Accounting for Research and Development Cost

Monograph on Accounting for Research and Development Costs

MONOGRAPH ON ACCOUNTING FOR RESEARCH & DEVELOPMENT COSTS

PREFACE

The advent of WTO related issues have once again surfaced on a strong platform, after

1st January, 2005, when the new patent, IPR regime will come into full effect. The main

theme of “ Competency Building under Global Competition under WTO scenario”, opens

the key issues relating to Accounting of Research and Development Costs. The Institute

of Cost and Works Accountants Of India, had come out with a major treatise on “

Management and Accounting for Research and Development – The Indian Praxis” by

Prof. S.K.Chakraborty in collaboration with Mr. Bipul K.Bhaumik, in the year 1984. The

macro and micro level issues on Research and Development Costs were deliberated in

detail in the publication. The current brief update on Accounting for Research and

Development Costs, takes off from the earlier views and opens the area, that has to

evolve in Accounting for Research and Development Costs. The Chapter on “Product

and Project Costing and Monitoring of R & D Costs” is thorough analysis of R&D Costs

replete with practical examples and the author as well as the Committee felt that it will

be most appropriate to include it as part of this monograph. The Accounting Standard –

8 –Accounting for Research and Development is also included as a reference, as the

accounting treatment is a key issue on the treatment of Research and Development

Costs. We hope that this brief monograph, evolves standard practices in future, that can

be helpful to the management accounting fraternity and various users.


We thank Mr.S.Srinivasan, Cost Accountant, Chennai, who alongwith

Mr.S.Ganapathisubramanian, Cost Accountant, Chennai, helped in producing this well

thought out monograph.

We also acknowledge the help rendered by S/Sri.A.S.Durgaprasad, A.N.Raman,

J.S.Anand, K.S.Subramanian and R.Narayanan, as part of the Technical Committee, for

providing valuable technical support for the publications.

We are also grateful to Dr.H.R.Subramanya, President, ICWAI, who germinated the

idea of bringing out special publications on topical issues and which will form the plank

on which the future guidance notes and cost accounting standards will emanate.

M.Gopalakrishnan

Chairman- Technical Committtee.

Diamond Jubilee Celebrations.



INDEX

Sl.No Topics1 Research & Development Scenario in India2 Private Sector Initiative3 Need for Fresh Approach4 Types of R & D Activity5 Evolution of Accounting Standards6 Provisions in the Cost Accounting Records Rules7 Provisions in the Cost Audit (Report) Rules, 20018 Practices in some Leading Companies9 Earlier Research by ICWAI10 Issues to be included in the Suggested Guidelines11 Product and Project Costing and Monitoring of R & D

Costs



1. Research & Development scenario in India

Research & Development activity in India is carried out through three major

channels.

a) Departments of the Central Government and the various research

laboratories functioning under their jurisdiction

b) Research in various higher centers of learning, viz., IITs and Universities

c) Private sector Industrial undertakings

The following are some of the major organisations falling under category (a)

1. Department of Science and Technology

2. Department of Space

3. Department of Atomic Energy

4. Council of Scientific and Industrial Research (CSIR)

5. Defence Research and Development Organisation (DRDO)

6. Research Design and Standardisation Organisation, Railways (RDSO)

7. Indian Council of Agricultural Research (ICAR)

8. Indian council of Medical Research (ICMR)


There are several other institutions functioning under state and central governments.

The CSIR alone has nearly 40 R&D institutions working in diverse areas, employing

over 10000 scientists. The income arising out of patent rights is a significant

component of CSIR's current turnover of about $80 million.

There are more than 150 universities and institutes of technology undertaking research,

which are funded by the University Grants Commission, State and Central governments

and Private sector industries.

There are hundreds of R&D centers run by private sector companies and registered

with the Department of Science and technology.

Products and technologies developed by the government research laboratories are

taken up for commercial exploitation by the National Research Development

Corporation (NRDC).

2. Private sector initiative - A historical perspective

R&D activity in the private sector in the past was driven primarily by tax planning

considerations. A number of industries had foreign technical collaboration and the

technical know-how was imported for which a royalty or lump sum fee was paid. Fiscal

incentives (Eg., Sec.35 of the Income tax act) gave an impetus to R&D effort, and


prompted many companies to setup R&D centers. The registration with the Department

of Science and Technology was a pre-requisite for getting the tax benefits.

However no substantial progress was made by private sector for nearly four decades.

3. Need for fresh approach:

The following developments during the last 20 years have forced a paradigm shift in the

approach of private sector industry to R&D activity.

1. Rapid technological advancement, especially in the information technology,

electronics, bio-technology and pharmaceutical sectors.

2. Number of multi national companies setting up shop in India with huge

investment and infrastructure exclusively for R&D

3. Multi national pharma companies outsourcing R&D activity in India

4. Globalisation of Trade resulting in cut throat competition and the advent of the

WTO regime

5. Changes in patent laws/trade related intellectual property rights (TRIPS)

- the number of patent filings by Indian companies through the Patent

Co-operation Treaty (PCT) route available with the World Intellectual

property organisation (WIPO) is increasing year after year.

All the above developments have collectively led to a shift in emphasis from pure

accounting and tax planning considerations to strategic planning and survival in a

globally competitive market.


There is therefore an urgent need to evolve a fresh standard for collection of costs and

accounting thereof, which will help the management in

a) Strategic planning,

b) Pricing of intellectual property rights (fixing of royalty rates etc.)

c) Deciding on the amount of funds to be invested in R&D

d) Meeting of requirements of tax laws/other statutory regulatory bodies.

4. Types of R&D activity

The following are some of the areas towards which R&D effort is directed

a. Improvements in existing products

b. Design and development of new products

c. Development of new processes

d. Adaptation of imported technology to suit Indian conditions

e. Import substitution of material/ components

f. Conservation of energy

g. Market research for existing and new products

5. Evolution of accounting standards

Treatment of costs of R&D in financial statements is a controversial accounting area.

