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Turning Lead to Gold: The Art of SG&A Allocation

Regardless of your Predominant Business Model©, you are probably running a Solution Provider firm with multiple practices or lines of business (LOBs). As long as you categorize your costs correctly (as you do since you follow the Normalized Solution Provider Chart of Accounts© in your S-L Index benchmarking), it is fairly easy to determine your line of business gross margin and your total Sales, General and Administrative (SG&A) expense.

However, key management questions remain:

Hence, there is a need to fairly allocate a portion of your SG&A to each line of business such that all of it is paid for.

The question is how to do a fair allocation? There is no standard, and it is something of a black art. As usual, Service Leadership goes where many fear to tread, to help you out.

A common but misguided method is by headcount. My Managed Services line of business has 4 people out of my total of 12 people, hence I should allocate 33.3% of my SG&A to my Managed Services operation. Thus, if my SG&A for a given month is, say, $100k, then each person “carries” $8,500 in SG&A. The MS line of business has 4 people, so it should “carry” 4 x $8500 = $34,000 in SG&A.

The problem with this is it fails to recognize that some people are in a line of business and some are not in any line of business (i.e. they are in SG&A). If 3 of my people are in SG&A – a salesperson, an office manager/bookkeeper and myself (the owner) – then I have 9 people who are in a line of business. Since it is the lines of business to which I am apportioning by SG&A, I should really divide my $100,000 in SG&A by 9 people, not 12. So really, each line of business person should carry $11,111 ($100k divided by 9). So the MS practice should carry 4 x $11,111 = $44,444 in SG&A.

This method has a flaw as well: it fails to recognize that different lines of business require different levels of SG&A investment to be healthy and grow. Let’s take two totally different businesses: a shoe manufacturer and a shoe distributor.

A shoe manufacturer has relatively high expenses. They have to:

Clearly, that is a hefty SG&A load, as a percent of each dollar of shoes sold. One hopes they have high gross margin.

Conversely (sorry), a shoe distributor runs on extremely thin gross margins (in the IT business, just look at Ingram’s SEC filings and keep in mind they are among the most well run.)

But then (not to belittle their valuable and challenging role in getting shoes to you) the distributor has much less overhead. They do almost none of the above things, and do not have such other areas of expense as would replace them. Running a distributor simply takes less investment, and less risk. It is also less rewarding, by the way.

If both these lines of business were in one company, allocating SG&A between them by headcount would be very unlikely to match the correct SG&A investment with the two disparate business needs.

In your multiple-line-of-business company, you have the analogous problem.

Your services business is essentially a factory. You “OEM” services: you take essentially each one of the steps to get to market as does the shoe manufacturer described above. You have to design your services, build the factory, build the brand, take the risk. One hopes, you too, have high margin.

Further, if you do T&M support, projects and Managed Services, you have three widely different service “products”, each of which requires a different assembly line. As each scales up, the degree of commitment to each – in terms of SG&A investment – increases, but each at a different rate.

If each line of service is a different “factory”, what is the proper level of SG&A investment?

T&M support is the least sophisticated product to manufacture: the cost of doing things inefficiently is more likely to be shared with the client here than in the other two lines of services. You do need some “factory” infrastructure: typically a PSA and dispatch desk. In addition, commitment duration is low, so if a mistake is made that the client won’t cover, exposure is minimal. . A good number here is to allocate is around 32% of revenue for SG&A. This allows a healthy reinvestment in “product” design (service definition), marketing, R&D (how to deliver the service), sales and so on.

Project Services are the next most sophisticated services. Here, methodology counts for more; that is, the efficiency and effectiveness of your assembly line. In addition, product design (service definition) is even more important: commit to the wrong IP telephony system around which to build your project practice, and you’re going to be in a world of hurt. Since projects last longer than T&M events, getting the pricing wrong can mean a lengthy loss. And since the customer is committing more, it takes more sales and marketing to convince them your product (i.e. your project methodology) is really superior. In this line of business, 38% of revenue or so must be invested in SG&A.

Managed Services are the most sophisticated service. MS requires you to build and staff additional “factory” infrastructure: the NOC. Your methodology has to be the tightest, because you are now on flat fee, and because your time commitment to the client is measured in years, not projects or hours. In addition, small inefficiencies really stack up when increments by hundreds or thousands of incidents are processed a day. Get pricing wrong, or design the wrong product (and hence wrong assembly line), and you are upside down for a long while. Here, an SG&A investment of 42% may be reasonable.

As you can see, SG&A as a percent of revenue rises as the service value proposition becomes more complex, and the methodology, marketing and sales processes which convey it to the market must be more robust.  But each of these must earn higher margins to offset their higher cost and risk: projects must earn higher margin than T&M, and MS higher still.

Your product resale business is – while not easy – is not all that much more complicated than a distribution business. You do not design the products, nor manufacture them. You have comparatively low risk. Consequently, you do not earn high margin on them, and you’d best run that line of business with low SG&A indeed: 7% or 8% is about the max.

