On a company's income statement, you'll see a line for selling, general, and administrative (SG&A) expenses. These are the costs incurred in the quest to generate sales—part of the day-to-day operating expenses that keep a firm in business.
SG&A costs pertain to the overall operation of the company. Selling costs can include advertising, sales commissions, and promotional costs. General expenses would be things such as rent, utilities, office supplies, and insurance. Finally, administrative costs encompass salaries for administrative staff and executives, as well as fees or salaries for professional services such as IT, accounting, or attorneys.
In contrast to these operating costs, the cost of goods sold is the actual cost to produce and deliver a product to the customer, from the raw materials to make it to the shipping costs and taxes required to get it to the buyer.
SG&A Can Be Fixed or Variable Costs
When it comes to SG&A expenses, differences exist between a company that has a mostly variable cost structure and one that has a mainly fixed cost structure.
The company with high fixed costs is said to have high operating leverage because it has a set, predictable amount of costs it must cover, and then makes a profit beyond that level.
Fixed costs are one of the reasons a business can fail. For example, say a firm's revenue declines from $2 million to $800,000. That's still a high number by small business standards, but if fixed costs are $900,000, it's not good enough.
A variable cost structure is one in which the SG&A expenses keep pace with sales. Think of a furniture importer that has only a warehouse and almost no other fixed expenses, just a 15% commission that they pay to independent road salesmen. As sales vary each month, the costs follow accordingly, protecting the business and its shareholders in a down market.
Companies with highly variable cost structures are said to have low operating leverage. All else equal, businesses with low operating leverage might have more competition, but they can more easily survive painful declines in revenue and cash flow since the business doesn’t need to cover a fixed expense load each month.
Excessive SG&A Spending
High SG&A expenses in relation to revenue can be problematic for almost any business. Management often attempts to keep SG&A expenses limited to a certain percentage of revenue, though that figure may vary significantly depending on sector and industry, as well as from company to company, as different firms target their own operational models.
Say that a bank invests heavily in improving its customer service experiences, spending far more than many other banks. As such it has higher selling expenses on its income sheet. But this bank also has higher sales, since better customer interaction leads to more deposits and more customer loans. Therefore the profitability increased, too, and offset those higher costs.
When SG&A expenses grow too large without a corresponding rise in sales, or if sales drop for an extended period of time, companies must often reduce SG&A costs by implementing cost-cutting moves, including employee layoffs.
Many companies in the past have had bloated SG&A expenses that cost shareholders billions in profit. For example, in the 1980s, investor Warren Buffet was reportedly shocked to find out that one of his investments, television network ABC, was spending $60,000 on florists, as well as providing stretch limos and private dining rooms for its executives. At the same time, the ABC executives also squandered shareholders' capital through out-of-control expenses.
It was later revealed that they artificially padded earnings by selling the original Jackson Pollack and Willem de Kooning paintings the network owned, keeping the figures up so they could avoid cutting their egregious spending.
Analyzing the Costs
You might encounter a potential problem when analyzing an income statement as you compare two firms in the same industry. Some expenses can be classified under either the cost of goods sold section or the SG&A section. This can make the gross profit margin and the operating profit margin appear to differ even if the businesses are otherwise financially identical.
Look for additional detail and insight on cost component classification in the company’s financial statement footnotes to verify that you’re comparing companies on the same basis.