Operating Expenses: SG&A, R&D and Other Costs

Introduction

Operating expenses are where a company's strategy becomes visible in its accounts. What it spends on finding customers, developing products and running its head office, relative to its revenue, says more about how it competes than almost any other part of the income statement. Alphabet spent about $49.3 billion on research and development in 2024, more than its sales and marketing and its general and administrative costs combined; a consumer goods company of similar size would show the opposite pattern, with marketing dwarfing research.

These costs sit between gross profit and operating income. Unlike the cost of goods sold, most of them do not rise automatically with each unit sold, which is what gives businesses operating leverage. And because the line items are less standardized than they look, comparing operating expenses between companies requires knowing what each line contains. Where the operating expense block sits in the overall statement is covered in how the income statement works.

Most companies present two or three main lines, sometimes with a few smaller ones:

Selling, general and administrative expenses (SG&A)

The operating costs of selling a company's products and running the business that are not part of producing them, such as sales and marketing, executive and administrative salaries, professional fees and corporate overhead. SG&A sits between gross profit and operating income.

Alphabet's consolidated statement of income shows the three main lines of a technology company:

Revenue grew about 14%, but the three operating expense lines combined grew only about 2%, so operating income rose about 33%. That is operating leverage in its clearest form: when revenue grows faster than overhead, a larger share of each additional dollar of gross profit reaches operating income.

Under US generally accepted accounting principles (US GAAP), Accounting Standards Codification (ASC) 730 requires research and development costs to be expensed as incurred, even though the spending is intended to produce benefits for years. The reasoning is that the future benefit of any particular project is too uncertain to measure reliably, so the accounting does not try. The consequence is a systematic gap between economics and accounts: a company that is investing heavily in new products reports lower profits today and a balance sheet that omits the technology it has built.

Research and development (R&D) expense

The cost of activities aimed at discovering new knowledge or developing new products, processes or technology. Under US GAAP, ASC 730 generally requires these costs to be expensed when incurred rather than recorded as an asset.

Software is the main exception. Costs of developing software to be sold are capitalized once technological feasibility is established, and costs of developing internal-use software are capitalized during the development phase, then amortized. In practice, many software companies capitalize little, because feasibility is reached close to release, while companies building large internal systems can capitalize significant amounts. The rules and their effect on earnings before interest, taxes, depreciation and amortization (EBITDA) are covered in R&D accounting under US GAAP.

Because R&D is expensed, its level is a strategic choice that flows straight through to margins. A pharmaceutical company that cuts research spending can raise its operating margin immediately at the cost of its future pipeline, and an acquirer may plan exactly that, which is why bankers look at R&D as a percentage of revenue against peers and over time.

Operating expense lines look standardized, but what sits in each depends on company policy. Four differences come up repeatedly:

The practical consequence is that operating expense ratios should be compared only after reading the policy notes, and that stock-based compensation, which can be large in technology companies, should be identified line by line from the equity compensation note. Its accounting is explained in stock-based compensation accounting.

Comparison gets easier: Accounting Standards Update (ASU) 2024-03 requires US public companies to split each relevant expense caption in the notes into employee compensation, depreciation, intangible amortization and inventory purchases, starting with 2027 annual reports for calendar-year companies.

Restructuring deserves particular care because it moves between periods. Under ASC 420, a commitment to an exit plan does not by itself create a liability: one-time severance is recognized once the plan has been communicated to employees (or spread over any period they must keep working), and contract termination costs when the contract is actually terminated. A single year can therefore carry the cost of a program that produces savings over several years. Whether such charges should be removed from earnings, and when they have become recurring enough to stay in, is covered in one-time items.

In a model, operating expenses are usually forecast either as a percentage of revenue or line by line from drivers such as headcount and salary inflation, with a view on which costs are fixed and which vary with sales. The split matters most in two situations. In a downturn, fixed overhead does not fall with revenue, so operating income falls faster than sales. In an acquisition, overlapping SG&A, such as duplicate head offices, finance teams and sales forces, is the main source of cost synergies, the savings a buyer expects to achieve by combining two companies.

Fixed Costs and Operating Leverage in Numbers

Consider a company with $1,000 of revenue, a 50% gross margin and $300 of operating expenses, of which $240 is fixed and $60 varies with sales. Operating income is $200. If revenue falls 10% to $900, gross profit falls to $450 and operating expenses only to $294, so operating income drops to $156, a fall of 22% from a 10% decline in sales. The same arithmetic works in reverse when revenue grows, which is why the fixed share of operating expenses is one of the first questions in any downside case.

Research and development is treated differently from the rest. Because it is an investment expensed for accounting purposes, some analysts capitalize it in their own models, amortizing past spending over an estimated life to estimate the return a company earns on its innovation. Whether or not that adjustment is made, R&D intensity is one of the clearest indicators of how much a company is investing in its future, and of how much its current margins depend on that investment continuing. How the capitalize-or-expense choice moves EBITDA more generally is set out in capitalizing vs expensing costs.