The impact of overbooking on hotels’ operation

management
Todorov, Andrey and Zhechev, Vladimir

September, 2010

About the authors

Vladimir Zhechev received his Bachelor Degree in Business

Administration from HAN University, Arnhem Business School, the
Netherlands. He is currently an MBA student at University of Wales
Institute, Cardiff, UK and simultaneously occupies a marketing
assistant position in a private organization.

Andrey Todorov is a graduate of International University College,

Bulgaria holding a Bachelor Degree in Hospitality Management. His
specialty is in tourism industry management.

Electronic copy available at: http://ssrn.com/abstract=1698103

Abstract

In order to optimize operational efficiency and increase their profitability hotel managers put
emphasis on implementing successful operational techniques. Overbooking is seen as an
important Revenue Management tool in the hotels’ operation management and is one of the
commonly used revenue strategies implemented in the hotels’ management practices.

In this regard, the current report aims to discuss and outline the main characteristics of
overbooking and its impact on the hotels’ operation management. Moreover, it analyzes and
presents the consequences of successful or inappropriate overbooking management
decisions because depending on the way the overbooking is planned and managed it can
have positive (increased long-term revenue, better management capacity, etc.) and negative
(loss of room revenue, decreased customer loyalty, loss of hotel reputation, etc.) influence
over the hotel’s profitability.

The paper also evaluates several publications as overbooking is a commonly discussed topic
in the academic literature. In addition to the literature and theoretical background, the
report examines overbooking from practical point of view and reviews its implementation
within the hotel industry.

Key words: Revenue Management, overbooking, hospitality industry

Introduction

Companies throughout the entire hospitality industry focus on implementing successful

operational techniques in order to optimize their efficiency and increase profitability.
Revenue Management is seen as an important technique in the hotels’ operation and
therefore to maximize their revenues, hotels are increasingly implementing Revenue
Management practices (Hwang and Wen, 2009). As a consequence of implementing such
systems, many companies in the service sector such as hotels systematically overbook
capacity in order to maximize the revenue at one particular point in time (Wangenheim and
Bayón, 2007).

Electronic copy available at: http://ssrn.com/abstract=1698103

Overbooking is the oldest and one of the most commonly used revenue strategies
implemented in hotels’ operation management. Its importance is acknowledged not only
within the academic fields but also within various industries because inappropriate
overbooking decisions can be very expensive for a particular hotel and in short-term, it is
only a loss of room revenue; conversely over the long-term, the consequences may include
decreased customer loyalty, loss of hotel reputation, etc. (Karvy, 2006). However if
overbooking is well-managed and successfully performed it can positively impact hotel’s
profitability by maximizing its long- term revenue.

The current report focuses on discussing and outlining the main characteristics of
overbooking and its impact on hotels’ operation management both from theoretical and
practical perspective.

Literature and Theoretical Analysis

Revenue Management

“Yield” or Revenue Management is an important tool for matching supply and demand by
segmenting customers into different segments based on their willingness to pay and
allocating limited capacity to the different segments in a way that maximizes company’s
revenues (Haddat, Ropper and Jones, 2008). It is also defined as “the application of
information systems and pricing strategies to allocate the right capacity to the right
customer at the right price at the right time” (Kimes and Wirtz, 2003).

Firstly developed by the airline industry, Revenue Management has grown from its origins in
airlines, to its status today as a common business practice in a wide range of industries
(Talluri, Ryzin, Karaesmen and Vulcano, 2009). In fact, there are multiple sources of
literature that outline the positive impacts of Revenue Management on a company level
(Barth, 2002; Cross, 1997). In addition, Esse (2003) suggests that Revenue Management
provides more benefits to customers and this leads to greater performance results. In its
essence, other scholars conclude that Revenue Management encompasses activities that
concentrate on proper allocation of resources by virtue of which better profits can be
achieved (Kimes, Chase, and Choi, 1998).
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Apart from being a tool that enables maximum utilization of resources, Revenue
Management can also serve the need of investigating the evolution of customer demand
(Wind et al, 2002). In addition, the application of Revenue Management techniques has
been most effective when applied to firms that have fixed capacity, demand that can be
segmented into clearly identified segments and that is variable, perishable inventory, varying
customer price sensitivity, advanced product or service selling, low marginal sales costs but
high marginal production costs (Kimes, 1989; Kimes and Wirtz, 2003, Wirtz and Kimes, 2007)

The hospitality industry is one of the business fields which witnesses extensive utilization of
Revenue Management techniques (Kimes and Wirtz, 2003). Hotel industry is among the
major areas of Revenue Management application as hotels’ products are perishable, hotel’s
fixed costs are higher that the variable costs, and the demand varies over time (Chiang, Chen
and Xu, 2007). O’Connor and Murphy (2008) also add that “maximizing revenue is important
for hotels because of their high fixed costs and their fixed capacity”. In this regard Revenue
Management is accepted as one of the most vital areas of consideration for the hotel’s
success.

