Consumer products, whether it be food products or gaming software, are initiated from intense research and development before launch. This test bed, also known as research and development or “R&D,” resides in most companies and refers to a systematic process of creating new products or technologies or improving existing ones through research and experimentation. Developing new R&D products can be very expensive and can run into the thousands and even millions of dollars for some companies. For this reason, careful management of a research and development budget, including all planned project expenses, is important.
To accurately budget for newly introduced products, every cost related to labor, material and indirect overhead needs to be accounted for, and this is done by the Finance team working closely with the Project Stakeholder. The approach I have taken for this is to assign new R&D projects a project code and assign costs that are directly attributable to the project. Costs that are not easily assigned, such as indirect overhead costs, will be applied using rates from an assumptions table.
Let’s review the lifecycle on a research and development budget for projects starting with project code assignment then accounting for all costs using bill of materials. Let’s also explore the process for obtaining management approval and working close with Project Stakeholders to accurately reforecast project budgets.
Assigning Project Codes
A finance partner working closely with the R&D team will understand how expenses flow within the department. Either the expenses are standard department operating expenses related to brainstorming ideas or expenses directly related to projects and budgeted accordingly.
In the brainstorming stage, also known as discovery/exploration phase, the focus is on generating ideas, conducting preliminary research and exploring potential opportunities. The goal is to identify promising concepts or research directions that have the potential for further development.
It’s not until the potential new product gets to the concept development stage where a prototype may be created. It’s this stage that a project code is then assigned, and costs are then tracked to help build-up the initial budget layout. Most ERP systems allow for project tracking within the GL account stream, which helps with monitoring and controlling activities specifically related to projects. Once the project code has been set up with information such as project description, owner name, default GL expense account, expenditure limits, approval limits, approval routing names, etc., then the new project code can be handed to the Project Stakeholder for ordering materials and accounting for coding of vendor invoices and cross-department resource charges.
Bill of Materials (BOM) Planning
Planning for any project takes a considerable amount of communication with the Project Stakeholder to identify the goals, deliverables and milestones. This understanding will help align the budget with the specific project requirements.
The Stakeholder will set the stage on the length of the project from concept to development. They will also lay out the number of hours required for each skill level (e.g., software developer, electrical engineer, food tester). Additionally, the Finance partner and Stakeholder should work together to build up a bill of materials (BOM). The BOM is a comprehensive list of components or ingredients, raw materials and other required items to assemble one finished product. For planning purposes, the BOM will serve as a structured document that outlines all needed materials, quantities, labor hours and overhead.
Table A1 below shows an example of a BOM schedule. The schedule is broken out by material cost, labor cost and indirect and overhead costs. For the material section, a full description is provided, along with the part number, vendor, quantity, cost and total cost. For labor, the required skill labor is shown including the number of hours and fully loaded rate. Finally for each indirect and overhead cost, the driving rate, which comes from an assumptions table, see Table A2, is applied against the quantity to produce the total indirect and overhead costs.
Below is a more defined description for each BOM category and sources for obtaining estimated costs.
The BOM will also layout the required hours needed for each skill set. Working with the Payroll department will help to obtain fully loaded rates, which will include both salary and benefits. Working also with the Project Stakeholder to estimate the resource requirements for the project. This includes personnel costs, such as salaries, wages and benefits for researchers, scientists, engineers, technicians and support staff. Consider the time commitment of personnel, including full-time equivalents (FTEs) and any additional resources required, such as equipment, facilities or external consultants.
Direct costs are those directly attributable to the project, such as materials, equipment, prototype development, testing and data collection. Sourcing material costs requires working with Supply Chain to obtain material pricing. New material, not already set as standard costs, will require new pricing from vendors.
Indirect Overhead Costs
The final costs to include are indirect overhead that support the operations R&D line of business. Indirect costs include shared costs that support R&D activities but are not project-specific, such as laboratory or facility expenses, utilities, IT infrastructure and administrative overhead. There are several ways to allocate costs and every company does it differently. I have found it easier to build an assumptions tab within your model and set specific rates as drivers to the model. (See Table A1 as an example.) If the plan calls for a change with planned unit sales, which would result in a rate change, it can easily be done from the assumptions tab. Having the rates linked to the model would result in immediate and live changes to the rest of the budget model.
Project Funding Approval
Obtaining project approval from management is the single most important step in the project’s lifecycle. Without proper approval, the project is closed. For most companies, all projects will be reviewed during the review process. This will include existing projects, new projects and projects requesting additional funding. The reason for reviewing existing projects is to track its status and determine if the project is still aligning with the company’s strategic goals. Or perhaps another project that carries more importance will supersede another less important project and therefore the budget dollars will shift over.
The project review process is certainly a strategic process of allocating funds toward projects that make the most sense. The primary reason behind the shifting is because companies will generally only have a set annual research and development budget for all projects, and management will determine how much to allocate on a quarterly basis based on projected cash flow. For example, if a company has an annual budget of $10M for R&D projects, then management will determine, based on cash flow, how much to allocate per quarter. As mentioned, this is also a time for any existing projects to request additional funding if the project is deemed to go over budget or over its initially projected BOM plan.
Finance is responsible for managing this process and preparing a detailed financial evaluation of all projects, as shown in Table A3. The summary will include a list of all projects to be reviewed, which as mentioned includes existing, new and projects requesting additional funding. There are a few factors that go behind management approving a project – for example, market demand for the product, sufficient return on investment (ROI) and strategic company alignment on its long-term objectives. It’s at this time that the management team will review and discuss each of the project proposals, and it will decide to either approve as is, approve with cuts or not approve the project. In some cases, management may request revisions or seek additional information before making a final decision. Once management approves the project, the necessary budget funding and resources can be applied.
Stakeholder Partnership and Project Re-Forecasting
Keeping the project spending on budget is crucial and it’s the partnership of both finance and the Project Stakeholder to work together on this goal. As mentioned, although a project has been approved, the project will be re-evaluated at each Project Review cycle. This is not always the case with companies; however from my experiences, this is most common. Utilizing the project code assigned to the project helps keep track of actual spending coming from the ERP system, compared to budget. Table A4 illustrates actual project spending for the first two quarters compared to budget. With an annual budget for the company of $10M, YTD spending through the first two quarters is already over $1.3M. To get back to the annual budget, management will need to decide on what project(s) to reduce or eliminate. From our example on Table A4, the Dual dosing of WF6 was decided by management to be eliminated for the rest of year (ROY) after Q2. Also, the Tomography Module project was reduced in the 4th quarter by $100K.
Making budget cuts are not easy, but it is necessary if a company is to achieve their strategic objectives and maintain investor confidence.
Research and Development Budget Takeaways
In summary, the key to effectively creating a project research and development budget starts with good communication between Finance and the Project Stakeholder. Absorbing all costs is crucial to build an effective BOM. Additionally, proper documentation, analysis, and weekly meetings with the Project Stakeholder to review spending are helpful to stay on budget. Stepping outside of the box and engaging other Project Stakeholders to provide input into your project will feed positive constructive criticism. Lastly, consider taking notes as lessons learned to be carried on to future similar projects to enhance the accuracy and effectiveness of future project budgets.
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