Projecting Margins and Costs#

Once you've forecasted revenue, the next question is: how much of that revenue becomes profit? The answer depends on understanding a company's cost structure and how it changes as the business grows.

Why Margins Matter: A company growing revenue at 20% with expanding margins is worth far more than one growing at 20% with shrinking margins. The same revenue can produce wildly different cash flows depending on cost efficiency.

Understanding Cost Structure#

Every business has two types of costs:

Fixed Costs vs. Variable Costs#

Cost Type	Definition	Examples
Fixed Costs	Don't change with production volume	Rent, salaries, insurance, software subscriptions
Variable Costs	Scale directly with revenue	Raw materials, sales commissions, transaction fees
Semi-Variable	Have fixed and variable components	Utilities, support staff, shipping

Example: Restaurant Analysis

Monthly Revenue: $100,000

Fixed Costs:
- Rent: $8,000
- Manager salary: $6,000
- Insurance: $1,000
Total Fixed: $15,000

Variable Costs (as % of revenue):
- Food costs: 30% = $30,000
- Hourly wages: 25% = $25,000
- Supplies: 3% = $3,000
Total Variable: $58,000

Profit: $100,000 - $15,000 - $58,000 = $27,000 (27% margin)

Operating Leverage: The Margin Multiplier#

Operating leverage describes how sensitive profits are to revenue changes. High fixed costs mean high operating leverage—profits swing dramatically with revenue changes.

The Operating Leverage Formula#

Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in Revenue

Example: Two Different Business Models#

Company A (High Fixed Costs): Software Company

Revenue: $100M
Fixed Costs: $60M (R&D, servers, salaries)
Variable Costs: $20M (20% of revenue)
EBIT: $20M (20% margin)

If revenue increases 10% to $110M:
- Fixed costs: $60M (unchanged)
- Variable costs: $22M (20% of $110M)
- EBIT: $28M (25.5% margin)
- EBIT grew 40% on 10% revenue growth
- DOL = 40% / 10% = 4.0x

Company B (High Variable Costs): Retailer

Revenue: $100M
Fixed Costs: $15M (store leases, management)
Variable Costs: $70M (70% of revenue - inventory)
EBIT: $15M (15% margin)

If revenue increases 10% to $110M:
- Fixed costs: $15M (unchanged)
- Variable costs: $77M (70% of $110M)
- EBIT: $18M (16.4% margin)
- EBIT grew 20% on 10% revenue growth
- DOL = 20% / 10% = 2.0x

The Double-Edged Sword

High operating leverage is great when revenue grows—margins expand rapidly. But it's dangerous when revenue declines—losses accumulate quickly. This is why high-fixed-cost businesses (airlines, hotels, software) are more volatile investments.

Projecting Gross Margin#

Gross margin reflects the profitability of what a company sells, before operating expenses.

Factors That Affect Gross Margin#

Factor	Impact	Example
Pricing power	Higher prices = higher margin	Luxury brands vs. commodity retailers
Scale economies	Larger purchases reduce unit costs	Walmart vs. local grocery
Product mix	Some products have better margins	Apple's services vs. hardware
Competition	Price pressure reduces margins	Airline tickets
Input costs	Raw material prices affect margin	Oil prices for airlines

Historical Gross Margin Analysis#

Before forecasting, analyze trends:

Year	Revenue	COGS	Gross Profit	Gross Margin
2020	$500M	$300M	$200M	40.0%
2021	$600M	$348M	$252M	42.0%
2022	$720M	$403M	$317M	44.0%
2023	$830M	$456M	$374M	45.0%
2024	$920M	$497M	$423M	46.0%

This company shows improving gross margins—likely from:

Pricing increases
Better supplier negotiations at scale
Higher-margin product mix shift

Projecting Forward#

Question: Will the trend continue?

Scenario	Assumption	Projected Margin
Bull case	Pricing power continues, costs stable	48% by 2027
Base case	Some margin gains, competitive pressure	47% by 2027
Bear case	Competition intensifies, margins compress	44% by 2027

For base case, you might assume:

Year 1: 46.5% (modest improvement)
Year 2: 47.0% (continued gains)
Year 3-5: 47.0% (plateau at sustainable level)

Projecting Operating Margin#

Operating margin adds overhead costs: R&D, sales & marketing, general & administrative.