Chiang et al (2007) distinguish several different areas of the Revenue Management - pricing,
capacity control, overbooking, and forecasting but they state that all of them “are highly
correlated and need to be considered jointly”. However, the scope of the current paper is to
focus only on one of the Revenue Management areas - overbooking.

The concept of overbooking has been commonly discussed and analyzed within the research
literature as it is the oldest Revenue Management practice and in financial terms, among the
most successful and economically important functions of Revenue Management. (Talluri,
Van Ryzin, 2004; Chiang et al, 2007; Lan, Ball; Karaesmen, 2007).

Revenue Management and the hospitality industry

The occupancy in the hospitality industry has witnessed very rapid growth through the last
ten years. The growing number of visits also created some challenges related to retaining
current customers and catering their needs properly. The need to stay on a competitive edge

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has made Revenue Management techniques emerge as panacea. These techniques have
provided valuable options to hoteliers in terms of revenue maximization through maximum
utilization of existing capacity (McGill and Ryzin, 1999).

Revenue Management incorporates three chief elements: (1) product distribution, (2)
pricing and (3) Revenue Management:

The first category (product distribution) encompasses segmenting the customers according
to their purchase intentions and purchase power. By segmenting customers, hoteliers can
determine the degree of price sensitivity of particular groups of clients and can thus
facilitate the process of resource allocation more effectively (Vinod, 2003a).

The second category (pricing) involves determining the value offered with respect to prices.
Apart from segmenting customers, expanding the marketing outreach also plays an
important role in the contemporary settings of the hospitality industry. The most common
and widely acknowledged method of product distribution is through electronically mediated
communication. Some hotel booking search engines (such as booking.com) provide wide
range of services related to instant reservations of hotel rooms across the globe. It is a
preferred method by business customers who tend to purchase with insignificant price
sensitivity. Therefore, to remain on a competitive edge, hoteliers must ensure they have
listed all products and services they offer online. The information will thus be available to
multiple travel agents and final customers (Emmer et al., 1993).

Despite the positive impact of booking search engines and internet on the hospitality
industry in general as a source of optimizing occupancy, some scholars have found negative
projections of such types of product distribution on the profitability of hotels. In particular,
room occupancy utilization through multiple travel agents reservations also minimizes
margins, which decreases profitability (Vinod, 2003b).

The third category (Revenue Management) pertains maximizing revenues by achieving an

ultimate match between demand and supply (rooms available for accommodation).
Additionally, through the segmentation of the customer base and Revenue Management

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hoteliers can not only define and adjust pricing strategies, but they can also find the right
mix of customers put up in the most appropriate rooms according to their expected
profitability. In fact, in the context of hospitality industry, Revenue Management also
involves the selection of reservations to be accepted or rejected with the ultimate goal of
maximizing revenues (Cross, 1997).

Theoretical insights of overbooking

One of the central concepts in Revenue Management is overbooking. The practice of

overbooking can be defined as confirming more reservations than the hotels’ available
physical capacity to provide the service. (Ivanov, 2006; Ivanov, 2007; Chiang et al 2007;
McGill, van Ryzin,1999; Kamath, Bhosale, Manjrekar,2008). Hence, the objective of
overbooking is to improve the expected profit and instead of selling each room once, profit
can be increased by selling it several times (Birkenheuer, 2009).

In fact, overbooking as an integral part of Revenue Management has received significant

attention from literature. From a historical perspective, overbooking is present in the studies
of Falkson (1969), Simon (1968), Vickrey (1972) and many others. The major objective of
these studies was to outline a control practice for cancellations. Nowadays, overbooking has
become an emerging matter in industries with perishable products. It yields considerable
impacts on companies’ performance.

