Cost Structure and Operating Leverage (4/5)

When I review a target's cost base, I am not looking for accounting errors or trying to find savings to cut. I am trying to understand whether the cost structure can support the business the buyer thinks they are acquiring.

This distinction matters.

A cost base can be technically accurate and still misleading. Costs that look lean may reflect under-investment. Costs that look high may include one-offs that will not recur. The reported EBITDA may represent a level of profitability the business cannot sustain.

Cost analysis in due diligence is forward-looking.

The question is not "what did they spend?" but "what does this business actually need to spend to operate?"

The intuition gap: lean or starved?

Here is the pattern I see repeatedly. A business shows improving margins over the historical period. Costs as a percentage of revenue have declined. The seller presents this as operational efficiency, evidence of good management, proof that the business can scale.

Sometimes that story is true.

Sometimes the business has been quietly starving itself to dress up the numbers for sale.

The first instinct for someone new to transaction services is to view low costs as good news. Lower costs mean higher EBITDA, which means the buyer is getting more earnings for the same price.

But experienced buyers know that artificially low costs create hidden liabilities. Those costs will need to be incurred post-close, and they will come out of the buyer's returns.

This is where cost analysis becomes strategic. The goal is to distinguish between sustainable efficiency and deferred pain.

Fixed versus variable: what the mix reveals

The split between fixed and variable costs tells you how the business will behave as revenue changes.

Variable costs move with activity. Raw materials, direct labour on piece rates, sales commissions, shipping. If revenue drops 20%, variable costs drop roughly 20% as well.

Fixed costs stay constant regardless of volume. Rent, salaried staff, insurance, depreciation on equipment. If revenue drops 20%, these costs do not move.

A business with high fixed costs has high operating leverage.

Small changes in revenue produce large changes in profit. This cuts both ways. In growth, margins expand rapidly because incremental revenue falls mostly to the bottom line. In decline, margins collapse because the fixed cost base keeps grinding.

In practice, I look at the fixed/variable mix to understand two things.

First, scalability.

A software business with 80% gross margins and mostly fixed costs (engineering team, infrastructure) can grow revenue without proportional cost increases. Each new customer adds almost pure profit. A distribution business with 20% gross margins and high variable costs (inventory, freight) needs to add cost with every unit of growth. The scalability profiles are fundamentally different.

Second, downside risk.

High operating leverage means the business is vulnerable to revenue declines. If the buyer's investment thesis depends on growth, that may be acceptable. If the buyer is paying for stable cash flows, high operating leverage is a risk factor.

I have seen businesses where fixed costs represented 55 to 60% of total costs. In those cases, the EBITDA margin tracked closely with revenue. A 10% revenue increase might produce a 25% EBITDA increase. But the reverse was also true. A 10% revenue decline could cut EBITDA by 30% or more.

Personnel costs: where the truth often hides

Personnel is typically the largest cost category, and it is where normalization issues concentrate.

Headcount and cost per FTE

I always request headcount by function and average cost per FTE over the historical period. This simple analysis reveals more than most people expect.

Rising cost per FTE might indicate wage inflation, seniority creep, or recent senior hires. Falling cost per FTE might indicate junior hires replacing departing senior staff, or deliberate cost reduction. Either pattern has implications for the forward run-rate.

A business that reduced headcount by 15% over two years while maintaining revenue may have genuinely improved productivity. Or it may have pushed existing staff to unsustainable workloads and will need to hire back post-close. The numbers alone do not tell you which story is true. You need to understand what the people actually do.

The founder salary problem

In family-owned and founder-led businesses, I almost always find compensation that does not reflect market rates.

Sometimes the founder takes below-market salary. They own the business, so they extract value through dividends or eventual sale rather than payroll. The EBITDA looks higher than it should because management compensation is understated.

I have seen cases where a founder-CEO drew €150k per year when a market-rate replacement would cost €350k. That is a €200k negative run-rate adjustment. At a 10x multiple, that is €2 million off the enterprise value.

Sometimes the pattern runs the other way. The founder loads personal expenses through the business: cars, travel, family members on payroll who do not work. These are positive adjustments that increase EBITDA.

The key is to establish what a market-rate management team would cost and adjust accordingly. In carve-out situations, this extends to all shared services and allocated costs. What does standalone management actually cost?

Vacancy and overlap

I pay attention to positions that were recently filled or are currently vacant.

A CFO hired three months before the transaction has only one quarter of salary in the LTM numbers. The run-rate cost is four quarters. That is a negative adjustment.

A sales director who left six months ago and has not been replaced means zero cost in recent periods. If the position needs to be filled post-close, that is a negative adjustment.

Overlap works the other way. If the company had both an outgoing and incoming CFO for two months during a transition, those overlap costs should be removed as non-recurring.

Embedded one-offs: costs that hide in plain sight

One-off costs are supposed to be identified and adjusted. In practice, many one-offs remain embedded in the operating cost base because they were not flagged as exceptional.

