Hotel Management Deficiencies

HOTEL MANAGEMENT CONTRACTS
AND DEFICIENCIES IN OWNER–

OPERATOR CAPITAL EXPENDITURE
GOAL CONGRUENCY
Michael J. Turner
University of Queensland, Brisbane, Australia
Chris Guilding
Griffith University–Gold Coast Campus, Australia
A review of the findings of prior empirical research concerning hotel management con-
tracts between owners and operators is undertaken. It is noted that management con-
tracts 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. Although 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 RI
is preferable to ROI is outlined.
Keywords: hotel management contract; return on investment; residual income;

capital expenditure
Collier and Gregory (1995a) feel that capital budgeting research is particu-
larly warranted in hotels because of their dual role of property and guest man-
agement and because of their high proportion of capital intensive assets.
Furthermore, hotels are vibrant organizations characterized by complex build-
ings that are costly to maintain (Chan, Lee, & Burnett, 2001). The importance
of these assets underscores the view that the most important budget in a hotel is
the capital budget (Condon, Blaney, & Harrington, 1996; Lynch, 2002).
Guilding (2003, 2006) notes heightened capital budgeting complexity in
hotels operating with a management contract, because the capital outlay decision
must traverse organizational boundaries in satisfying investment criteria of both
Authors’ Note: The authors would like to acknowledge helpful suggestions provided by attendees
at the Performance Measurement Association Conference in Dunedin, New Zealand (April 14-17,
2009), and also the detailed commentaries provided by three reviewers that have resulted in the
article being strengthened.
Journal of Hospitality & Tourism Research, Vol. 34, No. 4, November 2010, 478-511
DOI: 10.1177/1096348010370855
© 2010 International Council on Hotel, Restaurant and Institutional Education
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Turner, Guilding / HOTEL MANAGEMENT CONTRACTS AND DEFICIENCIES 479
owner and operator. Given the high incidence of owner–operator hotel manage-
ment contracts and the particular governance challenges arising, Field (1995)
expresses surprise at the minimal academic research directed toward furthering
our appreciation of this idiosyncratic governance arrangement.
Although there is a large literature concerning capital budgeting practice in
hotels (e.g., Brander-Brown, 1995; Collier & Gregory, 1995a, 1995b; Damitio
& Schmidgall, 2002; DeFranco, 1997; Eder & Umbreit, 1987; Eyster & Geller,
1981; Field, 1995; Guilding, 2003, 2006; Guilding & Hargreaves, 2003;
Guilding & Lamminmaki, 2007; T. Jones, 1998; Schmidgall & Damitio, 1990;
Schmidgall & Ninemeier, 1987), few studies have investigated the particular
capital budgeting issues arising in hotels governed by a management contract
(Field, 1995; Guilding, 2003, 2006). This is surprising as Beals and Denton
(2005) contend that expectations concerning operators’ appropriate expenditure
of owners’ money have been severely undermined by field observations and law
court judgments. This beckons a fundamental examination of this critical aspect
of the owner–operator relationship.
These factors provide the contextual motivation for this study. The study’s
objective is twofold. First, it seeks to provide an examination of management
contract provisions pertaining to hotel operator remuneration and explicate
shortcomings of these provisions in promoting owner–operator capital expendi-
ture goal congruency. Second, it examines the relative merits of alternative
determinants of hotel operator fees, such as return on investment (ROI) and
residual income (RI). The importance of remunerating a hotel operator in a
manner consistent with promoting owner–operator capital expenditure goal
congruence becomes particularly evident when we recognize that it is the hotel
operator that generally initiates capital expenditure proposals (Guilding, 2006).
Should capital expenditure goal congruency be deficient, operators may fail to
share with owners capital expenditure ideas that significantly serve owner inter-
ests but are minimally aligned to their interests.
By exploring hotel owner–operator contractual relations, this study contrib-
utes to agency theory, as it focuses on exposing contractual problems arising
when an agent (hotel operator) has the capacity to act in a self-interested manner
that is inconsistent with the principal’s (hotel owner) interests (Berle & Means,
1962; Jensen & Meckling, 1976). The agency model has been employed in a
wide variety of business settings concerned with a range of issues, for example,
vertical integration (Walker & Weber, 1984), executive compensation (Baker,
Jensen, & Murphy, 1988), and tender offers (Cotter & Zenner, 1994). It has also
been applied in a range of disciplinary contexts, for example, accounting
(Demski & Feltham, 1978), marketing (Basu, Lai, Srinivasan, & Staelin, 1985),
and organizational behavior (Eisenhardt, 1988)). This study concerns the
owner–manager agency relationship that has been the dominant focus in agency
theory-based studies (Eisenhardt, 1989; Walsh & Seward, 1990).
The authors are not aware of any prior academic work that provides a sys-
tematically conducted expose of the relative merits of hotel operator incentives
used widely in hotel management contracts. We are also not aware of any prior
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480 JOURNAL OF HOSPITALITY & TOURISM RESEARCH
consideration given to the extent to which ROI and RI may represent preferable
bases on which to base hotel operators’ fees. This article’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 RI represent alternative performance bases that would result
in heightened levels of owner–operator goal alignment. 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. The article can also be seen as represent-
ing a particular contribution to the application of agency theory in the hotel
management context.
The remainder of the article is structured as follows. The next section sum-
marizes findings of prior research suggesting increasing use of hotel manage-
ment 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. An exam-
ination of the relative merits of ROI and RI 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 management contracting provided herein.
GROWING INCIDENCE OF MANAGEMENT CONTRACTS
Regardless of how a hotel’s assets are owned, hotel owners face a number of
choices regarding their operating structure. In many cases, the party that owns
a hotel does not operate the hotel (Hayes & Ninemeier, 2004). Considered inter-
nationally, the three main hotel operational methods are the owner–operator,
franchise agreement, and management contract (Gannon & Johnson, 1997).
Hotel owners that choose to operate their hotel avoid any loss of control over
day-to-day operations (Field, 1995). The use of the owner–operator hotel own-
ership structure is, however, dwindling in many developed Western markets,
such as the United States, Europe, Australia, and New Zealand (Gross-Turner,
1999; Ingram & Baum, 1997; P. Jones, 1996; Phillips, 2003; Slattery, 1992).
Furthermore, there is little use of the hotel owner–operator structure in the bur-
geoning economies of India, China, and other parts of Asia (Haast et al., 2006).
As a result, usually only “flagship” properties remain independently owned and
operated (Gannon & Johnson, 1997).
Garcia-Falcon and Medina-Munoz (1999) define hotel franchising as an
arrangement where:
For a fee, an independent hotel [i.e., owner–operator] adopts the franchiser’s name
and trademarks and receives services in return, including the preparatory steps of
feasibility, site selection, financing, design, and planning. Almost all the advan-
tages of the chain are available for the franchisee: mass purchasing, management
consultation, wide advertising, central reservations, and systems designs. (p. 106)

Table 1
Percentage Distribution of Hotel Operating Modal Types
by Major Geographical Region
Modal Choice North America Europe Asia
Owner–operator (fully owned) 9.46 28.60 22.40