In terms of the hospitality industry, the profitability of hotels is largely dependent on their
utilization of capacity. Conversely, demand for rooms and extensions of stay are very
unstable and are hard to predict (van Ryzin, 2005). Hoteliers are challenged by how to
determine the occupation of rooms for customers who are financially unequal and
meanwhile – maintain a stable rate of demand given the hard to predict circumstances
(Okumus, 2004). This is all possible utilizing overbooking, which enables proper allocation of
resources and optimization of sales.

However, maximizing the number of sold rooms per night cannot be easily accomplished.
One of the most challenging tasks of the hotel operation management is to deal with the

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unpredictable nature of the customers, because not all booked reservations will turn into
real service consumption (Lai et al, 2005). To this end overbooking may entail a company
from the hospitality industry not being able to serve all its customers properly because of
lower number of initially expected people that do not appear as agreed. In this respect,
overbooking may have both positive and negative impact. On the one hand, it may result in
refusal to provide a service, but on the other, it can also take the form of compensation for
those bookers, who cannot received the value package they have agreed on and paid for
(Kimes and Wagner, 2001).

“From their practical experience managers know that all not bookings confirmed for a
particular date will be really used” (Ivanov, 2006). There are several possible scenarios that
can cause this. Despite of their reservations, because of different circumstances some guests
cancel their stay and terminate their reservations, some does not cancel their booking but
fail to show up, or other guests reduce their stay and as a result the room remains unsold
and hence capacity not utilize is lost forever (Ivanov, 2006, Talluri et al, 2004; Chiang et al,
2007; Hung, 2004; Bitran; Leon, 1989).

Therefore hotels adopt overbooking in order to protect against losses with no-shows and to
offset the effect of cancellations and shortened stays (Hwang and Wen, 2009; Kamath et al,
2008; Selmi, 2008; Chiang et al 2007; Hung, 2004; Sulistio, Kim, and Buyya, 2008).

Impacts of overbooking on hotels’ operation management

Apart from the opportunity of the hotel to minimize the effect of reservation uncertainties
there are possibilities the number of cancellations and no shows to be less then the number
of overbookings, then some of the clients will not be accommodated and should be walked
to other hotels (Ivanov, 2006).

Thus, if a hotel decides to employ overbooking in its operations it should manages carefully
not only the opportunity cost of the unsold room but also the overbooking costs for
alternative hotel accommodation and transportation that the hotel has to pay in order to
compensate a customer in case of overbooking (Ivanov, 2006; Hung, 2004).

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Besides the evident financial costs occurring in case of walking a guest having already
booked, “costs the lost hotel’s goodwill and reputation and the risks of dissatisfaction, loss
of trust, loss of future customer loyalty are much more expensive for the hotel” (Selmi,
2007).

Overbooking policy and control

According to Selmi (2007), “the risk of customer refusal appears if the overbooking is no
realized precisely”. In this regard, Kimes (1989) emphasized on the importance of a clearly
stated overbooking policy within the hotel operation management.

The objective of overbooking policy and control is to find an optimal overbooking level to
maximize the expected revenue and to minimize the potential risk of denied service (Chiang
et al 2007).

Netessine and Shumsky (2002) as cited by Ivanov (2006; 2007) proposed a basic
mathematical model for calculating the optimal number of overbookings and according to
his findings the optimal overbooking level is “inversely related to the amount of cancellation
charges applied – the closer the cancellation charge to the room rate, the lower the missed
benefit from the unoccupied room and the less stimuli to overbook”. In case of presence of
guaranteed and non-guaranteed bookings, Ivanov (2007) suggests that the optimal number
of overbookings has to be set separately for each type.

Alternatively, according to Hung (2004) factors that could be considered while setting
overbooking limits include: probabilities of cancellation and no-show; room demand
distribution over time and conditions of length of stay; stay extension probabilities
influenced by the intended length of stay. Moreover Hung (2004) assumes that the
proportion of cancellations depends on the customer category, intended length of stay, day
of week of first stay over, and time until first stay over.

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 Impact of overbooking on customer behavior

According to Talluri et al (2004) overbooking is frequently cited in customer complaints and

remains the primary source of dissatisfaction. Moreover, results of an experiment made by
Wangenheim and Bayón (2007) confirm that the practice of overbooking is likely to be
perceived as unfair by service customers. Wangenheim and Bayón (2007) analyze behavioral
consequences of the fairness towards overbooking by proposing and confirming several
hypotheses. According to their research the negative consequences of service failure arising
from overbooking are stronger for the high – status customer than for the low – status
customers and therefore, hoteliers have to carefully “overbook its high-values classes”.
Additionally, Wangenheim and Bayón (2007) emphasize on the importance that if a hotel
ignores the log-run behavior consequences of overbooking, this may lead to negative
consequences on its operations.

