Analysing companies’ operating expenses

In the >previous article of this series, we had a brief look at how one could analyse a company’s income over a particular period. In today’s article, we will take a look at the key expenditure constituents (operating costs) of a company and how one could view and analyse these over a particular period.

Operating expenses can be broadly segregated into 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, the cost 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 be a part of COGS as they are related to the manufacturing process. To give a similar type of example for a service company, such as an IT firm, costs of software development will be its COGS. This will include costs of the software developers.

A common method to calculate COGS is shown below.

COGS = Opening stock of inventory + purchase of goods – closing stock of inventory

COGS can be calculated by 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. 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 starts with Rs 10 m worth of inventory, makes Rs 2 m in purchases and ends the period with Rs 8 m in inventory, its cost of goods for the period would be Rs 4 m (Rs 10 m + Rs 2 m – Rs 8 m).

SG&A: The SG&A head includes costs that are not part of the manufacturing process. As such, this category includes the cost 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 could one analyse operating costs?

For analysing operating expenses, a common method is to compare each cost head to the sales of a particular period. We shall take the help of an example to understand this point better. Below we have given the break-up of the various cost heads of Indian food major, 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).

During FY07, raw material costs firmed nearly 64 per cent of sales. However, during FY08, raw material costs increased by 11.1 per cent YoY in absolute terms, but as a percentage of sales, it dropped by 3.5 per cent YoY. Further, employee costs increased by 18.1 per cent YoY in absolute terms during FY08, but when compared to sales, these remained flat at 3.5 per cent. On the other hand, advertising costs increased by 32.5 per cent YoY in absolute terms during FY08.

As raw material forms a major part of Britannia’s expenses, a slower increase in their cost (as compared to sales) has helped the company boost its margins by 3.1 per cent YoY.

Similarly due to lower other expenses, the company was marginally able to improve its operating margins. However, as advertising costs do not form a big part of the company’s expenses, when compared to sales, these increased by a mere 0.8 per cent YoY.

Likewise, if you can follow this method for companies over a long run, it would help you analyse and view the trend expenses over a long period.

In the next article of this series, we will take a detailed look at interest and depreciation costs and how one should analyse them.

This article is authored by >Equitymaster.com , an independent equity research initiative.

Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.

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