Owner–operator (partially owned, 11.46 6.20 22.93
e.g., joint venture)
Franchise agreement 38.31 28.66 12.45
Management contract 40.76 36.53 42.21
Source: Adapted from Contractor and Kundu (1998).
Despite relatively high franchising fees, studies show that in both developed
and emerging markets, conditions are more supportive of franchising arrange-
ments than owner–operator structures (see, e.g., Fladmoe-Lindquist & Laurent,
1995; Huszagh, Huszagh, & McIntyre, 1992; Kedia, Ackerman, Bush, & Justis,
1994; Shane, 1996).
Despite the well-established franchising model, recent surveys show that the
third main hotel operational approach, the management contract, has become
the most popular of the three options. The separation between ownership and
management through the use of a hotel management contract is now widespread
(Beals & Denton, 2005; Corgel, 2007; Panvisavas & Taylor, 2006) and is one
of the driving mechanisms for the rapid internationalization of hotels (Beattie,
1991; Dave, 1984; Dunning & McQween, 1981; Eyster, 1997; Litteljohn, 1991;
Litteljohn & Beattie, 1992). Table 1 highlights the predominance of the man-
agement contract across North America, Europe, and Asia in the late 1990s.
Furthermore, Slattery (1996) noted 75% of listed Asian hotels operating under
a management contract. Contractor and Kundu (1998) found 41% of U.S. hotels
had a management contract, whereas Smith Travel Research (2003) noted an
increase to 55%. Beals and Denton (2005), Panvisavas and Taylor (2006), and
Corgel (2007) have provided further recent testimony to the increasing popular-
ity of management contracts.
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, on behalf of, and for the account of the owner. The contract includes
a description of the operator’s remuneration fee determination (Schlup, 2004). It
enables a hotel owner to retain legal ownership of the hotel site, building, plant
and equipment, furnishings and inventories, whereas the operator assumes
responsibility for managing the hotel’s day-to-day business (Guilding, 2003).
Management contracts do suffer, however, from some drawbacks. A funda-
mental problem concerns agency challenges, as the divorce of ownership and
operation can create a volatile mix of economics and power manifested because
of differing owner–operator time horizons (Beals, 1995; Beals & Denton,
2005). It is generally held that operators focus on short-term cash flows,
whereas owners have more of a long-term orientation (Guilding, Kennedy, &
McManus, 2001; Lynch, 2002). This tension is widely referred to as the “horizon
problem” (Dechow & Sloan, 1991; Ittner, Larker, & Rajan, 1997; B. Johnson,
1987; Smith & Watts, 1982) and can lead agents to promote low net present
value (NPV) projects yielding relatively high short-term accounting earnings at
the expense of higher NPV projects that yield lower short-term accounting earn-
ings (Baber, Kang, & Kumar, 1998). Operators also tend to focus on maximizing
their brand values and the longevity of their management contracts to increase
the room stock under their management (Beals & Denton, 2005; Haast et al.,
2006; Schiff, 2006). With regard to the brand value maximization incentive, it
is notable that a large proportion of a hotel company’s assets are made up of
goodwill associated with their brand name (Dev, Morgan, & Shoemaker, 1995).
The importance of hotel brand value signifies that operators have an incentive
to support capital expenditures that are consistent with projecting a favorable
brand image, even though the expenditure may provide limited equity value
enhancement for the hotel owner. Consider, for example, a proposed hotel
lobby refurbishment. On incremental cash flow grounds, the refurbishment
expenditure may not be viable. However, in terms of improved brand alignment
for the operating company, the proposed lobby refurbishment may be highly
desirable. These examples of conflicting interests underscore the fact that man-
agement contracts are frequently associated with owner–operator agency con-
flict (Dimou, Chen, & Archer, 2003).
MANAGEMENT CONTRACTS AND OWNER–OPERATOR CAPITAL

EXPENDITURE GOAL CONGRUENCY
Because of the considerable agency issues arising in the hotel management

contract context, 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, 2006). Armitstead and Marusic (2006) note the imperative of
designing management contracts that engender goal congruence. Berger (1997)
comments on the particular importance of the operator’s remuneration basis,
which can be a source of significant tension between the contracting parties.
An operator’s remuneration is widely referred to as a “management fee”
(Rushmore, 2002). Three basic management fee structures are found in practice:
(a) a base fee only, (b) an incentive fee only, or (c) a base fee combined with an
incentive fee (Goddard & Standish-Wilkinson, 2002). The combination of a
base and incentive fee is the most common.
With respect to the combined base and incentive fee structure, it has been
conventional to view the base element as covering the management company’s
operating expenses, whereas the incentive fee contributes to the operator’s
profit (Rushmore, 2002). Although the base fee can be a fixed amount, it is most
usually determined as a percentage of gross revenue. 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,” providing operators with an incentive
to increase hotel revenue. Table 2 summarizes the findings of prior studies
Table 2
Prior Research Into the Calculation of Hotel Operator Base Management Fees
Geographic Contracts Percentage Determinant of Base Fee

Author Focus Analyzed of Incidence and Typical Amount
Eyster United States 77 55.8 Gross revenue (2%to 7%)
(1988) (58 contracts) 10.4 Fixed amount
and (U.S.$800,000-$1,400,000
international per year)
(19 contracts) 6.5 Percentage of room revenues
(3% to 5%) and of food and
beverage revenues (3% to 5%)
3.9 Gross revenue (4% to 6%),
with portion of fee
subordinated to cash flow after
debt service (1% to 2%)
13.0 No base fee
Eyster United States 17 58.8 Gross revenue (1.5% to 4%)
(1993) 23.5 Fixed amount
(U.S.$36,000-$180,000/year)
11.8 No base fee
Sangree and United States 32 — Gross revenue (2.9% mean)
Hathaway
(1996)
Eyster (1997) United States 18 94.4 Gross revenue (1% to 6%)
5.6 Fixed amount (unspecified)
+ gross revenue (1.5% to 3%)
Johnson United States 50 96.0 Gross revenue (2.7% mean)
(1999) 2.0 Fixed amount (did not specify)
2.0 No base fee
Barge and Asia-Pacific 50 66.0 Gross revenue (1.5% mean)
Jacobs (Australia 26.0 Sliding scale (% of gross
(2001) included) revenue)/Mixed (% of gross
revenue and divisional
revenue)/Fixed
8.0 No base fee
Europe 24 66.7 Gross revenue (1.8% mean)
25.0 Sliding scale (% of gross
revenue)/Mixed (did not
specify basis)/Fixed
8.3 No base fee
Americas 28 78.6 Gross revenue (2.7% mean)
14.3 Gross revenue sliding scale
(2.7% mean, after stabilization)
3.6 Fixed fee (did not specify)
3.6 No base fee
Goddard and Middle-East 9 44.4 Total revenue (1% to 3%)
Standish- 33.3 Gross revenue (1.5% to 2.0%)
Wilkinson 22.2 No base fee
(2002)
(continued)

