In the past 24 months, the tours and activities sector has moved from, to borrow a Cinderella analogy, the cinders to the palace, where its untapped potential has moved into the sights of major travel retailers and investors.
These retailers and investors, as we know, included Booking Holdings, Tripadvisor and SoftBank via their investments in Klook and GetYourGuide.
These moves have led to lots of opportunities for operators and consumers alike, but, as always, change does not come without its casualties.
Some operators are to dealing with distributors and they understand that such partners can be both partner and competitor.
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For others - and, in the case of tours and activities, this is a sizable portion - it is entirely new and some operators are now selling themselves short with online travel agencies.
The situation has been complicated further by vertical integration in the sector, where OTAs - in the form of Booking Holdings and Tripadvisor - purchased B2B offerings (FareHarbor and Bokun).
These companies control operators' direct channels - i.e., their websites, pricing, availability and connections to distributors. There is a moral dilemma around expecting the B2B and B2C parts of these businesses to operate independently and not prioritize their profits over operators (more on this later).
But, at a simpler level, it is just incredibly confusing. Operators have moved from an era of low online penetration to high online penetration, from low levels of OTA penetration to high levels of OTA penetration.
In the midst of all these changes, it’s not surprising that some operators are getting caught out.
Understanding cost structures
In any business, it’s important to understand your cost base, both fixed and variable, and to be able to price in a profit margin to cover debt, pay dividends to shareholders or reinvest in the business.
When selling a product you need to decide where to market and sell it. For many years, for example, Ryanair eschewed the travel industry to focus on direct online sales, selling 98% of seats itself.
This will not work for everyone, particularly in tours and activities, where small- to medium-size businesses will struggle to find the resources to market to a diverse customer base.
Therefore, incoming tour operators, online travel agencies and hotel concierges offer operators the opportunities to sell their products to a wider audience than they might otherwise generate themselves.
When doing this, it’s crucial to understand the difference between net and retail rates.
Net rate = operating costs + profit margin
- This is calculated by adding together all the fixed and variable costs of operating your business and the profit margin you wish to make per sale. The net rate is the absolute minimum you could sell your product and still make a profit.
Retail rate = net rate + distribution (commission costs)
- Once you have established the costs of operating your product (net rate), you can then factor in the costs of using distributors to sell your product. This will give you a retail rate. You provide your retail rate when dealing directly with customers. The retail rate is what the customer pays and should be consistent across the entire distribution network.
Understand your average commission
The distribution cost applied to your retail rate is dependent on your average commission rate - this is where things get tricky.
If the sales mix changes rapidly from direct sales to indirect sales, then the average cost of distribution goes up.
With the risks the coronavirus present, it’s vital to ensure the unit economics are sound. The pure volume game is fraught with risk if operators can’t manage their overheads when volumes decline sharply.
Commission rates for retail travel agencies should be in the range of 10-15% and not the 20-30% ranges we hear that OTAs are contracting.
It looks like the tradition of selling to wholesalers in tours and activities meant that operators were offered the same commission to OTAs as to incoming agencies that were reselling their products multiple times and sharing margin. This made the margins more attractive and, subsequently, this fueled big advertising campaigns by OTAs.
The average commission is calculated by multiplying the sales proportion per channel by the commission rate for that channel and then summing the weighted commission rates per channel.
For example, if you sell 80% direct and you assume a 10% cost for these bookings, then the weighted commission is 8%. If the balance is sold on OTAs at a 25% commission rate, then the weighted commission for this channel is 5%. The average commission is the sum of the two or 13% (8%+5%).
However, if this ratio moves to 50:50 then the average commission increases to 17.5%. Therefore, to retain the same profit the retail price would need to increase by 4%-5%.
Of course, this assumes that the cost of distribution has been added in the first place, if it hasn’t and the retail rate is the same as the net rate, then you could be in trouble. The change in booking share will dramatically affect profits.
Follow best practice
Based on conversations we've had with our customers and the market in general, we were worried this was the case for a sizable minority of operators. To confirm this suspicion, we surveyed operators across our business and beyond.
When asked if operators add the cost of distribution to the price of their trips, two-thirds answered: “Yes,” but a third answered “No.”
Asked whether operators know the fixed and variable costs to run their tours: 70% said “Yes” but again a sizable minority, 30%, responded “No” or “Not really.”
For operators with equipment (vehicles, rafts, etc.), 40% did not add the depreciation cost of their equipment to the cost of the tour. Some may see this as a fixed cost and allocate it to annual business costs, but this could lead to inefficiencies and some expensive surprises, especially if you suddenly had to purchase new vehicles or boats.
Perhaps many of this cohort are not currently selling with OTAs and, indeed, when asked why they didn’t price in the distribution cost to the price of their trips, many responded that they didn't work with OTAs as the commission rates are too high.
However, in time, OTAs will penetrate deeper into the market and if operators are complacent with their pricing and their understanding of the economics of their businesses, they could run into cash flow difficulties as the average commission cost rises sharply when OTAs start generating higher volumes.
In the midst of a storm, it’s generally harder to make adjustments without undermining the quality of your offering.
Price based on value and not purely what competitors are charging
This leads us on to my next bugbear: purely market-based pricing. For many, their pricing strategy is to simply look at what the competition down the road is charging and then offer their product at a slight discount, premium or the same as the competitor, with little or no thought to the relative value of the two products.
This sector is all about experiences, there are infinite opportunities to differentiate our products and offer value to our customers. First, make sure you know the market you want to target.
Is it the student market? Retirees? Families?
Then create products that these groups will value, work out the costs to deliver and add a reasonable profit and distribution margin. If the product is well received, your customers may even be willing to pay a premium to enjoy it.
If operators do this right, they should have no fear of working with OTAs as the commission will be priced in. Of course, it is important to look at the balance of your distribution as you don’t want the average commission to rise to unsustainable levels where price increases are required to cover your profit expectations.
So, spread distribution across a wider number of channels, don’t neglect the direct channel and decide which products to more aggressively market with partners.
For example, if you feel you can fill the demand for tours yourself, even if this comes late in the season, why give all the capacity on these tours to OTAs?
Focus on unit economics rather than volume
Now back to the moral dilemma of where B2C companies own B2B booking and channel management software.
Bokun's recent move to update their default minimum cut-off times, and previously to change their pricing from 0.1% across all distribution channels to 2.9% for direct online bookings, a 2,800% increase for direct bookings, highlights there is no free lunch.
More importantly, it highlights that the market power of a B2C company is far greater than that of a B2B company and operators have little influence over the relationship.
Additionally, Tripadvisor has also started experimenting with dynamic pricing while maintaining the same net payouts for operators. If operators haven’t correctly calculated and contracted their net rate, then they are giving Tripadvisor all the upside and reducing profits with each incremental booking.
With the risks the coronavirus omnipresent, it’s vital to ensure the unit economics are sound. The pure volume game is fraught with risk if operators can’t manage their overheads when volumes decline sharply.
As Warren Buffet said: “It’s only when the tide goes out that you learn who is swimming naked.” Just don’t get caught with your pants down.
* An update was made to reflect an agreement between Tripadvisor and TrekkSoft over the wording of the section regarding minimum cut-off times and payouts.