In this workout, we're going to cross the bridges for this made up company, chemical Company X.

You can see that we have all the makings of a bridge here in that we have prior year sales being 10 billion.

We're expected to then connect that to this year's sales, 2023 sales and analyze the impact on revenues.

We've then got some assumptions around pricing costs and the relationship of fixed costs to variable costs, which we'll explore a bit later in more detail.

And then we have a similar bridge for EBITDA where we have prior year ebitda and we're going to analyze the effect of pricing, the raw material, the fixed cost to variable cost balance to arrive at the EBITDA in this year.

And the idea of this is to analyze the performance of this company, and we're also going to spend some time flexing these assumptions just to explore the definitions of everything and really get a good understanding.

First, let's work with the numbers as they are before we start flexing.

Generally, bridge information like this will be additive, and so the overall impact on revenues from volumes will be 10 and then of prices will be five, so there will be an overall organic growth of 15.

The reason it's called organic is because this is being made by the company internal to the company.

Arguably this might be distinguished in some reports that you see with impacts of mergers and acquisition or Forex.

We've ignored those here and we are only doing organic growth.

If we apply that organic growth to prior year sales, this is the impact of the organic growth.

We can then add that to the prior year sales and you'll see that the revenue bridge is fairly straightforward.

There's been an impact because of volumes and there's been to a lesser extent and impact due to either pricing or mix of products that this chemical company has sold and those have added together to create an impact on the sales and enables crossbridge from last year's sales to this year's sales.

Let's explore these EBIT D bridge items which are more challenging.

The first item we have is pricing drop through.

This is the extent to which pricing has an impact on EBIT due to factors in costs other than the ones that we've specifically forecast.

In other parts of the model, we've specifically forecast raw material cost inflation.

Here it's commonly very important to chemical companies, and so it gets its own line of forecast.

Notice that we haven't forecast any kind of inflation in say labor, and so labor forecast inflation or costs would actually be contained in the pricing drop through.

Fixed cost inflation would also be contained in row 13 of this model because we haven't got a specific standalone line for fixed cost inflation here.

The relationship that we have here of 98% suggests that some of our non raw material costs are outstripping our ability to pass those costs on to our customers, and this is going to have a lower effect than you'd expect of pricing increases on the EBIT margin or EBITDA margin.

In this case, the operating leverage represents something else entirely.

It represents the balance of fixed to variable costs.

What we're going to do is we're going to link it to volumes and we're going to find that the higher the operating leverage, the more fixed costs there are in this business.

These will not rise in line with volumes and it will mean that volumes are more impactful to our EBIT margin.

Like I said, we're gonna flex these numbers to further reinforce that, but let's work with the numbers as they are now.

First thing is let's work out the margin as it is.

This is last year's margin, so it'll be last year's EBITDA divided by last year's revenue.

You can see they've got a nice easy number there, 10% easy to follow.

Next we're going to find in terms of euros, the impact of pricing on the margin.

The first thing we'll do is a little bit like the price to revenue relationship.

We'll find last year's revenue, we'll multiply it by the price increase.

Now in a simple business, every time you increase the price, it would have a one-to-one impact on the EBIT, but here what we've got is the drop through.

You can see that if the 5% increase in price filtered through to the EBITDA perfectly, you would expect that to say 500, but it doesn't.

It says four 90, and what that represents is that there are forces at work internal to the company that are being represented by these numbers.

You could think about it as the non raw material costs inflating quicker than the price would suggest.

Perhaps your labor is going up quicker than your price increase, and that is eroding your margin and that is being captured by this number here.

Next we're going to do raw materials.

We're gonna do raw materials and attach them to last year's revenue.

We're going to say that they will increase by 9%, so whatever was in those revenues will also increase by 9% in terms of the raw material cost.

You may be wondering about the revenue we attached the raw material impact to the change in EBIT.

Due to the change in raw material prices has been modeled against prior years revenue.

This is to show the inflation from prior year raw material.