International accounting standards have been introduced to improve quality, degree of


comparability, credibility and usefulness of the financial statements through out the

world. International accounting Standard 9 (IAS 9) lists the elements of costs, which

may be included under the head R&D expenditure and charged as an expense of the

period in which they are incurred. It also spells out the criteria for treating a portion of

the R&D costs as deferred costs. The Institute of chartered accountants of India has

also issued AS-8 for Accounting for R&D in 1985. However this standard stands

withdrawn after AS-26 (covering intangible assets) becomes effective in respect of the

concerned companies. The Indian standard is more or less in line with the IAS 9. AS-8

gives the definition of the terms "Research" and "development" as follows

(i) Research is original and planned investigation undertaken with the hope

of gaining new scientific or technical knowledge and understanding;

(ii) Development is the translation of research findings or other knowledge

into a plan or design for the production of new or substantially improved

materials, devices, products, processes, systems or services prior to the

commencement of commercial production.

The Indian standard also spells out the criteria for deferral of development costs.

Copies of these two standards are attached.

6. Provisions in the Cost Accounting Record Rules:

A typical clause in the Cost Accounting Record Rules prescribed under section 209(1)

(d) relating to the research and development expenses reads as follows:


(1) The proper records showing the details of expenses, if any, incurred by the

company for the research and development work on the products covered under

these rules, according to the nature of development of products i.e. existing or

new products and processes, development of process of manufacture - existing

and new, design and development of new plant facilities and market research for

the existing and new products, shall be maintained separately. The records shall

also indicate the payments made to outside parties for the research and

development work. The basis of charging such amount including lump sum

payment and its treatment shall be indicated in the cost records.

(2) The basis of charging these expenses to the cost of production under reference

and to other products shall be indicated in the cost records. Where the utility of

research and development work extends to over more than one financial year,

such expenses shall be charged to the cost of products under reference and to

all other products on equitable and reasonable basis and applied consistently

indicating the criteria on the basis of which it has been decided to extend the

utility period of these expenses to more than one financial year.

(3) The expenses incurred by the research and development department for

providing technical know-how to outsiders shall be recorded separately and

excluded from the cost of products under reference. The amount recovered for

providing technical know-how to outsiders shall also be indicated separately and

excluded from the income arising from the sale of products under reference.


7. Provisions in the Cost Audit (Report) Rules, 2001.

The above rules call for information on research and development expenses in Para 13

of the annexure to the cost audit report. The details are to be given separately for

process development and improvement, existing product development and new product

development and also the amount capitalised/ deferred out of the total amount spent.

8. Practices in some leading companies:

The practices followed by some leading companies are given below;

1. Ashok Leyland Ltd -

Expenditure on design and production of prototypes is charged to revenue as

incurred

2. TATA Motors Ltd. -

Product development costs incurred on new vehicle platforms, variants on

existing platforms and new vehicle aggregates are recognised as intangible

assets (included under fixed assets) and amortised over a period of thirty-six

months from the commencement of commercial production.


Product development costs relating to minor product enhancement, facelifts

and upgrades are charged off to the Profit and Loss Account as and when

incurred.

3. Tamilnadu Newsprint and Papers Ltd.

Research and development expenditure of revenue nature are

charged off to Profit and Loss Account every year.

4. Chemplast Sanmar Limited

Revenue expenditure on research and development is charged as an

expense for the period in which it is incurred.

9. Earlier research by the ICWAI

The Institute of Cost and Works Accountants of India has published a treatise

on Management and accounting for R&D - the Indian Praxis in 1984. Chapter

VI of this treaties deals with the product and project costing and monitoring of

R&D costs. The learned authors have elaborately dealt with the subject with

a number of illustrations, which are still current and hence the same chapter

is reproduced.


10. Issues to be included in the Proposed guidelines

In these guidelines the terms Research & Development will have the following

meanings:

(i) Research is original and planned investigation undertaken with the

hope of gaining new scientific or technical knowledge and

understanding;

(ii) Development is the translation of research findings or other

knowledge into a plan or design for the production of new or

substantially improved materials, devices, products, processes,

systems or services prior to the commencement of commercial

production.

Research & Development Activities - These activities can be defined as any systematic

and creative work undertaken in order to increase the stock of knowledge and the use

of this knowledge to devise new applications. R&D activities include any one or more of

the categories of research such as basic research, applied research and experimental

development.

Basic Research - Basic Research may be defined as any experimental or theoretical

work undertaken primarily to acquire new knowledge of the underlying foundations of

phenomena and observable facts, without any particular or specific application or use in

view.


Applied Research - Applied Research may be defined as any original investigation

undertaken in order to acquire new knowledge. It is, however, directed primarily

towards a specific aim or objective.

Experimental Development - Experimental development may be defined as any

systematic work, drawing or existing knowledge gained from research and / or practical

experience that is directed to produce new materials, products and devices, and/or to

improve substantially those already produced or installed.

Research and development costs shall include:

1. Salaries and wages and other related costs (cost to the company) of

personnel in research and development

2. Cost of material and services consumed in R&D activity

3. Depreciation of building, equipment and facilities, to the extent they are used

for R&D

4. Overhead costs related to research and development activities,

apportioned/allocated based on Cost Accounting Standard - 3

5. Payment to outside bodies (Research laboratories / universities etc.) for R&D

projects related to the enterprise

6. Other costs related to R&D such as amortisation of patents and licences


7. Expenditure incurred for obtaining patents for new products / processes.

The total expenditure on R&D, collected under the above heads shall be allocated /

apportioned to the specific products / processes under development on an appropriate

basis.

The amount of the research and development costs described above should be

charged as an expense of the period in which they are incurred except to the extent that

development costs are deferred in accordance with the following paragraph.

Development costs of a project may be deferred to future periods if all the following

criteria are satisfied:

(a) The product or process is clearly defined and the costs attributable to the

product or process can be separately identified;

(b) The technical feasibility of the product or process has been demonstrated;

(c) The management of the enterprises has indicated its intention to produce

and market, or use, the product or process;

(d) There is a clear indication of a future market for the product or process or, if it

is to be used internally rather than sold, its usefulness to the enterprises can

be demonstrated; and

(e) Adequate resources exist, or are reasonably expected to be available, to

complete the project and market the product or process.

The deferral of development costs of a project under the above criteria should be limited

to the amount that, taken together with further development costs, related production


costs, and selling and administrative costs directly incurred in marketing the product,

can reasonably be expected to be recovered from related future revenues.

If an accounting policy of deferral of development costs is adopted, it should be applied

to all development projects that meet the above criteria.

