A revenue beat should reach profit at a rate you can calculate in advance; the gap is the cost that grew when it should not have.
Flow-through is the change in EBITDA divided by the change in revenue, against budget or prior year. On an illustrative business that beat a 50.0 million revenue budget by 4.0 million and EBITDA by 0.7 million, flow-through is 17.5 per cent, against an expected 55 per cent once the extra revenue is split into volume at a 40 per cent contribution margin and price at 100 per cent. The 1.5 million gap is cost that grew faster than it should have, even though the EBITDA margin rose.
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Flow-through, also called incremental margin or drop-through, answers the question a revenue beat always raises: how much of it reached profit? The ratio itself is one division. The work is in knowing what it should have been, because a revenue beat from price and one from volume should flow through at very different rates.
| Line | Budget | Actual | Change |
|---|---|---|---|
| Revenue | 50.0 | 54.0 | 4.0 |
| Variable costs | 30.0 | 32.6 | 2.6 |
| Fixed costs | 12.5 | 13.2 | 0.7 |
| EBITDA | 7.5 | 8.2 | 0.7 |
| EBITDA margin | 15.0% | 15.2% |
Volumes came in 6 per cent above budget, worth 3.0 million of revenue at budget prices, and a price increase added the other 1.0 million. Variable costs are budgeted at 60 per cent of revenue, so the contribution margin is 40 per cent.
Flow-through = (actual EBITDA − budget EBITDA) ÷ (actual revenue − budget revenue)
In Excel: =(EBITDA_act-EBITDA_bud)/(Rev_act-Rev_bud), here 0.7 ÷ 4.0 = 17.5 per cent.
On its own the figure says little. The margin went from 15.0 to 15.2 per cent, which looks like a good year. Whether 17.5 per cent is good depends on what the extra revenue should have earned.
Each source of extra revenue has its own natural rate:
Expected flow-through = (volume revenue × contribution margin + price revenue) ÷ total revenue change
(1.2 + 1.0) ÷ 4.0 = 55 per cent, or 2.2 million of expected EBITDA improvement.
| Item | Amount |
|---|---|
| Expected improvement from volume and price | 2.2 |
| Variable costs above the flexed budget, 32.6 against 31.8 | −0.8 |
| Fixed costs above budget, 13.2 against 12.5 | −0.7 |
| Actual improvement | 0.7 |
The flexed budget, 60 per cent of revenue at budget prices on 6 per cent more volume, allowed 31.8 million of variable cost. The business spent 32.6. Together with 0.7 million of fixed cost creep, 1.5 million of the revenue beat never reached EBITDA. The volume-adjusted comparison is the same logic as the flexible budget variance; flow-through simply states it as one percentage the board can remember.
Why the margin is a poor test. A rule of thumb that the extra revenue should earn the budget margin of 15 per cent expects only 0.6 million, and the actual 0.7 passes it comfortably. It takes the fixed costs as if they scaled with revenue, which they do not, and so it lets a weak year read as a good one.
| From price | From volume | Expected EBITDA | Expected flow-through |
|---|---|---|---|
| 0.0 | 4.0 | 1.6 | 40% |
| 1.0 | 3.0 | 2.2 | 55% |
| 2.0 | 2.0 | 2.8 | 70% |
| 4.0 | 0.0 | 4.0 | 100% |
| Revenue | EBITDA | Change in revenue | Change in EBITDA | Flow-through | Margin |
|---|---|---|---|---|---|
| 46.0 | 5.9 | −4.0 | −1.6 | 40% | 12.8% |
| 48.0 | 6.7 | −2.0 | −0.8 | 40% | 14.0% |
| 52.0 | 8.3 | 2.0 | 0.8 | 40% | 16.0% |
| 54.0 | 9.1 | 4.0 | 1.6 | 40% | 16.9% |
On the way down the same arithmetic gives the decremental margin: a 4.0 million volume shortfall should cost 1.6 million of EBITDA, so management retains 60 per cent of the lost revenue as saved cost. If EBITDA falls by more, costs were not flexed down.
Flow-through is the EBITDA change over the revenue change, judged against what volume at the contribution margin and price at 100 per cent should have delivered. Here 17.5 per cent against 55 per cent exposes 1.5 million of cost growth behind a rising margin. The quarter that beats one document and misses another is the subject of the free workbooks for Financial Planning and Analysis.
The one your own cost structure predicts. Extra volume should flow through at the contribution margin, 40 per cent in this example, and price increases at close to 100 per cent. A beat of 3.0 million of volume and 1.0 million of price should therefore deliver 55 per cent; 17.5 per cent means costs grew faster than the revenue required.
Flow-through measures how much of a revenue increase reaches EBITDA; decremental margin measures how much EBITDA a revenue decline takes with it. With a 40 per cent contribution margin, a 4.0 million volume shortfall should cost 1.6 million of EBITDA, keeping 60 per cent of the lost revenue as saved variable cost.
Because margin compares with the average, flow-through with the marginal economics. Here margin rose from 15.0 to 15.2 per cent, yet the 4.0 million beat delivered 0.7 million of EBITDA against 2.2 million expected. Judging the beat at the 15 per cent budget margin would have expected only 0.6 million.
This article is one calculation from Financial Planning and Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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