The Hindu Business Line : Make the most of those costs!

As much as a company would like to quell it, it’s almost impossible to operate without incurring expenses. While extolling expenditure’s key role in a company’s performance appears rather pointless, it is worth to note that expenditure wields a considerable influence on a company’s profitability, margins and, of course, what is left for its shareholders. Read on to understand how to analyze expenditure when evaluating companies.

How has it grown?

Sketch how total expenditure has moved over a period of time, say, three years or more, as well as quarterly, giving you a general idea of the trends in expenditure. Compare these with movement in sales figures. If both are in tandem, it may be assumed that expenditure contributes to sales; the company is able to generate sales proportional to the amount its spending to produce its goods or render services. For example, sales growth of construction player CCCL beats that of expenditure in the past three years, averaging 70 per cent versus the 67 per cent clocked by expenditure-meaning the company has been able to translate increased expenditure into higher sales every year.

That said, where expenditure growth outpaces sales, flag it red; it may mean that either the company is unable to generate sales or its expenses are spiralling. While slower growth in expenditure over that of sales is ideal, a marginal increase may be acceptable. To differentiate the good expenditure from the bad, ferret out possible reasons—sudden spikes in raw material cost (a phenomenon that eclipsed earnings in the second and third quarter of the current financial year), temporary sales slowdown and so on. These reasons, however, hold good only as long as they aren’t regular; if heightened expenses are here to stay, you may have to rate the company on its ability to prune cost without affecting its sales as much.

However, keep in mind that some costs are fixed and cannot be cut simply because sales are going through a rough patch. For instance, retail companies face fixed costs in rentals on shop space, store maintenance and so on, incurred regardless of how sales are faring.

Break it up

Once you get the general trend in expenditure, determine its drivers. A proportional break-up of the expenditure gives an idea of its biggest contributor. For most companies, this would be raw material and the like.

For instance, rubber is the key input for tyre manufacturers. A run up in rubber prices last year was followed by a drop in the later months, now showing signs of a recovery. During times when prices of key inputs are as erratic, manufacturers need to design strategies to deal with such price fluctuations to determine how costs will affect profits and margins. In another example, for jewellers, though gold is the main raw material, gold price run-up may not inflate costs since they are passed on to customers. The squeeze here may actually be on the customers’ side, showing up in demand.

As with total expenditure, look at movement in individual expenditure heads to spot trends therein, again comparing these to that of total expenditure and sales. Note that some expenses may be critical to a company, even if they don’t contribute the most. These may vary according to industry; their identification, and the direction they are likely to move henceforth, will help predict cost and margin movement.

For example, employee costs are critical for services companies such as IT or retail, where workforce is substantial and is the medium through which services are rendered. For a manufacturing set-up, however, it is power and fuel used for powering factories, transport and the like that make for high costs.

Room for more

Take the proportion of total expenditure to sales to check how far sales is being eaten up by expenses essential to run the business. Interest costs and depreciation will further have to be incurred, so operating costs must leave room for these. Taking out that proportion of must-incur expenditure works as an indicator of the cushion available to absorb any future expense surges.

Need more details?

Notes to the accounts give details of the individual expense heads. Annual reports indicate cost structuring initiatives or reasons behind cost run ups. Earlier years’ reports may be used to see if any cost strategy has beendevised, which, compared with expenditure in later years may verify the efficacy of implementation.

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