Operating expenses are where a cost base is most often incomplete, and where the gap is most precisely quantifiable. That combination makes this the area where diligence most often produces an adjustment the buyer can defend to the last decimal rather than describe as a judgement.
The framing question is not what the target spent. It is what the cost base will be for a stand-alone owner after closing.
The four-way payroll reconciliation
People cost is the largest operating expense in most targets, and it is testable against four independent records of the same workforce.
| Record | What it establishes |
|---|---|
| HR headcount roster | Who is employed, in which entity, on what contract type |
| Payroll register | What is actually paid, through which channel, and in which period |
| Social insurance and housing fund filings | Who is enrolled, and on what contribution base |
| Individual income tax filings | What is declared to the tax authority |
Where the four reconcile, the cost base is established and the work is done. Where they do not, the difference needs to be broken into its components: a difference in who is included across the four records, and a difference in the basis on which contributions are calculated. Both are recurring costs to the buyer, and quantifying them separately makes them far easier to defend in negotiation than a single blended adjustment.
Selling expenses
Three items deserve specific attention:
- Commissions to intermediaries. Whether they are recorded in the period they relate to, whether the rate is consistent across customers, and whether any arrangement is documented only in correspondence.
- Rebates and channel incentives. Whether they are netted against revenue or recorded as expense — a presentation choice that changes gross margin without changing profit.
- Marketing and travel. Whether the spend has a measurable relationship to revenue growth, and whether it is genuinely discretionary or effectively committed.
Development expenditure
Where the target capitalises development costs, compare the criteria applied with what the standard requires, and then test consistency: is the same threshold used for every project, and are there projects that continue to be capitalised after the commercial case has weakened?
The useful output is a sensitivity rather than a verdict: what operating profit would have been if the policy had been more conservative. That number belongs in the model, not in a footnote.
Owner-related and shared costs
Two directions matter, and buyers often work only one of them.
Costs to add back: expenses run through the company for the owner's benefit — vehicles, travel, entertainment, personal staff. These are removed from the maintainable cost base.
Costs to add in: functions provided by an affiliate without a charge, or at a rate below what a stand-alone business would pay. Finance, IT, HR, warehousing and logistics are the usual candidates. After separation from the group, the target will pay market rates for these, and the cost base rises.
The owner's salary belongs in the same adjustment. Where the company pays the founder a nominal salary, removing personal expenses without adding back a market salary overstates the adjusted earnings.
Non-recurring items
Asset disposals, one-off gains and other non-recurring income should be identified, quantified and excluded from the maintainable base — but separately from the cost adjustments, because they affect reported earnings rather than run-rate cost.
The test is the same in each case: whether the item is part of how the business trades, or an event that happened to occur in the period. An item that recurs every year without being contractual is still not a permanent part of the earnings base, and it should be shown separately rather than blended into the normalised figure.
Benchmarking the cost base
Finally, test whether the cost base is plausible for the business rather than only whether it is complete. Operating expense as a percentage of revenue, revenue per employee, and cost per head compared with listed peers are crude measures — and they reliably surface targets whose expense ratio sits far outside the range for their sector, in either direction.
What to request
- HR headcount roster, by entity and location
- Twelve months of payroll registers
- Social insurance and housing fund filings, by location
- Individual income tax filings
- The general ledger and trial balance, at account level
- Contracts for shared services provided by affiliates
- Details of capitalised development projects
The reconciliation is mechanical once the records exist. The practical risk is that payroll, social insurance and tax filings are held by three different functions and produced on three different schedules. Asking for all four together, in the first data request, is what makes this area resolvable within the transaction timetable.
Common questions
What is a four-way payroll reconciliation?
It compares four records of the same workforce: the HR headcount roster, the payroll register, the social insurance and housing fund filings, and the individual income tax filings. Where the four disagree, the difference shows what a stand-alone owner would actually carry as people cost.
Should a buyer normalise the founder's salary upward?
Yes. Where the owner takes a nominal salary and part of the return through other channels, removing the personal expenses from the cost base without adding back a market salary overstates the adjusted earnings. Both adjustments belong in the same bridge.
How do you establish a complete operating cost base?
By comparing the reported cost base with what a stand-alone owner would incur: payroll against its four underlying records, shared services charged at market rates, and costs that sit in another group entity rather than being absent. Each adjustment is quantified separately so it can be defended in negotiation.
This article describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Views are my own and do not represent any firm.