4. Operating Expenses

 
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Overview

Operating expenses such as sales and marketing are those that cannot be directly tied to revenue. In this lesson, I analyse the operating expenses of MarkerCo, line-by-line.

Lesson Notes

Operating Expenses

- Operating expenses are those that cannot be matched directly to revenue
- Examples include:
--- Research and Development
--- Sales and Marketing
--- General and Adminstrative
--- Depreciation and Amortisation

Depreciation and Amortisation

- Special entries in the income statement because they do not directly cost money
- Account for the gradual reduction in value of company assets
- Depreciation covers tangible assets (e.g. manufacturing equipment)
- Amortisation covers intangible assets (e.g. patents, brand)
- SG&A / Gross Profit tells an analyst how much a company's running costs affect profit

Transcript

Below gross profit on the Income Statement are operating expenses. These are all the expenses that can not be directly matched to revenue, and include research and development costs, selling and marketing expenses, general and administrative expenses, and lastly depreciation and amortization. Let's go through these line items now in detail. Research and development is pretty straightforward. When a company is developing a new product, it requires upfront costs that are not directly related with revenue. Pharmaceutical companies can often have higher R and D costs as opposed to say a hotel operator, which may have hardly any. Next up are sales and marketing expenses. This is a crucial entry in some businesses, for example B2B Software, where this expense line item can be by far the biggest operating expense. Let's take a look at the Income Statement for Box, a cloud storage company as an example. From their Income Statement, sales and marketing is by far the biggest expense, dwarfing even the cost of goods sold. Underneath sales and marketing expenses, are general and administrative. Sometimes these two items are grouped together, but it's better for the analyst if they are not. General and administrative include period costs such as payroll, legal fees, management salaries, etcetera.

When it comes to these two entries, I like to understand what percentage of gross profit, selling, general and administrative comprise of. In the case of MarkerCo, let's find out. I'll create a new row with "Alt + I, R," and I'll entitle this, "SG and A divided by gross profit," and this will equal to E17 plus E16, divided by the gross profit.

And I'll copy across for the remaining cells, and convert into a percentage. And I'll just italic this line, as well.

And as you can see, SG and A makes up between 33 and 38 percent of our gross profit during the last four years. This doesn't show a lot of variability, but it is something the company might want to monitor as it continues to grow its business. In general, companies performing well have a consistent SG and A divided by gross profit percentage that does not deviate too much over time. Companies in trouble can see huge jumps in this percentage as revenue falls in a bad year, but the SG and A remains constant. If the company can't cut SG and A fast enough, it can start eating into the companies profits very quickly. The last item under operating expenses here is depreciation and amortization. Depreciation is a loss incurred due to the wear and tear of tangible assets such as machinery and buildings. Say, for example, MarkerCo buys a machine to make a new hardware product for $2 million. The machine has a lifetime of 10 years. Every year of the machine's life, I need to incur a loss to account for this gradual wear and tear. Different methods of depreciation are used in different cases, but straight-line is the easiest to understand. In the example above, under straight-line depreciation, the value of my machine falls by the same amount every year, which is 200,000. Note that I don't actually pay the $200,000 out in cash, but I must recognize it as a loss on the Income Statement. Depreciation is applied to tangible assets such as buildings and machinery, whereas amortization is applied to intangible assets, such as patents.

As you can imagine, depreciation and amortization require some interpretation on behalf of the company, and as a result, can be manipulated to adjust earnings. Say, for example, I operate a fleet of trucks with a depreciated life of eight years. If I change the depreciated life to 12 years, this could boost my profit substantially. As a consequence, analysts need to have a good understanding of a company's depreciation and amortization policies, particularly in asset-heavy industries, like haulage and manufacturing. Once I subtract all of these operating expenses from gross profit, I get earnings before interest and taxes, commonly called EBIT. Let's now explore how we go from EBIT to net profit in the next lesson.