in the preparation of hotel management contracts in Australia indicate that it would be very rare for capital employed charges (whether relating to debt or equity) to be included in the calculation of the profit basis used to determine an operator’s incentive fee. Baiman. that exclusive use of performance measures is unlikely to curb potential dysfunctional operator behaviour. 2004). The relative merits of each are commented on in the hospitality management accounting normative literature (e. 2005). 2007). suggest this optional form of operator reimbursement is not common. 2006. 1980. Despite the commonplace nature of performance-based termination provisions.because they both represent an explicit charge for the full cost of any capital outlays made. signifying a capacity to induce operators to minimise the owner’s capital outlay. occupancy and RevPAR both suffer from no recognition accorded to capital outlay. 2007). There is a current trend away from stand-aside provisions. If appraised on RevPAR It should be noted that charges for debt and equity appear to be little used outside the U. Goddard and StandishWilkinson. 2002). Schmidgall. Performance standard clauses typically take into consideration the effect of economic cycles. similar to the rationale already outlined. When drawing up a management contract. e. summarised in Table 4. 2004). Haktanir and Harris. 2001. The fee bases noted in Table 4 do not warrant any further examination as none constitute novel approaches that have not already been discussed above. 1987. Jagels. Evans et al. 1997. so that circumstances that are beyond the operator’s control do not adversely affect an operator’s contractual standing (Crandell.. Dickinson et al. 6 7 . this aspect of contracting can often be a source of significant owner-operator conflict (Beals and Denton.S. Eyster’s findings. 2003. if not met.g. 1994. however. whichever is greater.g. because owners have limited capacity to extract all private information pertaining to performance (Magee. for the selected measures. It is widely noted. The findings of prior empirical research appraising the nature and incidence of operator performance measures are summarised in Table 5. Eyster. With respect to their implications for capital expenditure decision making.. the contracting parties would have to agree on minimum performance levels. The only measures documented in Table 5 that have not already been considered in the earlier discussion are occupancy and revenue per available room (RevPAR). 2005). A second dimension of the management contract that draws on accounting metrics to promote owner-operator goal alignment concerns the identification of a set of performance standards which. the deployment of minimum performance standards in hotel management contracting is expected to increase commensurate with rising hotel operator competition levels (Rainsford. can be invoked by an owner as grounds for terminating the contract with a poorly performing operator (Dutta. Despite this. unless the operator is compensated with higher incentive fees for taking on this greater risk (Bader and Lababedi. This standaside is usually structured as a loan repayable to the operator out of profits achieved in later periods (Schlup. Baima. however.6 Eyster (1988. as a balance needs to be struck between an operator’s quest for flexibility to manage unforeseen market circumstances and an owner’s quest for meaningful performance standards. 1990).
8 . however. an operator would have an inducement to rank a $50. Generally accepted finance practice holds that the preferred investment appraisal criterion is NPV and that capital expenditure proposals are justifiable if they yield a projected positive NPV (Butler.000 capital expenditure opportunity that results in a 2% increase in occupancy and $5 increase in RevPAR behind a $1. In the AsiaPacific region. So although NPV is the preferred approach for evaluating capital expenditure proposals. Where an operator is performing poorly. Return on investment and residual income as alternative determinants of operator fees The foregoing analysis has highlighted widespread use of hotel operator remuneration bases that appear deficient with respect to promoting owner-operator capital expenditure goal congruency. NPV would not be a good basis for determining hotel operator management fees. 2007). We now turn to consider alternative performance measures that. of the two options. Prior empirical research findings concerned with appraising the incidence and nature of termination without a cause management contract provisions are summarised in Table 6. The fact that it is becoming harder for owners to invoke management contract termination clauses underscores the importance of ensuring that a negotiated management contract is conducive to a high degree of owner-operator goal alignment.and occupancy. the only other termination option for an owner is to invoke termination without a cause provisions. it does not lend itself to gauging a hotel operator’s performance.. Although the first option can be expected to represent a higher return on investment. Formulation of a NPV calculation requires the provision of projected cash flows. Consistent with the challenge of activating operator performance measures. 1999).000. Table 6 highlights that around one-third of management contracts feature termination without a cause provisions. Emphasis on occupancy and RevPAR performance measures can also be expected to raise the priority attached by an operator to accommodation related capital expenditures as opposed to expenditure on other hotel facets such as restaurant and bar activities. Management contract termination impediments combined with deficient owner-operator goal congruence signifies a high propensity for protracted hotel operational decisions that are inconsistent with owner interests. Monitoring past achievements involves much less subjectivity than the development of projected cash flow estimates. the first yields the lower occupancy and RevPAR. even if they clearly and demonstrably lack the ability to profitably operate the hotel. Carrington-Heath et al. a priori.000 outlay that results in a 3% increase in occupancy and $6 increase in RevPAR.. for example. Davis et al. termination without a cause provisions are becoming increasingly difficult to invoke because they contain many qualifications and caveats (Dickson. (2008) claim that it is becoming almost impossible to terminate an operator. This highlights the use of further performance measures that are deficient in promoting owner-operator capital expenditure goal congruence. 1993. represent inducement bases more consistent with promoting owner-operator capital expenditure goal congruency. This is because operator management fees need to be based on an objectively verifiable performance measure. Dickson et al. Payne.