(A quick side note here to explain one of the reasons why many Product-centric firms struggle so hard to grow their services business. With SG&A of around 8%, many Product-centric firms have a hard time believing it would be possible to afford to spend even 20% of revenue SG&A , much less the 30% to 40% discussed above. So they under-invest in services methodology and go-to-market, making it hard to build a differentiated service that clients will be happy with and sales reps will trust. As the same time, they often have a hard time imagining that clients – since they heartily resist paying even 15% margin on product – would pay anything more than about 25% margin or so for services. As a result, they earn low gross margins which can’t sustain a healthy services SG&A. To top it off, many Product-centric firms then high expensive “pre-sale” engineers without requiring them to hit a reasonable billability target, further taxing the already-thin gross margin of their product re-sale business. There are proven techniques for overcoming these challenges and growing a healthy services business – or even becoming services –centric – but the first step is, for most leadership teams, the most difficult: having the stomach to step through the looking glass into a very different go-to-market model.)

These are the levels of SG&A investment which in each case should result in healthy lines of business. If they receive this investment, and they fail to perform, then they are not being correctly run. If they do not receive this level of investment, and they still perform, an especially impressive feat has been accomplished.

So how does this translate into SG&A allocation? Let’s start with your $100k of SG&A. Let’s say your total revenue is $300k, and each line of business contributes equally: product is $75k, and each line of service is $75k apiece. Together, these four must absorb the $100k of SG&A.

Our method is to first say: Given the above target percentages of SG&A investment, what dollar amount of SG&A should each line of business be targeted to carry?

This can be answered in the table below:

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To simplify things, we have provided some targeted gross margins as well.

By multiplying the revenue for each line of business by its targeted SG&A percent we have arrived at its targeted SG&A dollar amount.

However, that targeted SG&A dollar amount ($90,000) does not absorb the entire actual SG&A amount ($100,000). Hence we have extra SG&A to pass around.

We do this by looking at the proportion of targeted SG&A each line of business absorbs, and applying that same proportion to the actual SG&A. The table continues below:

Click to enlarge

Taking Product as an example, its $6,000 in target allocation equates to 6.7% of the $90,000 in total target allocation. So it must carry 6.7% of the actual SG&A, or $6,667.00 (6.7% x $100k).

In this way, each line of business carries its fair share of the actual SG&A.

Now we can see how well each line of business pulls its weight of SG&A, by calculating the bottom line profit for each line of business:

Click to enlarge

The sharp eye will notice that as we progress up the SG&A allocation levels, each line of business is delivering successively higher GM%, so each is delivering a successively higher profit. All is in order.

Actually not. The sharper eye will notice that actual SG&A dollars are 11.1% higher than the target SG&A dollars ($100k vs. $90k).

The company is expending more than the ideal amount of SG&A to get its business done. As a result, it is generating only 9.2% profit, when we know that a best-in-class firm with the same Predominant Business Model (Infrastructure – Balanced in this case) generates 11.3% bottom line profit (See the S-L Index 2010 Annual Solution Provider Industry Profitability Report©).

It is spending 2% more of its revenue in SG&A than it should. So we can look at anything from facilities costs, to administrative overhead, to sales and management costs, and trim where we can. This would bring SG&A in line with revenue.

We can also perhaps balance the profit equation by looking at the line of business gross margins and see where they may be below best in class. Product GM% in this case, looks low by a few percent, as does T&M support GM%. In each of these areas, the effectiveness of leveraging “its” SG&A to produce gross margin is questionable: they are under-producing gross margin. Either SG&A needs to be trimmed and invested elsewhere, or gross margin must improve soon. Projects and MS gross margin percentages look good; would additional SG&A investment accelerate growth in these better-performing lines of business?

And – importantly – even if line of business gross margins were strong, and therefore the bottom line was strong, we would still counsel finding ways to trim the extra $10k of SG&A, or expand (profitable) revenue without adding to that amount. Though not easy, there is no good reason not to.

Our title says that allocating SG&A is an art, yet the above sounds pretty concise. The fact is, however, that this allocation method, while the best yet, is still less than perfect. Here’s the test: if these four lines of business were each in a separate company, it’s likely some of their SG&A spend would be higher, simply because economies come from renting and using larger space, negotiating better supply deals, and so on. On the other hand, smaller companies require fewer layers of management, which reduces some SG&A items. So, while the above method is good enough, and it sets a re-usable standard, there is still a need for interpretation. Hence, the art.

Allocating SG&A by line of business, by using target SG&A percentages for each line of business as your healthy baseline, allows you to budget for correct investment in each, and measure the results of each relative to its investment, while still allowing you control over total SG&A spend. Because SG&A allocation still contains elements of art, use this method to clear away as much uncertainty as possible, and then apply judgment.