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Yellow Alert on Cost of Revenue
Wednesday, June 13, 2018

Last week we examined trends in Sales, General, and Administrative costs among the S&P 500 — specifically, whether SG&A costs were rising faster in first quarter 2018 than revenue.

The good news in that analysis was that SG&A costs weren’t accelerating faster than revenue; revenue in Q1 2018 increased by 9.64 percent from the year-ago period, while SG&A costs increased only 7.86 percent.

This week we decided to ask the same question for Cost of Revenue, the line-item that reports the cost of manufacturing or delivering products and services (also sometimes identified in financial statements as Cost of Goods Sold or Cost of Services).

As the title of this post implies, financial analysts and CFOs may have more concerns here.

We examined the financial data from 1,687 companies with annual revenue above $250 million, and which were not in financial services. (The cash flows in financial services make that sector a special case, so we put it aside.) Bottom line: the costs to produce goods or services accelerated 0.82 percent faster than the revenue companies made from selling them.

Take a look the chart below, which give us numbers for all companies in our sample as one group.

Of the 1,690 companies we examined, 876 of them reported a negative spread — where Cost of Revenue grew more than Revenue did.

Why does this matter? Because those higher production costs need to go somewhere. Companies can either raise prices, which stokes inflation and eventually leads to higher interest rates. Or they can cut SG&A costs, which can lead to anything from scaled back marketing, to layoffs, to passcodes for the photocopier. Or they can swallow lower profit margins, which leads to falling stock prices and investors screaming bloody murder.

This possibility should weigh on the mind these days. Inflation stood at 2.8 percent in May, the fastest rate we’ve seen in six years and a number certain to keep the Fed on its current path of raising interest rates.

And we also seem to be on the brink of a trade war with Canada, Europe, China, and lord knows who else. Those tariffs (on aluminum and steel, among other items) are likely to hit components manufacturers buy to make goods. Which will drive up the Cost of Revenue line even faster.

As we noted in last week’s post about SG&A, plenty of companies are already seeing those costs rise faster than revenue. If a company experiences acceleration on both fronts, an analyst has to start asking about the company’s ability to pass along price increase, or cost management programs, or whatever other tricks the CFO has up his or her sleeve.

Like we said, nothing in the numbers is a red alert yet — but they are a yellow alert. You may want to dive into the data a bit more on your favorite companies, and see just how brilliant yellow the alert is for each one.


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