000 X 100). R. "Earnings. as the hotel’s ROI would increase from 18% to 21. 2003). Australia. i. Anthony and Govindarajan. Easton and Howard Peirson. and V. "Adopting residual income-based compensation plans: Do you get what you pay for?" Journal of Accounting and Economics 24: 275-300..000 ÷ $700.. (1997). McGraw-Hill. RI has been widely promoted as a measure that averts some of ROI’s shortcomings (see Rogerson.Two measures of past performance that give recognition to the amount of investment involved in generating a return and are widely discussed in the management accounting literature are return on investment (ROI) and residual income (RI) (Langfield-Smith. Anthony and Govindarajan. Thorne et al. 2007).000 that would increase annual profit by $18. The flaw in the ROI incentive becomes apparent when it is recognised that the hotel chain is preparing to buy an asset that will earn a 9% ROI ($18.8 In a hotel management investment decision making context.. 2003. and Bishop. The major benefit of ROI is that the agent is discouraged from excessive investment in assets. book value. Social Science Research Network. J. residual income. H. This problem is averted if RI Forms of residual income often appear under various names such as abnormal earnings (Ohlson. 1997.. and J. and (4) as ROI data is typically available for competitors. (1995). it is apparent that ROI is calculated by dividing profit by assets employed to generate the profit (Danfy. Accordingly. Australia.4% ($68. Anthony. M. G. 8 A detailed description of how the imputed interest rate is estimated is beyond the scope of this study but can be found in finance textbooks such as Peirson.000 investment (ROI of 18%). Prentice Hall. and is meaningful in an absolute sense.e. Hotel B would have an incentive to sell an asset that generates $21.. or Economic Value Added (EVA®). (3) it can be applied to any unit within an organisation responsible for profitability. Crapp and Twite Bishop. 2003.. Feltham et al. Usefulness of operating income.600 ÷ $180. working paper. A.4% ($38. RI is calculated as profit minus an imputed charge for capital employed. et al. 2007). The imputed charge is generally linked to the cost of capital (Langfield-Smith. Further advantages of ROI include: (1) it reflects anything that affects the financial statements.. 1975). as will be seen below. J. R.. Chen. Hotel A is earning a $20. 2003). "Does EVA beat earnings? Evidence on associations with returns and firm values.000 X 100). Brown. C. Govindarajan (2007). Langfield-Smith. Dutta and Reichelstein. Ittner and Larcker. Corporate finance. et al. If performance measurement is ROI based.. New York. 2002. Guilding (2002) demonstrates how RI represents a preferred incentive basis to ROI. RI’s improvement over ROI stems from its formula containing an important piece of data that is absent from the ROI formula. Business finance. (2004). and dividends in security valuation. North Ryde. 1998..7 From examples already provided. Thorne et al. G. Frenchs Forest. Thorne et al.000 return on a $500.. (2) it is easy to calculate. Also.000 book value.. McGraw-Hill Irwin.000.000 investment (ROI of 4%). Dodd (1997).000 ÷ $200. simple to understand. Hotel A would have an incentive to purchase an asset costing $200.600 for its $180. the organisation’s required rate of return on invested capital (Langfield-Smith.000). Ohlson. as the hotel’s ROI would increase from 4% to 5. 2007). Crapp. (2006). Thorne et al. R. R.000 return on a $500. not an absolute dollar amount. Bowen." Journal of Accounting and Economics 24: 301-336. R. Wallace. S. (1997). which is a technique popularised by the consulting firm Stern Stewart & Co Biddle. 7 9 . S. it can be used as a basis for comparison (Anthony and Govindarajan. Management control systems. NY. regardless of the size or type of the business. A major disadvantage of ROI is that it can encourage agents to defer asset replacement and also discourage agents from investing in some capital projects that are viable from an owner’s perspective.000) while at the same time selling a second asset earning a higher ROI of 12% (21." Contemporary Accounting Research 11(2): 661-687.400 ÷ $320. et al. ROI constitutes a ratio. and EVATM: A value-relevance perspective. 2002. L. He considers two hotels that are part of the same chain that is seeking a 10% target ROI. Christensen. Hotel B is earning a $90. Brown.