One such negative consequence is proposed to be a customer who faces a denied service
due to overbooking and still remains hotels’ client because of either high fixed switching
barriers or current loyalty membership programs. However, in response to the service failure
“the customer may adjust its investment into the exchange relationship not only by
decreasing the number of sales, but also by trying to take advantage of discount offers or
purchasing lower level services from the hotel” (Wangenheim and Bayón, 2007).

On the other hand, Hwang and Wen (2009) analyze the effect of the perceived fairness
toward hotels overbooking and compensation practices by examining customers’ reactions
toward hotel overbooking. Some of their most vital findings from this study are that “women
are more likely than men to feel that overbooking is unfair”, customers' perceptions to the
fairness of overbooking is not affected by other customer variables including length of stay,
membership status, payer source, reservation channel, and reservation time; participants'
perceived fairness toward the hotel's overbooking and compensation policies were strongly
correlated with positive word-of-mouth publicity. One of the most important results of the
research shows that the perceived fairness of the participants toward the hotel's
compensation policy is related to their loyalty. Therefore, Hwang and Wen (2009) propose

9
that hotels should consider designing compensations that help positively influence
customers’ perceived fairness toward overbooking and that encourage customers’ ongoing
patronage and loyalty.

In a conclusion, issues like determining the optimal number of excess reservations,

minimizing compensation cost, and dealing with the negative effects from customers facing
a denied service are considered as the most challenging areas of the practice of overbooking
and every hotel striving to maximize its profitability should not underestimate them (Sulistio,
Kim, and Buyya, 2008).

Practical Implications of overbooking

As the hospitality industry is evolving, hotel owners and hotel managers are constantly
seeking to update their approaches in order to achieve optimal allocation of resources.
Novelli, Schmitz and Spencer (2006) have discovered that hoteliers make every effort to
employ contemporary technologies in their business. By this implication, hotel managers and
owners do not only sustain competitive advantage, but also create new products and
services. In view of this, it can be concluded that implementation of new technologies that
create new products is a technological innovation (Evangelista, 1999).

On the other hand, the implementation of innovative technologies to a service company can
have a significant influence in terms of operational efficiency (Freeman and Soete, 1997).
Additionally, Porter (1990) supports the latter thesis by highlighting that the performance of
a company is highly dependent on new technologies. In view of technological innovations
today many hotels recognize the importance of overbooking practice and thus its
implementation has become generally accepted step toward hotels’ successful operations.

The practical application of Revenue Management and Overbooking incorporates the

following integral elements (Vinod, 2004):

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Figure 1 Revenue Management application

Source: Vinod, B. (2004), Journal of Revenue & Pricing Management

Market segmentation: Segmenting customers according to their preferences and spending

patterns is a must to make sure the most appropriate customers with perfectly fitted
attributes are sold the proper rooms that can maximize revenues (Oliveira, 2003).

Defining rate classes (inventory pooling): Involves creating groups of the existing rates that
close in terms of value (Vinod, 2004).

Demand forecasting: demand forecasting is essential to determine room occupancy. In the

context of Revenue Management it is important as it can control occupancy using the data
of length of stay. This can be achieved by possessing data on rate class demand and duration
of stay (Vinod, 2004).

Supply forecasting: earlier and late checkouts can also determine room occupancy, which is
an element also involved in Revenue Management.

Overbooking control: encompasses sales of rooms exceeding the maximum available

number of rooms to offset for no shows and cancellations. However, there are some risks

11
associated with overbooking as it may result in grievances from unsatisfied customers who
have received an inappropriate room. In such cases hoteliers offer compensations and fringe
benefits (Smith, 1982). According to Vinod (1992) Revenue Management can bring 20% of
the total revenues.

Revenue mix control and exception processing: involves planning important future dates
with discretion and matching them with overbooking levels (Vinod, 2004).

Performance measurement and management reporting: closely scrutinizing the Revenue

Management processes is essential to track down the data quality and future planning basis.

However, in order to lead a hotel into a winning direction, overbooking has to be managed
and controlled very carefully. Ivanov (2006) defines the management of overbooking as a set
of “managerial techniques and activities connected with continuous planning, reservation
and control” and he outlined two main groups of activities that should be performed in the
daily hotel operation. The hotel managers should on one hand, to define an optimal number
of overbookings for each date and continuously to modify it according to the market
changes of the hotel and the specific demand and booking patters and on the other hand, to
manage carefully decisions and operational activities related with walking guests with
overbookings. In this regard, Ivanov (2006) proposes that factors such as length of stay,
rooms rates and client status have to be considered by hotel managers while dealing with
walking a guest with confirmed reservation.

