In the tech world, SG&A costs occupy a large part of the company’s costs. For many companies, these costs will inevitably occupy a high cost on the income statement.
The higher expenses make sense if we think about it a little. Because a company like Crowdstrike sells software as a service, the creators (people) of the service help Crowdstrike grow and its competitive advantage.
Crowdstrikes people are the assets because they don’t have factories creating their products.
Selling, general & administrative expenses have changed over the years. They have become assets to the company, depending on the business model. Sales teams can make or break a company, especially in the SaaS world.
In today’s post, we will learn:
- What Are SG&A Expenses?
- Different Types of SG&A Expenses
- Accounting for SG&A Expenses
- Real-World Examples of SG&A Expenses
- Digging Deeper Into SG&A Analysis
Okay, let’s dive in and learn more about the selling, general & administrative expenses.
What Are SG&A Expenses?
In a company’s income statement, the selling, general, and administrative expenses (SG&A) category comprises all general and administrative costs (G&A) and all direct and indirect selling costs. All expenses included in this line item don’t relate to producing a good or providing a service. The expenses include running the business and providing its goods or services.
To simplify today’s post, we will refer to selling, general & administrative expenses as SG&A going forward.
In determining a company’s profitability and break-even point, SG&A is crucial. Additionally, SG&A is among the first areas managers attempt to cut staff after mergers or acquisitions. Because of this, a management team hoping to increase revenues rapidly will find it an easy target.
We can separate direct and indirect costs when it comes to selling expenses. Costs associated with direct selling only appear after selling a product. The company will incur indirect selling both during and after the product’s production.
The company’s overhead consists of G&A costs. The G&A costs may not tie to any one department or function. The reason why is they may not incur during regular business activities.
G&A costs remain one-time costs regardless of production or sales.
Many SG&A expenses remain unavoidable. For example, companies must carry insurance to maintain their headquarters. They can’t avoid the cost, which can run at higher levels.
Different Types of SG&A Expenses
Let’s look at the different types of SG&A expenses by each category:
- Selling expenses
- General expenses
- Administrative expenses
Selling expenses connect to the costs required for the business to communicate with clients directly. These kinds of costs consist of the following:
- Selling costs. Selling costs include salespeople’s salaries, wages, commissions, payroll taxes, and perks.
- Marketing. Marketing costs could include costs directly connected to a business’s product range, services, brand, or image. Although some businesses may have sufficient justification to separate these charges, a corporation may combine marketing and advertising expenses.
- Advertising. These costs can take on any shape, and a business can use numerous distinct general ledger codes to hone further how it accounts for advertising.
- Travel expenses. These expenses involve in-person occasions or professional commitments like trade displays or client meetings.
Running a business frequently requires paying general expenses. Regardless of the kind of business a firm operates in or the industry it produces for, they need to pay for these expenses. These kinds of costs consist of the following:
- Rent. Companies include the expense of renting an office or headquarters, but it may also include additional necessities for rent that are unrelated to the manufacturing process.
- Utilities. These relate to costs for utilities such as energy, water, sewer, or waste that are not necessary for manufacturing.
- Office supplies. These cover expenses such as equipment rentals and one-time, immaterial charges that don’t meet capitalization standards.
- Supplies. Supplies contain standard office equipment required for administrative staff to do their duties.
- Insurance. This comprehensive coverage is essential for running the company.
The cost of staff closely connects to administrative costs. These folks could be internal employees or outside contractors. These persons frequently have no direct involvement in the production or sale of commodities. These kinds of costs consist of the following:
- Human resources payroll
- Accounting payroll
- Information tech/IT payroll
- Legal counsel – can include in-house or external expertise
- Consulting fees – often paid for third-party expertise
Regarding income statements, we can see whether companies separate or combine these expenses. For example, Microsoft separates sales and marketing from general and administrative, whereas Roper Technologies lumps them together.
Each company will list them as they see fit, depending on how they think it will impact investors.
The bigger takeaway: understand the different expenses and their impact on the business.