Eyster’s (1993) study cites examples of contracts where the basis for the remuneration fee is GOP (or cash flow) adjusted for items such as debt service and return on equity. Cambridge. London. customer satisfaction. C. (1997).. RI motivates managers to maximise profits from the resources that they have at their disposal and to only invest in additional resources when the investment will produce an adequate return (Anthony and Govindarajan. Tsuruni.9% of contracts examined by Eyster where the operator remuneration is based on cash flow after debt service and return on equity. Free Press. Adjusting profit for debt service can be seen as a ‘partial RI’ measure for although it embodies a charge for debt capital.000 – (0. K. can include market share Morishima. D. MIT Press. 1992). The enigma of Japanese power. 1989. The winning streak.000 ($20. (1988). efficiency / productivity. many commentators suggest combining financial and non-financial performance measures in an attempt to better align the interests of principals and agents (Aggarwal. equity and debt). Ezzamel and Hart.S. Clutterbuck (1984). Analysis of hotel management contracts in the U.. Cambridge University Press.000)) to -$32. innovativeness Goldsmith. Multinational management: Business strategy and government policy.000 – (0. product quality. The drop in the two hotels’ respective RIs signify that neither should make the asset changes under consideration. its RI would drop from $40. MA. and others. it should be noted that it is not a measure devoid of shortcomings. (1989). Ezzamel. employee satisfaction Ittner. "The choice of performance measures in annual bonus contracts. F. M. provides some support for the view that RI represents a preferred basis for determining hotel operator remuneration.000)). for example.1 X $500.9 A further shortcoming of using ROI or RI relates to Healy’s (1985) bonus plan hypothesis. 1986. Weidenfield & Nicolson.1 X $320. Larker. This is because the measure involves a charge made for all long-term capital funding (i. If Hotel B were to make the $180.maximisation is adopted as the performance measurement criterion. This issue is noteworthy as Eyster (1993) found a high proportion of contracts where the base fee is determined by gross revenue. (1984). Cambridge. Prestowitz..000 ($38. MA. Kakati and Dhar. V. Van Wolferen. 9 10 . Performance measures that are based on accounting numbers are widely criticised for instilling a short-termist outlook (Rappaport.e. 2007). and D. Appendix A presents a simulated exercise that demonstrates how RI represents a performance measurement basis that promotes a higher degree of owner-operator capital expenditure goal congruency relative to traditional hotel operator fee bases that are tied to revenue and profit. In light of this. Ballinger Press.. Y. While this signifies the existence of some management contracts promoting a better alignment of owner-operator capital expenditure interests. W. For the 5. When applying the RI algorithm. Wong (1985). 1992). RI is a financially denominated measure that is calculated from accrual accounting numbers. Why has Japan succeeded. Britain's top companies reveal their formulas for success. As a result. (1982)." Journal of Marketing Management 1(2): 119-137.1 X $500. market standing Saunders. this improved alignment will be largely negated if this type of incentive fee is combined with a base fee determined by gross revenue.000 ($90. Healy (1985) explains how the remuneration conditions existing between a principal and Non-financial performance measures. we have a closer approximation to RI.1 X $700. Cambridge. J. C. Trading places. any investment that exceeds an organisation’s required rate of return yields a positive RI. Although this study promotes using RI as a basis for determining operator fees.. et al.000 asset purchase.400 – (0.000 asset sale. "In search of excellence in the UK.000)) to $36. no charge is made for equity funding.000)).400 ($68. 1991.000 – (0. and V. If Hotel A were to make the $200." The Accounting Review 72: 231-255. New York. 1991. its RI would drop from -$30. Slagmulder and Bruggeman.
