Research and Development Costs on an Income Statement
Investing Lesson 4 - Analyzing an Income Statement
I want to spend some time talking about a particular type of expense called Research and Development Expenses, or R&D expenses, that appear on the income statement of certain businesses, particularly those engaged in scientific undertakings. Research and Development costs are one of the most important expenses on the income statement for certain types of enterprises because they represent future growth, innovation, and, if well-managed and executed, profits; a stream of outlays that could very well turn into a cash generating powerhouse years down the line.
Whether it is a pharmaceutical company spending hundreds of millions of dollars trying to discover a breakthrough drug to fight cancer, a technology company developing a new line of hardware, a toy manufacturer testing different design configurations, or a packaged food giant attempting to figure out how to reduce calories while retaining sweetness, research and development is the lifeblood of not only a flourishing economy, but a thriving business.
The percentage of revenue devoted to research and development costs will depend on both the specific firm (certain management teams will prioritize innovation and launches above other considerations, while others might prefer to milk existing successes to fund bigger dividends and share repurchases) and the sector or industry in which it conducts its commercial activities. Apple, the designer of everything from iPhones and iPads to iMacs and MacBooks spent a whopping $8.07 billion, or 3% of its enormous sales base on R&D 2015; developing new ideas, testing new concepts, attempting to work out viable new product lines such as the long-rumored Apple car.
South Korean technology conglomerate Samsung spends almost double that. Swiss-based pharmaceutical titan Novartis lays out what amounts to nearly 17% of its revenue, or $10+ billion, on R&D expenses. Car companies are also major research and development spenders; the reason civilization has gone from the relatively simple automobiles of the early twentieth century to the safer, more fuel efficient, and better-appointed vehicles. The nicest Rolls Royce in the 1920's can't hold a candle to a basic Ford Explorer off the lot today in terms of comfort and convenience; an accomplishment made possible by generations of R&D investment.
How Much Money Should a Company Spend on Research and Development?
Like so many questions in life, the answer to this question: It depends. Generally, a good place to begin is by comparing the firm you are studying to competitors in its industry. If everyone in a specific niche sector of the economy is putting 10% to 20% of sales back into R&D, and a firm you are trying to value is spending only 5%, that may or may not be a red flag. (At the very least, it warrants further investigation because R&D costs are somewhat akin in economic consequence to capital expenditures at a theme park.
Economically, they cost real money but they are too important to ignore. Just as a theme park operator can get away with boosting cash flow temporarily by neglecting capital expenditures on new rides or maintenance expenses to keep the doors freshly painted, the pavement smooth, and the grounds well-gardened, technology, pharmaceutical, automobile, and other firms can do the same by cutting research and development. If times are tough, it may be tempting to scale back on finding the next HIV treatment or smartphone breakthrough, forgetting that, if successful, those things could produce obscene, outsized profits.
In the end, when you starve research and development revenue is bound to fall is this path is taken because customers lose interest just as the neglected theme park no longer attracts visitors at its existing ticket prices. There is a reason that The Walt Disney Company is able to fill its parks at a price that fills other resorts with envy. They prioritize the experience, or "magic" as they say, over the profits which ultimately leads to greater profits despite it seeming counter-intuitive at first glance.
This is one of the dangers of having a highly innovative firm run by a so-called "bean counter" who focuses too much on short-term financial metrics.)
Another useful exercise in attempting to determine an appropriate level of research and development expense is to compare a company's own historical R&D spending to its past. This includes measuring it as a percentage of revenue and as a percentage of gross profit. This is because some firms are simply more efficient at converting a dollar of research and development costs into a dollar of revenue. Perhaps they have better scientists. Maybe their internal processes are more conducive to entrepreneurial experimentation.
The important thing is to revenue that it is not always true that more spending is better. There have been cases in the past where management teams allowed R&D to get out of control as divisions squandered precious shareholder capital on their pet projects that never showed any meaningful results.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.