Accounting for SG&A Expenses
SG&A sits on an organization’s financial statement. The gross margin always shows below the net revenue, which we always see at the top. The list of expenses, including SG&A, follows the gross margin.
Operating profit is the outcome after deducting these costs from the gross margin. It’s crucial to remember that we have not tallied all costs when estimating operating expenses. Some costs, such as interest and tax, are listed below as operating revenue.
A corporation has various options for reporting SG&A. Businesses can combine these costs into a single SG&A line or separate selling charges from general and administrative costs.
Healthcare and telecommunications industries have high SG&A costs as a percentage of revenue, compared to real estate and energy businesses, which have modest costs.
SG&A costs and operating costs are interchangeable. Both include costs associated with running a firm that is not related to the price of producing items.
Operating expenses and SG&A expenses differ in many minor ways. Since it is simpler for businesses to track and analyze costs in these groupings, larger companies divide these costs into smaller, more granular SG&A categories. When categorizing this cost, management has discretion over how they report many of these expenses on the income statement.
Some accounts may demand a particular approach that exempts them from SG&A. Costs associated with R&D, for instance, companies separate from SG&A.
Depreciation expenses are also included in this part of the income statement but not in SG&A.
We will see these types of separations in the next section. As mentioned earlier, Microsoft separates the expenses. As investors, it is nice when a company separates them; it gives us better clarity into particular expenses and their impacts.
The separation allows us to analyze the impact of R&D on revenues and how those investments pay off. It also allows us to see if a company runs up payroll too much or if there are any other impacts related to expenses.
As investors, we want as much clarity in the financials as possible.
The more clarity a company provides, the better we can assess management and their execution. It’s all part of the game of assessing management. We want as many answers as possible without having to guess, and clear financials help give us clarity and indicate open management.
Take Berkshire Hathaway, for example.
Warren Buffett and his team will probably give us more information that we can use. But he remains the standard bearer of shareholder-friendly management.
Real-World Examples of SG&A Expenses
Let’s look at three companies’ financials to see how different companies list their SG&A expenses.
Microsoft reported its annual results on June 30, 2022. They reported $52,237 million of total operating expenses for the year. Of these expenses, sales and marketing made up $21,825 million, or 41% of operating expenses. The company also saw general and administrative expenses of $5,900 million or 11% of operating expenses.
We can see Microsoft breaks its operating expenses into three components:
- Research & Development
- Sales & Marketing
- General & Administrative
Next, we can look at Roper Technologies, which lists all its operating expenses under the selling, general & administrative under one umbrella.
The company’s latest annual report lists $2,333 million in operating expenses, excluding the one-time impairment. Diving deeper, we see Roper generated an operating income percentage of 25.6%. We can determine the percentage by dividing the operating income of $1,480.2 million by the net revenues (sales) of $5,777.8 million.
Operating income percentage = $5,777.8 / $1,480.2 = 25.6%
Lastly, if we look at Cloudflare’s latest annual report, ending December 31, 2021, the company also breaks the SG&A expenses into two separate buckets.
The company reported total operating expenses of $636.976 million. They saw sales and marketing expenses of $328.065 million or 51.5%, and general and administrative of $119.503 million or 18.7%
Cloudflare lost money from operations, which equals an operating income percentage of (19.4). The company is in a different stage of its life cycle than either Roper or Microsoft, which means it will reinvest aggressively to continue to grow.
In fact, the company stated they intend to manage operating expenses even with revenues continuing to grow. At some point, the company will evolve from the growth stage to a more mature point, a la Microsoft.
Microsoft still grows at a 14-16% clip, which at their size remains impressive. But, they grow much slower than Cloudflare, which is much smaller but grows in the 40-50% range.
In addition to the general and administrative categories, Cloudflare additionally explains in the notes to its financial statements what they include in the sales and marketing area.
Digging Deeper Into SG&A Analysis
Digging deeper into analyzing the operating expenses, we can compare SG&A expenses to revenue. Using these comparisons allows us to see trends in the company and possible comparisons among the industry.
