Structured Approach to SG&A Expense Forecasting in Corporates

Classifying SG&A Costs by Behavior

The classification of SG&A (Selling, General, and Administrative) costs according to their behavior will help professionals understand the nature of these costs so that they know how to forecast them individually rather than using one growth rate for all SG&A expenses.

For example, SG&A costs may be classified as follows:
• fixed SG&A costs (e.g., rent, annual software license fees, statutory audit costs)
• variable SG&A costs (e.g., sales commissions, performance-based incentives, selling costs related to logistics)
• semi-variable SG&A costs (e.g., salaries, IT support costs, office maintenance costs).

Example of fixed SG&A costs are super competitive contractually and should be maintained for future projections. Variable SG&A costs might be based on an increase in revenue or sales volume, and can be forecasted with the aid of activity drivers. For semi-variable SG&A costs, the professional may exercise some level of judgment as to the rates that may be projected over time. Defining costs by their history allows professionals to incorporate reasoning into their projections. Thus, forecasts based on cost experiences will be more realistic and can be easily justified in a management review. Additionally, this definition allows for sensitivity analysis by observing how SG&A costs will change or react to changes in business assumptions.

Choosing the Right Forecasting Approach

Forecasting sales, general, and administrative costs (SG&A) can be done in multiple ways. The appropriate way to forecast will depend on the type of business, data available, and level of expectations by management. Most forecast analysts will use multiple forecasting systems instead of solely relying on one method.

The three common SG&A forecasting methods are:
• Percentage of revenue method, which can be used for variable selling costs.
• Driver-based method for commission, marketing, and headcount-related expenses occurred.
• Inflation based increases to static administrative costs.
• Zero based budgeting method during cost consolidation/restructuring activities.

Among all methods, it is preferable to use driver-based forecasting because this method is tied to business activity for Leadership and Financial Planning & Analysis (FP&A); i.e., HR expenses can be evaluated based on expected headcount; marketing expenses can be attached to Customer Acquisition Targets (CATs).

If companies choose the best forecasting system, they improve the accuracy of their forecasts and give senior management confidence in their analysis, while also providing a level of analytical sophistication that is highly regarded in FP&A and finance positions.

Using Revenue as a Cost Driver for SG&A

Linking certain expenses with revenues is one of the most widely used techniques for forecasting SG&A expenses. This method assumes that when there is an increase in revenue (either in the current period or in the future), that there will be an increase in SG&A expenses at the same rate, specifically in the areas of selling and marketing. Although this forecasting method is easy to implement, it must be utilized carefully in order to avoid incorrect forecasts.

Sales commissions, promotional expenditures, or total customer acquisition costs can be linked to revenue performance. Most analysts will calculate the historical SG&A to Revenue ratios based on their observations of those same ratios during various phases of revenue growth. In most cases, a constant ratio can be taken as a basis for forecasting, however, it would be a mistake to use this method for all SG&A expenses.

There are many SG&A expenses that will not be linked to revenue for the purpose of forecasting. Examples of this include compliance costs, office space rent, or building lease payments which are generally not linked to sales in the near term. Using the percentage of revenue method as a means of forecasting total SG&A will generally lead to over or under forecasting.

In the FP&A world, revenue linkage as a forecasting method should only be used when warranted; it should also be substantiated with logical reasoning based on input from sales and management to ensure accurate forecasts. When applied properly, this method provides an effective, fast and intuitive manner of forecasting variable SG&A expenses.

Headcount-Based Forecasting of SG&A Expenses

Linking certain expenses with revenues is one of the most widely used techniques for forecasting SG&A expenses. This method assumes that when there is an increase in revenue (either in the current period or in the future), that there will be an increase in SG&A expenses at the same rate, specifically in the areas of selling and marketing. Although this forecasting method is easy to implement, it must be utilized carefully in order to avoid incorrect forecasts.One of the simplest and most common ways of forecasting selling and administrative (SG&A) expenses is through estimating by the number of employees (i.e., headcount). Because employee compensation makes up a large portion of SG&A expenses, linking these costs to a planned headcount increases the potential for managing both the expenses and visibility into them.

