Episode 1: The Only Accurate Number on Your P&L Statement Is the Date

In one of the final podcasts that Nik and I recorded in 2023, we had on as a guest Cody Pfloker. I really enjoy talking to other executives that are operating and in the weeds of eCommerce businesses. We speak a language that few understand. 

The episode was really entertaining, and Cody talked about how he had prepared for Black Friday, launched a unique product during the holiday season, and had his best day of sales ever. It was really interesting, but one of the gems that I thought we didn’t delve into enough was how he thought about his marketing expenses with respect to his P&L statement. 

The truth is that P&L statements are subjective and not objective. I had a professor at Harvard once tell me that the only accurate number on a balance sheet was the date. Everything else was subject to interpretation. Simply put, while there are some widely accepted principles, there are very few hard-and-fast rules. 

In our line of work, the primary audience of the P&L is you - the CEO - of the business. 

Profit and loss statements give you a snapshot of the health of the business and can guide you in decision-making and what to change or focus on. The critical parts to putting together P&L statements are ensuring they are (i) easy to make, (ii) easy to understand, and most importantly, (iii) honest. 

Marketing

Cody said something that triggered this thought, because he said that he thought all variable marketing expenses were Marketing expenses and all fixed marketing expenses were “Sales, General & Administrative (SG&A)” expenses. 

Let me give you an example of what he means. If you hire a Facebook Ad agency that charges $10,000 per month, that cost sits under SG&A. If you hire a Facebook Ad Agency and they charge 10% of your ad spend, and you spend $100,000 per month, you have to pay that agency $10,000 that month. However, since this is a variable expense, Cody would classify this as SG&A. 

Why does it matter, you might be rightfully asking yourself? Really, who gives a shit - you spent $10K either way. The reality is, it matters a great deal for three reasons. Your marketing expense will matter when you (i) go out and raise money, (ii) compensate your marketing executives who are likely compensated based on if they achieve certain revenue objectives while keeping costs under control, and (iii) when you go to sell your business. 

How many dollars are you spending in marketing to get to your revenue goals? If you are spending 33% of revenue on marketing, $1 in marketing expenses should earn you $3 in revenue. If you can hide some marketing costs in SG&A, your business appears healthier. That’s because unlike marketing expenses, SG&A shouldn’t scale with revenue. It should be rather flat. So if you hide some of your marketing expenses in SG&A (like maybe agency costs), you might be able to say that $1 in marketing expenses will earn you $4 in revenue. 

What are other ways outside of agencies that you can do this? Easy - just bring stuff in house. Instead of hiring an agency to hand out postcards outside of a subway, hire employees to do it. Now, you just brought that cost into SG&A!

Even today, I believe that many publicly traded DTC businesses are hiding marketing expenses in their SG&A line so their business looks healthier. Some spend more than 50% on SG&A, and less than 15% on marketing!

So is Cody right? Should agencies that charge a flat fee be SG&A, and agencies that are variable be marketing? Well, maybe. 

First, if you set it up this way, you have every incentive to hire agencies that are flat fee. Why? Because it lowers your marketing expense, and makes your business appear healthier. 

What sounds better? A company with $1M in sales and $100k in marketing expense and $10K in SG&A, or a company with $1M in sales and $90K in marketing expense and $20K in SG&A. In my opinion, the former sounds better. With the latter, you can cut costs like getting a crappier office, reducing headcount, etc. On the surface, it looks like there is more cost cutting possible in the second business with higher SG&A. That will get your SG&A down and make you more profitable. But in this case, they are literally the same company - they just classified that agency separately.

In addition, your head of marketing will also care. Every department head in your company should have some sort of KPI, and Head of Marketing’s is almost certainly CAC. Marketing spend / customers acquired means that it benefits them to shovel as much expense out of marketing as they can to keep CAC low. So, in theory, your Head of Marketing should want to classify as many things as SG&A as possible, so he/she will be able to meet CAC targets and earn a big fat bonus. 

But there’s a pro and a con to every decision, and the downside here is that categorizing fixed agency expenses out of marketing and into SG&A means that your Head of Marketing managing that agency relationship no longer has an incentive to control the fixed portion of the agency expense. If the agency figures that out, they can exploit it. At the end of the year, they can suggest that they increase the fixed portion of their fee, and reduce the variable portion. Or eliminate the variable portion altogether and move to a fixed fee relationship. That adverse incentive is crazy, and you have to be aware of this. 

There may also be incentives for you at play here too. For example, my compensation package with P&G had something like this (more on that in a book I’m working on). As a result, I could have hired a massive team without detriment to my compensation. I didn’t do that, because I can’t stand people who aren’t hard workers, but I did realize the agency cost existed, and that it was bananas. 

Creative Costs

Another question I’ve seen come up is how to account for creative costs. For instance, imagine you’re an apparel company and spend a fortune on photoshoots. I’ve seen apparel companies spend $1M on shoots, while doing $50M a year in sales. That is 2% of revenue in photoshoots!

Two questions arise here. 

First, are photoshoots marketing expenses or SG&A? My short answer is: if you want the spend to be highly scrutinized then put it in marketing, as the incentive for your Head of Marketing is to keep it in check. I also think this is fair, since these assets are in direct support of your marketing efforts. Marketing literally would not function without them. They go hand-in-hand, and so decision-making around these costs should also go together.

Second, how should these shoots be expensed - cash or accrual? That is, if you have a photoshoot in November for your winter lineup, and that photoshoot cost you $300K, should it all be expensed in November? Or should some be expensed in December, January, and February when you’re still using those assets?  If you have a short-term incentive as CEO and your goal is to keep your monthly P&L looking as healthy as possible (say, if you are actively fundraising), then you might expense this over 24 months since some of those assets may even be used in the following years. But if you are less short-term focused and want an honest understanding of your cash position and profit and loss, then expensing these costs over the winter season might make more sense. 

What’s the right answer to all of this? My suggestion is to be as disciplined as possible. If you accrue expenses, you’ll feel rich and your employees will feel that too. All of a sudden, you might be having nicer holiday parties than you should and not caring when people take 2 hour lunches. My advice is to expense everything right away, and take the hit. 

Build a business that is incredibly disciplined, and teach your employees to be that way too. That way, your business can survive anything. 

Freight

There might be other areas of your P&L where you’ll face this same dilemma of hitting the P&L on a cash or accrual basis. Freight for transporting goods is a big one that comes to mind. 

The issue with freight is that rates can change dramatically all the time. At Native, I could see one shipment come in with a freight expense of $0.10 per unit, another the next month at $0.25 per unit. In an ideal world, you’re able to track when you’re actually selling through the units with the $0.10 freight cost versus the $0.25 freight cost and translate that into your total COGS in the month those different units were sold. But unfortunately we don’t live in an ideal world and that kind of tracking is quite simply, big company shit. Does P&G do that? Probably. Was I going to do that? Well, going back to the idea of making it easy to make a P&L, fuck no. 

That is, in the name of not spending untold hours of frustration trying to work it out, I would just expense the freight as I incurred it on a cash basis.

Why does all this matter?

The P&L is fundamental to your business. It helps you make decisions day-to-day, but it also is the key input into your valuation. So, how you choose to account for things isn’t just a paper-pushing task. These decisions are maybe some of the most important you’ll make as a CEO. Pay attention. And, most of the time it comes back to incentives. And as Charlie Munger famously said, “show me the incentive, and I'll show you the outcome.”