If development costs of a project are deferred, they should be allocated on a systematic

basis to future accounting period by reference either to the sale of use of the product or

process or to the time period over which the product or process is expected to be sold

or used.

The deferred development costs of a project should be reviewed at the end of each

accounting period. When the criteria, which previously justified the deferral of the costs,

no longer apply, the unamortised balance should be charged as an expense

immediately. When the criteria for deferral continue to be met but the amount of

deferred development costs (and other relevant costs as set out in paragraph18) that

can reasonably be expected to be recovered from related future revenues is exceeded

by the unamortised balance of such costs, the excess should be charged as an

expense immediately.

Development costs once written off should not be reinstated even through the

uncertainties which had led to their being written off on longer exist.


PRODUCT AND PROJECT COSTING AND MONITORING OF R&D COSTS(Extract from “ Management and Accounting for Research and Development – The Indian Praxis”

by Prof. S.K.Chakraborty in collaboration with Mr. Bipul K.Bhaumik, and ICWAI Publication.)

I Product and Project Costing of R&D Costs

While the question of project wise cost finding and control of Research & Development

expenditure is relatively straightforward, that of product costing is not so simple. How do R&D costs find

their way into product costs and prices? Or do they get debited straight to the profit and loss account? If

they are treated as overhead costs, do they form a part of corporate or manufacturing or administrative

overheads? Is any distinction drawn between Research costs and Development costs? It is to these

issues that the present section addresses itself.

A Practical Illustration:

(A) In a public sector chemicals firm two distinct stages of R&D work are involved, viz., the laboratory

experiments and trials, and the pilot plant operations. While each pilot plant is a large capital expenditure

by itself, and is subjected to independent evaluation at the time of selection, and costing during operation,

the system in use for the laboratory phase of R&D is something like that shown in the following Table.

ANNUAL LABORATORY R&D COSTS

Year

(Rs. In lacs)

1. Salaries and wages 5.53

2. Laboratory chemicals 2.00

3. Maintenance (lab. bldg. and equip.) 0.93

4. Insurance 0.25

5. Depreciation 1.70

6. Interest (on proportionate term loan at weighted interest rate) 1.15

7. Common Services 5.31

_____

TOTAL 16.87

=====

Table

Now, 50 per cent of Rs. 16.87 lacs is assumed to be for 'Research', and is allocated to various

manufacturing plants in proportion to the gross profits from each. The remaining 50 per cent considered

as 'Development', is distributed amongst the plants in proportion to the estimated cost of production in

each plant.


In other words, the above methodology illustrates the following important management

accounting principles:

(a) 'Research' costs are treated differently from 'Development' costs.

(b) 'Research' costs apparently do not form a part of product costing, and, therefore, not of product

pricing either. These costs are charged straightway against gross profits. (At least that is the

logical implication of allocating 'Research' costs in proportion to gross profits).

(c) 'Development' costs form a part of product cost-probably because they are much more visibly

correlated with current operations. But these costs enter into product cost, apparently, via

administrative overheads.

(d) Gross profits are derived after paying for Development costs.

(e) It is reasonable, therefore, to infer that while Research costs do not enter into product prices,

Development costs do.

It is not clear, however, as to why laboratory costs are split into Research and Development as

50:50, and not on any other basis. Except as a general thumb rule there seems to be no stronger

argument for this procedure.

(B) In an intermediate-cum-capital goods firm the practice is to include R&D expenditure within

corporate overheads. Records are available for total project times (man hour-wise) under separate

business centres. Total R&D costs are apportioned to these business centres in proportion to these

project times. But what happens after this apportionment is done? Does the apportioned cost get added

to the manufacturing or administrative overhead of the business centre? If it does get included in either, it

then forms a part of the cost of current production in the centre. However, closing inventory valuation will

differ, if the basis of valuation is only manufacturing cost, while R&D costs are included in either

manufacturing or administrative overheads. Since the firm claims that R&D costs enter into product cost,

it is clear that they are not charged off directly to the centre's profit and loss account.

(C) A large engineering concern has for one of its Divisions a 'Design and Development Department'

D&D. There are several products in this manufacturing division. Each product has a number of models

within its range. All D&D costs, project wise, are accumulated for each product separately. The total D&D

costs for each product (say covering three D&D projects over the year) are then split amongst the various

models of that product in proportion to the shop costs of the respective models. Shop costs comprise:

- direct materials

- direct labour

- shop overheads.


This method implies that higher the total shop cost (no of units X cost per unit) of a model, the

greater is the burden of D&D expenditure shared by it. The idea probably is that: let the model with larger

production (and sales) value bear a bigger proportion of D&D costs incurred for that product.

It is not clear, however, as to whether the product-wise D&D costs, which are apportioned to

various models, are a summation of the overheads of the D&D department apportioned to the particular

product (which may, in turn, include share of apportioned corporate overhead costs) and the direct costs

of each of the three D&D projects for that product. In our view this would be a simpler process to adopt.

While it may be useful to apportion D&D overheads to individual D&D projects for their costing, for model

wise costing this step is redundant.

(D) We have just referred to the question of D&D overheads being absorbed into various D&D

projects. Let us exemplify this aspect too. In another Division of the same company mentioned in C. which

has a 'Research Centre (probably indicating a genuine difference in the nature of R&D work done in the

two Divisions), the method of project wise overhead absorption is as follows.

The Research Centre itself being quite large, it has several distinct 'cost centres'. Each such

centre has its own manpower allotment for a given year. This available manpower is converted into

'engineer man-hours' available for the year. Next, the 'overheads' of each cost centre are computed

(implying a sharing out of the Research Centre's own common facilities and expenses to the various R&D

cost centres.) With these two pieces of information, a man hour rate or shop rate is calculated, as simply

as below, for each cost centre:

Cost centre overheadsShop rate = ——————————

Engineer Man Hours

Finally, when actual engineer man-hours spent on each project within a cost centre are known,

this figure is multiplied by the shop rate to find out the overhead cost for each project within a cost centre.

It is obvious that by this method, under or over-absorbed overheads may arise. They will need to be

appropriately disposed of.

The point to note is that while this process of accounting for project-wise R&D overheads is

necessary from the viewpoint of project cost control, product costing with respect to R&D costs need not

be affected by any particular method adopted for apportionment, or even by non-apportionment altogether

to R&D projects. This is because R&D cost centres is non-conterminous with manufacturing cost centres.