Table 2 (continued)
Geographic Contracts Percentage Determinant of Base Fee

Author Focus Analyzed of Incidence and Typical Amount
Haast, Asia-Pacific 28 64.3 Gross revenue (1.4% mean)
Dickson, (Australia 17.9 Gross revenue sliding scale
and Braham included) (1.4% mean, after stabilization)
(2005) 17.9 No base fee
Europe 29 62.1 Gross revenue (2.2% mean)
34.5 Sliding scale (% of gross
revenue)/Mixed (did not
specify basis)/Fixed
3.4 No base fee
Americas 28 85.7 Gross revenue (2.8% mean)
14.3 Gross revenue sliding scale
(2.8% mean; after stabilization)
Panvisavas Thailand 8 — Gross revenue (1% to 6%)
and Taylor
(2006)
concerned with ascertaining how hotel operator base fees are determined. It is
evident from this table that internationally, the majority of management contract
base fees are determined by gross revenue.
The continued widespread popularity of revenue-determined operator base fees
appears somewhat surprising given Feldman’s (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” (p. 43). Two further noteworthy
implications arise from remunerating operators based on hotel revenue:
1. Aligned to the issue noted by Feldman (1995), operator remuneration

based on revenue provides the operator with an incentive to promote
capital expenditure proposals that maximize revenue, without necessarily
having a positive impact on profit. An operator with a base fee incentive
of maximizing 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%.
2. An operator with a remuneration based on revenue would have no incen-
tive to initiate cost-saving hotel capital expenditure proposals. An example
of a cost-saving capital expenditure that carries no implication for revenue
would be the option of upgrading laundry facilities that will result in less
laundry labor hours worked, reduced maintenance costs, reduced laundry
detergent costs, reduced water consumption, and reduced wear and tear to
laundered items. Although this type of proposal may have the potential to
carry a major positive impact on profit, the absence of an effect on revenue
may cause an operator with a revenue-maximizing inducement to exclude
it from capital expenditure proposals submitted to a hotel owner.1
Table 3 summarizes prior research findings concerned with the determination

of operator incentive fees. From this table, it is apparent that most incentive fees
are based on either a percentage of gross operating profit (GOP), GOP minus
specific charges, cash flow, or cash flow minus specific charges. There is a
small incidence of incentive fees based on GOP relative to gross revenue, appre-
ciated value of property, percentage above an owner’s priority return, a percent-
age of GOP that exceeds a base fee amount, a percentage of net operating profit
more than a fixed amount, or a percentage of the amount by which cumulative
cash flow exceeds a cumulative set aside amount.
Emphasis attached to profit when determining an operator’s incentive fee
appears to have considerable potential to promote capital expenditure dysfunc-
tionalism. Consider the case of two mutually exclusive projects: Project A requir-
ing an initial investment of $1,000,000 and projected to return $50,000 per annum
and Project B requiring an initial investment of $500,000 and projected to return
$45,000 per annum. If an operator is remunerated according to a profit-based
incentive fee, it will prefer Project A as it generates the highest profit. However,
project B provides a superior ROI of 9% ($45,000 ÷ $500,000 × 100) compared
with Project A’s 5% ($50,000 ÷ $1,000,000 × 100). Prior to taking this invest-
ment appraisal methodological analysis further, this simple scenario provides a
clear indication that a hotel owner is likely to prefer project B, whereas an operator
remunerated on a basis linked to profit can be expected to prefer project A.
As already noted, Table 3 highlights that some hotel operators’ remuneration
is based on GOP or cash flow minus one or more charges relating to asset
investment. Remuneration bases that involve these types of deduction appear to
provide a better basis for promoting owner–operator capital expenditure goal
alignment. This is because they represent algorithms affording recognition to
asset involvement in profit generation. Charges against profit or cash flow noted
in Table 3 that recognize asset involvement in profit generation include property
taxes, insurance, FF&E (furniture, fittings, and equipment) reserve allocation,
and debt service.
With respect to making a charge for the FF&E reserve allocation, it is noted
by Schlup (2004) that because the adequate maintenance of a hotel is also in the
best interest of the operator, it appears fair that contributions to the FF&E
reserve be treated as operating expenses, signifying a reduced fee paid to
operators remunerated on a profit basis. Understanding the implication for an
operator when FF&E reserve allocations are deducted from the profit figure
used in determining incentive fee payments is complicated, however. To appre-
ciate this, we need to recognize that the FF&E reserve allocation is generally set
at around 3% of gross revenue (Brooke & Denton, 2007; Phillips, 2003;
Ransley & Ingram, 2001; Turner & Guilding, 2010). Consider the case of a
hotel operator evaluating a capital expenditure opportunity that will provide a
$1,000 increase in revenue. If the operator is paid a 3% of gross revenue base
fee, they stand to benefit by $30 (3% of the $1,000 increase in revenue). With
respect to the operator’s incentive fee, 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
(text continues on p. 490)
Table 3
486
Prior Research Into the Calculation of Hotel Operator Incentive Management Fees
Contracts Percentage of
Author Geographic Focus Analyzed Incidence Determinant of incentive fee and typical amount
Eyster (1988) United States 77 24.7 GOP (3% to 30%)

(58 contracts) 10.4 GOP less property taxes, insurance, and FF&E reserve allocation
and international (8% to 20%) subordinated (or portion) to debt service (10%)
(19 contracts) 6.5 Cash flow after property taxes, insurance, FF&E reserve allocation,
and debt service (10% to 25%)
6.5 GOP after property taxes, insurance, FF&E reserve allocation, and
debt service (6% to 16%; or 5% GOP before deductions + 5% GOP
after deductions)
6.5 GOP after property taxes, insurance, FF&E reserve allocation, debt
service, and return on equity charge (10% to 15%; or 5% GOP after
debt service + 5% to 10% GOP after required return on equity
charge [typically 8% to 10%])
5.2 Cash flow after property taxes, insurance, FF&E reserve allocation,
debt service, and required return on equity charge (10% to 30%
[8% to 12% required return on equity charge])
3.9 GOP (6% to 12%) + percentage of cash flow after property taxes,
insurance, FF&E reserve allocation, and debt service (10% to 25%)

2.6 Dollar amount by which GOP before fixed charges percentage
amount percentage amount exceeds gross revenues
2.6 GOP (8% to 15%) + percentage of cash flow after property taxes,
insurance, FF&E reserve, debt service, and return on equity charge
(20% to 40% [7% to 10% return on equity charge])
19.5 No incentive fee
(continued)
Table 3 (continued)
Eyster (1993) United States 17 29.4 GOP (5% to 15%)
17.6 Cash flow after debt service (10% to 28%)
11.8 Improvement in GOP (10% to 30%)
5.9 Adjusted GOP (8% to 20%; adjustment not specified)
5.9 Cash flow after debt service and return on equity charge (18% to 30%)
5.9 Appreciated value of property (10%)
Sangree and Hathaway United States 32 Most common Percentage increase in GOP compared with a predetermined figure
(1996) (14.0% mean)
Common GOP (7.9% mean)
Common Percentage beyond an owner’s priority return (17.1% mean)
Less common Percentage of GOP that exceeds a base fee amount (did not specify)
Less common Percentage of NOP over a fixed amount (did not specify)
Less common Percentage of the amount by which cumulative cash flow exceeds
cumulative set-aside amount (did not specify)
Eyster (1997) United States 18 27.8 Cash flow after debt service (0% to 32%)

