How to budget for R&D costs
The Business of Food
by Jennifer Barney
How to budget for R&D costs
3-min read
When it comes to R&D, most bootstrapped startups will tell you they developed their products themselves or spent very little on an outsourced food scientist so they have little to no R&D startup costs in their budget.
As I’ve described before, making your product commercially will have costs associated with developing a process in production, and that development cost will hit your P&L in the first year one way or another.
What happens if I don’t budget for process?
I once had a startup create a new product on the bench which they were sure would work in production. When they went to go shop it around to co-mans, one bid required some upfront cost in process testing before even doing a run. The startup wouldn’t even consider that co-man thinking the spend was a waste, so they signed up with someone else. Unfortunately, their first run was a total disaster – the product molded because, they later found out, the process of manufacturing and packaging had to be done in-line rather than the typical batch and hold overnight.
For illustrative purposes, let’s pretend the loss was equivalent to 1/10th of the total amount of product they were planning to make in year 1. Since you still have to pay your co-man even though it didn’t work out, you’re out all your COGS for that run.
What happens on the unit P&L is illustrated on the right “Without R&D Expense”, where the cost is spread over the entire year’s volume, in this case an added $0.18 per unit in COGS.
Alternatively, let’s pretend they went with the first co-man who was going to charge them $10K upfront. Since the total unit volumes for the year are 100K this ends up at $0.10 per unit, taken below the line as an expense, which you can see on the left side “With R&D Expense”.
In this comparison, Operating Income is higher with the upfront R&D expense, which is accounted for in Operating Expenses. Without R&D expense the loss is accounted for in COGS resulting in a lower Gross Profit. Converting to percent, a Gross Margin below 40% is a red flag.
40% Gross Margin
If I haven’t drilled into you enough yet, the Gross Margin is supremely important. It’s the metric that is thrown around board meetings, shareholder reports, and most importantly, investor pitch decks as a measure of health and viability of the business. A good Gross Margin is 40%. Most investors do not believe startups when they say COGS will come down with volume, nor will they have the patience to understand the story of what happened when you messed up your first run(s).
Moral of the story is it’s better to pay upfront for R&D, and budget it as an expense!
All my best,
Jennifer
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