The Metric for Overhead Expenses Can Be an Early Red Flag
Adam Smith, Scottish philosopher and political economist, was famous for writing what has simply become known today as “The Wealth of Nations”. Written in 1776, during the founding of this nation, Smith wrote about many economic subjects, most notably regarding economies of scale.
Economies of scale are defined by Investopedia as “The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.” There-fore, it might cost $10,000 to produce 5000 widgets, but only $12,000 to produce 10000.
The opposite of this is diseconomies of scale, where companies become less efficient and it happens more than you think and is cause for major concern. This can best be illustrated in looking at the Selling, General and Administrative expenses (SGA) that we see in example income statement:
Revenue (sales) 65,000
COGS (cost of goods sold) 42,500
Gross Profit 22,500
SGA (selling, general and administrative expenses) 19,000
EBITDA (earnings before interest, taxes, depreciation & amortization) 3,500
The cost of goods sold (COGS) represent the material and labor costs of creating or obtaining the product sold. Subtracted from revenue, one arrives at the gross profit of the company. From that, all expenses not related to the actual production of the product, including salaries, bonuses, pensions, marketing costs, rent, insurance, utilities and other possible non-production type expenses (SGA) are subtracted from the gross profit in order to arrive at Ebitda or operating income.
The relationship between SGA and Gross profit will tell us a lot regarding the efficiency or economies of scale with a company.
SGA/Gross Profit or 19000 / 22500 = 84%
The SGA/GP metric is best looked at individually for each company and/or industry. You are looking for trends as to whether the SGA is rising faster than your Gross Profits, which will shortly have a devastating impact. This is an excellent metric because it allows you to sometimes see negative things “before they happen”. SGA is also very difficult to manipulate.
For instance, you will notice that Bed, Bath and Beyond (BBBY, Financial) has improved the trend in the last five years. The ten year average indicates SGA outpacing profit slightly, but the cutting of costs over the last few years has made BBBY a more efficient company. This is ideally, what you want to see.
Looking at Best Buy (BBY, Financial), you will see that SGA has steadily risen in relationship to Gross Profit. This is a red flag. SGA is cutting into profit and will, at some point become a major issue.
If you compare companies, you should compare within the same industry. The business plan should be very close to one another, or the numbers could be meaningless for comparison purposes. The best use of the metric is to study year to year to see if a rising trend over 5 or 10 years will lead to a future problem.
If I compare Visa (V, Financial) and MasterCard (MA, Financial), the SGA/Gross Profit is:
Visa: 40%
MasterCard: 48%
How big of a difference does this 8% represent? MasterCard’s revenue is $5539 million, therefore; an 8% reduction in cost represents approximately $443 million in savings. This could have increased their pretax income approximately 16%, which is significant.
Research and Development should normally be shown as a separate line item, however; some include R & D in the SGA number. Make certain that you are comparing apples to apples.
And have fun!
Adam Smith, Scottish philosopher and political economist, was famous for writing what has simply become known today as “The Wealth of Nations”. Written in 1776, during the founding of this nation, Smith wrote about many economic subjects, most notably regarding economies of scale.
Economies of scale are defined by Investopedia as “The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.” There-fore, it might cost $10,000 to produce 5000 widgets, but only $12,000 to produce 10000.
The opposite of this is diseconomies of scale, where companies become less efficient and it happens more than you think and is cause for major concern. This can best be illustrated in looking at the Selling, General and Administrative expenses (SGA) that we see in example income statement:
Revenue (sales) 65,000
COGS (cost of goods sold) 42,500
Gross Profit 22,500
SGA (selling, general and administrative expenses) 19,000
EBITDA (earnings before interest, taxes, depreciation & amortization) 3,500
The cost of goods sold (COGS) represent the material and labor costs of creating or obtaining the product sold. Subtracted from revenue, one arrives at the gross profit of the company. From that, all expenses not related to the actual production of the product, including salaries, bonuses, pensions, marketing costs, rent, insurance, utilities and other possible non-production type expenses (SGA) are subtracted from the gross profit in order to arrive at Ebitda or operating income.
The relationship between SGA and Gross profit will tell us a lot regarding the efficiency or economies of scale with a company.
SGA/Gross Profit or 19000 / 22500 = 84%
The SGA/GP metric is best looked at individually for each company and/or industry. You are looking for trends as to whether the SGA is rising faster than your Gross Profits, which will shortly have a devastating impact. This is an excellent metric because it allows you to sometimes see negative things “before they happen”. SGA is also very difficult to manipulate.
For instance, you will notice that Bed, Bath and Beyond (BBBY, Financial) has improved the trend in the last five years. The ten year average indicates SGA outpacing profit slightly, but the cutting of costs over the last few years has made BBBY a more efficient company. This is ideally, what you want to see.
Looking at Best Buy (BBY, Financial), you will see that SGA has steadily risen in relationship to Gross Profit. This is a red flag. SGA is cutting into profit and will, at some point become a major issue.
If you compare companies, you should compare within the same industry. The business plan should be very close to one another, or the numbers could be meaningless for comparison purposes. The best use of the metric is to study year to year to see if a rising trend over 5 or 10 years will lead to a future problem.
If I compare Visa (V, Financial) and MasterCard (MA, Financial), the SGA/Gross Profit is:
Visa: 40%
MasterCard: 48%
How big of a difference does this 8% represent? MasterCard’s revenue is $5539 million, therefore; an 8% reduction in cost represents approximately $443 million in savings. This could have increased their pretax income approximately 16%, which is significant.
Research and Development should normally be shown as a separate line item, however; some include R & D in the SGA number. Make certain that you are comparing apples to apples.
And have fun!