For example, let’s use Cloudflare as our guinea pig. If we look at the last five years of results, we can see:
The chart above gives us a nice visual of the SG&A expenses compared to Cloudflare’s revenues. We can see that as the company scales up their revenues, they also scale up its expenses.
The percentages of SG&A to revenues can tell us a good story too:
- 2016 – 63.9%
- 2017 – 60.9%
- 2018 – 93.2%
- 2019 – 83.9%
- 2020 – 70.4%
- 2021 – 68.1%
- TTM – 66.8%
Costs associated with sales and marketing (S&M) merit more examination.
It may be unavoidable for any business software/tech company that S&M costs will be the largest cost line item on the income statement. It is intriguing how the sales commission amortizes for initial contract acquisition in various tech companies.
While CrowdStrike (CRWD), SentinelOne (S), and Salesforce (CRM) amortize their sales commission over four years, Cloudflare spreads the sales incentive over three years.
Even the sales commission is amortized over five years by Zscaler (ZS) and Palo Alto Networks (PANW). So, what is the right answer? Since it depends on the economy, retention, churn, etc., it isn’t easy to know from an outside perspective.
The fact that ZS and PANW amortize the sales commissions longer than CRM, which undoubtedly has a more durable platform than those companies, raises some suspicions in my mind.
These overly optimistic accounting projections may cause your operating margins to appear better than they actually are. Compared to the majority of the firms I looked at, Cloudflare’s amortization timeline is more conservative.
One of the reasons S&M expenditures are difficult to amortize over time for tech companies is that some (or maybe a significant portion) of them are effectively fixed costs.
Salespeople receive a base salary, of course, but a significant portion of their total remuneration is contingent on successfully gaining new clients and generating upselling, cross-selling, and renewals.
Salespeople receive a commission for any of these sales. Still, businesses decide how to spread out the commission over time, typically on a straight-line basis (for example, if a business spreads out a $100 sales commission over four years, it will account for $25 in S&M costs on the income statement in year one and the remaining held $75 on the balance sheet, which will then be amortized by $25 in each of the following three years).
As was previously mentioned, companies may have different amortization schedules (higher is more aggressive and lower is more conservative, all other things being equal), and their total compensation structures, such as commission rates or a base mix of salaries, may vary from company to company.
We can observe how drastically different the businesses mentioned above are if we look at how much sales commission they have capitalized on their balance sheets.
In 2021, Cloudflare’s capitalized costs as a percentage of S&M expenses were just 23.3%. Still, Palo Alto’s capitalized costs were 63.7% of S&M.
Since this is essentially your fixed costs going through your income statement over time, the larger the amount, the more difficult it is to quickly generate leverage on your cost base.
Therefore, if you made many sales hired in 2021, those expenses will continue to be amortized over the next two to four years, giving your income statement a fixed cost base. It may take some time for the cost optimization to completely reflect in your margins, even if you scale down hiring immediately.
As renewals have a lower commission rate than new customer sales, companies can benefit from leverage at maturity when weighing more heavily sales commission towards renewal than the commission for new customers.
In order for a company to enjoy S&M leverage, it must build a robust platform so that newly acquired customers renew at a fairly high rate.
To operate a business, a company must pay a wide range of costs unrelated to the production of certain goods. These general expenses fall under selling, general, and administrative expenditures. These costs are reported separately from COGS and subtracted from gross margin to determine a company’s net income.
As we have seen, analyzing the costs associated with operating the business, from the cost of goods sold to operating expenses, gives us insight into how management thinks. Plus, it gives us insight into where they are in the life cycle and how management invests in the company.
As we saw, Cloudflare and others in their industry invest in both R&D and SG&A.
They need R&D to build products and services to sell to the customers, and a company like Cloudflare lives and dies by product innovation. But they also need salespeople to find customers to buy those products and services.
And with that, we will wrap up our discussion regarding selling, general and administrative expenses.
Thank you for reading today’s post; I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,