The Scaling Question#

As companies grow, operating expenses typically don't grow as fast as revenue. This is called operating leverage or margin expansion.

Common Patterns by Cost Category:

Cost Category	Typical Behavior	Why
R&D	Declines as % of revenue	Fixed engineering team serves larger customer base
Sales & Marketing	May stay flat or decline	Brand recognition reduces customer acquisition costs
G&A	Declines as % of revenue	Corporate overhead spread over larger business

Example: SaaS Company Margin Projection#

Historical pattern for CloudCo:

Year	Revenue	Gross Margin	R&D %	S&M %	G&A %	Op Margin
2022	$200M	75%	25%	35%	15%	0%
2023	$280M	76%	23%	32%	13%	8%
2024	$370M	77%	21%	28%	11%	17%

The pattern is clear: each cost line is declining as a percentage of revenue. Projecting forward:

Year	Revenue	Gross Margin	R&D %	S&M %	G&A %	Op Margin
2025E	$470M	78%	19%	25%	10%	24%
2026E	$580M	78%	18%	23%	9%	28%
2027E	$680M	78%	17%	22%	8%	31%

Don't Over-Project Margin Expansion

Every SaaS company claims they'll reach 30-40% operating margins "at scale." But competition, reinvestment needs, and market changes often prevent this. Look at mature companies in the same industry for realistic targets. Mature SaaS companies average 20-25% operating margins, not 40%.

Industry Benchmarks: What's Realistic?#

Different industries have different margin structures. Use these as sanity checks:

Industry	Typical Gross Margin	Typical Operating Margin
Software/SaaS	70-85%	15-30%
Pharmaceuticals	60-80%	20-35%
Consumer Goods	30-50%	10-20%
Retail	25-40%	3-8%
Airlines	25-35%	5-15%
Grocery	25-30%	2-5%

If your projection shows a grocery chain with 25% operating margin, something is wrong.

Common Margin Forecasting Mistakes#

1. Ignoring Competition#

If a company has 50% gross margins while competitors have 35%, ask why. The gap either closes (competitors copy the advantage) or the company has a durable moat.

2. Assuming Linear Improvement#

Margins don't improve forever. There are natural limits based on:

Industry structure
Need for ongoing investment
Customer price sensitivity

3. Forgetting About Investments#

Growth requires investment. A company that stops investing in R&D or marketing might show better margins short-term but worse growth long-term.

4. Missing One-Time Items#

Historical margins may include:

Restructuring charges
Legal settlements
Asset write-downs

Normalize these out before projecting. A company with 15% "reported" operating margin might have 18% "normalized" margin.

Putting It Together: Margin Build#

Here's a complete margin build for TechCorp:

Line Item	2024A	2025E	2026E	2027E	2028E
Revenue	$1,467M	$1,555M	$1,679M	$1,797M	$1,887M
Growth %	5.0%	6.0%	8.0%	7.0%	5.0%
Gross Profit	$734M	$778M	$856M	$935M	$991M
Gross Margin %	50.0%	50.0%	51.0%	52.0%	52.5%
R&D	($220M)	($226M)	($235M)	($243M)	($247M)
R&D % of Revenue	15.0%	14.5%	14.0%	13.5%	13.1%
S&M	($293M)	($295M)	($302M)	($305M)	($302M)
S&M % of Revenue	20.0%	19.0%	18.0%	17.0%	16.0%
G&A	($117M)	($117M)	($118M)	($116M)	($113M)
G&A % of Revenue	8.0%	7.5%	7.0%	6.5%	6.0%
Operating Income	$104M	$140M	$201M	$271M	$329M
Operating Margin %	7.1%	9.0%	12.0%	15.1%	17.4%

Key Takeaways

Fixed costs don't change with volume; variable costs scale with revenue
Operating leverage amplifies profit changes—high fixed costs mean big swings
Gross margin depends on pricing power, scale, product mix, and competition
Operating margin improves as overhead grows slower than revenue
Use industry benchmarks to sanity-check projections
Don't over-project margin expansion—look at mature competitors
Normalize one-time items before using historical margins for forecasting
Build margins line-by-line: Gross Margin → R&D → S&M → G&A → Operating Margin