Seizing control of SG & A: any benchmarking of selling, general and administrative expenses can be tricky, and companies treat such expenses in very different ways. Taking a holistic approach and observing certain caveats can help bring such expenses in line.

It goes without saying these days that reducing costs and maximizing productivity are paramount to staying competitive. During the recent economic downturn, few areas within companies escaped the chopping block, including selling, general and administrative expenses (SG & A). Now, with margins pressured in many industry sectors by increased energy and other commodity costs, companies are looking for new ways to minimize expenses, achieve lean overall business operations and regain their competitive edge.

The fiduciary responsibility to curtail corporate overspending remains every bit as significant in good times as well as in bad. It is not surprising, therefore, that SG & A spending--often highly discretionary in nature--is a ripe target for cost reduction.

Most companies have worked to minimize costs in manufacturing and operations. As challenging as these reductions are, they are more straightforward than containing SG & A. After all, some SG & A costs may be mandated by law or are necessary for business operations. Others are potential revenue producers. Some costs are growing as, for instance, reporting requirements increase under The Sarbanes-Oxley Act. Others are declining, as the outsourcing of selected SG & A activities grows.

Although challenging, there are very powerful ways to sort out the complexities associated with containing SG & A and contributing fundamentally and permanently to the bottom line.

How Should You Benchmark SG & A and Set the Right SG & A Targets? Truly comparable benchmarking can be useful in defining SG & A spending target ranges. Unfortunately, the highly variable way that SG & A is treated by different companies makes it difficult to understand how to benchmark SG & A costs and how to set fact-based SG & A spending targets.

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If you ask several CFOs what is in their SG & A buckets, you'll likely get different answers. Some include R & D; others do not. Some account for a high percentage of SG & A costs in the SG & A cost category, while others may account for considerable SG & A headcount and cost in the cost of goods sold (COGS). Human resources costs, for example, might show up in both SG & A and COGS. The same may be true of finance, supply chain management, IT costs and others. This is clearly illustrated in an analysis of Cost Management Index, or CMI, which represents COGS plus SG & A. In this analysis, spending seems to flow fairly readily between SG & A and COGS (see box, "The SG & A Shell Game").

In fact, appropriate SG & A levels cannot be set without evaluating "shadow spend," which refers to categories of spending that are SG & A-oriented but are categorized as COGS. Examples include plant-level HR and controlling functions. This shadow spend has run up to 50 percent of SG & A categorized expenses in some cases. There are many examples of companies playing the SG & A "shell game" by moving expenses and resources to COGS from SG & A and vice versa. Redundant roles and responsibilities also may exist between "shadow" and conventional SG & A organizations.

This shifting of funds means that SG & A-categorized spending is, in and of itself, not completely rational. Further, PRTM analysis clearly shows that SG & A spending is correlated to gross margin, not to any rational driver. (see box, "The More Companies Have, the More They Spend").

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Complicating the ability to benchmark is the fact that SG & A is "sticky," with costs increasing .55 percent for every 1 percent increase in sales, and decreasing only .35 percent for every 1 percent decrease in sales. Shedding poor businesses does not, therefore, translate into a proportional reduction in SG & A.

All of these complications mean that benchmarks need to be applied on a CMI basis with known COGS removed. Setting the right SG & A targets requires triangulating such benchmarks with maintenance of the business, or MoB, the minimum spending required for survival mode-level spending. MoB excludes investment in growth and strategic initiatives. Once MoB levels of SG & A spending are set, executives can then rationalize the value of associated incremental spending above MoB.

How Do You Size SG & A Without Endangering Business Performance? Many financial executives want to know how they can cut headcount as much as possible. But, focusing on headcount reductions without considering critical strategic priorities, such as the need to integrate acquisitions and opportunities to improve efficiencies, only leads to a short-term income boost and eventual self-defeat.

Consider a company that had targeted significant growth through acquisitions. Every time this company did a deal, management would temporarily take people from their day-to-day jobs and focus them on integrating IT, HR, Finance and other operations. Unfortunately, this company decided to reduce SG & A, without any consideration of future integration support. So, when the next round of acquisitions came, few resources were available to adequately support the integration, dramatically increasing risk to the business. For this company, optimal SG & A spending required its building acquisition integration capabilities into the organization.

Another company wanted to significantly cut its environmental health and safety (EHS) expenses. After conducting a thorough distribution of effort (DoE) evaluation, an analysis that establishes how personnel across the company actually spent their time, it was determined that the potential risks associated with cutting EHS expenses were too high. However, the DoE analysis clearly revealed overlaps and how best to optimize EHS support. The company ended up replacing higher-paid EHS managers with lower-paid technicians, since it was the technicians who performed the vast majority of the on-site EHS support work.

