SG&A: Selling, General, and Administrative Expenses
Companies incur selling, general and administrative (SG&A) expenses such as payroll costs (salaries, commissions, and travel costs of executives, salespeople, and employees) advertising, and other expenses it incurs in the quest to generate sales.
These costs pertain to the overall operation of the company, while another cost category, cost of goods sold, contains the costs directly involved in producing products for sale.
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 between sector and industry, and from company to company, as different firms target their own operational models.
Fixed vs. 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 to cover, and then makes a profit beyond that level.
For example, consider a McDonald's franchise. Due to the high startup costs that include the building, cooking equipment, restaurant seating, fixtures, and other outlays, you would probably need to bring in more than $1,000,000 in annual sales to break even. Beyond that point, you'll cover your fixed costs so you can generate far higher profits.
That is, each incremental sale is more valuable to you, as an owner. Fixed costs are one of the reasons a business can fail. For example, if revenue declines from $2,000,000 down to $800,000 it may not cover a firm's fixed costs, even though the company’s still a decent size by small business standards.
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. They have only a 15-percent commission that they pay to independent road salesmen. As sales vary each month, the costs follow accordingly, which protects the business and 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 will likely have more competition, but they can more easily survive painful declines in revenue and cash flow as the business doesn’t need to cover a fixed expense load each month.
Excessive SG&A Spending
Say that a bank invests heavily in improving its customer service experiences than many other banks, so it has higher expenses. This bank also has higher sales that lead to more profitability, as better customer interaction makes it easier for the bank to increase customer deposits, and get borrowers to take out loans.
However, when SG&A expenses grow too large without a corresponding rise in sales or sales drop for an extended period of time, companies must often reduce SG&A costs by implementing restructuring plans, cost-cutting maneuvers, and employee layoffs.
Many companies in the past have had bloated SG&A expenses that cost shareholders billions in profit. According to Roger Lowenstein, 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. At the same time, the ABC executives also squandered shareholders' capital through out-of-control expenses.
It was later revealed that 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 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. Certain 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 economically identical. You can often find 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.