Case 043Sector economicsCore

Tarvik Tractors sells 60% of its volumes in rural areas. A weak monsoon cuts industry volumes 12%. With 45% of costs fixed and a 14% EBITDA margin, what happens to EBITDA?

The situation

Tarvik Tractors has revenue of Rs 8,000 crore and a 14% EBITDA margin, Rs 1,120 crore. 60% of its tractors go to farmers; the other 40% go to haulage, construction and other non-farm uses. Of its costs, 45% are fixed in the short run: plant overheads, staff, dealer support and advertising. The rest, mainly steel, castings and engines, move with volume.

After a weak monsoon, industry forecasts show farm demand down 16% and non-farm demand down 6%, a 12% fall across the industry. Tarvik's mix matches the industry, and it does not plan to change prices.

Your task

What happens to Tarvik's EBITDA and margin, why is the fall so much bigger than the volume fall, and what can management do about it?

Quick check

Volumes fall 12%. Roughly how far does EBITDA fall?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

EBITDA falls about 45%, from Rs 1,120 crore to about Rs 614 crore, on a 12% volume fall, and the margin drops from 14% to about 8.7%. Revenue falls Rs 960 crore but only variable costs, 47.3% of revenue, fall with it; Rs 3,096 crore of fixed costs stay. Each 1% of volume costs about 3.8% of EBITDA. Cutting fixed costs 5% would soften the fall to about 31%.

Step 1Why does a 12% volume fall become a 45% profit fall?

A taxi owner with a fixed loan instalment earns less on a slow day but pays the same instalment, so a 12% drop in fares can take far more than 12% of what she keeps. Costs that do not move with volume stay behind when revenue leaves, so every rupee of lost revenue takes only its variable cost with it and the rest comes straight out of profit. Tarvik's costs are Rs 6,880 crore: Rs 3,096 crore fixed and Rs 3,784 crore variable, 47.3% of revenue. This is operating leverageThe way a business with mostly fixed costs turns a small change in revenue into a larger percentage change in profit..

Fixed costs do not fall with volume, so EBITDA takes the hit, Rs croreVariable costs 3,784Fixed costs 3,096EBITDA 1,120Revenue 8,000BeforeVariable costs 3,330Fixed costs 3,096EBITDA 614Revenue 7,040After a 12% volume fallEBITDA-45%on -12% volume
When Tarvik's volume falls 12%, revenue drops from Rs 8,000 crore to Rs 7,040 crore and variable costs fall with it, but Rs 3,096 crore of fixed costs stay, so EBITDA falls from Rs 1,120 crore to Rs 614 crore, -45%.
Step 2How do you work it out quickly?

First the volume fall: 60% of volume down 16% and 40% down 6% is 9.6 plus 2.4, 12%. Then the contribution lost. Each rupee of revenue carries 52.7 paise of contribution after variable costs, so losing Rs 960 crore of revenue loses Rs 506 crore of EBITDA. Rs 1,120 crore less Rs 506 crore is Rs 614 crore. The shortcut is the ratio of contribution margin to EBITDA margin, 52.7% over 14%, about 3.8: that is how many per cent of EBITDA each per cent of volume carries.

The relationship
ΔEBITDAEBITDA=contribution marginEBITDA margin×Δvolume=52.7%14%×(−12%)≈−45%\frac{\Delta \text{EBITDA}}{\text{EBITDA}} = \frac{\text{contribution margin}}{\text{EBITDA margin}} \times \Delta \text{volume} = \frac{52.7\%}{14\%} \times (-12\%) \approx -45\%
contribution marginrevenue less variable costs, as a share of revenue: 52.7%
EBITDA margin14% before the fall
Delta volumethe 12% fall in tractors sold
What it says in wordsThe percentage fall in EBITDA equals the volume fall multiplied by how much bigger the contribution margin is than the EBITDA margin.
Every 1% of volume costs about 3.8% of EBITDA-20%-40%-60%0%Dashed: if EBITDA fell only as much as volume-12% volume: EBITDA -45%with fixed costs cut 5%: -31%0%5%10%15%20%Fall in tractor volumes
With 45% of costs fixed and a 14% margin, each 1% of volume Tarvik loses costs about 3.8% of EBITDA, so a 12% fall cuts EBITDA 45%, against 31% if fixed costs are cut by 5%.
Step 3What can management do, and what could make it worse?

Management can cut the costs that are fixed only in the short run: overtime, advertising, dealer incentives. A 5% cut in fixed costs, Rs 155 crore, lifts EBITDA to about Rs 769 crore, still down 31%. The risk runs the other way if rivals discount to hold volume: a 2% price cut on Rs 7,040 crore of revenue takes EBITDA down to about Rs 473 crore. In a monsoon downturn the analyst's job is to say which of those two is more likely, based on how the industry behaved in the last weak year.

Where candidates lose it

The usual loss is cutting EBITDA by the same 12% as volume, which ignores the fixed costs and understates the hit nearly fourfold. Interviewers ask this precisely to see whether you split costs before you calculate.

The second is applying the 12% only to the rural 60% and cutting volume 7.2%. The case says the whole industry falls 12% and gives you the farm and non-farm split so you can check it; read what the 12% already includes.

What the interviewer asks next

  • What volume fall would wipe out Tarvik's EBITDA entirely?
  • How does a good monsoon the next year play out through the same arithmetic?
  • Tarvik holds 60 days of dealer inventory. How does that change the timing of the hit?

Company names and figures are illustrative.