Gross profit is what is left after paying for the product. What happens to it next separates businesses that build wealth from businesses that simply survive.
Two lines on the income statement matter most here: selling, general and administrative expenses (SG&A) and research and development (R&D). Both are necessary. The question is how much of each dollar of gross profit they consume, and whether that share is stable. Warren Buffett and the Interpretation of Financial Statements treats both as important signals of whether a business has a durable competitive advantage, and it offers one of the book’s more counter-intuitive ideas: that heavy research spending can be a warning sign rather than a strength.
This article explains how to read these lines, introduces an idea we will call the cost of standing still, and draws out what it means for anyone designing products or running a business.
What sits in SG&A
Selling, general and administrative expenses cover almost everything needed to run a business that is not directly part of producing the product:
- selling: sales salaries and commissions, marketing, advertising, trade shows
- general: office rent, utilities, insurance, IT, professional fees
- administrative: finance, human resources, management and support staff
In smaller businesses these are often simply called overheads. Different companies classify costs differently, so it is worth reading the notes to see what is included.
Measuring overheads against gross profit
The book suggests judging SG&A as a share of gross profit rather than of revenue, and offers rough bands drawn from the companies Buffett favoured:
| SG&A as a share of gross profit | What it often suggests |
|---|---|
| Under about 30% | Unusually efficient; the business keeps most of what it earns |
| Roughly 30% to 80% | Common, including among businesses with genuine advantages |
| Close to or above 100% | The business spends everything it earns just to operate |
Why gross profit rather than revenue? Because gross profit is what is actually available to pay for overheads. Two businesses can have the same revenue but very different gross profits; measuring overheads against gross profit shows how much room each really has.
As with every measure in the book, consistency matters more than any single year. Overheads that swing sharply from year to year suggest a business that is reacting to competitive pressure (spending heavily on promotion to defend share, cutting deeply when times are bad) rather than operating from strength.
Why overheads behave as they do
Overheads have a particular character: they tend to rise easily and fall reluctantly.
In good years, businesses add people, systems, offices and marketing programs. Each addition seems reasonable on its own. When conditions tighten, cutting them is painful and slow: leases run for years, systems are embedded and redundancies are costly. The result is that overheads often creep up as a share of gross profit over time unless managed deliberately.
Businesses with durable advantages are not immune to this, but their strong gross margins give them more room, and the best of them manage overheads with unusual discipline. Their need to spend on marketing is also often lower, because customers already know and trust them.
Why research spending can be a warning sign
This is one of the book’s more counter-intuitive points. Research and development looks like investment in the future, and often it is. But Buffett’s preference, as the authors describe it, was for businesses that do not need heavy research spending to stay competitive.
The reasoning is straightforward. If a company’s advantage depends on a patent or on staying technically ahead, it must keep spending to renew that advantage. Patents expire. Competitors catch up. New technology resets the field. The research budget is not a one-off investment but a permanent cost of staying in the race, and it can absorb a large share of gross profit indefinitely.
Compare that with a business whose product barely needs to change. It does not have to fund the next generation every few years. The money it would have spent can be kept.
The book is careful here, and so should we be. Heavy research does not make a business bad, and some research-intensive companies have been extraordinary. Many important industries (medicine, advanced manufacturing, technology) depend on research, and society benefits enormously from it. The point is narrower: an advantage that must be bought again every year is less durable, from an owner’s perspective, than one that persists on its own.
The cost of standing still
Put overheads and research together and you get a useful idea: the cost of standing still. How much must this business spend each year just to keep its current position?
For some businesses that cost is low. The product is established, customers return out of habit, and the main job is to keep doing the same thing well. For others the cost is enormous: constant redesign, aggressive marketing to hold share, continual investment to avoid falling behind.
Two businesses with identical gross profit can produce very different results for their owners, depending on this one difference.
An illustration
Consider two hypothetical businesses, each with $20 million of gross profit.
| Business A | Business B | |
|---|---|---|
| Gross profit | $20.0m | $20.0m |
| SG&A | $6.0m (30%) | $11.0m (55%) |
| R&D | $0.5m (3%) | $5.0m (25%) |
| Remaining before depreciation, interest and tax | $13.5m | $4.0m |
Business A sells an established product that customers buy repeatedly; its marketing mostly maintains familiarity. Business B sells a technology product that must be substantially redesigned every two years to keep up with competitors, and it must advertise heavily at each launch.
Both may be well managed. Business B may even be growing faster. But Business A keeps more than three times as much of its gross profit, year after year, and can use it to reinvest, reduce debt or reward owners.
Separating maintenance from growth
Not all overhead and research spending is the cost of standing still. Some is genuine investment in growth: entering new markets, developing new products for new customers, building capability that will produce future returns.