Litigation and settlements

A business may have €200k of legal fees in the current year related to a specific dispute. If that dispute is resolved, the cost will not recur. But if legal fees are simply booked to "professional fees" without separate identification, they sit in the cost base as if they were normal.

I always ask for a breakdown of professional fees by matter. What specifically were lawyers and consultants working on? Recurring compliance work is one thing. One-off litigation defence is another.

Restructuring buried in operating costs

Not all restructuring appears in a dedicated restructuring line. Severance payments sometimes run through payroll. Lease termination costs sometimes sit in rent expense. Write-offs of abandoned inventory sometimes hit cost of goods sold.

The accounting may be defensible, but the effect is to bury one-off costs in the operating base. If management made significant organisational changes over the historical period, I want to understand where those costs landed.

Bad debt spikes

Bad debt expense is a normalisation candidate in almost every deal. The question is whether the historical provision level represents a sustainable run-rate.

If the business had a major customer default and took a €500k bad debt charge, that should be removed as non-recurring. But the base provision rate might also need adjustment. If the company has been under-provisioning (aging analysis shows overdue receivables not adequately covered), reported EBITDA is overstated.

I look at bad debt as a percentage of revenue over time, the aging profile of receivables, and specific write-offs to determine whether the historical provision rate is reasonable.

Related party transactions

Transactions with related parties require careful scrutiny because they may not occur at arm's length.

Management services from shareholders

Private equity-backed businesses often pay management fees to the sponsor. Family businesses often have service arrangements with entities controlled by family members. These fees may be higher or lower than market rate.

In one transaction, the target paid €275k annually to entities controlled by board members for "business development services." The question was whether those services would continue post-close, and if so, whether the price was market-rate. The buyer concluded the services were genuinely provided but would be insourced post-acquisition at a lower cost. The net effect was a positive adjustment.

The opposite case is also common. A parent company provides shared services (IT, HR, finance) at below-market rates as an implicit subsidy. Post-close, the buyer must either pay market rate to the former parent during a transition period or build internal capability. Either path costs more than the historical numbers suggest.

Intercompany pricing

In carve-out transactions, transfer pricing between the target and retained businesses rarely reflects market economics. Products may be sold at cost. Services may be under-charged. Overhead allocations may follow arbitrary formulas rather than actual resource consumption.

Establishing standalone costs requires rebuilding the cost base as if the target operated independently. This is one of the most complex areas of financial due diligence and frequently reveals material adjustments.

Run-rate adjustments: what the future costs

Run-rate adjustments bridge the gap between historical costs and forward-looking requirements. They are almost always negative (increasing costs, reducing EBITDA).

New hires not in the numbers

If the business hired a sales team in August, LTM September numbers include only two months of that cost. The run-rate impact is twelve months. The adjustment is ten months of incremental salary and benefits.

I create a schedule of all significant hires in the past twelve months, their start dates, and their annual cost. The sum of the stub period adjustments can be material.

Known step-ups

Some costs are contractually scheduled to increase.

Rent escalations are common. A lease signed three years ago at €100k per year may have an escalation clause that takes it to €120k next year. The LTM numbers show €100k. The run-rate is €120k.

Regulatory costs also step up. A new compliance requirement coming into force next year may require additional staff, systems, or external services. If management knows about it, it should be in the run-rate even though it is not in the historicals.

Inflation and wage pressure

In inflationary environments, historical costs understate future requirements. A workforce with €10 million of annual compensation will cost more next year simply due to wage inflation.

I have seen transactions where management argued that historical cost levels were sustainable while simultaneously telling employees that wage increases were coming. Both statements cannot be true. If the business needs to raise wages to retain staff, that is a run-rate cost.

Under-investment: the hidden liability

Under-investment is the most dangerous pattern in cost analysis because it flatters historical results while creating future problems.

Deferred maintenance

Capital-intensive businesses can defer maintenance spending to boost short-term profits. Equipment continues operating, but reliability degrades and major repairs become inevitable.

I look at maintenance and repair costs as a percentage of fixed assets over time. A declining ratio may indicate efficiency. It may also indicate a maintenance backlog that will require catch-up spending post-close.

In manufacturing businesses, I ask for the maintenance schedule and any deferred items. In real estate, I ask for the capital expenditure reserve study. The deferred spend is a hidden liability that should adjust either EBITDA or the balance sheet.

IT and systems

Technology spend is easy to defer. Systems continue functioning, but they become outdated, unsupported, and eventually unable to meet business needs.

I have seen businesses running critical operations on software versions that were no longer supported by the vendor. The cost to upgrade was substantial, but it was not in the historical numbers because management had been deferring it for years.

Questions I ask: when were core systems last upgraded? Are any systems at end-of-life? What is the planned technology roadmap, and what does it cost?

