Costs are important to the growth of the company through their effect on leverage, their effect on earnings quality and on future growth through new product development. Costs that are available through the standard accounting data can be broken into three categories; fixed costs, variable costs and non-cash costs.

Variable costs increase or decrease with the volume of goods or services produced by the company. These costs of goods sold are an important component of the gross margin.

The two important fixed costs are selling, general and administrative expenses (SG&A) and interest costs. SG&A expenses are mostly fixed corporate expenses which are independent of the volume of goods or services produced by the company. As sales increase these costs tend to fall as a proportion of sales providing leverage to EBITDA. SG&A expenses included research and new product development expenses and we will often see these costs ramp up in as a company develops a new product line. When sales of the new product begin sales growth moves up and SG&A expenses move down producing leverage to EBITDA. Interest costs are strictly fixed according to the financing terms that created them. That is why a highly financially leveraged company is considered more risky.

Regardless of what happens to sales, interest expenses must be paid. As sales increase, interest costs fall as a proportion of sales leveraging the wealth of the shareholder.

Non-cash costs are accounting conventions to account for the amortization of one-time expenses, or to account for the depreciation of a fixed asset. Since these costs do not effect the real wealth of the shareholder, we do not included them in our wealth calculation.

Falling costs can mask top line weakness. If sales growth is falling, and the gross margin is moving down, but lower SG&A expenses and lower depreciation expenses are hiding the slowdown from earnings and EBITDA, the quality of earnings is deteriorating. Often this will result in earnings and EBITDA rising a more rapid rate than the share price, making the stock look cheap.

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