22.2 Cash flow after debt service and return on equity (0% to 40%)
22.2 Improvement in GOP (8% to 25%)
22.2 GOP subordinated to a negotiated cash flow amount (5% to 10%)
5.6 Improved property value (10% to 25%)
(continued)
487
Table 3 (continued)
488
K. Johnson (1999) United States 50 76.0 GOP less property taxes, FF&E reserve allocation, debt service, and
owner’s priority return (21% mean)
12.0 GOP less property taxes and FF&E reserve allocation (did not specify)
8.0 GOP less property taxes, FF&E reserve allocation, and debt service
(did not specify)
4.0 GOP less property taxes (did not specify)
Barge and Jacobs Asia-Pacific 50 42.0 GOP (8% mean)
(2001) (Australia 40.0 GOP sliding scale (5% to 10%; most popular range)
included) 10.0 Unspecified
Europe 24 54.2 GOP (6.9% mean)
41.7 GOP sliding scale (5% to 15%; most popular range)
Americas 28 21.4 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% to 80% of the difference)
21.4 Percentage of NOP over a certain threshold (unspecified)

17.9 GOP (4%)
Goddard and Middle East 9 77.8 GOP (8% to 10%)
Standish-Wilkinson 11.1 Adjusted GOP (14%; adjustment not specified)
(2002) 11.1 NOP (17.5%), but operator to receive a minimum of US$180,000
per annum
(continued)
Table 3 (continued)
Haast, Dickson, Asia-Pacific 28 39.3 GOP (11.2% mean)
and Braham (2005) (Australia 35.7 GOP sliding scale (5% to 10%; most popular range)
included) 10.7 Other (not specified)
Europe 29 31.0 Adjusted GOP by deducting the base management fee (9.2% mean)
27.6 Profit share, which can include
NOP thresholds
Owner’s priority return deducted from GOP
GOP targets
20.7 GOP sliding scale (5% to 10%; most popular range)
17.2 Other sliding scales (unspecified)
Americas 28 21.4 NOP after payout of owner’s priority return (20%)
17.9 GOP (7.6% mean)

21.4 Other (not specified)
Panvisavas and Taylor Thailand 8 Most common GOP (0% to 10%)
(2006)
Note: GOP = gross operating profit; FF&E = furniture, fittings, and equipment; NOP = net operating profit.
489
revenue, then an additional $30 (3% of $1,000) will be allocated to the FF&E
reserve and deducted from the profit basis used for determining the incentive
payment. Say that 10% of the adjusted profit is being provided to the operator
as their incentive fee, the result of the $1,000 increased revenue on the incentive
fee paid is a reduction of only $3 ($1,000 × 3% × 10%).2 This worked example
highlights the extent to which deducting FF&E reserve allocations from GOP
used in determining operator incentive fee payments contributes minimally to
greater owner–operator capital expenditure goal congruency. Furthermore, it is
notable that the amount allocated to FF&E reserve does not represent a good
proxy for FF&E capital expenditure, 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 (Barge & Jacobs, 2001; Brooke & Denton, 2007;
Eyster, 1988, 1997; Ferguson & Selling, 1985; Haast, Dickson, & Braham,
2005; Mellen, Nylen, & Pastorino, 2000; Ransley & Ingram, 2001; Reichardt &
Lennhoff, 2003; Turner & Guilding, 2010).3
Of the asset-related deductions from GOP that are noted in Table 3, 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. This is because they both represent
an explicit charge for the full cost of any capital outlays made, signifying an
operator incentive to minimize an owner’s capital outlay.4
A second dimension of the management contract drawing on accounting
metrics to promote owner–operator goal alignment concerns performance stan-
dards that, if not met, can be invoked by an owner as grounds for contract termi-
nation (Dutta, 2003; Haktanir & Harris, 2005). This aspect of contracting can be
a source of significant owner–operator conflict (Beals & Denton, 2005). Despite
this, the deployment of minimum performance standards in hotel management
contracting is expected to increase commensurate with rising hotel operator
competition levels (Goddard & Standish-Wilkinson, 2002; Harris & Mongiello,
2001; Rainsford, 1994). It is widely noted, however, that exclusive use of per-
formance measures is unlikely to curb potential dysfunctional operator behavior,
because owners have limited capacity to extract all private information pertain-
ing to performance (Baiman, 1990; Baiman, Evans, & Noel, 1987; Magee, 1980).
The findings of prior empirical research appraising the nature and incidence of
operator performance measures are summarized in Table 4.
The only measures documented in Table 4 that have not already been con-
sidered are occupancy and revenue per available room (RevPAR). The relative
merits of each are outlined in the hospitality management accounting normative
literature (e.g., Jagels, 2007; Schmidgall, 2006). With respect to their implica-
tions for capital expenditure decision making, consistent with the rationale
already outlined, occupancy and RevPAR both suffer from no recognition of
capital outlay. If appraised on RevPAR and occupancy, an operator would have
an inducement to rank a $50,000 capital expenditure opportunity that results in
a 2% increase in occupancy and $5 increase in RevPAR behind a $1,000,000
outlay that results in a 3% increase in occupancy and $6 increase in RevPAR.
Although the first option can from
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Table 4
Management Contract Termination: Incidence and Nature of Operator Performance Thresholds
Proportion of Hotels Identifying

Geographic Contracts Criteria For Management Performance
Author Focus Analyzed Contract Termination Measure Performance Threshold Requirement
Eyster (1988) United States 77 36% of chain operators GOP Actual GOP is compared against the
(58 contracts) that have no equity invested (most common) performance of other competitive
and international 18% of chain operators properties
(19 contracts) with equity invested Cash flow after Suitability of measure determined with
14% of international debt service reference to a comparison of projected
operators (common) and actual inflation rates for the period
under consideration
Cash flow after Suitability of measure determined with
debt service and reference to a comparison of projected
return on equity and actual inflation rates for the period
(less common) under consideration
Occupancy Actual occupancy percentage is
percentage compared against the performance of
(seldom) other competitive properties
Eyster (1993) United States 17 37% of chain operators GOP Agreed-on 3- to 5-year annual budgeted
32% independent operators projections of GOP compared with

actual GOP each year
Eyster (1997) U.S. 18 58% GOP Agreed-on 8- to-10-year annual budgeted
projections of GOP compared with actual
GOP each year
Barge and Jacobs Asia-Pacific 28 Did not specify GOP Agreed-on annual projections of budgeted
(2001) (Australia GOP compared with actual GOP each
included) year (actual GOP must typically be 80%
or more of budgeted GOP for
performance to be deemed satisfactory)
491
(continued)
Table 4 (continued)
492
Euorpe 50 62.1% GOP Agreed-on annual projections of budgeted

GOP compared with actual GOP each year
(actual GOP compared with the trading
results of three comparable hotels)
Americas 24 Did not specify GOP Agreed-on annual projections of budgeted
GOP compared with actual GOP each year
Actual GOP can also be compared with
similar hotels in the area, established
industry standards, established standards
of the operator, or to a specified star rating.
NOP Agreed-on annual projections of budgeted
NOP compared with actual NOP
each year
Actual NOP can also be compared with
similar hotels in the area, established
industry standards, established standards
of the operator, or a specified star rating.

