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What is a feasibility study? – Part 2

When determining the feasibility of a business or facility, a critical element is an accurate cost estimate -- and the key word is “accurate.” This article details often overlooked factors in creating cost estimates that can potentially doom a project from the get-go. Also learn the how-to’s of developing attendance and pro forma financial projections.

Part 1 of this article appeared in our June 2009 Leisure eNewsletter. We discussed the following components of market and financial feasibility studies for location-based entertainment projects:

• Defining the market or trade area
• Analyzing the trade area’s demographics and socioeconomic/lifestyles
• Defining the target niche market
• Refining the concept and mix
• Right-sizing the project
• Developing a preliminary floor and site plan
• The consequences of an inaccurate cost estimate

In Part 2 of this article, we’ll continue the discussion of the cost estimate and then explore developing the attendance and pro forma financial projections.

The cost estimate, continued

Developing preliminary floor and site plans along with general finish specifications is absolutely essential to accurately estimate a project’s construction cost, including its interior finish cost. The construction estimate should be developed by a general contractor experienced in entertainment projects and their unique design requirements. (At a minimum, the contractor should be experienced in restaurant and specialized retail construction.) Preliminary floor and site plans don’t reflect many details of the construction and finishes. Building codes requirements vary throughout the country, and code requirements also vary, based on the size of the project and the type of building construction. Only a contractor experienced in location-based entertainment (or restaurant and specialized retail) and who understands local code requirements can accurately anticipate what will go into the project and be able to prepare a realistic construction cost estimate.

If site development is involved, then a preliminary site plan needs to be developed that reflects local governmental zoning and other requirements for such items as mandated green space, set-backs, storm water retention, fire truck access, etc. All these requirements can have a dramatic impact not only on what will fit on the site, but the site development cost, as well. For example, in many areas of the country, storm water retention is required. Depending on the elevation of the storm retention pond outfall, 20% or more of the land may be required for just this. Or underground retention storage may be needed if the site is too small for aboveground ponds. Some governmental jurisdictions require a large percentage of the land to be dedicated to green space (grass, trees and bushes). Some jurisdictions restrict the removal of large trees. The list goes on and on.

Where many LBE developers go awry in construction cost estimates is by using per square foot cost estimates, such as $140 per square foot. This number is then multiplied by the floor area of the building. Unless the developer constructed an identical project within the last few years in an area with similar governmental regulations and building code requirements, using square foot estimates will definitely result in an inaccurate cost -- most likely too low. This applies not only to new building construction, but also to an existing store or leased building in which only interior build-out and finishes are involved.

The other areas of cost estimation filled with potential minefields are the hundreds of other items, including furniture, fixture and equipment (FF&E), installation and soft costs involved in project development and start-up. An inexperienced LBE developer is sure to miss many items that will add up to sizable dollars. Even getting cost estimates from suppliers of major attractions can result in missed costs. Sometimes attractions require additional equipment for installation or to make them operate that the supplier does not sell. Then there are the installation and hook-up costs, some of which the general contractor might have to do.

One big area of cost often overlooked or underestimated are soft costs, which can be 15% to 20% of total cost, depending on the nature of the project and how it is being financed. Soft costs include not only financing fees and expenses, but also design, consulting, legal and accounting fees; development of marketing collateral and websites; and preopening operating and labor costs. You get the picture.

There are a multitude of items a cost estimate needs to include. A properly prepared cost estimate can include 100 or more line items, some of which are only totals of more line items. On one FEC our company produced, we counted 620 cost line items.

Although at the very beginning stage of developing an LBE, setting a realistic construction and FF&E budget has implications besides just project funding. The construction and FF&E budget needs to reflect the appropriate level of quality and finishes required to attract the targeted socioeconomic/lifestyle (SEL) groups. How cheap can I build it? no longer works in the marketplace of high customer expectations. Consumers judge LBEs based not only on other LBEs, but on all the other location-based businesses they frequent, including restaurants, stores, malls, airports, hotels, etc. Each SEL group has different expectations for quality and finishes. Not spending enough on quality and finishes is actually more risky than overspending, as the targeted SEL group will stop visiting. Where there might be restaurant chairs available for $75 each, a $150 chair might be required to attract the desired SEL group. If the construction and FF&E budget is not matched to the target market’s expectations, the LBE’s performance will be sub-optimal, or worse, it may fail.

No matter how detailed and accurate the cost estimate may be, it still needs to have an added contingency factor. The size of the contingency percentage depends on whether it is new building construction or renovation of an existing space, in addition to the comfort level with the more uncertain cost line items.

Attendance and per capita expenditures

Professional pro forma financial projections do not just jump directly to forecasting revenues for LBEs. First, attendance figures must be determined for the different categories of LBE visits, such as general admission, birthday parties, groups, school field trips, etc., in addition to the average per capita expenditure for each. For each category, the attendance multiplied by the per capita expenditures equals its line item revenues in the projections. Revenues for each category of attendance also need to be separately determined, as the cost of goods for each will be different and must be calculated individually in the projections.

How do you project attendance and per capita expenditures? The answer is complex. Factors to examine include the project’s mix and level of finishes, its targeted market, the performance of comparable projects, the demographics and SELs of the project’s trade area compared to other similar projects, competition and its location in the market area, the value-price equation for entertainment in that market, possibly seasonality factors, whether a tourist market exists, whether schools operate on a typical summer vacation schedule or on a track schedule, etc. This is where the skill of a knowledgeable and experienced professional can make all the difference in accurately predicting the LBE’s revenues.

Other line items in the pro forma projections include cost of goods sold, labor costs, utilities and the various other ongoing operating expenses. An often overlooked category involves replacements, whether for updating games or attractions to keep the LBE fresh, or for replacing things that just wear out or begin to look too worn. The total costs for replacements become more sizable after the first year of operation.

Projections are much more meaningful if initially prepared on both the basis of EBITDA (earnings before interest, taxes, depreciation and amortization) and cash flow rather than on profit and loss. (Although the two are similar, there are differences.) A business can be making a profit, but still not have enough cash to pay its bills. For a new project, what is most important is to determine the cash flow available for debt services and to generate a return for the investors and owner. Projections also need to address issues like return on investment, debt coverage ratios and the return to investors.

The feasibility study is the foundation for an LBE’s success. Mistakes or oversights in any aspect of preparing the feasibility study can seriously handicap or doom the project.

Additional reading:

• Finding the investment sweet spot

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