Overview
When conducting due diligence in mergers and acquisitions (M&A), understanding cost models is crucial. These models help businesses forecast ongoing expenses and plan for future investments. Below are three different high-level cost models you can use when conducting an IT due diligence. Each model is a way to organize and analyze costs in a way that is MECE (mutually exclusive, collectively exhaustive):
- CAPEX vs OPEX
- Fixed vs. Variable Costs
- Labor vs. Non-Labor
1. CAPEX vs. OPEX: Long-Term Investments vs. Daily Operations
Capital Expenditures (CAPEX) and Operating Expenditures (OPEX) focus on different types of spending:
- CAPEX refers to long-term investments in IT infrastructure, hardware, or software that provide benefits over several years. For example, purchasing servers or building data centers falls under CAPEX. These costs typically show up on the balance sheet as assets and are depreciated over time.
- On the other hand, OPEX covers the daily operating costs required to keep the IT systems running. This includes expenses such as software subscriptions, utility bills, and maintenance contracts. Unlike CAPEX, OPEX costs are fully expensed in the year they are incurred, making them an immediate hit to the profit and loss statement.
Key Difference: CAPEX represents long-term, one-off investments, whereas OPEX is concerned with the recurring, short-term operational costs. When modeling costs for M&A due diligence, CAPEX requires forecasting for large upfront investments, while OPEX helps plan for ongoing, predictable expenses.
2. Fixed vs. Variable Costs: Predictability vs. Flexibility
- Fixed costs are those expenses that do not change with the level of business activity. These might include costs like rent for data centers, annual software licensing fees, or salaries for permanent IT staff. Fixed costs are predictable and make budgeting simpler.
- Variable costs, however, fluctuate depending on how much the IT infrastructure or resources are used. For example, cloud services often work on a pay-as-you-go model, where costs increase or decrease depending on storage and computing power usage. Similarly, hiring temporary IT consultants or contractors to handle increased workloads or special projects adds variability to the cost structure.
Key Difference: Fixed costs are stable and predictable, regardless of business activity, while variable costs provide flexibility but can spike during periods of high usage. In due diligence, understanding the balance between fixed and variable costs helps assess the scalability and adaptability of IT operations.
3. Labor vs. Non-Labor Costs: Workforce vs. Infrastructure
In IT, breaking costs down into labor and non-labor categories provides a clear picture of where resources are being allocated.
- Labor costs include salaries for full-time employees, contractors, and offshore teams. They also cover benefits, training, recruitment, and overtime pay. Labor is one of the largest ongoing expenses in IT, making it essential to evaluate during due diligence.
- Non-labor costs encompass everything else required to run IT systems, including software licenses, hardware, cloud services, and cybersecurity tools. These costs can fluctuate depending on the infrastructure and third-party service providers used by the company.
Key Difference: Labor costs focus on the people powering IT operations, while non-labor costs account for the infrastructure and technology they use. Labor costs tend to be ongoing and may increase with business growth, while non-labor costs can be managed or optimized through vendor negotiations or technology upgrades.
Choosing the Right Model for IT Due Diligence
Each of these cost models provides a unique lens for analyzing IT expenditures. Depending on the requirements of the due diligence, it can help to choose one of the cost models to focus on to drive analysis and deliver a comprehensive report.
Sometimes it can even be useful to combine elements of multiple models to get a complete picture. For example, labor costs could be classified as fixed if most of your IT staff are permanent employees or variable if contractors are heavily relied upon. Likewise, infrastructure investments (CAPEX) might contain both fixed and variable cost elements.