Is R&D Included in Cost of Goods Sold?

Research and Development (R&D) costs and Cost of Goods Sold (COGS) serve distinct purposes in financial reporting. Understanding their definitions, accounting treatments, and potential intersections is important for accurate financial analysis. This article clarifies R&D and COGS, explaining how they are accounted for and when R&D-related costs might influence COGS.

Understanding Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs a company incurs to produce the goods it sells during a specific period. This metric is fundamental to financial reporting, as it directly impacts a company’s gross profit, which is calculated by subtracting COGS from revenue. COGS adheres to the matching principle of accounting, ensuring that the expenses directly associated with generating revenue are recognized in the same period as that revenue.

COGS components include direct materials, direct labor, and manufacturing overhead. Direct materials are raw inputs that become part of the finished product, such as lumber for furniture or steel for cars. Direct labor refers to wages paid to employees directly involved in manufacturing. Manufacturing overhead encompasses indirect production costs, such as factory utility costs, depreciation on factory equipment, and indirect labor within the production facility.

For merchandisers, COGS is calculated using a formula: Beginning Inventory + Purchases – Ending Inventory. Manufacturers account for COGS through a more complex process involving work-in-process and finished goods inventories, where direct materials, direct labor, and manufacturing overhead accumulate as products move through the production cycle. COGS includes only the costs of goods sold during the period, excluding costs related to unsold inventory.

Understanding Research and Development Costs

Research and Development (R&D) activities involve systematic investigation aimed at discovering new knowledge or applying research findings to create new or significantly improved products, processes, or services. Activities classified as R&D include laboratory research, the design and testing of prototypes, and the operation of pilot plants that are not yet in commercial production. It also encompasses costs for materials, equipment, facilities, and personnel directly engaged in R&D activities.

Under U.S. Generally Accepted Accounting Principles (GAAP), R&D costs are expensed as incurred. This immediate expensing is due to the uncertainty of future economic benefits from R&D activities; it is often unclear whether these efforts will result in a commercially viable product or process. The rationale is to prevent companies from overstating assets on their balance sheets based on speculative activities that may not generate future revenue.

For tax purposes, Section 174 of the Internal Revenue Code governs research and experimental (R&E) expenditures. Historically, businesses could deduct these costs in the year they were incurred. Under changes introduced by the Tax Cuts and Jobs Act of 2017, R&E expenditures incurred in taxable years beginning after December 31, 2021, must be capitalized and amortized. Domestic R&E expenditures are amortized over five years, while foreign R&E expenditures are amortized over 15 years, starting from the midpoint of the taxable year in which they are paid or incurred. This mandatory capitalization for tax purposes differs from GAAP’s expensing of R&D.

The Relationship Between R&D and COGS

R&D costs are not included in Cost of Goods Sold. The distinction lies in their purpose and timing within the product lifecycle. R&D costs are incurred to generate new knowledge or develop new products or processes, occurring at an earlier, experimental stage. Conversely, COGS represents the direct costs of manufacturing and selling existing products already in commercial production.

Despite this separation, circumstances exist where R&D activities can indirectly affect costs reflected in COGS. One area is the capitalization of software development costs. While initial research and planning for software development are expensed as R&D, certain costs incurred after technological feasibility is established and before the software is ready for general release can be capitalized. These capitalizable costs include direct expenses like salaries for developers and external consulting fees.

If this developed software is sold as a product, the amortization of these capitalized software development costs can be included in COGS. If the software is for internal use, the amortization would be an operating expense.

Pilot plants and prototypes are another example. Costs for building initial prototypes or operating pilot plants for testing and refining a new product or process are classified as R&D and expensed. These activities are part of the development phase, proving feasibility or refining design. Once the product or process moves beyond this experimental stage and enters commercial production, manufacturing costs, including materials, labor, and overhead, become components of COGS.

If R&D activities lead to a tangible asset for internal use, such as specialized machinery for a new manufacturing process, its cost is capitalized. The depreciation expense of this capitalized asset is allocated to manufacturing overhead if used in production. This manufacturing overhead becomes a component of COGS. Initial R&D phase costs, such as conceptual formulation and initial testing, remain separate and are expensed. The connection to COGS arises when R&D activities culminate in a capitalizable asset used in production or becoming part of the goods sold.

Implications of Correct Classification

The classification of R&D costs, whether as an operating expense or a capitalized asset, impacts a company’s financial statements. On the income statement, expensing R&D means it is reported as an operating expense below the gross profit line. If R&D were incorrectly included in COGS, it would directly reduce gross profit, distorting the gross profit margin. This misclassification can make a company’s core production efficiency appear worse, affecting how analysts perceive its profitability before other operating costs.

The classification also affects operating income and net income. While both expensing R&D and including it in COGS reduce net income, the specific line item where the expense is recognized provides different insights into a company’s operational structure and efficiency. On the balance sheet, if R&D costs are capitalized, as with certain software development, they appear as an intangible asset. Conversely, if expensed, they do not create an asset on the balance sheet, which some argue can understate the value of a company’s innovative efforts.

The cash flow statement is also affected by R&D classification. Expensed R&D is treated as an operating cash outflow. If R&D costs are capitalized, they are classified as investing cash outflows, reflecting the acquisition of a long-term asset. This distinction is important for financial analysts and investors assessing a company’s cash generation and investment activities. Correct classification is important for ensuring financial statements represent a company’s performance and financial position, supporting comparability across companies and adherence to accounting standards.