2006. Bernard and Skinner. the operator may still support the expenditure if the benefit to their brand value outweighs any potential incentive management fee reduction. and profit in a particular year is negative. Research examining Healy’s (1985) hypothesis provides equivocal results. If ROI or RI is used to incentivise an operator. there would appear to be a considerable potential to manipulate the period in which substantial expenses are charged. 11 . Gaver et al. 1996). This factor underscores an owner’s need to carefully scrutinise any brand standard provisions included in a proposed management contract. 2006). however.. The rationale provided offers considerable potential to stimulate further debate into hotel owner-operator contracting and to change the structure of operator fee incentive terms widely used in hotel management contracting.. although the use of ROI or RI might suggest that the operator’s capital expenditure interest will be well aligned to the owner’s interest. the operator may have the right to terminate the contract (Beals and Denton. 2005. It is increasingly becoming the case that if owners fail to meet an operator’s ‘brand standard’. 1995. In such a situation. Generally Accepted Accounting Principles (GAAP) and hotel management contracts provide little guidance resolving the issue of how to differentiate between asset related expenditure that is to be expensed or capitalised (Schmidgall. 1991. it is also pertinent to identifying appropriate performance measure thresholds that can be invoked by an owner as grounds for contract termination. 1989. it would appear to be in owners’ interests to require operators to meet performance thresholds stated in terms of ROI or RI.agent can cause the agent to make profit increasing or decreasing accounting policy choices. 1997). the operator may be induced to ‘take a bath’ by selectively expensing any potential future capital expenditure in the current period in order to reduce capital charges assigned to future years. Dechow. Damitio et al. Holthausen.. Sloan et al. Studies supporting Healy’s hypothesis include (see Kaplan. see DeFond and Park.. McNichols and Wilson. If an owner deems a particular capital expenditure proposal as unjustifiable on the grounds of failing to meet financial criteria but the operator sees the expenditure as necessary to meet their brand standard. Although a proposed expenditure may have a negative ROI or RI (thereby potentially reducing an operator’s incentive management fee). the operator can invoke management contract termination provisions (Dickson. In any discussion of accounting measures that can be used as a basis of operator management fee determination. 1985. 1988. Based on the rationale outlined. Research providing conflicting evidence includes (see Gaver. Haast. The paper can also be seen as representing a particular contribution to the application of agency theory in the hotel management context. it is important to recognise the role that operator brand standards can play in hotel capital expenditure decision making. 2005). Conclusion and discussion This paper’s primary contribution is to provide a systematic examination of the shortcomings of conventional performance measures used to determine hotel operator fees and to advance the case that ROI and residual income represent alternative performance bases that would result in heightened levels of owner-operator goal alignment. This force concerns the operator’s need to protect their brand value (Beals and Denton. if the owner rejects the proposal. 2007). Schiff. there is a second potentially powerful force at play affecting the operator’s capital expenditure perspective. 1995. Schipper. 1997). Adler et al. see Jones. Larcher et al. 1995. Given the high asset base associated with hotels. While the discussion in this section has been conducted in the context of a quest for improved bases of hotel operator fee determination..
40 22. the General Manager feels accountable to the owner as well as the operator. 11. 1995). 1997. i. e.45 42. Clearly. 2003). 2007). while in other situations the salary is initially paid for by the operator but is eventually reimbursed by the hotel owner (Eyster. In some management contracts.46 joint venture) Franchise agreement 38. Regardless of which method is adopted. 1997. understanding the relative motivations of General Managers and the way they manage tensions in interest between owners and operators would likely sharpen our appreciation of the dynamics at play in hotel capital budgeting.53 Asia 22.. Dickinson et al. 2004). 2005).A potential line of research enquiry extending the current study’s focus could examine the nature of a General Manager’s engagement in hotels operating with a management contract. 