One of the great parts about my job is that I get to work with very intelligent and hardworking people in really interesting places. I just got back from five days of client meetings in New York. It really fires me up to work with such motivated and passionate people in the industry.
During our meetings, one of the things that we discussed at length was SG&A expenses — or Selling, General, and Administrative expenses. SG&A expenses are sometimes referred to generally as overhead. Sometimes these expenses are described as “the cost of doing business” or “things that are outside of our control”. But SG&A management can make or break a business.
Regardless of your business, SG&A expenses are critical. I tend to do a lot of work with companies in the automotive aftermarket. But the same holds true in every industry I’ve worked in. SG&A expenses are generally divided into two categories — variable and fixed. Variable expenses are those that move up or down depending on the overall sales of the business. Fixed costs, on the other hand, are expenses that are the same amount every month, regardless of sales.
One of the reasons industry consolidation takes place over time is due to the fixed costs involved in operating a business. The more sales you can leverage across a base of fixed costs, the greater the economies of scale. The greater the scale, the greater the marginal profitability of the business.
Why does SG&A matter?
In many businesses I work with, SG&A expenses are a key driver of profitability. Often, there is an overwhelming focus on efficiency and gross margin, or on the productive staff that is doing the day-to-day work of the business. But sometimes there is less of a focus on the efficiency of the support staff — the staff and managers that oversee the productive staff.
SG&A can be thought of as all the expenses of the business that are not directly attributable to manufacturing, distribution, assembly or service offering of the product. An easy way to differentiate between SG&A costs and direct costs is to ask the question: office or shop floor? If the activity takes place in a warehouse or shop floor, then it is most likely a direct expense. If the activity takes place in the office, then it is most likely an SG&A expense.
Put differently, your SG&A expenses are a major driver of operating income. Depending on how you organize your P&L, Gross Margin – SG&A = Operating Income, otherwise referred to as EBIT. And EBIT is the foundation of EBITDA — Earnings Before Interest, Taxes, Depreciation, and Amortization.
So not only does SG&A drive profitability, it also drives the value of your business.
Diving Deep on SG&A
While this varies by industry, often the two biggest buckets of SG&A expense are buildings and people. In accounting terms, Plant, Property and Equipment Expense (often consisting of rent, maintenance, property insurance, etc.) and General Overhead Expense (consisting of administrative and “non-productive” staff, office expense, workers comp and other insurance benefits, and other miscellaneous benefits like vacation, paid time off, etc.). Facility expenses tends to be rather fixed, and general overhead tends to be somewhat variable, but not completely variable.
These two buckets are a major portion of SG&A expense. There are specific metrics for facility expense depending on your business, geography and customer mix. But the large players in every industry have specific metrics they look at for both overhead payroll expense and facility expense. If you want to compete with these large players, it pays to know what their metrics are.
The Bottom Line
A profitable business requires a focus on both direct expenses as well as indirect expenses. Or, a focus on both gross profit and operating profit. SG&A consists of indirect expenses, and can be as important, if not more important, of a role as direct expenses and gross margin. If you are looking to build a profitable business that increases in value over time, or looking to buy a business that will do that, a focus on both gross and operating margins is key.
Taking control of your SG&A (and therefore a better position from your EBITDA) can help you get a better sale price when it comes time to exit your business and will also make you more competitive in the market.
I’m eager to know how you feel you stack up. Do you look at their cost structure and compare it to your own business? If so, let me know how you compare with other businesses in your industry. If you’re way ahead, congratulate yourself on a job well done.