In another situation, a commodity-oriented company wanted to significantly reduce marketing and sales costs. After conducting DoE and customer profitability analyses, it was determined that the company's sales and marketing organization was far from optimally deployed. Marketing activities were fragmented. Sales representatives were spending less than 25 percent of their time actually selling, in part because they were spending 45 percent of their time managing orders. On the other hand, the order management group, which was part of the sales organization, was only spending 40 percent of its time executing orders.

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In addition, some customers with lower EBITDA (earnings before interest, tax, depreciation and amortization) were over-serviced, while others with much higher EBITDA were under-serviced. A new, lean sales and marketing organization addressed these issues by consolidating order management into the supply chain function, by increasing less costly in-house sales support and by reducing the number of highly paid direct sales representatives, many of whom had been spending much of their time servicing unprofitable accounts.

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What is the Best Way to Balance Shared Services and Distributed SG & A? Over the past few years, companies have moved towards standardizing and consolidating shared services into centrally shared service groups in order to reap significant costs savings. However, it can be difficult to find the right balance of local versus central support. When consolidating services, it is critical to differentiate among the often very different requirements associated with different business units (BUs). It is also critical not to allocate costs back to the BUs based on sales, but to apply an activity-based approach.

Without these considerations, executives run the risks of implementing a "one size fits all" approach, which often results in increased cost for some BUs. For example, one company that PRTM worked with had a combination of growth-oriented specialty and cash-generating commodity businesses, each of which had very different HR support needs. The growth-oriented businesses valued high levels of hiring and organizational development support; they were hiring new people and acquiring new businesses.

However, the cash-generating commodity businesses did not value such services; their workforces tended to be well established and long-serving, with very low turnover. After going to a centralized shared services approach, these BUs' HR costs actually increased over 20 percent.

In addition to receiving higher levels of service than they actually needed, these businesses lost critical capabilities. The "one size fits all" solution eliminated critical plant HR personnel whose primary role had been to manage the unions for BUs with unionized workforces. The result was significantly increased tension between these businesses and unionized employees.

As these examples demonstrate, it is critical to determine the appropriate service levels for each BU and the appropriate associated charge-out mechanisms by establishing how internal markets for shared services should be segmented. This can be based on growth rate, acquisition plans, cash generation and profitability targets, as well as other critical parameters that influence required SG & A support.

By taking a holistic approach to managing total cost, financial executives have the power to reduce total costs, while maintaining critical added value to their businesses. Companies that adopt such an approach can tame SG & A spending by understanding their companies' true SG & A costs and by setting the right targets. Companies that do this can expect permanent reductions of 25 to 50 percent to their SG & A cost base.

The More Companies Have, The More They Spend

Can appropriate SG & A spending levels be determined based on rational drivers? To find out, PRTM analyzed the same chemicals and food & beverage industry data and tested it with hypothesized business attributes, which should drive SG & A levels. For example, business and product complexity, geographical footprint, number of products, business size, channel strategy and similar factors should all significantly influence SG & A.

The results were surprising. After attempting to correct for the differences in SG & A spending due to accounting treatment, no correlation between hypothesized SG & A drivers and actual SG & A spending exists. On the contrary, companies appear to spend more if they have more to spend. As figure 3 illustrates, there is a strong correlation between SG & A and gross margins.

RELATED ARTICLE: The SG & A Shell Game

PRTM analyzed chemicals and food and beverage companies' SG & A spending to see how it related to cost of goods sold (COGS). For the analysis, PRTM collected data on approximately 100 companies for fiscal 2000-2003 in these two industries. The sample was limited to public information available from the SEC.

From the data, it was apparent that companies tend to play a "shell game" by shifting costs between the SG & A and COGS buckets. As Figure 1 illustrates, companies are generally distributed along the Cost Management Index (CMI) Frontier (CMI represents COGS plus SG & A). This distribution is the result of moving expenses between SG & A and COGS: as SG & A increases, COGS decreases and vice versa, while CMI remains constant.

If we focus on CMI versus Net Income (Figure 2) we see a more realistic picture of how the cost picture plays out. Focusing on total cost reduction will increase net income. Therefore, meaningful cost reduction needs to enable movement across the CMI frontier by reducing total costs; focusing on a single metric provides a false snapshot.

Tavor White ([e-mail]) is a Director and Eric Dieckman ([e-mail]) is an Associate with PRTM, a management consultancy that helps companies make improvements in best practices, IT-enablement and core business processes.