2006).60 6. the owner also has the authority to remove the General Manager for unacceptable performance (Crandell. asset managers’ attention is often “directed to short-term operational performance rather than long-term value enhancement”. An examination of the extent to which this represents a viable and productive means for promoting increased owner-operator goal congruency would provide a useful contribution to our understanding of the likely evolution of owner-operator contracting. Guilding. Dickson et al.66 36. Johnstone and Duni. Armitstead. 2006). 2004). It is usual for the operator to engage the General Manager (Eyster.31 Management contract 40. 1997. the owner’s financing of the General Manager’s salary continues throughout the entire term of the management contract.46 Owner-operator (partially owned. it is notable that asset managers are traditionally recruited from the ranks of hotel management companies.g. 2003. 1995. Haast. Research could also be directed towards determining the extent to which hotel owners are requiring operators to take an equity stake in the ownership of the properties that they manage. In most cases. Although asset manager engagement is designed to promote improved owner-operator interest alignment (Bader and Lababedi. Bader and Lababedi. 2002. 2004).. this appointment requires the approval of the owner (Eyster.76 Adapted from: Contractor and Kundu (1998) Europe 28. 2004.21 Table 1: Percentage distribution of hotel operating modal types by major geographical region 12 . 2002). Guilding. This development can be seen to parallel growing owner realisation of inconsistencies between owner and operator interests (Feldman.e. 2003.93 12. It is noteworthy that in some situations the owner pays for the General Manager’s salary immediately (Dickson and Williams.20 28. Further research could also examine factors arising from the growing incidence of owner engagement of asset managers to monitor operators (Geller. as a mechanism to promote greater owner-operator goal congruency. 2002. however. As a result. which detracts from their potential to serve owners’ interests (Bridge and Haast. Modal choice North America Owner-operator (fully owned) 9.. Field study research into issues surrounding the degree to which asset managers can promote owner-operator capital expenditure goal congruency is likely to be insightful and therefore welcomed. Guilding. such an employment arrangement gives rise to conflict because it detracts from the operator’s degree of absolute control exercised over the General Manager. 2007). where they have been previously employed as General Managers or Vice Presidents (Bridge and Haast. Rushmore. Given the key role a General Manager plays in capital budget formulation (Rushmore.
7 25.6 14.S. U. U.8 94.3 3.8 10. U. after stabilisation) Gross revenue (1 – 6%) 50 Barge and Jacobs (2001) 24 Americas 28 Goddard and StandishWilkinson (2002) Middle-East Asia-Pacific (Australia included) 9 28 Haast.5 – 4%) Fixed amount (US$36.7% mean) Gross revenue sliding scale (2.0 66. Asia-Pacific (Australia included) Europe 17 32 18 50 % incidence 55.S.S.7% mean.9% mean) Gross revenue (1 – 6%) Fixed amount (unspecified) + gross revenue (1.Author Geographic focus U.000 per year) Percentage of room revenues (3 – 5%) and of food and beverage revenues (3 – 5%) Gross revenue (4 – 6%).400.5% mean) Sliding scale (% of gross revenue) / Mixed (% of gross revenue & divisional revenue) / Fixed No base fee Gross revenue (1.5 3.7 14.5 11. after stabilisation) Fixed fee (did not specify) No base fee Total revenue (1 – 3%) Gross revenue (1.9 13.0 8.0 2.8% mean.4 6.3 - Determinant of base fee and typical amount Gross revenue (2 – 7%) Fixed amount (US$800.4 85.9 62.4 33.5 3.S.000 .6 3.9 17.1 34.8% mean) Sliding scale (% of gross revenue) / Mixed (did not specify basis) / Fixed No base fee Gross revenue (2.5 – 3%) Gross revenue (2.0 66. and Braham (2005) Europe Americas 29 28 8 Panvisavas and Taylor (2006) Thailand Table 2: Prior research into the calculation of hotel operator base management fees 13 .$1.7% mean) Fixed amount (did not specify) No base fee Gross revenue (1. (58 contracts) & international (19 contracts) Contracts analysed 77 Eyster (1988) Eyster (1993) Sangree and Hathaway (1996) Eyster (1997) Johnson (1999) U.5 – 2.8 23.3 22.000/year) No base fee Gross revenue (2.0 8. with portion of fee subordinated to cash flow after debt service (1 – 2%) No base fee Gross revenue (1.6 44.0 26. Dickson.0 2.0%) No base fee Gross revenue (1.8% mean) Gross revenue sliding scale (2.4 5.2 64.4% mean.0 58. after stabilisation) No base fee Gross revenue (2.S.6 96.3 78.2% mean) Sliding scale (% of gross revenue) / Mixed (did not specify basis) / Fixed No base fee Gross revenue (2.000 – $180.3 17.4% mean) Gross revenue sliding scale (1.