Additionally, Kimes (1989) analyzes several managerial concerns essential for an effective
overbooking practice and states that “top management cannot assume that Revenue
Management will just happen, it requires careful planning and training”. Thus employees
have to be intensively trained in order to clearly understand the aim and characteristics of
overbooking. Moreover, employees who are directly dealing with overbooking decisions
have to be periodically trained how to behave in possible customer conflicts and “to take
their own decisions in an unfamiliar situation” (Ivanov, 2006). In order to be minimized the
possible customer dissatisfaction in case of overbooking, it is vital for the hotel to establish
service recovery programmes with standardized procedures and to make employees to be
aware and follow them (Ivanov, 2006)

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For a profitable applied overbooking in the hospitality industry, hotels must understand not
only consumers’ behavior but also to consider the impact of competition and the currently
economic situation that imposes significant supply and demand fluctuations.

As hotels compete with each other in order to attract more customers, Revenue
Management decisions of one hotel inevitably influence the demand for other hotels in the
same region or area.

However, recent trends propose that hotels should collaborate with is competitors that
result in increased number of formed alliances with each other to maximize their revenue
(Chiang et al, 2007)

Revenue Management’s challenges in the hospitality industry

As explained before, Revenue Management finds application to two significant industries:

hospitality and airline. The first one, however, is much more complex in terms of industry
saturation and rooms management. This creates hurdles for the optimal operation of
Revenue Management techniques. In the hotel industry Revenue Management can be
applied either locally or via centralized system. The second one involves gathering data and
taking decisions from a focal site for other properties. In practice only a limited number of
hotels and hotel chains are able to manage centralized data processing and therefore the
majority of players on the hospitality industry opt for property based Revenue Management.

Recommendations for future research

Despite of the acknowledged importance of overbooking as one the most effective

successful Revenue Management techniques used in hotel operation and widely discussed
topic in research literature, there are no current studies discussing the overbooking
management of Bulgarian hotels and its impact on their operation. Therefore, future
research may focus on the possible application of Revenue Management techniques to the
Bulgarian hospitality industry. Future studies may also focus on the demand side of Bulgarian
tourism as the country has witnessed fluctuating visitor rates during the past two decades
despite the growing profits generated by the particular industry.

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Conclusions

In order to survive in the furious competition and to generate more revenue while using the
same amount of recourses it is necessary and critical to the hotels operation management to
use effectively its reservation inventory and to increase its occupancy rate (Hung, 2004).
Revenue Management techniques and the models of overbooking if applied appropriately
would maximize the revenues of hotels (Kamath et al, 2008). However, the possibilities of
customer dissatisfaction, and risk of loss of reputation because of denied service, force many
hotels to avoid the practice of overbooking. Therefore, before hotel managers to deicide
whether or not to implement overbooking they should first consider what Birkenheuer
(2009) explained “the best estimation of risk and opportunity will provide the best profit”.

In this study we have outlined the dynamic nature of service industries and have
demonstrated the importance of Revenue Management and most notably – one of its most
significant aspects – overbooking. We have narrowed the scope of this research down to the
hospitality industry and have found major differences in the demand patterns towards such
companies in the former industry. Some customers prefer flexible cancellation terms, while
others are not much attentive to that. Hoteliers offer differential pricing to their own
advantage to hedge against fluctuating demand.

We have also found that substitution is one of the most effective method of managing
overbooking practices, but yet a cost/benefit analysis must be performed in order to track
down the real consequences. Essentially, within the current dynamic decision making
situation in the hospitality industry, overbooking levels have been found to have significant
revenue maximizing properties. In view of this, through this study we have discovered some
of the chief management objectives that could be achieved through overbooking in the
framework of Revenue Management: profit maximization; capacity allocation; maximization
of average revenue per customer; maximization of net present value; and minimization of
customer grievances. Finally, as hospitality industry on a global scale is a mass volume-driven
business, overbooking has become an emerging topic as vacant rooms do not bring any
profits. However, perhaps even more significant remains the problem how to manage
customer disappointment, in cases they cannot be relocated to similar hotels as a result of
overbooking.

14
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