What is R&D?
The Research and Development (R&D) expense refers to spending related to funding internal initiatives around introducing new products or further developing their existing offerings.
What Does R&D Stand For?
R&D is an abbreviation for “research and development,” and represents the costs associated with product innovation and the introduction of new products/services.
By re-investing a certain amount of earnings into R&D efforts, a company can remain ahead of its competition and thereby fend off any external threats (i.e. shifting industry trends).
Hence, it is crucial for such companies to avoid being blindsided by new disruptive technologies that serve as headwinds to the company.
While R&D costs can easily accumulate over time (and often not create any results of any significance), the R&D can pay off if there is a breakthrough that can directly lead to long-term profitability and a sustainable competitive advantage.
For instance, R&D spending can lead to defensible market positioning through:
- Intellectual Property (IP)
- Technological Systems
Research and Development (R&D): Definition in Business
The definition of research and development, or “R&D”, is as follows:
- Research → The strategic pursuit of obtaining new knowledge and findings that are applicable to the company’s operations. The long-term objective is for the compiled knowledge to be actionable and have a tangible impact in the development of new products or services, which will benefit the company’s existing offerings or be a new separate offering.
- Development → The application of the findings gathered from the research, where the company designs and tests new prototypes, or attempts to modify or implement new processes.
R&D Expense: Operating Expense on Income Statement
Is R&D Capitalized or Expensed?
Under U.S. GAAP, the majority of research and development costs (R&D) must be expensed in the current period due to the uncertainty surrounding any future economic benefit.
However, companies can opt to capitalize software costs in certain scenarios (e.g. software development).
Since R&D tends to operate on a longer-term time horizon, these investments are not anticipated to generate immediate benefits.
R&D spending is treated as an expense – i.e. expensed on the income statement on the date incurred – rather than as a long-term investment.
There is some controversy, however, regarding whether this approach is the correct classification given the duration of the benefits.
Considering how long-term the expected economic benefits could be, one could make the case that all R&D should instead be capitalized rather than treated as an expense.
Forecasting R&D Expense in Financial Models
In terms of how research and development expenses are projected in financial models, R&D is typically tied to revenue.
To forecast R&D, the first step would be to calculate the historical R&D as a % of revenue for recent years, followed by the continuation of the trend to project future R&D spending or an average of the past couple of years.
The intuition is that the more revenue growth there is, the more capital could be allocated towards R&D – much like the relationship between revenue and discretionary capital expenditures (Capex).