People and capabilities

Businesses can defer hiring, skip training, and stretch existing staff. This depresses costs in the short term while degrading capability.

I pay attention to employee turnover, tenure profiles, and management commentary about staffing adequacy. A business running lean because it cannot find qualified people is different from a business running lean by choice. The former has a hiring problem that will cost money to solve.

The judgment call: efficient or unsustainable?

The hardest question in cost analysis is distinguishing between genuine efficiency and temporary depression.

There is no formula for this. It requires understanding the business model, the competitive environment, and the specific actions management has taken.

Some indicators that low costs represent sustainable efficiency:

The business has invested in automation or process improvement that permanently reduces resource requirements. Cost reductions came from structural changes (consolidating facilities, renegotiating supplier contracts) rather than simply spending less. Benchmarks against comparable businesses show similar cost levels. Management can articulate specifically how they achieved the efficiency and why it will persist.

Some indicators that low costs represent unsustainable depression:

Cost reductions coincide with the sale process timeline. Discretionary spending (training, marketing, R&D) has been cut disproportionately. Staff workloads appear stretched based on headcount versus activity levels. Management cannot explain specific efficiency drivers. Benchmarks show the business is an outlier on cost levels.

When I am uncertain, I stress-test by assuming costs need to normalise upward. What happens to returns if personnel costs increase 10%? If maintenance returns to historical averages? If IT requires a catch-up investment? The sensitivity analysis reveals how much the investment case depends on cost assumptions.

What buyers and investment committees focus on

At the IC level, cost analysis informs several critical decisions.

Integration planning

A buyer who understands the target's cost structure can plan integration intelligently.

If the target has high fixed costs in areas where the buyer has excess capacity (finance, IT, HR), there may be synergy opportunities. If the target's cost base depends on related party arrangements that will terminate at close, replacement costs must be budgeted.

The cost analysis directly feeds the integration budget and synergy model.

Valuation and pricing

Run-rate adjustments directly affect the EBITDA multiple calculation.

If reported EBITDA is €10 million but run-rate EBITDA after adjustments is €8.5 million, the effective multiple at a given price is materially higher. The buyer may still proceed, but they should price off the adjusted number, not the reported number.

Negative run-rate adjustments also affect debt capacity in leveraged transactions. Lenders underwrite to adjusted EBITDA. Lower EBITDA means lower leverage capacity, which means more equity required.

Post-close expectations

Perhaps most importantly, cost analysis sets expectations for what the business will actually deliver.

I have seen deals where buyers were surprised by post-close cost increases that should have been foreseeable from the due diligence. The founder left and needed to be replaced at market rate. Deferred maintenance came due. IT systems required emergency upgrades. Each of these was visible in the data if you knew where to look.

The cost analysis should produce a clear view of what the business will actually cost to run. Surprises in this area reflect gaps in due diligence, not bad luck.

Illustrative example: a professional services firm

Consider a professional services business being sold with the following profile:

Historical costs (LTM):

• Personnel costs: €12.2 million (82% of revenue)

• Other operating costs: €1.8 million

• EBITDA: €4.1 million (22% margin)

What the analysis revealed:

Founder compensation: The founder-CEO drew €180k annually. Market replacement cost for a CEO in this sector and size: €320k. Negative adjustment: €140k.

Recent hires: Three senior consultants hired in the past four months at €90k each. Stub period in LTM: approximately €90k total. Full-year run-rate: €270k. Negative adjustment: €180k.

Vacant positions: One senior manager role vacant for six months following a resignation. Position needs to be filled. Annual cost: €110k. Negative adjustment: €55k (half-year).

Litigation costs: €95k of legal fees in LTM related to a resolved employment dispute. One-off, positive adjustment: €95k.

IT systems: Core practice management system is end-of-life. Replacement required within 18 months. Estimated cost: €400k capital plus €60k annual maintenance. Negative run-rate adjustment for incremental maintenance: €60k. Capital cost flagged for net debt adjustment.

Bridge to run-rate EBITDA:

The run-rate EBITDA is 8.3% lower than reported. At a 10x multiple, this represents approximately €3.4 million of value difference.

Closing thoughts

Cost analysis requires scepticism without cynicism. Most businesses are not deliberately manipulating their cost base. But the incentives during a sale process naturally favour presenting costs in their most favourable light.

The advisor's job is to understand what the business actually needs to operate. This means looking beyond the reported numbers to the underlying resource requirements. It means asking whether cost levels are sustainable or whether they reflect temporary circumstances. It means identifying the adjustments that bridge historical spend to forward-looking economics.

When I finish a cost analysis, I want to be able to answer three questions: Is this cost base sustainable? If not, what does a sustainable cost base look like? And how does that affect the value of the business?

Those answers inform every subsequent decision in the transaction.

This is Part 4 of a 5-part series on Quality of Earnings. Part 5 will cover how QoE findings shape deal outcomes.