Definition
The discretionary cost to sales ratio allows analysts to quantify the unrestricted expenses that can be eliminated in the near term. When faced with an economic or industry downturn, companies can bolster profits by eliminating what are deemed optional expenses. Calculating their discretionary cost to sales ratio allows companies to understand the magnitude of this opportunity.
Calculation
Discretionary Cost to Sales Ratio = Discretionary Costs / Sales Revenues
Where:
Discretionary costs include expenses such as routine maintenance, service contracts, employee training, meals, entertainment, travel, as well as participation in efforts such as syndicated research.
Explanation
When the economy enters a recession or an industry pulls back, companies oftentimes look for ways to lower expenses in the near term. By taking an inventory of what might be seen as discretionary costs and normalizing this value against sales, the company has a better idea of the potential lift in gross profit margin.
Unfortunately, reducing discretionary expenses in the near term can result in a substantial increase in future expenses. For example, delaying routine maintenance in the near term may result in significant repairs to equipment in the future. For this reason, reducing discretionary expenses is deemed a near term strategy to meet an immediate need.
Example
Company A's industry was hit hard by what the forecasting team believes will be a near term reduction in sales due to an economic recession. Company A's management team asked their business analysts to pull what they've concluded are discretionary expenses from last year's actual results.
The table below was provided to Company A's management team, which concluded they could offset a loss of nearly 4% of sales by eliminating discretionary costs.
| Discretionary Costs | |
| Service Contracts | $295,218 |
| Periodic Maintenance | $177,131 |
| Syndicated Research | $161,028 |
| Meals and Entertainment | $64,411 |
| Industry Conferences | $42,941 |
| Employee Travel | $32,206 |
| Total Discretionary Costs | $772,934 |
| Sales Revenues | $21,470,400 |
| Discretionary Costs to Sales Ratio | 3.6% |
.jpg)
