There’s no way around selling, general, and administrative (SG&A) costs. Regardless of how lean your clients are able to make their small businesses, they’ll always have bills to pay that don’t directly relate to making products or providing services. Here’s a few common ways SG&A costs are allocated, why these methods don’t always work, and what you can do to help your clients overcome common pitfalls.
Traditional Methods Are Always Correct, Right?
There are a few common ways to allocate SG&A costs. One is the percentage-of-sales method. Divide your client’s total SG&A costs by total revenue. This percentage represents the amount of SG&A costs allocated to each product line. If 20% of the expenses are SG&A costs and the best product line sold $500,000, $100,000 of SG&A would be allocated to this product line. Another common method is cost-of-sales allocation. Under this method, you allocate SG&A costs based on the expenses incurred compared to other product lines. These two methods help provide more information on how to price goods. Unfortunately, these and other arbitrary methods of spreading SG&A costs don’t help price your client’s products correctly. There’s more to consider than just total revenue or total costs.
Distortion From the Cost of Materials
When your client makes a product, it needs to buy materials. Some of these products naturally cost more than others. Some of the materials are harder to come by or your client may need a larger quantity per good. This means product lines with higher materials costs receive more allocated overhead costs such as rent and utilities. Using traditional methods of spreading SG&A costs based on profit margins penalizes the products that cost more just based on what goes into them.
To work around this issue, allocate your client’s costs based on the labour and overhead costs that go into each of those products. To start, add direct labour and direct overhead costs for your client’s entire company. Then, divide this total into total SG&A costs. This new allocation method disregards your client’s materials cost and instead emphasizes the amount of time spent on each product line.
Distortion From Market Segments
Your clients don’t always sell to the same customer group. They might work directly with individual customers. For some products, they may work with retail outlets or manufacturing plants. Some of their goods may be sold in bulk to general contractors. Each of these markets has different shipping practices that can’t be accurately reflected through general allocation. Normally, all of your client’s selling costs would be added together and spread based on what their goods cost or sold for. Instead, some of these costs should be spread based on to whom the goods are sold. Take your client’s actual shipping, warehousing, advertising, delivery, and other costs and aggregate them based on each customer group. Ideally, you’re able to look at these costs over a period of time. Using this information, you can create an estimated rate to apply. Every once in a while, check to see if the rate is reasonable. After a one-time setup of seeing what the costs are actually like across markets, you can use this rate to apply SG&A costs.
Distortion Caused by Sales Volume
Some of your client’s product lines will do better than others. This is especially true if products are seasonal. If this is the case, it’s harder to spread SG&A costs using arbitrary methods because the allocation rates won’t be consistent. For instance, your client’s sweatshirt product line will have higher allocation rates during the winter. If it also sells socks year-round, the allocation rate for socks will fluctuate during the year. Even if it spends the exact amount of SG&A on socks across two months, the amount of costs allocated in June would be substantially lower than in December. To avoid running into allocation of cost issues based on sales volume, consider sticking some product lines with a fixed allocation rate. Give certain products a set amount of SG&A costs. In the example above, socks could receive 5% of SG&A costs every month or a set $1,000 per month.
Distortion Impacts Pre-Tax Profits
Each of the distortions mentioned above impacts your clients’ net income in more than one way. Not only are they potentially allocating too much or not enough SG&A costs, they may be incorrectly calculating the amount of tax each product line or department is responsible for. For example, say their best product line earned $100,000 of revenue, and had $60,000 of direct expenses and $5,000 allocated SG&A costs. A 20% tax rate means the department also has $7,000 of tax expense. If you were to adjust the amount of SG&A to $15,000, your client’s net income before taxes decreases to $25,000 and the allocated tax is $2,000 less. This 2% could incorrectly be a factor that your client considers when evaluating product lines.
There’s no perfect way to trace every expense to every product your client makes. Because there’s a certain level of guessing involved when allocating SG&A costs, be mindful of common pitfalls that distort the spread. These inaccuracies can lead your client to incorrectly price its goods or make business decisions based on inaccurate information. It’s okay to allocate SG&A costs; just know how to avoid or correct the downfalls that standard allocation methods create.