Where, however, a certain R&D project is identified with a specific product then of course the method

used for R&D project costing will affect product costing too.

(E) In the large chemicals and consumer goods firm we have been mentioning earlier, the practice


apparently is to include Research & Development expenses within corporate overheads. At the same

time, an explanation is offered that whatever Research & Development expenses can be identified with

various profits or business centres on the basis of original requisitions and approvals are first allocated to

them properly. If this is to be conceded, then the first version of the treatment of Research & Development

costs is rendered meaningless. In fact, for the firm cited in (B) too we catch a glimpse of this anomaly.

Both these instances show that where the enterprise is divided into distinct business or profit centres, and

the Research & Development unit woks for all of them on the basis of requests and approvals, there is no

point in first saying that Research & Development costs are treated as corporate overheads, and then

beginning to qualify it.

A description was given in para D, section II of the previous chapter about the method adopted in

this firm for project cost estimation via 'standard unit manpower cost' (i.e., estimated total revenue costs

of R&D for the year, divided by total manpower units in terms of standard units for various categories-the

latter being multiplied by available hours during the year). This total revenue cost estimate has three

components of roughly the following magnitudes:

- chemicals and glassware : 15 %

- salaries : 50 %

- rest (i.e., overheads) : 35 %

From this it is obvious that R&D project cost estimation is done in a direct manner within the R&D

function itself. If there is at all a corporate overheads category, the R&D function must be receiving a

share thereof, which is merged in the 'rest' above.

Let us come back to the treatment of R&D costs for 'product costing'. While it is true that directly

traceable R&D costs find their way into the respective operational or business centres of the firm, the

question still remains as to whether the allocated R&D costs are debited in lump sum to the operating

income of the division, or they also find their way into product cost (and thence to product pricing) through

one or other category of divisional overhead costs. We got no clear answer to this question in our first

round of discussions with R&D personnel.

A second round of discussions with corporate finance personnel, however, brought more clarity

and insight into the picture. For accounting purposes a strict distinction is maintained between Research

and Development. The latter is carried out in the manufacturing sites of each business centre with a

separate set of personnel reporting to the Head of Manufacturing. Upto bench scale work (in the

Research Centre) on any project, all costs are considered as Research. Beyond that, there is a formal

transfer of Research results to Development in the relevant manufacturing site, and all costs relating to

Development form a part of the 'manufacturing overheads' of that business centre. In other words, all


products in that centre are loaded with a share of' Development costs via manufacturing overheads.

So far as Research is concerned, there is a Research Centre with elaborate facilities in a location

physically distant from all the manufacturing sites. Here Research projects are identified separately for

existing products or processes, as well as for new ones for each business centre. In fact 80% of the

budget of the Research Centre (treated entirely as Research) consists of such projects handed over to

the Centre by various business centres. Within the Centre separate costing is maintained for each such

project. For product costing within each business centre, however, the total Research costs incurred on

its behalf during a period are included as a part of its administrative overhead. This is in contrast to

Development costs, which become a part of 'manufacturing overheads'.

But what happens to the balance 20 per cent of the Research budget, which is funded by the

corporate level for futuristic corporate R&D (and not for any ongoing business centre)? Although no clear

answer emerged on this point, we could infer that this was charged off directly to the profit and loss

account add did not enter into product costing.

This problem was raised with a large pharmaceutical firm too. Here also the discussion was

insightful. If the R&D work is essentially Development work related to specific products, then such cost is

a legitimate part of the cost of current production and sale of such items. It could, therefore, enter into

product cost via the administrative overhead cost heading. In this method product-specific costing is

sacrificed however.

But difficulty arises when there are centralised Research costs of a basic or background nature.

They are not usually connected with any of the ongoing production operations. So, it might be argued,

why should current products be burdened with a share of these costs? The answer, therefore, would

seem to be: debit Research costs to the corporate profit and loss account without taking it through any

overhead cost heading. The counter-argument is that, since Research is a continuous activity, and since

current products are receiving the benefits of past research, and future products will be reaping the

advantage of current Research, on the whole their effects and incidences balance out. So it is equitable if

basic R costs also find a place in current product costs. However, in order to achieve this, it might be

sensible to amalgamate R with corporate overheads and from thence distribute it to business centres and

to their products.

By way of comparison between the previous consumer goods firm and the pharmaceutical firm, it

appears that in the Research Centre of the latter almost the whole of the expenditure is on futuristic

Research, unlike a mere 20 % for the former. And hence, practically the entire amount of R probably

remains outside product costing. This aspect has, however, broader implications regarding pricing policy


under the Drug Price Control Order (to be discussed in a later section of this chapter).

It may be noted that the 'shop rate' of the firm in (D), and the 'standard unit man-power cost' in (E)

are different in two major ways:

(a) In (D), it is only the cost centre overheads which appear in the numerator, whereas in the case of

(E) it is the total revenue cost of the entire R&D unit which appears in the numerator.

(b) In (D) the engineer hours of each cost centre only are aggregated. But in (E) all categories of

R&D personnel as a whole are expressed in terms of standard units. It appears that the additional

refinement in (E) could lead to more sensitive cost estimation of R&D projects in terms of widely

divergent combinations of various categories 'of manpower budgeted for each.

(F) In a pharmaceutical and consumer goods firm (not the one referred to in E) all costs of the R&D

unit are treated as 'overhead' costs. They arc then apportioned to the three manufacturing plants in

proportion to the net assets employed in them. Within each plant, the apportioned R&D cost finds its way

into various products in proportion to machine hours used by each product.

It thus appears that this firm steers clear of the vagaries of sales revenue or gross profit of each

plant in apportioning R&D costs. Perhaps gross assets would be even better from that point of view.

In-plant apportionment to products, based as it is on machine hours, seems to indicate a manufacturing

overhead cost treatment for R&D costs. Obviously R&D costs enter into product pricing decisions.

Interestingly enough in this firm Research has three times the revenue outlay for Development

(as against 50:50 in the consumer goods firm in E), yet product costing does not seem to take cognisance

of this distinction along the lines mentioned in E above. Of course, the internal impact of ignoring this

important management accounting distinction could be small, although for various government regulation

purposes it may be rather significant (see section III later).