RevPAR RevPAR compared with annual results of
a competitive set
Goddard and Middle East 9 55% GOP Agreed-on annual projections of budgeted
Standish-Wilkinson GOP compared with actual GOP each year
(2002) Negotiated Negotiated dollar target is set down for
dollar target each year of the agreed period
Base figure Base figure is increased annually by
Consumer Price Index, or part thereof,
for the life of the contract
(continued)
Table 4 (continued)

Haast, Dickson, and Asia-Pacific 28 57.1% GOP Agreed-on annual projections of budgeted
Braham (2005) (Australia (most common) GOP compared with actual GOP each
included) year (actual GOP must typically be 80%
RevPAR RevPAR is typically relative to a
(less common) competitive set, market, or even a
particular property, which is often a hotel
managed by the same hotel operator
Europe 29 50+% GOP Agreed-on annual projections of budgeted
GOP compared with actual GOP each
year (actual GOP must typically be 80%
RevPAR RevPAR is typically relative to the
average of a competitive set
Americas 28 92.9% RevPAR No further details given

57.1% NOP Must achieve a percentage of
budgeted NOP
57.1% Owner’s priority Expressed as a percentage or in
return whole dollars
Panvisavas and Thailand 8 Unspecified GOP Agreed-on annual projections of budgeted
Taylor (2006) GOP compared with actual GOP each year
RevPAR RevPAR is typically relative to a
comparison of competitive properties in
the same local market area
493
Note: GOP = gross operating profit; NOP = net operating profit; RevPAR = revenue per available room.
the lower occupancy and RevPAR. It should also be noted that emphasis on
occupancy and RevPAR performance measures would likely raise the priority
attached by an operator to accommodation-related capital expenditures relative
to expenditure on other hotel activities such as restaurant and bar.
Where an operator is performing poorly, the only other termination option
for an owner is to invoke termination without a cause provisions. Prior research
findings concerned with appraising the incidence and nature of such provisions
are summarized in Table 5, which highlights that around one third of manage-
ment contracts include termination without a cause provisions. Consistent with
the challenge of activating operator performance measures, termination without
a cause provisions are becoming increasingly difficult to invoke because of their
extensive qualifications and caveats (Dickson, 2007). This underscores the
importance of ensuring that a negotiated management contract is conducive to
a high degree of owner–operator goal alignment. Management contract termina-
tion impediments in combination with deficient owner–operator goal congru-
ence signify a high propensity for protracted hotel operational decision making
that is inconsistent with owner interests.
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. We now turn to consider alternative
performance measures that, a priori, represent inducement bases more consistent
with promoting owner–operator capital expenditure goal congruency.
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, Davis, Pike, & Sharp, 1993; Payne,
Carrington-Heath, & Gale, 1999). Formulation of an NPV calculation requires the
provision of projected cash flows. NPV would not be a good basis for determining
hotel operator management fees, however. This is because operator management
fees need to be based on objectively verifiable performance measures. Monitoring
past achievements involves much less subjectivity than projected cash flow for-
mulation. So although NPV is the preferred approach for evaluating capital expen-
diture proposals, it does not lend itself to gauging a hotel operator’s performance.
Two measures of past performance that give recognition to the amount of invest-
ment involved in generating a return and are widely discussed in the management
accounting literature are ROI and RI (Anthony & Govindarajan, 2007; Langfield-
Smith, Thorne, & Hilton, 2003).5 Formulae for these measures are the following:6
ROI = Operating profit ÷ Operating assets; or Operating

profit ÷ Sales × Sales ÷ Operating assets
RI = Operating profit − (Cost of capital × Operating assets)

Table 5
Incidence and Nature of Owner Options to Terminate Management Contract Without a Cause
Percentage Penalty Fee in Relation to

Contracts of Incidence Management Fees (Base
Author Geographic Region Analyzed Type of Operator of Adopting and Incentive)
a
Eyster (1988) United States 77 Branded 30 At any time: 3-5 years
(empirical (58 contracts) After a predetermined period:
observation) and international After 6 months: 3-5 years
(19 contracts) After 1 to 2 years: 3-5 years
After 3 to 4 years: 2- 4 years
After 5 years: 1-3 years
Nonbranded 53 At any time: 1-5 years
After a predetermined period:
After 6 months: 1-5 years
After 1 to 2 years: 3 years
After 5 years: 1 year
Eyster (1993) United States 17 Branded 22 After a predetermined period:
First 3 years—cannot terminate

After 11 years: 2 years
Non-branded 31 After a predetermined period:
First 1 to 3 years - cannot terminate
After 6 years: 1 year
(continued)
495
496
Table 5 (continued)
Percentage Penalty Fee in Relation to

Contracts of Incidence Management Fees (Base
Author Geographic Region Analyzed Type of Operator of Adopting and Incentive)
Eyster (1997) U.S. 18 Branded 23 After a predetermined period:
First 1 to 3 years—cannot terminate
Years 2 to 4 onwards: 2-4 years
Non-branded 68 At any time: 0.5-2 years
After a predetermined period:
First 1 to 3 years—cannot terminate
Years 2 to 4 onwards: 0.5-2 years
K. Johnson (1999) United States 50 Branded and nonbranded 33 At any time: Most common 2.5 years
Barge and Jacobs Asia-Pacific 50 Branded and nonbranded 36 Unspecified
(2001) (Australia included)
Europe 24 Branded and nonbranded 31 Unspecified
Americas 28 Branded and nonbranded 25 Unspecified

Haast, Dickson, Asia-Pacific 28 Branded and nonbranded 25 Unspecified
and Braham (2005) (Australia included)
Europe 29 Branded and nonbranded 17 Unspecified
Americas 28 Branded and nonbranded 23 Unspecified
a. Results of independent operators where their owner is in foreclosure omitted.