A useful exercise, for investors and owners alike, is to estimate how much of the spending is:
- maintenance: needed just to keep the current business at its current level
- growth: discretionary investment aimed at expanding the business
Companies rarely report this split, so it requires judgement. Clues include whether spending rises and falls with competitive pressure, whether products are refreshed on a forced cycle, and what management says about the purpose of spending. A business with low maintenance costs and attractive growth opportunities is in a strong position; one whose spending is mostly maintenance is running hard to stay in place.
Finding the numbers
For a listed company, the figures come from the income statement and its notes in the annual report. A practical method:
- Find gross profit. Some companies report it directly; others report revenue and cost of sales, and you subtract one from the other. Some service and technology companies do not report it at all, which makes this analysis harder.
- Find SG&A. It may appear as one line or several (selling, marketing, administration, distribution). Add together the lines that represent running the business rather than producing the product.
- Find R&D. Many companies disclose it separately or in the notes. Be aware that some research costs may be capitalised (recorded as an asset and expensed gradually) rather than expensed immediately, which lowers the reported expense in the short term. The notes usually explain the policy.
- Divide each by gross profit, and repeat for as many years as you can find.
The resulting ratios, laid out across a decade, show far more than any single year’s figures.
Reading the trend
Over ten years, a few patterns are worth watching:
- SG&A rising faster than gross profit suggests creeping inefficiency or increasing competitive pressure.
- R&D rising as a share of gross profit may indicate a technology race intensifying.
- Stable, modest ratios alongside rising earnings suggest an established advantage.
- Sharp cuts in overheads or research can boost short-term profits while weakening the business; it is worth asking whether cuts are efficiency or underinvestment.
What this means for product businesses
For anyone designing products, this is uncomfortable but useful.
- Prefer problems that stay solved. A product that meets a stable, long-lasting need can be refined rather than reinvented.
- Be wary of competing on features alone. If the only reason customers choose you is that you are slightly ahead technically, you will have to stay ahead, every year, at your own expense.
- Distinguish improvement from churn. Continuous improvement that lowers cost or raises quality builds an advantage. Change for its own sake mostly builds expense.
- Design for longevity. Products built to last, with replaceable parts and stable interfaces, reduce the pressure to redesign.
- Build advantages that persist: reputation, service, distribution and customer relationships, which do not expire like patents.
What this means for running a small business
Small businesses face the same dynamics in miniature.
Know your overhead ratio. Divide total overheads by gross profit. If the result is creeping upwards, find out why before it becomes a problem.
Grow overheads only as gross profit grows. Early overheads have a habit of becoming permanent. A new hire, a bigger office or a software subscription should be justified by gross profit that already exists or is very likely.
Prefer variable costs early. Contractors, flexible workspace and pay-as-you-go services keep the cost of standing still low while the business is proving itself.
Review subscriptions and recurring costs regularly. Small recurring costs accumulate quietly.
Invest in improvements that compound. Better processes, documentation and training reduce future costs; that is investment, not overhead creep.
A worked example
A small business makes and sells specialised ergonomic office accessories. This is an illustration.
In its first years, it competes by releasing new models every year with incremental features, supported by launch advertising. Gross margins are healthy, but design and marketing consume most of the gross profit. Profits stay thin.
The founder reassesses. Customer feedback shows that buyers value durability and comfort far more than new features, and that most new customers come from recommendations. The business narrows its range to a few proven products, extends their design life, invests in better materials and a strong warranty, and shifts marketing towards customer referrals and workplace partnerships.
Over three years, the cost of standing still falls sharply. Fewer redesigns are needed, marketing costs drop as referrals grow, and a larger share of gross profit becomes profit. The products are no less useful; the business is simply no longer running on a treadmill.
Common mistakes
Measuring overheads against revenue only. Gross profit shows the real capacity to pay for them.
Treating all R&D as investment. Some is the price of staying in the race.
Ignoring overhead creep. Small additions accumulate into a permanent burden.
Cutting the wrong things. Slashing research or marketing that genuinely sustains the business can damage it.
Competing on features when customers value reliability. It raises the cost of standing still without raising what customers will pay.
Questions to ask
- What share of gross profit goes to overheads, and is it rising?
- How much does the business need to spend on research just to remain competitive?
- How much of current spending is maintenance, and how much is growth?
- Would the business still sell well if it stopped changing its products for three years?
- For your own business: which overheads would you not add again if you were starting today?
Bringing it together
Overheads and research spending show how much of each dollar of gross profit is consumed just to keep a business going. Businesses with durable advantages tend to keep that share modest and stable, because their customers stay without constant persuasion and their products do not need constant reinvention.
None of this argues against investment. Businesses must spend to serve customers, develop people and improve what they offer. The question is always what the spending buys: a stronger, more durable position, or simply the right to keep competing on the same terms next year.
The cost of standing still is a useful idea for investors, managers and founders alike. The lower it is, the more of the business’s earning power is genuinely available, and the more freedom the business has to grow, to weather hard times and to reward the people who own it.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