(G) So far as R&D 'project costing' is concerned, in the pharmaceutical firm cited in F above the

practice is quite straightforward. No project-wise cost collection is done. At the year-end the Head of R&D

gives the total number of management man-hours spent on all projects (obviously this datum is logged

project-wise). Total R&D costs are apportioned to projects in proportion to their respective usage of R&D

management man-hours. Broadly, it is a correct approach because management manpower is the major

and critical cost element in R&D. And MBO results guides include management man-hours spent as an

important objective to assess the effectiveness of progress made in R&D projects.

(H) A smaller pharmaceuticals company makes on apportionment of costs to the R&D function from


other parts of the factory system for internal costing purposes. Costs incurred directly within R&D are

included in 'miscellaneous expenses' for the Profit and Loss account. Nor are any efforts made to trace

R&D costs to the individual products. Thus, a straight charge against annual revenue is made. For a small

firm, pharmaceuticals would be a highly competitive business to be' in, and so the cost structure of each

product is probably not allowed to be influenced by R&D cost allocations.

(I) A paints and chemicals company follows almost the same practice as described for the firm in F

above. The central R&D costs are apportioned to each product group on the basis of net capital

employed. This apportioned cost, along with the product group's own separate R&D activity costs, is then

apportioned to individual product lines in terms of recorded machine hours used by each one of them.

For project costing, however, man-hour is the relevant apportionment as well as assessment

parameter.

In another paints company, R&D expenses are combined with 'administrative overheads', which

is charged to the Profit and Loss Account. While this may be true for financial accounting, it is not clear

whether for product costing too the R&D costs remain out of the picture. Neither project nor product

costing for R&D costs seems to be established on a clear footing in this case.

(J) In a public sector drugs and formulations manufacturing company the Head of R&D maintained

that strictly speaking project-wise budgeting was not done in this case. Flexibility was more important, and

that budgeting served this aim adequately. No project-wise justification was also needed to be submitted

to the top management. However, at the completion of a specific project (e.g., for an anti-malarial drug)

retrospective cost computation was attempted on an approximate basis.

The Research Centre has three divisions: biology which carries out only basic Research,

chemicals which does both Research and Development, and the pilot plant which performs only

Development work. The laboratories and manpower are clearly demarcated for all the three units of the

Research Centre. And yet all the costs of this centre are treated as 'general overheads'. For monthly cost

sheets they form a part of administrative overheads and are charged to various products as a percentage

of cost of materials and operating supplies.

Discussions with the Head of Finance, however, revealed that cost of R&D projects on existing

products is charged to those products in the annual cost sheet. On the other hand, costs of projects on

future products are deferred in the annual cost sheet. They are charged off later when commercial

production of such new products begins. In other words, existing products do not seem to bear the cost of

Research on future products.


(K) In a defence-related public sector enterprise each project in the Design and Development (in lieu

of R&D) department is separately budgeted. At the time of commencement of each project a

Development Work Order is issued. In it are booked all costs of the project (labour hours x man-hour rate,

materials, fabrication and testing costs etc.) On project completion the Work Order is closed. The total

accumulated project cost is capitalised and treated as deferred revenue expenditure in the balance sheet.

These costs are later charged off during three to five years to the concerned products when their actual

production commences after incorporating the improvements. Whenever a project ends in failure, its

accumulated costs are not deferred. The entire cost is written off to the year's profit and loss account after

obtaining the approval of the Board. For projects which are treated at first as deferred revenue

expenditure, and subsequently charged off to production costs, the latter form a part of the cost structure

used for pricing purposes. On the other hand, the cost of unsuccessful R&D projects does not affect

product costing and pricing.

In sum, our findings from the above survey broadly conform to what the 1979 NAA report has

found to be the practice in the USA: 'A prevalent technique used to control R&D expense is to apply all

costs (both direct and indirect) of the R&D function to projects. All firms interviewed were using the

full-costing approach'.

There is, however, one noticeable difference between the 1979 NAA study and ours. The former

does observe: "When the R&D function is centralised, it is general practice to distribute the costs of R&D

to operating divisions. The purpose of this procedure is to determine the profit or loss of each division2

While this is a legitimate part of a management control system, the report stops short of exploring the next

step i.e., how do such distributed R&D costs find their way into product costs and prices in the respective

divisions? Neither is there any reference to the distinction between R costs and D costs in terms of

current product costing and pricing. Our survey of Literature suggests that there are indeed very few

references to this aspect of management accounting for R&D.

Thus, Batty makes the point that basic research, applied research, product development and

fixed assets development-all these four accounts, with all their accumulated costs, will be transferred to

either 'cost of sales' or 'profit and loss', or 'asset' account. There might be an implied hint of charging R&D

costs to product costs under the first option of debiting to cost-of-sales account. The other two methods

do not carry even this implied suggestion.

The earlier NAA Report of 1955 had, however, devoted about five pages to this topic. The survey

underlying this report discovered that normally D costs were recovered through product costing and

pricing by estimating the number of units to be sold with the new development, and dividing the D costs

by the estimated units. It should be appreciated that such charging of D costs to product costs for pricing


is a management accounting exercise, quite independent of the financial accounting treatment in terms of

debiting to the Profit and Loss Account or transferring to the Balance Sheet. Fundamental or basic or

general R&D costs may not, however, be charged in this fashion to individual products because there is

no specific relationship between these costs and the manufacture and sale of such products. It is this

class of R&D costs, which might be charged off directly to the Profit and Loss Account.

In our own survey we have examined the case of a large engineering firm, which is in the

business of designing and constructing big chemical, cement, fertiliser and similar plants for client firms.

Either this engineering firm, or its client(s) enter(s) into foreign collaboration agreements. 'Technology

adaptation' therefore becomes a vital aspect of executing such orders, and this task is performed by the

firm's R&D centre. Since, however, each order is of a unique type, the corresponding R&D work too is a

one-time exercise. There are no repetitive, continuous sales throughout the year stemming from such

R&D work. Accordingly, the issue of product costing-cum-pricing, incorporating R&D costs, does not

occur in this firm in the same way as the preceding paragraphs have indicated. Assuming that cost of

materials and labour on construction site are provided for by the client, this firm builds up its own bid price

estimate, including design and development costs, in the following style (figures are imaginary):

1. Manpower cost Rs. 7,20,000

2. Components and Materials Rs. 1,50,000

3. Overhead Costs @ 60 % of manpower costs Rs. 4,32,000

4. Transport and Sundries Rs. 1,00,000

Rs.14,02,000

5. Add, Margin of 100% Rs.14,02,000

6. Price Quoted Rs.28,04,000

==========

Reverting back again to the more common case of continuous manufacture of given product(s),

the fundamental questions underlying R&D cost allocation are:

(a) Should current customers pay for R&D outlay currently incurred?