The first step to completing a headcount based forecast is to obtain an understanding of the current structure of an organization, along with any anticipated changes in the number of employees via the hire, promotion, termination or death of existing employees. HR and department head staff members complete research on anticipated hiring numbers, anticipated role changes, and turnover rates with respect to obtaining this information.

Forecasting Marketing and Selling Expenses

• Selling and marketing is one of the most volatile parts of SG&A as it can be impacted by strategy, competition and growth objectives so it has to be predicted carefully.
• Analysts typically project marketing expenses based on items such as customer acquisition goals, new markets to enter and introducing new products. Prior year historical data usually serves as the basis for the projection yet should not be used exclusively, as a future projection should be based upon company strategy going forward as well.
• For instance, a company pursuing rapid growth will likely increase their marketing expense as a percent of total revenues. Conversely, a mature company will typically be focused on optimisng their expenses while maximising efficiency from the business as a whole.
• Selling expenses, including promotional costs, travel and discounting are commonly linked to sales activity. Thus, a projection needs to consider factors like number of salespeople, regions serviced and sales volumes. Properly projecting marketing and selling expenses requires constant communication with sales.

Forecasting Administrative and Overhead Costs

Corporate and administrative costs constitute the fixed foundation of SG&A costs. Examples of administrative costs include rent, lighting utilities, information technology support, legal fees, audit fees, other professional services, etc. Even though administrative and support costs do not change regularly, efficient forecasting of these costs is important.

• Administrative costs are generally based on contracts with fixed prices, and other inflation related increases. For instance, annual rent for an office is typically based on a signed lease agreement that states the rental rate for each year. Utility costs (electricity, gas, water, etc.) can rise from year to year because of either inflation or because of an increase in office space.
• Analysts should examine and understand all terms and conditions of all contracts, renewal dates and escalation clauses to make accurate forecasts. If they do not do this, they may be surprised by the amount budgeted at the end of the year.
• Certain types of overhead costs may increase because of business expansion, for example opening new locations, or upgrading IT systems. As such, these increases should be incorporated into the forecast as discrete events, rather than as an average during the forecast period.

Therefore, the administrative expense forecasting process demonstrates an overall level of discipline and attention to detail in the FP&A profession. Furthermore, it demonstrates to management that cost management can be effectively maintained while continuing to efficiently manage operations.

Incorporating Inflation and Cost Escalation

SG&A forecasting involves recognizing the effects of inflation, as various industries will continue to incur higher input costs periodically. As such, not considering inflation can result in lower expense estimates and unrealistic profitability assumptions.

• Typically, analysts incorporate the inflation factor into consistent or steady SG&A expense categories such as salaries & benefits; rentals; utilities; and professional fees by using inflation rate assumptions based upon macroeconomic indicators and expected (or forecasted) levels of growth by companies for similar industries.
• However, it is critical that the use of inflation assumptions be done selectively or with regard to the types of SG&A expenses that would be influenced differently by changes in the cost of goods sold (COGS). For example, while the cost of technology systems may decrease due to increased efficiencies, costs related to compliance will increase at rates higher than the general rate of inflation.
• From an MBA point of view, this emphasizes the significance of being cognizant of the macroeconomic environment during the financial planning process and also maintaining an equilibrium between what monetary trends indicate about overall economic activity and the ability of the organisation to maintain internal cost controls due to competition among competitors in the same or similar industries.

Using forecasts that have incorporated inflation as part of them will also give the organisation an opportunity to evaluate pricing strategies as well as determine how best to budget and optimise their SG&A costs.

