SGA: Selling, General, and Administrative Expenses
The next section of the income statement we are going to discuss covers Selling, General, and Administrative expenses, or SGA expenses.
SGA expenses consist of the combined payroll costs (salaries, commissions, and travel costs of executives, salespeople, and employees) and advertising outlays a company incurs in its quest to generate sales. High SGA expenses can be a serious problem for almost any business. A good management will often attempt to keep SGA expenses limited to a certain percentage of revenue, though that figure may vary significantly between sector and industry, and even company-to-company, as different firms target different customer service models.
An example of this is how the Wells Fargo bank tends to invest heavily in better customer service experiences than many other banks, so its expenses are higher but it is overall more profitable, as better customer interaction makes it easier for the banking giant to gather deposits, bring in clients for its asset management company, and get borrowers to take out loans. Finding the optimal line can be tricky, though; when SGA expenses grow too large, companies must often turn to restructuring plans, cost-cutting maneuvers, and employee layoffs.
There have been several cases in the past where bloated selling, general expenses, and administrative expenses have literally cost shareholders billions in profit. According to Roger Loweinstein, in the 1980s, television network ABC was spending $60,000 a year on florists, as well as providing stretch limos and private dining rooms for its executives. It was the shareholders who were footing the bill. Perhaps even worse, at the same time, these ABC executives squandered shareholders' capital through out-of-control expenses.
They were artificially padding earnings by selling the original Jackson Pollack and Willem de Kooning paintings the network owned, keeping the figures up so they could avoid the day their gravy train ended!
SGA Expenses and Fixed vs. Variable Cost Structure
When it comes to SGA expenses, there is a substantial difference between a company that has a variable cost structure and one that has a fixed cost structure. A company with high fixed expenses is said to have high operating leverage because the company loses money up to a break-even point and then makes a profit beyond that level.
A perfect example is a McDonald's franchise. Due to the high startup costs that cover the building, cooking equipment, restaurant seating, fixtures, and other outlays, you're probably going to need to bring in more than $1,000,000 in annual sales to break even. Beyond that point, your costs are covered so you generate far higher profits. That is, each incremental sale is more valuable to you, as an owner. That is one of the reasons a business can fail if revenue declines from $2,000,000 to $800,000, even though it is still a decent size by small business standards.
A variable cost structure is one in which the selling, general, and administrative expenses keep pace with sales. Think of a furniture importer that has almost no expenses except for a 15% commission paid to independent road salesmen. If sales fall, costs fall in line, protecting the business and shareholders. Companies with highly variable cost structures are said to have low operating leverage. All else equal, businesses with low operating leverage are going to be subject to more competition, but they can more easily survive painful declines in revenue and cash flow as the business naturally and organically right-sizes itself without a lot of hard decisions.
One potential problem when analyzing an income statement that you might encounter as you compare two firms in the same industry is the fact that certain expenses can be classified under either the cost of goods sold section or the selling, general, and administrative section. This can make the gross profit margin and the operating profit margin appear to differ even if the businesses are otherwise economically identical.