(b) Should future customers pay for R&D outlay currently incurred?

(c) Should shareholders pay for R&D outlay currently incurred?

Option (a) entails costing of current products with R&D outlays - either directly, or through an

overhead absorption rate. Option (b) entails deferring current R&D outlay as an asset, and costing future

production through an overhead rate or directly by including an amortised amount. Option (c) implies no

charge of R&D costs to production-either through an overhead rate, or as a direct charge. There is a

straight debit to the P & L A/c - either as a charge or an appropriation. If it is a charge then, of course, the

government also bears a part of the R&D cost. A choice amongst these three options shall always


depend on the management's judgment about the strength of competition, discretion enjoyed in pricing,

level of profits anticipated, and shareholders' attitudes. As a general guideline the following scheme might

be worth considering:

(a) For Development work relating to a specific product, a direct charge to the product could be made

by estimating its total sales, say, over the next 5 years (if it is a joint product, suitable

apportionment may have to be done). This charge mayor may not be included for pricing,

depending on assessment of competitive strength.

(b) For Development work relating generally to all products, a charge to all products through a

general overhead rate, which mayor may not be included for pricing.

(c) For Research work, straight debit to P&L a/c.

While options (a) and (b) will affect product profitability - either with or without pricing being

affected by R&D, option (c) will affect company profitability without affecting product profitability. A firm

facing stiff competition and squeezed margins may prefer to choose option (c) for Development as well,

and thus pass on the cost of R&D to the government and shareholders.

II Project wise Monitoring of R&D Costs

Project-wise control is probably the only sensible way of monitoring R&D costs. This is so

because projects are allotted to individuals, or teams of individuals with leaders, and then the

responsibility centre concept for accountability becomes operative. Let us examine some of the practices.

(A) In the public sector chemicals company mentioned earlier, there is a quarter/y review for all

laboratory trial phase projects. This review is done by a Technical Subcommittee comprising the:

- Chairman and Managing Director

- Technical Director on the Board

- R&D Manager.

For pilot plant R&D projects, however, much more elaborate monitoring arrangements exist-

obviously because the outlays and stakes in them are much greater. Chart 6.1 shows the layout of the

reporting format for pilot plant projects in which data are periodically sent up to the Board and the

concerned Ministry.

(B) In a container-manufacturing firm the principal monitoring method is to review each project on the

basis of two monthly reports - one for costs, and the other for physical progress. Charts 6.2 and 6.3 show

the formats of these two reports.

As a policy in this firm, if a more than 15 per cent overrun is revealed-either for time or cost-as a

sequel to project review, then the project originator has to submit revised data, and go through the

process of submitting a fresh Project Initiation Report (PIR). This automatically ensures some measure of

control and discipline.


MIS FORMAT (PILOT PLANT)

A. Basic Information

1. Capacity of plant

2. Completion date

B. Physical Progress

C. Financial Progress

1. Sanctioned cost.

2. Expenditure upto (say) March 1980,

3. Budget for the year (say) 1980-81.

4. Expenditure incurred during April 1980. 5. Balance likely expenditure during 1980-81.

6. (a) Commitments already entered upto April 1980.

(b) Likely to be liquidated in 1980-81

(c) Likely to be liquidated in subsequent years.

7. (a) Further commitments likely to be made during the year.

(b) Likely to be liquidated in 1980-81.

(c) Likely to be liquidated in subsequent years.

8. Balance to be committed in subsequent years.

Chart 1

PROJECT EXPENDITURE STATEMENT (MONTHLY)

PIRNO: DESCRIPTION:

AUTHORlSED AMT: TOTAL EXP. UPTO: BALANCE AVAILABLE:

Capital

Revenue

Total

PRESENT ESTIMATED EXPENDITURE:

FOR PROJECT COMPLETION:

REMARKS:

Chart 2


PROJECT STATUS REPORT (MONTHLY)

PIR NO.: DESCRIPTION:

PRESENT STATUS:

REASONS FOR DELAY:

DATE OF APPROVAL OF PROJECT:

EXPECCED DATE OF COMPLETION:

Chart 3

(C) In a storage battery making firm there is a system of quarterly review of total R&D expenditure

according to expense heads as well as in terms of projects.

Since manpower resources are the major constraint, special attention is claimed to be given to

the control of usage of this resource by individual projects. To facilitate this central objective, a milestone

achievement report for each project is prepared every quarter.

There is an R&D Committee, consisting of representatives from R&D, manufacturing and

marketing, which meet every month to review progress.

Since it is a multinational company, the Indian R&D outfit has an overall liaison man to coordinate

between the international R&D centre and its Indian counterpart. Further, each project leader in India has

a corresponding linkman at the international R&D centre. All control and -review reports are regularly sent

there.

(D) For the Division of a large engineering company referred to in (C) in Section I above, the

monitoring process is like this. It has a Product Development Committee comprising the Divisional

Manager, Production Managers for various products, Sales Managers and Design and Development

Manager. This PDC meets every month to review the progress of each project. A computerised report is

made available as shown in Chart 4.

PROJECT-WISE CONTROL REPORT

Debiting Depts. Labour Hours Labour Cost Materials Cost Overhead Total (Rs.)

Chart 4


It is obvious that the data contained in Chart 6.4 alone are insufficient for proper control. It does

not show budgeted figures. Physical progress data should also be available in addition. However,

complementary to the project-wise financial data reporting, department or cost centre-wise financial data

are reported in a separate format as shown in Chart 6.5. In Chart 6.5 too there is nothing to show relative

performances of the departments in respect of physical progress of R&D work in them.