It can be seen from these formulae that ROI constitutes a ratio, not an absolute
dollar amount. It has become commonplace for normative expositions of ROI
in the management accounting literature (e.g., Anthony & Govindarajan, 2007;
Horngren, Datar, & Foster, 2007) and the hospitality management accounting
literature (e.g., Guilding, 2009) to demonstrate how ROI can be dissected into
two underlying components: profit margin (profit ÷ sales) and sales turnover
(sales ÷ assets). It is evident that there is some convergence between the profit
margin element of ROI and conventional hotel operator incentives, because of
the latter’s emphasis on sales and profit. The element that is completely lacking,
however, is the incentive to maximize sales for a given level of investment, as
conventional operator incentives lack a measure that taps into the investment
construct. RI is calculated as profit minus an imputed charge for capital employed.
The imputed charge is generally linked to the cost of capital (Langfield-Smith
et al., 2003).
The major benefit of ROI is that the agent is discouraged from excessive
investment in assets.7 Further advantages of ROI include the following: (a) it
reflects anything that affects the financial statements; (b) it is easy to calculate,
simple to understand, and is meaningful in an absolute sense; (c) it can be applied
to any unit within an organization responsible for profitability, regardless of the
size or type of the business; and (d) as ROI data is typically available for com-
petitors, it can be used as a basis for comparison (Anthony & Govindarajan,
2007).8 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, as will be seen below (this
is sometimes referred to as an “underinvestment problem”). A second disadvan-
tage is that managers evaluated on the basis of ROI may be dissuaded from
investing in some positive NPV projects. This is because such projects may
have low levels of profit and ROI in the early years of their useful lives.
Consistent with most other accounting measures, a third disadvantage of ROI is
that it does not represent an economic rate of return on capital, because account-
ing profit excludes many value increases such as land appreciation prior to sale,
as well as intangible asset growth such as increases in brand value.
RI has been widely promoted as a measure that averts some of ROI’s short-
comings (see Anthony & Govindarajan, 2007; Christensen, Feltham, & Wu,
2002; Dutta & Reichelstein, 2002; Langfield-Smith et al., 2003). RI’s improve-
ment over ROI stems from its formula containing an important datum that is
absent from the ROI formula, that is, the organization’s required rate of return
on invested capital (Langfield-Smith et al., 2003).9 Despite the theoretical
strength of RI, Drury, Braund, Osborne, and Tayles (1993) note that surveys
(e.g., Reece & Cool, 1978; Scapens, Sale, & Tikkas, 1982; Skinner, 1990) have
indicated that practitioners show a strong preference for ROI because: (a) as a
ratio, it can be used for comparisons within or between divisions, (b) ROI can
be compared with other organizations or within an organization’s divisions, and
(c) ROI is generally considered a measure of overall profitability and is there-
fore used more by outsiders.
Table 6
Illustration of the Merit of RI Versus ROI
Hotel A Hotel B
Current scenario
Investment in assets $500,000 $500,000
Operating profit $20,000 $90,000
ROI (Profit ÷ Assets) 4% 18%
RI ((Profit − (Cost of capital × Assets)) −$30,000 $40,000
Additional opportunity
Purchase asset $200,000
Sell asset $180,000
Change in profit +$18,000 −$21,600
ROI associated with asset purchase or sale 9% 12%
ROI subsequent to asset purchase or sale
Assets $700,000 $320,000
New ROI 5.4% 21.4%
RI subsequent to asset purchase or sale
Assets $700,000 $320,000
RI −$32,000 $36,400
Note: ROI = return on investment; RI = residual income.
In a hotel management investment decision-making context, Guilding (2009)

demonstrates how RI represents a preferred incentive basis to ROI. The case he
depicts is reproduced as Table 6. The top panel provides the current scenario of
a hotel chain with two hotels: Hotel A generating a 4% ROI and −$30,000 RI,
and Hotel B generating an 18% ROI and $40,000 RI. The hotel chain is seeking
a 10% target ROI. Options that have arisen for the two hotels are outlined in the
table’s second panel, and the ROI impact of acting on these options is outlined
in the third panel. Hotel A has an incentive to purchase an asset costing $200,000
as it would increase its ROI from 4% to 5.4% ($38,000 ÷ $700,000 × 100). Hotel
B has an incentive to sell an asset that generates $21,600 for its $180,000 book
value, as the hotel’s ROI would increase from 18% to 21.4% ($68,400 ÷
$320,000 × 100). The flaw in the ROI incentive becomes apparent when it is
recognized that the hotel chain is preparing to buy an asset that will earn a 9%
ROI ($18,000 ÷ $200,000) while at the same time selling a second asset earning
a higher ROI of 12% ($21,600 ÷ $180,000). This problem is averted if RI
maximization is adopted as the performance measurement criterion. As is evi-
dent from Table 6’s final panel, if Hotel A were to make the $200,000 asset
purchase, its RI would drop from −$30,000 ($20,000 − (0.1 × $500,000)) to
−$32,000 ($38,000 − (0.1 × $700,000)). If Hotel B were to make the $180,000
asset sale, its RI would drop from $40,000 ($90,000 − (0.1 × $500,000)) to
$36,400 ($68,400 − (0.1 × $320,000)). The decline in the two hotels’ respective
RIs signifies that neither should make the asset changes under consideration.
When applying the RI algorithm, any investment that exceeds an organiza-
tion’s required rate ofDownloaded
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yields a positive
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2016 a result, RI motivates
managers to maximize 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 & Govindarajan, 2007). The appendix presents a
simulated exercise that demonstrates how RI represents a performance measure-
ment basis that promotes a higher degree of owner–operator capital expenditure
goal congruency compared with traditional hotel operator fee bases that are tied
to revenue and profit.
It was noted above that finance practice holds that the preferred investment
appraisal criterion is NPV. It is noteworthy, therefore, to recognize that RI,
considered over the long term, approximates to NPV. Using RI to evaluate
management performance can be expected to promote goal congruency, because
the information that is required for NPV and IRR converges (considered over
the long term, accruals-based differences between cash flows used in NPV cal-
culations and profit used in RI calculations disappear). We can thus conclude
that maximizing RI over time approximates to maximizing firm value.
Analysis of hotel management contracts in the United States provides some
support for the view that RI represents a preferred basis for determining hotel
operator remuneration. 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. Adjusting profit for debt service can be seen
as a “partial RI” measure, for, although it embodies a charge for debt capital, no
charge is made for equity funding. For the 5.9% of contracts examined by
Eyster, where the operator remuneration is based on cash flow after debt service
and return on equity, we have a closer approximation to RI. This is because the
measure involves a charge made for all long-term capital funding (i.e., equity
and debt). Although this signifies the existence of some management contracts
promoting a better alignment of owner–operator capital expenditure interests,
this improved alignment will be largely negated if this type of incentive fee is
combined with a base fee determined by gross revenue (the most common base
fee noted in Table 2). More recent hotel management contract surveys (e.g.,
Barge & Jacobs, 2001; Goddard & Standish-Wilkinson, 2002; Haast et al., 2005;
K. Johnson, 1999; Panvisavas & Taylor, 2006) have failed to identify any incen-
tive fees tied to cash flow after debt service and return on equity.
With respect to the adoption of RI as a generic performance measure,
Balachandran (2006) conducted an analysis of Compustat firms’ RI usage.
Table 7 provides an industry sector classification of Balachandran’s RI adoption
findings. The proportion of firms using RI measures ranged from 34.8% of
durable goods firms to 0% of real estate firms. Considered holistically, these
findings suggest limited application of RI across a range of industrial settings.
Although this study promotes using RI as a basis for determining operator
fees, it should be noted that it is not devoid of shortcomings. RI is a financially
denominated measure that is calculated from accrual accounting numbers.
Performance measures that are based on accounting numbers are widely criti-
cized for instilling a short-termist outlook (Ezzamel, 1992; Ezzamel & Hart,
1989; Rappaport, 1986). In light of this, many commentators suggest combining
Table 7
RI Adoption by Sector
Number of Sample percentage

