How to interpret key expenses of a company

In the previous article of this series, we had a brief look at how one could gauge a company's income over a particular period. In this article, we will take a look at the key expenditure constituents (operating costs) of a company and how in equity research one could analyse these over a particular period. Operating expenditure forms an essential part of investment analysis. The reason being that over long term, the company’s revenue model should be such that it is able to recover its operating expenses. If it is unable to do so in the short term, it would have to cut down expenses or even shut down production. If the trend continues over a longer time horizon, the company would have to look at alternate revenue models or shut down operations completely.

Operating expenses can be broadly segregated into two categories - cost of goods sold (COGS) and selling, general and administrative expenses (SG&A).

COGS: COGS are direct costs that a company incurs for producing or providing a product or service. These costs are directly attributable to the production of goods or services. For example, costs of items such as flour, sugar, fats and oils (various raw materials), laminations rolls (packaging material), amongst others will be the COGS for a biscuit manufacturer.

In addition to these expenses, costs such as power and fuel, wages, rent (of manufacturing unit), repair and maintenance (plant and machinery), amongst others will also form part of COGS as they are related to the manufacturing process. To give a similar type of example for a service company, like an IT firm, costs of software development will be its COGS. This would mainly include costs of the software developers.

While there are several ways of calculating COGS, a common method used is as follows.
 
COGS = Opening stock of inventory + purchase of goods- closing stock of inventory

Adding the opening stock of inventory with the total amount of goods purchased in a particular period and subsequently, deducting the ending inventory from it is a common way of calculating COGS. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period.

For example, if a company begins a year with Rs 10 m worth of inventory, makes Rs 2 m in purchases and ends the period with Rs 8 m in inventory, then its cost of goods for the period would be Rs 4 m (Rs 10 m + Rs 2 m – Rs 8 m).

If an individual is able to identify the costs related to the manufacturing, he should ideally add it to get the accurate figure.

SG&A: The SG&A cost head includes expenses that are not part of the manufacturing process. As such, this category includes costs of items such as marketing, salaries, electricity (office), travel, advertisement, office maintenance, rent (office), auditor costs, and distribution charges, amongst others. To take forward the example of the biscuit manufacturer, advertising costs, cost of distribution, the cost of labour used to sell the biscuits would all be part of SG&A. For an IT firm, SG&A costs would include cost of salaried employees which form part of the sales, marketing and admin teams.

How to analyse operating costs?
For analysing operating expenses, a common method is to compare each cost head to the sales of a particular period. The main idea for such analysis is to understand the long term expenses trend of a company.
We shall take help of an example to understand this point better. Below we have given the breakup of the various cost heads of Britannia Industries. We have compared each cost head to the respective year's sales figure also shown the change in expenses in absolute terms and in terms of percentage (of sales).

	FY10		FY11		Change
Items	Amt	% sales	Amt	% sales	Amt	% sales
Net Sales	34,035	100.0%	42,137	100.0%	23.8%
Expenditure
Consumption of Raw Materials (i)	21,636	63.6%	27,643	65.6%	27.8%	2.0%
Employee costs (ii)	1,058	3.1%	1,199	2.8%	13.4%	-0.3%
Advertising costs (iii)	2,688	7.9%	3,041	7.2%	13.2%	-0.7%
Other operating expenses (iv)	7,030	20.7%	8,013	19.0%	14.0%	-1.6%
Total operating expenses (i + ii+ iii +iv)	32,411	95.2%	39,897	94.7%	23.1%	-0.5%

During FY10, raw material costs formed 63.6% of the company’s sales. However, in FY11, raw material costs increased by 27.8% YoY in absolute terms (a faster rise as compared to the growth in revenues), thereby increasing by 2% YoY as a percentage of sales. All the other major expense heads declined as a percentage of sales during FY11. For instance, employee costs increased by 13% YoY in absolute terms. However, when compared to the percentage sales figure of the previous year, the same declined by a marginal 0.3% YoY

As you would have noticed, raw materials form a major part of Britannia's expenses. As such, a faster increase in raw materials costs (as compared to the increase in sales) would have impacted the company’s margins had it not been for the slower increase in other major cost heads of the company.
 
In the next article of this series, we shall have a discussion on interest and depreciation costs.