(E) For the identical Division referred to in (D) in Section I above, the monitoring system is somewhat

more sophisticated. In this Division project selection itself is done on the basis of decision trees and

probabilities. Accordingly, the approved decision tree for each project itself provides useful benchmarks

for monitoring its progress. It has been said that after the implementation of this methodology, coupled

with some version of MBO system, both time and cost over-runs have been brought down to nominal

levels.

Year to date DEP ARTEMENTWISE This Month

Actual Variance Annual Budget R&D COST Actual Variance

Dept. 1

Dept. salaries and Overheads

Direct MatIs. and other exp.

Dept. 2

Dept. salaries and Overheads

Direct MatIs. and other exp.

Dept. 3

Dept. salaries and overheads

Direct MatIs. and other exp. and so on

Chart 5

There is also a three-tier system of R&D project review:

- Every month the 'group leader' of a set of projects reviews all the projects under him with the

individual 'project leaders'.

- Every three months the Head of R&D holds reviews with the 'group leaders'.


- Every six months the Research Advisory Committee conducts a review session in a hall with all

the R&D personnel. While the Head of R&D and group leaders do the main talking and

explaining, other R&D personnel also stay there as observers. This is deemed to be a useful

training and orientation opportunity for junior personnel. The basic premise is said to be: R&D

bears the whole technical risk and liability of the company; hence their work must bear thorough

and comprehensive scrutiny.

Since the major cost of R&D is in respect of manpower, scrupulous time logging by R&D

personnel in printed cards is a standard and accepted practice within the Division. At the beginning of

each year each researcher has to prepare an estimated break-up of his total time to be spent on project

and non-project work respectively. The latter comprise visiting clients, attending conferences, doing

library work, spending time with design or production or marketing people and the like. The aggregate

distribution pattern between these two categories across an categories of R&D personnel is roughly

60:40.

The R&D department utilises in-company computer services for further help in monitoring and

controlling R&D activities. The Head of R&D receives the three following monthly reports from the

computer :,

(a) Project-wise data on manpower time and cost, materials and overhead costs

(b) Staff category-wise time spent on project and non-project work.

(c) Detailed manpower cost sheet.

Not all of them yet give full control information, because they confine themselves by and large to providing

the actual data only. Budgeted/estimated figures will need to be incorporated to enhance the utility of the

sound framework already created.

(F) In one of the three pharmaceutical firms covered in our study a monthly control report on each

project is prepared and sent to the parent company abroad. It seems to concentrate only on the

manpower (time spent) aspect of each project. It uses an index called 'manpower units' (MPU). This is

budgeted in total for each project, and periodic cumulative actual are compared against this budgeted

figure. A typical report for a project for a month appears as in Chart 6.

Chart 6

Project Monthly Project Report Year& Month

Budgeted MPU's Actual MPU's To-date

Group leader

Rest (excluding workers)


The nominal man-hours are multiplied by a certain standard fraction to derive the manpower

units. This is done most probably as a weighting device to account for diverse categories of research

personnel involved in each project.

Besides this monthly report, an annual report is also sent to the parent company, built on the following

lines (Chart 7).

Chart 7

ANNUAL REPORT

(A) Summary Budget Actual

(a) Section I: (i) No. of Ph.D's

(ii) Total salaries (Ph.D's)

(iii) Consultancy fees

(b) Section II: Do

(c) Section III: Do

(B) Project Details

(a) Section I: Narrative details of progress in various projects.

(b) Section II: Do

(c) Section III: Do

The 'sections' in Chart 7 refer to the various disciplines in which R&D work is carried on. It

appears that this research centre undertakes projects for outside clients at a price. Hence the entry

'consultancy fees'. Or, it may also mean fees paid to other agencies for R&D work farmed out to them.

(G) In the large chemical and consumer goods firm we have been referring to, review of R&D is done

at two levels. First, each project is reviewed quarterly within the R&D Centre along with the concerned

research scientists. In the second round, a review is done for each project three times a year by a group

consisting of profit centre Heads, the Chairman, Director (Technical) and the Head of R&D. The basic

data sheet for such project-wise reviews is of the style shown in Chart 8.

'Estimated units' in the upper right hand portion of Chart 8 refers to the standard manpower units

(after conversion of different categories of manpower into equivalent standard unit). Chart 8 does not

provide for separate mention of manpower, materials and overheads costs for each project. Nor does it

seem to provide for any indication of physical completion of the project.


LABORATORY PROJECT REPORT

Project Name and No. Year

Business Centre Project Coordinator

Concern Objective Section Percent Estimated Estimated Start Finish

Project No. Units Cost for Date Date

the year

Research Objective:

Review Estimated Estimated Actual Total Total Next Prepared

Date Completion Cost Cost Estimated Cost to Review by

Date Year Year Cost Date

Chart 8

(H) In a pharmaceutical firm which employs MBO there are two types of reviews for R&D work. One is

the twice-a-year MBO reviews based on the results guide of each individual, including that of the Head of

R&D. Performance against specific and agreed 'objectives' is reviewed in these sessions. The other

review is at the Board level, which has the following composition when the turn of R&D comes:

- Managing Director, MBO adviser, Corporate Planner, Finance Director, Divisional Directors,

and Head of R&D.

(I) In a paints-cum-chemicals firm major emphasis is laid on monitoring the apportionment (i.e., use)

of the time of top R&D personnel such as R&D Manager and Project Supervisors amongst various

projects. For lower level personnel, although no daily individual time cards are maintained, logbook

entries are available at one place where records are kept about the number of hours spent on individual

projects.

(J) In a very well-reputed private sector basic industry firm, with an annual revenue budget for R&D of

the order of Rs.2 crores, we came across an interesting case of how closer project-wise monitoring of

R&D costs was just being ushered in, and how the Head of R &D-originally a production man, and

thereafter associated with R&D for more than a decade and a half-was facing upto this change.


When we repeatedly pursued the idea of whether any standard project proposal format was in

use for R&D projects, the answer provided was that unlike in government laboratories (he is a nominee

on the Governing bodies of a few of them) 'much waste of time and effort on such formalities was avoided

in his set up. No project-wise man-hour budgets were built up either. According to the Head, monitoring

against budget formats did not seem to be practical, although theoretically that might be a right method.

