How do you know what the RIGHT balance is for SG&A?

As a Fractional COO, why would you want to answer a question like that? Would that not be for the CFO to understand? Yes, but as the COO plays a large role in helping understand what level of cost the business can manage while still servicing clients and customers as well as attaining the optimal EBITDA for the year. Several models can be created to understand the right amount of SG&A (Selling, General, and Administrative) expenses for a business. Here are some of the most common and effective approaches:

1. Historical Analysis and Trend Forecasting:

• Method: Analyze past SG&A expenses as a percentage of revenue over several periods (e.g., 3-5 years). Identify trends (increasing, decreasing, or stable) and use these trends to forecast future SG&A needs.

• Pros: Simple to implement, provides a baseline for comparison. Helpful in a steady state business and market.

• Cons: Assumes past performance is indicative of future results and doesn't account for changes in business strategy or market conditions.

2. Industry Benchmarking:

• Method: Compare the company's SG&A-to-revenue ratio with industry averages or competitors. This helps determine if the company is spending excessively or efficiently relative to its peers.

• Pros: Provides external validation, highlights areas for potential improvement.

• Cons: Industry averages may not be perfectly applicable due to differences in business models, size, or geographic location.

3. Zero-Based Budgeting:

• Method: Start from scratch each budget period and justify every SG&A expense based on its necessity and contribution to business goals.

• Pros: Encourages cost consciousness and eliminates unnecessary spending. This is a great model where fiscal discipline is lacking.

• Cons: Time-consuming, requires a detailed analysis of all activities. Battle is that the staff may not understand the importance of “adjusting” headcount to this model.

4. Activity-Based Costing (ABC):

• Method: Identify the activities that drive SG&A costs (e.g., customer service, marketing campaigns) and allocate costs accordingly. This provides a more accurate understanding of the cost of each activity and helps identify areas for efficiency gains.

• Pros: Provides detailed insights into cost drivers and supports better decision-making.

• Cons: Complex to implement, requires accurate data collection. Requires discipline and data that can be easily found and explained.

5. Regression Analysis:

• Method: Use statistical techniques to identify the relationship between SG&A expenses and various business drivers (e.g., revenue, number of employees, customer growth). This helps predict SG&A needs based on changes in these drivers. “Flow-through” or “Drop-through” ratios are established.

• Pros: Provides a quantitative and data-driven approach, can reveal hidden cost drivers.

• Cons: Requires statistical expertise and reliable data, may not capture all relevant factors.

6. Cost-Benefit Analysis:

• Method: Evaluate each SG&A expense based on its expected benefits (e.g., increased sales, improved customer satisfaction) and compare them to the costs. This helps prioritize spending and allocate resources effectively.

• Pros: Focuses on value creation, and ensures resources are used efficiently.

• Cons: Can be challenging to quantify certain benefits and requires subjective judgment.

Important Considerations:

• Business Strategy: The right amount of SG&A depends on the company's strategic goals. A growth-focused company may invest more in sales and marketing, while a cost-conscious company may prioritize efficiency.

• Business Lifecycle: SG&A needs may vary depending on the stage of the business. Startups may have higher SG&A costs relative to revenue due to investments in infrastructure and marketing, while mature companies may have lower ratios.

• Qualitative Factors: In addition to quantitative models, consider qualitative factors such as organizational culture, risk tolerance, and management philosophy.

By using a combination of these models and considering the specific circumstances of the business, companies can develop a more comprehensive understanding of their SG&A needs and optimize spending for maximum efficiency and profitability.