This is the assumption we've used in the forecast going forward, recognizing the best way to model the raw material impact is to drive it from last Year's revenue, and of course that will be a negative impact if it's rise.

In this case, you can see that this is seriously impactful to chemical company X.

They haven't been able to increase their price very much compared to the raw material cost inflation, plus the fact that their price increases were slightly consumed by non raw material cost inflation.

This has all added up to quite a bad picture from the point of view of price and raw material.

You might say that company X has increased its costs dramatically due to its inflation of say, titanium or hydrocarbons, and it has not been able to pass that effectively onto its customers, and that's kind of represented by that 9% there and the five, but not only that, its non raw material costs have also inflated quicker than its prices, and what that's done is overall it's made quite a big impact on the ebitda and as we'll see on the margin.

Now this company has an operating leverage of 50%, so you could see that as the balance of fixed cost to variable cost, and this means as volumes increase by 10% on a revenue basis, then that will have that kind of impact on the margin.

As you could imagine it, as half of the costs are not rising as the volumes rise and the others are rising.

So in terms of impact, the way you could imagine it is that these volume rises would be brilliant if all we had was fixed costs because every time we sold a new tin of paint or bit of packaging, then variable costs would not increase because all costs are fixed.

However, this is more of a more 50 50 split in this company, and that means as we sell a new tin of paint, it means more variable costs, and these are not capturing cost inflation that's been captured already by these two.

This is just capturing the mix of fixed and variable cost.

So you're probably sensing a theme here.

We're going to grab last year's revenue and we're going to say the volume impact was, and then we're going to attach the operating leverage to show its impact on the ebitda, and you can see that growing the business has had a very positive impact, but unfortunately it doesn't look like enough to contract, especially the raw material cost inflation, adding them up.

While it looks like a very positive effect, you can see that if we then grab the new margin being the new EBITDA over the new sales, although on an absolute basis the EBITDA has increased, we've had to sell lots and lots of new revenue to achieve that.

And so the efficiency on a dollar by dollar or in this case Euro by Euro basis has gone down and this has represented an erosion of the EBITDA margin.

To explore this further, we could now set this little model at some fairly extreme states just to explore the ideas and to reinforce them.

The first thing I'm going to do is to say that the volume impact is flat, so all revenue is coming from price increases.

This could be price or mix.

The second thing I'm going to do is set the pricing drop through to a hundred percent.

Now, what this means is that every dollar, or in this case, euro of extra price that we generate should have a one-to-one impact on the EBIT, but remember that the pricing drop through models the relationship with costs that haven't been specifically done elsewhere, such as raw materials.

So you can see that really to keep pace with the raw materials, we would need to increase our prices by 9%, have those prices drop through a hundred percent, so not get consumed by any non raw material cost inflation.

What we'd find is that there's no change between 2022 and 2023.

Unfortunately, the margin would still actually go down because we have grown revenue without growing ebitda.

Hopefully setting the model to this state has helped you to understand the relationship between this inflation here, the drop through, and the price increase.

I've set the model to a new state notice that I've increased the volumes now, but I haven't changed my prices.

All revenue increase is coming from volume increase, selling more products.

I've said that any pricing drop through there was would be perfectly increasing the ebitda, but considering that we don't have any pricing increase and our raw materials aren't doing anything for simplicity, that is not going to matter.

What matters now is the operating leverage, and that's what we're exploring now.

We can see that we've increased the revenue by a thousand because we've increased our volumes.

Those volume increases will partially lead to variable cost increases, and so you can see that half of the increases in revenue are being consumed by effectively variable cost increases, whereas the other half will lift up up the EBITDA representing fixed costs not rising, and you can see that this has done a good deal for the margin, and hopefully that really helps you to reinforce the idea that we've talked about time and time again in this playlist, which is that scale is very important to chemical companies.

That brings us to the end of this exploration, but of course, feel free to play around with the numbers to help you understand what's inside them.