Industry Adopters Percentage of Compustat Firms
Mining and construction 6 3.2 7.7
Food 7 3.8 2.3
Textiles, printing, publishing 19 10.8 5.1
Chemicals 7 3.8 1.8
Pharmaceuticals 4 2.7 2.8
Extractive industries 3 1.6 0.5
Durable goods 63 34.8 20.1
Computers 3 1.6 9.8
Transportation 10 5.4 5.7
Utilities 17 9.7 2.4
Retail 18 9.7 10.9
Financial institutions 10 5.4 11.5
Real estate 0 0.0 8.5
Service 13 7.0 9.8
Other 1 0.5 1.1
Total 181 100% 100%
Adapted from: Balachandran (2006, p. 386).
financial and nonfinancial performance measures in an attempt to better align

the interests of principals and agents (Aggarwal, 1991; Kakati & Dhar, 1991;
Slagmulder & Bruggeman, 1992).10 If attempting to use RI in a cross-hotel
comparison, it must be recognized that it is an absolute number, and larger
hotels would be expected to generate a higher RI than smaller hotels, although
this problem can be circumvented by using a hybrid measure that sees RI
divided by assets employed. Consistent with other accounting-based measures,
RI measures performance within a 1-year window. This year’s measure does
not capture impacts occurring in subsequent years that stem from actions taken
this year. For example, reducing maintenance or marketing to achieve a target
profit may increase the current period’s RI but jeopardize future hotel value.
A further shortcoming of using ROI or RI relates to Healy’s (1985) bonus
plan hypothesis. Healy (1985) explains how the remuneration conditions exist-
ing between a principal and agent can cause the agent to make profit increasing
or decreasing accounting policy choices. If ROI or RI is used to incentivize an
operator, and profit in a particular year is negative, the operator may be induced
to “take a bath” by selectively expensing any potential future capital expendi-
ture in the current period to reduce capital charges assigned to future years.
Given the high asset base associated with hotels, there appears to be consider-
able scope to manipulate the period in which substantial expenses are charged.
Generally accepted accounting principles and hotel management contracts pro-
vide little guidance resolving the issue concerning which asset-related expendi-
tures are to be expensed or capitalized (Schmidgall, Damitio, & Singh, 1997).
Research examining Healy’s (1985) hypothesis provides equivocal results,
however. Several studies support Healy’s hypothesis (see Bernard & Skinner,
1996; Dechow, Sloan, & Sweeney, 1995; Holthausen, Larcher, & Sloan, 1995;
J. Jones, 1991; Kaplan, 1985; McNichols & Wilson, 1988; Schipper, 1989).
Research providing conflicting evidence includes DeFond and Park (1997) and
Gaver, Gaver, and Austin (1995).
Although the discussion in this section has been conducted in the context of
seeking improved bases of hotel operator fee determination, it is also pertinent
to identify appropriate performance measure thresholds that can be invoked by
an owner as grounds for contract termination. Based on the rationale outlined,
it would appear to be in owners’ interests to require operators to meet perfor-
mance thresholds stated in terms of ROI or RI.
CONCLUSION AND DISCUSSION
In any discussion of accounting measures that can be used as a basis of

hotel operator fee determination, it is important to recognize the role that
operator brand standards can play in hotel capital expenditure decision making
(Beals & Denton, 2005; Haast et al., 2006; Schiff, 2006). If an owner deems
a particular capital expenditure proposal to be unjustifiable on financial crite-
ria grounds, but the operator sees the expenditure as necessary to meet their
brand standard, if the owner rejects the proposal, the operator may have the
right to terminate the contract (Beals & Denton, 2005). In such a situation,
although use of ROI or RI might suggest that the operator’s capital expendi-
ture interest is well aligned to the owner’s interest, there is a strong brand
standard factor at play that affects the operator’s capital expenditure perspec-
tive. Although a proposed expenditure may have a negative ROI or RI
(thereby potentially reducing an operator’s incentive management fee), the
operator may still support the expenditure if the benefit to their brand value
outweighs any potential management fee reduction.
This article has demonstrated that widely used clauses in hotel management
contracts provide an incentive for hotel operators to take actions consistent with
maximizing sales and profits, but not maximizing ROI. As the hotel manage-
ment contract is ubiquitous in the Western world, this propensity to make man-
agement decisions on the criteria of maximizing sales and profits without due
regard given to capital employed can be expected to be a systemic feature of
Western world hotel management. This signifies a potential systemic misalloca-
tion of effort and resources in the international hotel sector on a mass scale and
appears worthy of further academic enquiry. From a practitioner perspective,
the article can be expected to be of particular interest to hotel owner groups such
as the Asian American Hotel Owners Association, which has been active in
furthering owner’s interests through activities such as promotion of the fair
franchising initiative.11
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. It is usual for the operator to engage the General

Manager (Eyster, 1997; Guilding, 2003, 2006; Rushmore, 2002). In most cases,
however, this appointment requires the approval of the owner (Guilding, 2003;
Haast et al., 2005). It is noteworthy that in some situations the owner pays for
the General Manager’s salary immediately (Dickson & Williams, 2006),
whereas in other situations the salary is initially paid for by the operator but is
eventually reimbursed by the hotel owner (Eyster, 1997; Guilding, 2003).
Regardless of which method is adopted, the owner’s financing of the General
Manager’s salary continues throughout the entire term of the management con-
tract. In some management contracts, the owner also has the authority to remove
the General Manager for unacceptable performance (Crandell, Dickinson, &
Kanter, 2004). Clearly, such an employment arrangement gives rise to conflict
because it detracts from the operator’s degree of control over the General
Manager, that is, the General Manager feels accountable to the owner as well as
the operator. Given the key role a General Manager plays in capital budget
formulation (Rushmore, 2002), understanding the relative motivations of
General Managers and the way they manage tensions between owners and
operators would likely sharpen our appreciation of the dynamics at play in hotel
capital budgeting. Should research be made of performance-related pay of
General Managers, it would be useful to determine if hotels are effective in
distinguishing between the performance of a manager and the performance of a
hotel, as a hotel may be a poor performer that is affected by economic condi-
tions beyond a manager’s control.
Further research could also examine factors arising from the growing inci-
dence of owner engagement of asset managers to monitor operators (Armitstead,
2004; Bader & Lababedi, 2007; Geller, 2002). This development appears to
parallel growing owner realization of inconsistencies between owner and operator
interests (Feldman, 1995; Johnstone & Duni, 1995). Although asset manager
engagement is designed to promote improved owner–operator interest align-
ment (Bader & Lababedi, 2007), it is notable that asset managers are tradition-
ally recruited from the ranks of hotel management companies, where they have
been previously employed as General Managers or Vice Presidents. As a result,
asset managers often focus on short-term operational issues rather than building
long-term value (Bridge & Haast, 2004). Field study research into issues sur-
rounding the degree to which asset managers promote owner–operator goal
congruency has the potential to provide profound insights into the mechanics of
hotel capital expenditure management.
Research could also be directed toward determining the extent to which hotel
owners are requiring operators to take an equity stake in the ownership of the
properties that they manage, as a mechanism to promote greater owner–operator
goal congruency. An examination of the extent to which this represents a viable
and productive means for promoting increased owner–operator goal congru-
ency would provide a useful contribution to our understanding of the likely
evolution of owner–operator contracting.