Scenario Analysis and Sensitivity in SG&A Forecasting

The Scenario Analysis process of SG&A Forecasting gives Forecast Analysts an opportunity to develop multiple forecasts, which increases their level of confidence surrounding the Forecast. To best understand how SG&A Expenses will behave under various Business Scenarios (i.e., Business Results), the Forecast Analyst will create multiple Scenario Analyses. Three of the most commonly utilized scenario analyses are Base Case, Best Case, and Worst Case. For instance, the Best Case may project an increase in Selling and Marketing Expenses, while the Base Case may project Stable Administrative Expenses during the same period. If Sales Slowdown occurs, there will likely be a reduction in Discretionary Expenses (i.e., Advertising & Travel).

Sensitivity Analysis is the process of Assessing how changes in critical Assumptions will impact SG&A. For instance, a Forecast Analyst can conduct Sensitivity Analysis to determine the impact on SG&A of increasing or decreasing Headcount Growth Rate, Inflation Rate, or Revenue Assumption(s). With this type of analysis, FP&A Management can evaluate Business Risk and generate Contingency Plans. Furthermore, from an FP&A perspective, Scenario Analysis allows FP&A to build a level of Confidence in Forecasts, while also aiding in Decision Making during periods of Uncertainty, and providing evidence of an Analytical Maturity, which is highly valued in the Corporate Finance profession.

Reviewing, Validating, and Refining SG&A Forecasts

• The SG&A plan should be accurately represented in a developed financial outlook through a review/validation step that ensures the forecasted figures are both realistic and in line with Company strategy and therefore acceptable to Company Management.
• The SG&A forecast will be created by comparing the forecasted SG&A figures against historical trends, industry benchmarks, and internal Company Budgets to identify any large discrepancies. If there are large variances, this should be supported by a clear explanation for the difference (for example: Company is expanding).
• This review/validation step should include discussions with Department Heads (e.g., HR, Sales, Marketing, Operations, etc.) to validate the assumptions made regarding hiring, Marketing Spend, Overhead Costs, etc. The outcome of these conversations often results in further refinement of initial SG&A forecast estimates.
• There is also an important internal consistency check that needs to be performed when validating SG&A plan/forecast estimates. SG&A plan/forecast estimates should be aligned with projected Revenue, Headcount Plans, and Capital Expenditure Assumptions; otherwise, inconsistencies will create a lack of credibility in a Management's review.
• The iterative review/validation process is a reminder that forecasting is a continuous feat of improvement and that a good validation process will create accurate forecasts and foster trust between Finance and the Business Teams.

Conclusion – Building Practical SG&A Forecasts

Forecasting selling, general and administrative (SG&A) expenses involves both quantitative and qualitative analysis. Historically, companies have used a mix of historical data and formulas as part of their forecasts. But the ultimate accuracy of SG&A expense forecasts will depend on how well an analyst understands the internal mechanics of the company, its long term strategy and the cost behaviour of its various expenses. Financial analysts typically follow a structured approach for developing budgets and financial forecasts. This includes identifying expense categories, selecting appropriate expense drivers (i.e., unit sales/volume, services provided), accounting for inflation and creating various budget scenarios. Using this structured approach helps analysts create SG&A forecast estimates that have a higher degree of reliability, based on the large number of data points used to support their estimates.

By developing SG&A expense forecasts, analysts will build analytical, business partnership, and strategic thought capabilities. In addition, SG&A expense forecasting will allow analysts to further develop their financial modelling capability, as all expense specificities are tied back to their respective business drivers. From a managerial perspective, well-developed SG&A expense forecasts enable a company's management team to effectively manage their SG&A expenses, allow for timely allocation of resources to generate maximum return for the company, and increase profitability.

In an era when companies operate in an environment with increasing uncertainty within the financial markets, disciplined use of SG&A expense forecasting will become an essential driver of sustained growth for the company. The main purpose of SG&A expense forecasting is to create informed decision making and to develop long-range financial planning, not to determine static budgetary amounts.