Valuers often fall into the trap of merely forecasting the overheads to grow at an inflationary rate while revenue is forecast to grow at a different rate. This oversimplification can lead to understated expenses due to there being other factors that could influence the way in which costs fluctuate. In this article, we investigate how an oversimplified overheads cost forecast affects the forecast cash flow and as a result the final business valuation.
When overheads are forecast to grow at inflation and revenue is forecast to grow much faster, some questions come to mind: what is the relationship between overheads and revenue? Is the forecast operating margin consistent with the past?
Overhead costs need to be broken down into their fixed and variable components. The variable cost components should change according to their cost drivers’ changes. Revenue is often a dominant cost driver as it is an indicator of operating activities, which in turn drive other costs. If the current cost structure is applied in the forecast, the operating margin should remain approximately the same in the forecast.
Variable cost behaviour can be quantified by considering overhead cost compound growth rate in relation to the compound growth rate of revenue for the same historical period. This can be considered as the correlation between costs and revenue. This correlation factor can then be applied to forecast the change of overheads when applied to the forecast revenue growth, keeping in mind that such growth in costs should generally not be less than inflation.
There may be circumstances where there is a legitimate change in the cost structure or the correlation factor, e.g. restructuring, rationalisation, retrenchments or the digitisation of the workplace. These will all impact the variable cost component and would need to be considered when applying the correlation factor.
In conclusion, carefully consider your current cost structure and planned changes when doing a forecast. Having certainty that the cost growth assumption is sound, relates to the past and where changes are made the impact thereof can be explained, form the basis of a reasonable and accurate forecast and business valuation.