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.
High SG&A expenses can be problematic for almost any business, and a management team 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, a difference exists 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'll probably need to bring in more than $1,000,000 in annual sales to break even. Beyond that point, your fixed costs are covered so you 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 if revenue declines from $2,000,000 to $800,000 if this doesn’t cover its fixed costs, even though the firm’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 almost no fixed expenses, and has only a 15 percent commission paid to independent road salesmen. As sales vary each month, costs follow accordingly, 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 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 tends to invest heavily in better customer service experiences than many other banks, so it has higher expenses but it 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.
When SG&A expenses grow too large without a corresponding rise in sales, however, 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 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. At the same time, the ABC executives also 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 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.