When it Comes to Cost of Sales, Size Matters

Our Sales Analytics practice recently compared the total revenues and SG&A costs for eight software companies. We were pleasantly surprised to find that the relationship between total revenue and SG&A formed an interestingly shaped curve, where the SG&A Expense declines as a percent of revenue as a company grows larger, per the chart below.

Sales Benchmarks SG&A to Revenue Ratio

It is logical that SG&A expense as a percentage of revenue would go down as a company grows larger. This is a result of both economies of scale and economies of scope. Economies of scale allow for the overhead costs of larger sales organizations to be spread across greater headcount. Likewise, a sales force that can carry and sell multiple products achieves economies of scope by being able to sell additional product at a lower incremental cost than a sales force carrying (selling) a single product.

However, this theory breaks down when a rep carrying multiple products is not able to achieve the intended synergies. This occurs when the products are purchased by different buyers within the account, and/or when the buying process for the products is dissimilar. It can also occur if a company grows through acquisition but does not adequately merge or integrate sales forces.

A case in point – Company 6:

Notice how nicely all the companies “fit” along the polynomial trend line in the chart above, with one exception: Company 6. Their SG&A expense as a percentage of revenue of 45% is unusually high given the company’s total revenue, at least when compared with this group of eight software companies. The “fit” line indicates that Company 6’s SG&A Expense should be approximately 39% of revenue. The delta between 45% and 39% translates into $357M per year in SG&A Expense. If they were to realize more economies of scale and scope with their SG&A expense to align with the trend line, they could conceivably increase EPS by $0.47 per share. With a current PE ratio of 23, this in theory would raise the value of their stock price from just short of $18 a share (on 3/7/11) to nearly $29 a share, an increase of 60%.

Compare these results with Company 8, which has acquired over 100 companies in the last 10 years or so. Company 8 quickly and carefully integrates the sales force in each case. So as you can see, size matters. But only if you have the right sales strategy. Economies of scale and scope are available to sales leaders that thoughtfully chart their course of growth. Simply adding headcount organically or acquiring more headcount through acquisition can lead to bloated sales organizations and even more bloated costs.

Learn more at Alexander Group.

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