Cost Base Analysis in Financial Due Diligence
How to analyse the cost base in FDD: identifying normal vs abnormal costs, structural vs transient cost movements and normalisation adjustments.
Analysing the cost base is the other half of the QoE equation. Understanding what drives cost movements, what is structural vs transient, and where costs might change post-acquisition is as important as understanding the revenue quality.
Why cost base analysis matters
A business that reports EBITDA margins of 22% in the most recent year looked like 18% three years ago. Before accepting the improvement at face value, a buyer needs to understand:
- Is this genuine operating leverage from revenue growth?
- Is it cost discipline that will be maintained?
- Or is it the result of cost deferrals, underinvestment, or adjustments that are themselves unsustainable?
The answers to these questions come from a systematic cost base analysis.
The structure of cost base analysis
Gross margin analysis
Start with the gross margin (revenue minus cost of goods sold or cost of service delivery). Key questions:
- Has the gross margin improved, deteriorated or stayed flat over 3 years?
- Is the trend driven by pricing, volume, mix or input cost changes?
- Are there seasonal patterns in the gross margin?
A sustained gross margin improvement that's driven by mix (shifting towards higher-margin products) is more durable than one driven by temporary raw material price reductions.
SG&A analysis
Selling, General and Administrative costs are the most fertile ground for FDD adjustments. Break them down by category:
Staff costs: headcount evolution, compensation trends, key person dependencies. Are there management or commercial positions that will need to be replaced post-transaction?
Property and leasing costs: lease durations, market rate comparison, related-party property arrangements (owner-occupied then leased back at above-market rates).
Professional fees: separate recurring advisory fees (legal, accounting, HR consultants) from one-off transaction or restructuring costs.
IT and technology: maintenance vs development, licence renewals, any migration or transformation costs that should be one-off.
Marketing: campaigns that were paused or reduced in the pre-sale period (investment deferred to flatter near-term EBITDA).
Cost trends in % of revenue
Plotting each cost category as a % of revenue over the analysis period reveals structural trends and anomalies:
- A cost that is declining in absolute terms but rising as a % of revenue signals an underinvestment risk.
- A cost that is stable in absolute terms but declining as a % of revenue might reflect genuine efficiency improvement — or deferred spending.
Related-party costs
Transactions between the target and entities linked to the shareholders require arm's-length testing. Management fees charged by a holding company, rent charged by a property owned by the founder, services from a company controlled by a family member — all need scrutiny.
What to say in the interview
"I would break costs into gross margin and SG&A, then decompose SG&A by category. For each significant category, I'd look at the trend vs revenue, identify any one-off or unsustainable cost items, check for related-party arrangements, and flag any structural gaps — costs that appear low because of underinvestment or deferred spending."
The programme's case studies include detailed cost base analyses with real P&L data, allowing you to practise this methodology on live numbers.