Today, we’ll look at the other side of economies of scale in a common financial ratio used to forecast expenses: SG&A/Sales.

Fixed components of SG&A tend to give economies of scale to the SG&A/Sales ratio. Before taking an analytical approach (plotting %change in SG&A on the %change in sales each year), it is helpful to read the MD&A section of the 10k to uncover any potential movement in the ratio due to declared discretionary cost cutting. Also look for data on the historical movement of the ratio. Assuming there is evidence of economies of scale, plotting the ratio over time should give us an upward trend with %change in SG&A plotted on the Y-axis and %change in Sales plotted on the X-axis. In particular, the slop will be significantly less than one.

If the slope of the line is flatter when the %change in sales is negative, it also indicates that SG&A costs are declining but at a much slower rate. Therefore, it is harder to cut costs in bad times than it is to increase costs in good times! So when sales drop, economies of scale actually “cause” costs to stick around more. The point is that most managers tend to think of economies of scale as a GOOD THING: when sales increase costs do not increase as rapidly. True, but when sales decline the sword cuts the other way – costs do not fall as rapidly as sales.

This is typically the case when a firm is stuck with a cost structure that has a large fixed cost component. While it helps achieve economies of scale, it also imposes “operating leverage”, a type of risk, on the company. If the sales volume is highly variable then in periods of low volume the firm will be left high and dry, with all the fixed costs hanging around without sufficient sales to cover them, resulting in negative EBITDA margin!

There seems to be no way around this. A firm could reduce its operational risk by “renting” the infrastructure it needs for operations. However, when average selling price goes up, the renters jack up their rental fees, cutting into the potential profit margins of the risk-averse firm. No risk duly leads to minimal reward.

Hope you enjoyed this post!