5 77 5. insurance. and owner’s priority return (21% mean) GOP less property taxes and FF&E reserve allocation (did not specify) Eyster (1988) U. FF&E reserve allocation.0% mean) GOP (7.5 Determinant of incentive fee and typical amount GOP (3 – 30%).S.7 10.S.S. GOP less property taxes. FF&E reserve allocation. GOP (8 – 15%) + percentage of cash flow after property taxes. or 5% GOP before deductions + 5% GOP after deductions). Cash flow after property taxes. FF&E reserve allocation.S.8 22.5 6. Dollar amount by which GOP before fixed charges percentage amount percentage amount exceeds gross revenues. and return on equity charge ((10 – 15%.5 Most common Common Common Less common Less common Less common 27. adjustment not specified) Cash flow after debt service and return on equity charge (18 – 30%) Appreciated value of property (10%) No incentive fee Percentage increase in GOP compared to a predetermined figure (14. or 5% GOP after debt service + 5 to 10% GOP after required return on equity charge (typically 8 to 10%)). 50 14 . FF&E reserve allocation. GOP after property taxes.0 12.2 5. No incentive fee GOP (5 – 15%) Cash flow after debt service (10 – 28%) Improvement in GOP (10 – 30%) Adjusted GOP (8 – 20%. insurance. FF&E reserve allocation.6 76.9 5. and debt service (6 – 16%.6 2. GOP (6 – 12%) + percentage of cash flow after property taxes. and required return on equity charge ((10 – 30% (8 – 12% required ROE charge)).6 11. insurance.9 2. debt service.4 17. debt service.6 19. insurance. insurance.9% mean) Percentage beyond an owner’s priority return (17. and debt service (10 – 25%). 17 Sangree and Hathaway (1996) U. FF&E reserve allocation. and return on equity charge ((20 – 40% (7 – 10% ROE charge)).2 3. debt service.4 6. 18 Johnson (1999) U. GOP after property taxes.1% mean) Percentage of GOP that exceeds a base-fee amount (did not specify) Percentage of NOP over a fixed amount (did not specify) Percentage of the amount by which cumulative cash flow exceeds cumulative set-aside amount (did not specify) Cash flow after debt service (0 – 32%) Cash flow after debt service and return on equity (0 – 40%) Improvement in GOP (8 – 25%) GOP subordinated to a negotiated cash flow amount (5 – 10%) Improved property value (10 – 25%) GOP less property taxes.5 29.9 23.2 22. insurance. and FF&E reserve allocation (8 – 20%) subordinated (or portion) to debt service (10%). insurance. and debt service (10 – 25%). 32 Eyster (1997) U.2 22. (58 contracts) & international (19 contracts) 6.S. FF&E reserve. debt service.Author Geographic focus Contracts analysed % incidence 24.9 5.8 5.0 Eyster (1993) U. Cash flow after property taxes.
Asia-Pacific (Australia included) Barge and Jacobs (2001) Europe 50 24 8.0 8.0 10.0 42.3 35.9% mean) GOP sliding scale (5 – 15% most popular range) No incentive fee Percentage of the difference between an adjusted GOP (by deducting the base management fee) and a specified percentage of the purchase price of the hotel (25 – 80% of the difference) Percentage of NOP over a certain threshold (unspecified) GOP (4%) No incentive fee GOP (8 – 10%) Adjusted GOP (14%.1 GOP less property taxes.2% mean) Profit share.2 3.6 Haast.2 41. • Owner’s priority return deducted from GOP.3 Most common Americas Panvisavas and Taylor (2006) 28 Thailand 8 Table 3: Prior research into the calculation of hotel operator incentive management fees 15 .2% mean) GOP sliding scale (5 – 10%.4 21.0 40.4 Americas 28 Goddard and StandishWilkinson (2002) Middle-East 9 21.2 21.7 14.0 27. or • GOP targets GOP sliding scale (5 – 10%. which can include: • NOP thresholds. most popular range) Other sliding scales (unspecified) No incentive fee NOP after payout of owner’s priority return (20%) GOP (7.4 17. and debt service (did not specify) GOP less property taxes (did not specify) No incentive fee GOP (8% mean) GOP sliding scale (5 – 10%. Dickson.4 17.0 4.7 17. most popular range) Unspecified No incentive fee GOP (6.3 77.5%) but operator to receive a minimum of US$180.6% mean) Other (not specified) No incentive fee GOP (0 – 10%) Asia-Pacific (Australia included) 28 39.7 10.9 21.1 11.7 4.0 54.4 39. most popular range) Other (not specified) No incentive fee Adjusted GOP by deducting the base management fee (9. FF&E reserve allocation. and Braham (2005) Europe 29 20.8 11.000 per annum GOP (11. adjustment not specified) NOP (17.0 4.3 31.9 39.
