For a business planning to compete in an industry characterized by rapid technological advances, investment in product research and development is critical to the development of new innovative products. Research and development costs, sometimes referred to as R&D expenses, is a direct result of the activities referred to in the product and technology section of the business plan.
Although generally bracketed together, there is a distinction between research costs and development costs.
Research is original investigation carried out to gain new scientific or technical knowledge. At this stage there is no reasonable expectation of future revenue and so research costs are always charged to the income statement in the year they are incurred. In the business plan financial projections template, they are included as part of the operating expenses in the income statement.
Development is the application of research with a view to getting ready for commercial production resulting in product development costs, for example pre-production testing of a new machine model would be regarded as development. In such circumstances there might be a reasonable expectation of future revenue.
Development costs are also generally charged as expenses in the year in which they are incurred and included as part of operating expenses in the financial projection income statement.
However, if there is a reasonable expectation of future revenue, and the costs satisfy criteria set out in Accounting Standards, they are allowed to be capitalized. In this case the development costs might be included in the balance sheet of the financial projections, under the heading of fixed or long term assets and amortised.
Research and Development Cost Drivers
All costs are driven by activities, and in the case of research and development the key cost drivers include the following:
- Beta testing
- Time to market
- Patent and other intellectual property applications
Typical Research and Development Costs
It is important to decide from day one what will be classified as a research and development cost, and how they will be treated in the business plan financial projections.
The following are typical research and development costs:
- Research and development salaries (R&D manager, engineers, technicians)
- Product testing
- Pre-production design and construction
- Construction and operation of pilot plants
- Third-party development and programming costs
- Software development costs
Research & Development Costs Ratio
It is useful to calculate the research and development cost as a percent of revenue to give a financial ratio as follows:
This ratio is one of many expense ratios, and can be used to make comparisons to other businesses within your industry, to ensure that the research and development costs included in the financial projections are comparable and realistic.
In addition, it is important to monitor changes in the ratio over time to see that the investment in research and development is producing the required and planned result. A significant rise in the research development expenses to revenue ratio may indicate that the investment in research and development is not as cost effective as it should be.
Research & Development Cost Model
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.