Are EBITDA margins more variable than Gross Margins?
I had an interview in the past that asked me if I would choose a company that has around a 60% gross margin but 20% EBITDA margin or would I choose a company that has around a 50% gross margin but a 30% EBITDA margin. He said that typically, we would end up going with the company that has the higher gross margin but lower EBITDA margin, since EBITDA margins include more variable costs than gross margins. Therefore, we can bring down variable costs versus gross margins, where it's harder to bring down fixed costs.
Why is that the case? Aren't gross margins = (revenue - COGS) / revenue? And COGS are mainly variable costs. And then EBITDA margins = (revenue - COGS - other operating expenses (SG&A and R&D) + D&A) / Revenue. Aren't SG&A and R&D both fixed costs, so why aren't EBITDA margins more fixed than variable costs?
Any help would be greatly appreciated!
takes a 20 min zoom call to slash opex. lot more effort for cogs
but aren't opex fixed and cogs variable? aren't variable costs easy to slash / decrease versus fixed ones?
technically, yes. But you need to think it from another perspective. SGA and R&D and stuff are all internal costs that you can try to manage and can bring down at will.
For COGS, the market dictates the price and you can't do anything about it. Therefore it's harder to increase the margin, unless you increase prices.
Uhh...no, not at all (hourly employees can contribute to G&A costs baked into OPEX; direct overhead / leaseholding expense can contribute to COGS)
Plus, all your G&A costs (read: low-hanging fruit re: synergies) are baked into your EBITDA margin by excluded from Gross Margin. High GM but low EBITDA margin?
Sounds like there's a lot of room to run with slashing G&A and making the deal accretive (or ability to pay a higher price if you're working the buyside in a broad auction process).
Source: licensed CPA, former BB IB jr
You are right about gross margin and ebidta margin. The correct answer is dependent on the purchase price, industry, and company. If I were to ask this question, I’d provide more context or accept any answer as long it was well reasoned. Based on the details you provided, including your interviewer’s response, the question was dumb.
Agreed. Question as presented is confusing
i would think of it like this, COGS are direct costs, those expenses are required to have a product/service to sell, SG&A are indirect costs and there more useful to grow/operate the business, you can manipulate SG&A relatively easy and won't see any direct consequences, altering COGS directly impacts your revenue (can't sell as much)
If you sell light bulbs and it takes $5 of material to make a $10 light bulb, you can’t really improve gross margins past 50%. Sure there’s maybe a bit of scale or improvements but generally speaking, if it costs $x to produce a unit, there’s not much you can do about that.
Like others have mentioned, SG&A is way easier to control. You can cut a marketing budget if you need to or lay off an HR person without seriously disrupting the business.
There’s also economies of scale available - typically an extra $1 of revenue will raise your COGS proportionally but you get operating leverage on EBITDA (don’t need 2 CEOs just because you doubled revenue but you do need 2x the COGS).
Typically in a PE model, gross margins are forecasted flat unless there’s something obvious you can do to improve them, but pretty much every PE fund will underwrite a bit of EBITDA margin expansion in their forecast
to build on what others have already said, the lower EBITDA margin could be due to the company heavily investing in the business through SG&A and R&D. It might have better gross margins (assuming same COGS) due to customers recognizing the brand and willingness to pay more (marketing 101). So I'd say the higher EBITDA margin company is more of a stable cash cow while the other business has the potential to be a cash cow (by scaling back R&D/SG&A) but also has the opportunity to grow given all that investment (new products from R&D etc.).
The reason it's a "Variable Cost" is because the total cost depends on your Volume Sales. However, this doesn't mean it's easy to slash down the cost per item you're selling.
If you're selling Phone cases for $10 and your current cost per case is $5, you won't be able to get that cost lower unless you start selling substantially more and have greater bargaining power with your supplier.
On the other hand, a lot of Operating Costs can be reduced by improving efficiency.
Say each Company is generating $10M Revenue
Company A:
60% GM = $6M
20% EBITDA = $2M
Company B:
50% GM = $5M
30% EBITDA = $3M
So, without looking at the operational improvements that “could” be made - CoB is earning 50% more than CoB
From a risk-reward POV, the reward is you’re able to cut costs. The risk is you’re not
If you’re not able to cut costs, then CoA would have to increase its Sales by 50% ($5M) just to match CoB’s EBITDA
A 50% increase in Sales is also going to come with loads of additional costs, and so CoA will actually need to generate more than a 50% sales increase.
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