1 1.000). or gross revenue (3%) and GOP (8%). Contracts analysed 77 17 % incidence 9.Author Eyster (1988) Eyster (1993) Geographic focus U.000 .S.3 5. Whichever is greater of a fixed fee (US$35.9 Driver of base fee and typical amount Whichever is greater of gross revenue (3 – 4%) or GOP (10 – 20%) Whichever is greater of fixed fee (US$36.$75.000 . (58 contracts) & international (19 contracts) U.$60.000) or gross revenue (3%) or GOP (15%) Whichever is greater of gross revenue (3%) or GOP (10%) Table 4: Prior research into the incidence of options in operator fee determination 16 .3 1.S.
S.S. Agreed-upon eight-to-ten-year annual budgeted projections of GOP compared to actual GOP each year. Actual GOP can also be compared to similar hotels in the area. RevPAR compared to annual results of a competitive set. established industry standards.32% independent operators 58% Did not specify.36% of chain operators that have no equity invested . or to a specified star rating.Author Geographic focus Contracts analysed Proportion of hotels identifying criteria for management contract termination . Agreed-upon annual projections of budgeted GOP compared to actual GOP each year. established standards of the operator. Negotiated dollar target is set down for each year of the agreed period. Asia-Pacific (Australia included) Euorpe 17 18 28 50 62. Actual occupancy percentage is compared against the performance of other competitive properties. Actual NOP can also be compared to similar hotels in the area. Performance measure Performance threshold requirement Actual GOP is compared against the performance of other competitive properties.S. Agreed-upon annual projections of budgeted GOP compared to actual GOP each year (actual GOP compared to the trading results of three comparable hotels). Suitability of measure determined with reference to a comparison of projected and actual inflation rates for the period under consideration.37% of chain operators . Agreed-upon annual projections of budgeted NOP compared to actual NOP each year. U. GOP (most common) Cash flow after debt service (common) Cash flow after debt service and return on equity (less common) Occupancy percentage (seldom) GOP GOP GOP Eyster (1988) U. Agreed-upon three-to-five-year annual budgeted projections of GOP compared to actual GOP each year.1% GOP Barge and Jacobs (2001) Americas 24 Did not specify. Agreed-upon annual projections of budgeted GOP compared to actual GOP each year (actual GOP must typically be 80% or more of budgeted GOP for performance to be deemed satisfactory).18% of chain operators with equity invested . established industry standards. established standards of the operator. Agreed-upon annual projections of budgeted GOP compared to actual GOP each year. Suitability of measure determined with reference to a comparison of projected and actual inflation rates for the period under consideration.(58 contracts) & international (19 contracts) 77 Eyster (1993) Eyster (1997) U. GOP NOP RevPAR Goddard and StandishWilkinson (2002) Middle-East 9 55% GOP Negotiated dollar target 17 .14% of international operators . or to a specified star rating.
1% RevPAR (less common) Asia-Pacific (Australia included) Haast.1% 57. RevPAR is typically relative to the average of a competitive set. Agreed-upon annual projections of budgeted GOP compared to actual GOP each year (actual GOP must typically be 80% or more of budgeted GOP for performance to be deemed satisfactory). RevPAR is typically relative to a competitive set. Americas 28 Panvisavas and Taylor (2006) Thailand 8 Unspecified RevPAR Table 5: Management contract termination: Incidence and nature of operator performance thresholds 18 . or part thereof) for the life of the contract. or even a particular property. which is often a hotel managed by the same hotel operator . Agreed-upon annual projections of budgeted GOP compared to actual GOP each year (actual GOP must typically be 80% or more of budgeted GOP for performance to be deemed satisfactory). market.9% 57. RevPAR is typically relative to a comparison of competitive properties in the same local market area. and Braham (2005) Europe 29 50+% 92. No further details given. Dickson.Base figure GOP (most common) 28 57.1% GOP RevPAR RevPAR NOP Owner’s priority return GOP Base figure is increased annually by CPI (Consumer Price Index. Must achieve a percentage of budgeted NOP Expressed as a percentage or in whole dollars Agreed-upon annual projections of budgeted GOP compared to actual GOP each year.