APPENDIX
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, Project A or Project B, it will promote to the owner of a hotel
it manages. Project A will require an initial investment of $1,000,000, and Project B will
require an initial investment of $4,000,000. The projected revenue and profit projections
associated with the two investment alternatives are outlined below.
Project A Project B
Revenue Gross Operating Profit Revenue Gross Operating Profit
Year 1 $500,000 $200,000 $800,000 $320,000

Year 2 $500,000 $200,000 $800,000 $320,000
Year 3 $500,000 $200,000 $800,000 $320,000
Year 4 $500,000 $200,000 $800,000 $320,000
Year 5 $500,000 $200,000 $800,000 $320,000
Based on a typical traditional fee incentive of 3% of gross revenue and 10% of GOP,
we find that the operator would prefer Project B as it would result in an increase in the
operator fee revenue of $56,000 (3% of $800,000 + 10% of $320,000) per annum for the
5 years of Project B’s life. This is more than the $35,000 (3% of $500,000 + 10% of
$200,000) projected incremental fee revenue that would result if Project A were pursued.
On an ROI and RI basis, it can be seen than project A provides the higher return, however.
Project A provides an ROI of 20% ($200,000 ÷ $1,000,000 × 100) per annum, and Project B
provides an ROI of 8% ($320,000 ÷ $4,000,000 × 100) per annum. If the hotel owner imputes
a 10% required rate of return (based on its cost of capital) charge when calculating RI, we see
that Project A has a positive RI of $100,000 ($200,000 (0.1 × $1,000,000)) per annum, and
Project B has a negative RI of $80,000 ($320,000 − (0.1 $4,000,000)) per annum.
If the operator were to be paid an incentive that is set at (say) 40% of RI, pursuit of
Project A would result in an increase in the operator’s fee revenue of $40,000 (40% of
$100,000) per annum and pursuit of Project B would result in a decrease in the operator’s
fee revenue of $32,000 (40% of −$80,000) per annum.
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. Capital expenditure goal congruency is
promoted if the operator is remunerated based on RI (Project A has the higher RI), but
it is not promoted if the operator is remunerated based on a revenue and profit incentive,
as the operator would have an incentive to promote Project B.
NOTES
1. These two implications (i.e., promoting revenue-maximizing projects with no

regard given to profit impact and no incentive to pursue cost-cutting projects) will be
mitigated where a hotel management contract also provides a separate profit-based

incentive. Nevertheless, even the presence of a small proportion of an operator’s fee
based exclusively on revenue will introduce a bias, causing the operator to weight the
importance of revenue maximization more heavily than cost minimization or profit
maximization. As the proportion of an operator’s total remuneration that is revenue
based is increased, so too will the extent of this bias.
2. In the interests of parsimony, we have assumed that the $1,000 increase in revenue
has not resulted in a change in profit. This simplifying assumption does not affect the
rationale outlined.
3. 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.
4. It should be noted that charges for debt and equity appear to be little used outside
the United States. Discussions with a specialist in the preparation of Australian hotel
management contracts indicate that it is 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.
5. RI formulations often appear under various names such as abnormal earnings
(Ohlson, 1995) or Economic Value Added (EVA®), which is a technique popularized by
the consulting firm Stern Stewart & Co (Anthony & Govindarajan, 2007; Biddle,
Bowen, & Wallace, 1997; Chen & Dodd, 1997; Wallace, 1997).
6. It should be noted that, in practice, there can be much variation in the way that
companies define profit and assets. Profit can be profit before or after tax, earnings
before interest and taxes or net profit, whereas assets may be defined as total assets or
assets minus current liabilities.
7. The merit of ROI is apparent from the following comment provided in a lodging
sector company’s 10-K Report:
Return on invested capital is a key profitability measure that provides an indica-

tion of the long-term health of our concepts. This metric is based on a comparison
of operating profit to the average capital invested in our restaurants. We believe
return on invested capital is a critical indicator in evaluating our ability to create
long-term value for our shareholders.(P.F. Chang’s China Bistro Inc, 2008, p. 21)
8. Attempting cross-company ROI comparisons is not straightforward, however, as

the useful lives of depreciable assets will differ across hotels. As assets become fully
depreciated, the measure of investment declines and ROI increases, undermining the
merit of attempting cross-hotel ROI comparisons.
9. A hotel’s required rate of return on invested capital is its cost of capital. In a hos-
pitality management context Guilding (2009, p. 297) notes “the cost of capital is the
average cost (stated as a percentage) of the capital funds raised by a company.” Viewed
slightly differently, it is the rate of return that a company must earn for its market value
to remain unchanged (assuming a steady stock market).
10. Nonfinancial performance measures, for example, can include market share
(Morishima, 1982; Prestowitz, 1988; Tsuruni, 1984; Van Wolferen, 1989); innovative-
ness (Goldsmith & Clutterbuck, 1984); market standing (Saunders & Wong, 1985);
efficiency/productivity, product quality, customer satisfaction, employee satisfaction
(Ittner et al., 1997), and others.
11. Further information can be found at http://www.aahoa.com.
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Submitted August 4, 2008

Final Revision submitted May 6, 2009
Accepted May 8, 2009
Refereed Anonymously
Michael J. Turner, PhD (e-mail: [email protected]), is a lecturer of

accounting, Faculty of Business, Economics & Law in the UQ Business School at
University of Queensland (St. Lucia, Brisbane, Australia). Chris Guilding, PhD (e-mail:
[email protected]), is a professor of hotel management in the Department of
Tourism, Leisure, Hotel and Sport Management at Griffith University–Gold Coast
Campus (Queensland, Australia).

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HOTEL MANAGEMENT CONTRACTS

AND DEFICIENCIES IN OWNER–

Keywords: hotel management contract; return on investment; residual income;

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GROWING INCIDENCE OF MANAGEMENT CONTRACTS

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Modal Choice North America Europe Asia

Owner–operator (fully owned) 9.46 28.60 22.40

Source: Adapted from Contractor and Kundu (1998).

MANAGEMENT CONTRACTS AND OWNER–OPERATOR CAPITAL

Because of the considerable agency issues arising in the hotel management

Geographic Contracts Percentage Determinant of Base Fee

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Geographic Contracts Percentage Determinant of Base Fee

1. Aligned to the issue noted by Feldman (1995), operator remuneration

Table 3 summarizes prior research findings concerned with the determination

Eyster (1988) United States 77 24.7 GOP (3% to 30%)

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Proportion of Hotels Identifying

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Euorpe 50 62.1% GOP Agreed-on annual projections of budgeted

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Proportion of Hotels Identifying

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RETURN ON INVESTMENT AND RESIDUAL INCOME AS

The foregoing analysis has highlighted widespread use of hotel operator

ROI = Operating profit ÷ Operating assets; or Operating

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Percentage Penalty Fee in Relation to

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Percentage Penalty Fee in Relation to

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a. Results of independent operators where their owner is in foreclosure omitted.

Note: ROI = return on investment; RI = residual income.

In a hotel management investment decision-making context, Guilding (2009)

Number of Sample percentage

Adapted from: Balachandran (2006, p. 386).

financial and nonfinancial performance measures in an attempt to better align

CONCLUSION AND DISCUSSION

In any discussion of accounting measures that can be used as a basis of

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a management contract. It is usual for the operator to engage the General

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Imagine a hotel operator is considering which of two mutually exclusive potential

Revenue Gross Operating Profit Revenue Gross Operating Profit

Year 1 $500,000 $200,000 $800,000 $320,000

1. These two implications (i.e., promoting revenue-maximizing projects with no

mitigated where a hotel management contract also provides a separate profit-based

Return on invested capital is a key profitability measure that provides an indica-

8. Attempting cross-company ROI comparisons is not straightforward, however, as

Aggarwal, R. (1991). Justifying investments in flexible manufacturing technology: Adding

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Fladmoe-Lindquist, K., & Laurent, L. J. (1995). Control modes in international service

Submitted August 4, 2008

Michael J. Turner, PhD (e-mail: [email protected]), is a lecturer of

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Keywords: hotel management contract; return on investment; residual income;