SGA expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. 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. This can be accomplished through cost-cutting initiatives and employee lay-offs.
There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit. According to Roger Loweinstein, in the 1980's, ABC (later merged with CAP Cities, then bought by Disney) 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. (On a related note: at the same time these ABC executives were squandering shareholders' capital, they were artificially padding earnings by selling the original Jackson Pollack and Willem de Kooning paintings the network owned!)
SGA Expenses and Fixed vs. Variable Cost Structure
There is a big 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 lot of profit beyond that level. A perfect example is a McDonald's franchise. Due to the high initial investment in land, building, cooking equipment, restaurant seating, fixtures, and other costs, you may have to do, say, $800,000 to $1,000,000 or more to breakeven. Beyond that point, your costs are covered so you generate far higher profits. That's why a business can fail if sales fall 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.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.