(58 contracts) & international (19 contracts) 30% 77 Non-branded 53% Branded Eyster (1993) U.S.cannot terminate After 3 to 6 years: 4 years After 7 to 10 years: 3 years After 11 years: 2 years After a predetermined period: First 1 to 3 years . Asia-Pacific (Australia included) Euorpe Americas Asia-Pacific (Australia included) Europe Americas 50 50 24 28 28 29 28 Branded and non-branded Branded and non-branded Branded and non-branded Branded and non-branded Branded and non-branded Branded and non-branded Branded and non-branded 23% 68% 33% 36% 31% 25% 25% 17% 23% Penalty fee in relation to management fees (base and incentive) At any time: 3 – 5 years After a predetermined period: After 6 months: 3 – 5 years After 1 to 2 years: 3 – 5 years After 3 to 4 years: 2 – 4 years After 5 years: 1 – 3 years At any time: 1 – 5 years After a predetermined period: After 6 months: 1 .cannot terminate Years 2 to 4 onwards: 2 to 4 years At any time: 0.5 years After 1 to 2 years: 3 years After 3 to 4 years: 2 years After 5 years: 1 year After a predetermined period: First 3 years .S. and Braham (2005) U. 18 Non-branded Johnson (1999) Barge and Jacobs (2001) Haast.cannot terminate Years 2 to 4 onwards: 0. 17 Non-branded 22% 31% Branded Eyster (1997) U.5 to 2 years At any time: Most common 2. 19 .S.5 years Unspecified Unspecified Unspecified Unspecified Unspecified Unspecified Table 6: Incidence and nature of owner options to terminate management contract without a cause 10 Results of independent operators where their owner is in foreclosure omitted.5 to 2 years After a predetermined period: First 1 to 3 years . Dickson.cannot terminate After 3 to 5 years: 2 years After 6 years: 1 year After a predetermined period: First 1 to 3 years .S.Author Geographic region Contracts analysed Type of operator Incidence % adopting Branded Eyster (1988)10 (Empirical observation) U.
000 + 10% of $320.000 $200.000)) per annum and Project B has a negative RI of $80. however.000 and Project B will require an initial investment of $4. we find that the operator would prefer Project B as it would result in an increase in the operator fee revenue of $56.000 $200.000 ($200. A comparison of the projected ROIs for the two projects and the fact that Project B fails to satisfy the owner’s 10% required rate of return provides a persuasive case that the hotel owner would prefer to take Project A.000 – (0. If the operator were to be paid an incentive that is set at (say) 40% of RI.000.000 (40% of -$80. Project A Gross operating profit $200.Appendix A Simulation of operator management fees: Comparison of traditional management fee basis with residual income fee basis Imagine a hotel operator is considering which of two mutually exclusive potential investment opportunities. The projected revenue and profit projections associated with the two investment alternatives are outlined below.000 $500.1 X $4. pursuit of Project A would result in an increase in the operator’s fee revenue of $40.000 $320.000 – (0.000 $800.000) per annum for the five years of Project B’s life.000 Project B Gross operating profit $320.000 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue $500. as the operator would have an incentive to promote Project B.000 (3% of $800.000 ($320.000.000 Based on a typical traditional fee incentive of 3% of gross revenue and 10% of gross operating profit.000) projected incremental fee revenue that would result if Project A were pursued.000. 20 . we see that Project A has a positive RI of $100.000. If the hotel owner imputes a 10% required rate of return (based on its cost of capital) charge when calculating RI.000 (3% of $500.000.000 + 10% of $200.000 $800.000 $800. This is more than the $35.000 ÷ $1.000 ÷ $4.000 $500.000 $320. Project A will require an initial investment of $1. Capital expenditure goal congruency is promoted if the operator is remunerated based on RI (Project A has the higher RI).000.000 $500.000 (40% of $100. Project A or Project B.000) per annum and pursuit of Project B would result in a decrease in the operator’s fee revenue of $32.000 $500.000 $200.000) per annum. it will promote to the owner of a hotel it manages. it can be seen than project A provides the higher return.000.000)) per annum. On an ROI and RI basis.1 X $1. but it is not promoted if the operator is remunerated based on a revenue and profit incentive.000 $800.000 $320.000 X 100) per annum.000 X 100) per annum and Project B provides an ROI of 8% ($320.000 $200.000 Revenue $800.000 $320. Project A provides an ROI of 20% ($200.
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