Chapter 12: Selling, general, and administrative expenses

On the income statement under the heading of Selling, General & Administrative (SGA) Expenses is where the company reports its costs for direct and indirect selling expenses and all general and administrative expenses incurred during the accounting period. These include management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.

With a company like Coca-Cola, these expenses run into the billions and have a tremendous impact on the company’s bottom line. As a percentage of gross profit, they vary greatly from business to business. They even vary with companies like Coca-Cola that have a durable competitive advantage. Coca-Cola consistently spends on average 59% of its gross profit on SGA expenses. A company like Moody’s consistently spends on average 25% and Procter & Gamble consistently spends right around 61%. “Consistently” is the key word.

Companies that don’t have a durable competitive advantage suffer from intense competition and show wild variation in SGA costs as a percentage of gross profit. GM, over the last five years, has gone from spending 28% to 83% of its gross profits on SGA costs. Ford, over the last five years, has been spending 89% to 780% of its gross profits on SGA expenses, which means that they are losing money like crazy. What happens is that sales start to fall, which means revenues fall, but SGA costs remain. If the company can’t cut SGA costs fast enough, they start eating into more and more of the company’s gross profits.

In the search for a company with a durable competitive advantage the lower the company’s SGA expenses, the better. If they can stay consistently low, all the better. In the world of business anything under 30% is considered fantastic. However, there are a number of companies with a durable competitive advantage that have SGA expenses in the 30% to 80% range. But if we see a company that is repetitively showing SGA expenses close to, or in excess of, 100%, we are probably dealing with a company in a highly competitive industry where no one entity has a sustainable competitive advantage.

There are also companies with low to medium SGA expenses that destroy great long-term business economics with high research and development cost, capital, expenditures, and/or interest expense on their debt load.

Intel is a perfect example of a company that has a low ratio of SGA expenses to gross profit, but that because of high research and development costs has seen its long-term economics reduced to just average. Yet if Intel stopped doing research and development, its current batch of products would be obsolete within ten years and it would have to go out of business.

Goodyear Tire has a 72% ratio of SGA expenses to gross profit, but its high capital expenditures and interest expense--from the debt used to finance its capital expenditures--are dragging the tire maker into the red every time there is a recession. But if Goodyear didn’t add the debt to make all those capital expenditures/improvements, it wouldn’t stay competitive for very long.

Warren has learned to steer clear of companies cursed with consistently high SGA expenses. He also knows that the economics of companies with low SGA expenses can be destroyed by expensive research and development costs, high capital expenditures, and/or lots of debt. He avoids these kinds of businesses regardless of the price, because he knows that their inherent long-term economics are so poor that even a low asking price for the stock will not save investors from a lifetime of mediocre results.