Until now costs have not been monitored in any tangible way. But today top management was beginning

to ask for monthly cost sheets. What did this mean to and cost the R&D centre? Each month his

department would issue at least 500 stores requisitions, 200 purchase requisitions, import requisitions,

work orders to other departments, and so on. Keeping track of all this on a continuous basis was today

entailing the whole time deployment of four R&D engineers for every week in each month. He did not

think that this was a more useful employment of research manpower by any standard. When we showed

him a detailed manual for monitoring R&D projects in a large public sector company, he quipped with a

smile that this was like the hero in one of the plays of the French dramatist Moliere who had been talking

prose all his life without knowing it. Detailed discussions over two days did indicate that substantive

achievements and contributions had indeed been rendered by this R & D centre over the years-without

any elaborate budgeting and monitoring paraphernalia. It seems to us that such problems of transition

from informal to more formal controls will tend to be a recurring phenomenon in older and successful R &

D centres which are headed by senior researchers with effective personal styles of getting good results

out of their people. But in new organisations with multiple, far-flung and diverse units of operations, more

formal as well as relatively more acceptable systems might be introduced right from the beginning.

(K) We may now briefly discuss the monitoring and review system being used in the large public

sector heavy engineering firm just alluded to in (J) above.

Each project leader has to submit a 'project status report' to his group head who, in turn, passes it

on to the concerned general or deputy general manager (engineering) under which the concerned

engineering research group falls. This G.M. or DGM (Engg.) has a 'Working Group' to help him in the

monitoring process. Chart 6.9 shows the PSR format.

These PSR data are accompanied by a 'Quarterly Project-wise Engineering Man-hours and

Related Cost' Report. Engineering man-hour cost is here shown under three columns: estimated, this

quarter, and cumulative. Similar is the depiction of engineering man-hours.


P.S.R. FORMAT

For The Period:

Project No.:

Project Details:

(i) Project Title

(ii) Project Leader's name, dept. and division

(iii) Planned Date of Commencement

(iv) Actual Date of Commencement

(v) Planned Date of Completion

(vi) Expected Date of Completion

(vii) Project is on Schedule/behind schedule/before schedule.

Progress During Review Period (including status of the Project, reasons for delay, and effects on

Projected benefits)

Anticipated Activities During Next Review Period:

Chart 9

The frequency of the PSR is, however, left to the concerned research unit to decide

upon.

A Financial Status Report is also submitted for each project for each quarter to the

Corporate Research & Development office. This format is shown in Chart 10.

The format in Chart 10 appears defective because there are no columns for 'budgeted'

figures corresponding to column headings 4, 5, and 6.

While all these data are analytically very sound, their scope does indicate the extent of

minute and detailed accounting support required making a success of the system - in proper time.

In this enterprise there is another level of monitoring where the technical review of

Research & Development projects is done by concerned 'Technical Committees' covering several

Working Groups and including line personnel also. Except for small projects (each costing less

than Rs.50,000/-), all other projects are reviewed by the Technical Committees every quarter.

The same data as in formats 9 and 10 are submitted to these bodies. They record their

comments and prepare 'exception reports' on the status of research projects for submission to the

Board. Copies of the minutes of Technical Committees are sent to concerned research groups

and project leaders for necessary action.


Thus, the detailed formal monitoring procedure for this firm presents a study in contrast to

that mentioned in (J) above.

QUARTERLY FINANCIAL STATUS REPORT FOR PROJECT

Project ExpenditureExpense Head ————————————————————————————————————

Total Total Exp. During Cumulative Exp.Approved Budget Review period ——————————Outlay for the During Till

Year Year date

(a) Engg. Man-hourcost

(b) Drafting man-hourscost

(c) Sub-contracting forR&D

(d) Travelling expenses(foreign travel only)

(e) Computer expenses

(f) Materials:- Imported- Indigenous

(g) Equipment- Imported- Indigenous

(h) Prototype Mfg. cost

(i) Civil works

(j) TOTAL

(k) Foreign ExchangeComponent

REASONS FOR VARIANCE

Chart 10


Our survey has confirmed on the whole that, in conformity with general practice regarding

managed or policy costs, Research & Development costs too are not controlled by way of

variance analysis in the same style as manufacturing costs. Indian firms too do not consider an

adverse Research & Development cost variance-cost or time-to be necessarily a weakness. Nor

do so-called favourable variances invariably pass off as creditable achievements. The very fact

that most of the control formats illustrated above do not include budgeted figures is probably an

indication that while budgeting of some sort is normal practice, budgetary control is an exception.

Whether this is done consciously, or goes just by default is however a matter of debate. While

people like Dearden warn against controlling Research & Development by variances in the

conventional style, and insist that much of such control for Research & Development has to be

subjective, people like Batty nevertheless plead that some amount of control through properly

constructed budgets is possible, and necessary at least from the cash flow point of, view, if not

cost?

III Some Government Regulations For R&D Costs And Their Impact on Product Costing

and Pricing.

One of the most universal issues in his regard pertains to the concepts of 'manufacturing costs'

and 'manufacturing profits' for the determination of 'real value' used in calculating excise duty on

production and manufacture of goods under Section 4 of the Central Excise and Salt Act, 19448.

According to the Supreme Court of India (A. K. Roy Vs. Voltas Limited) real value can include

only manufacturing cost and manufacturing profit, since Excise duty is a tax on production or

manufacture.

From the point of view of this study the key question is : is Research & Development expenditure

a manufacturing cost? There is always a likelihood of tussle between the enterprise and the tax

authorities about non-inclusion or inclusion of Research & Development outlay in manufacturing

cost to serve as a tax base. The former would obviously like to exclude it, while the latter would

insist on its inclusion.

The ICWAI Guidelines referred to above categorically states that manufacturing costs are distinct

from research costs, development costs, marketing costs, general administration costs and

financing costs. More positively, manufacturing costs should include: .

- direct material cost.

- direct wages costs,


- direct expenses, and

- absorbed production overheads for normal activity

In listing out what items of cost should constitute absorbed production overhead, the Guidelines

does not include either Research or Developemnt.

However, the Guidelines has adopted the terminology of the Institute of Cost and Management

Accountants, London. Research and Development are defined therein as follows:

'Research cost is the cost of searching for new or improved products, new applications of

materials, or new improved methods.'

'Development cost is the cost of the process that begins with the implementation of the

decision to produce a new or improved product, or to employ a new or improved method

and ends with the commencement of formal production of that product or by that method.'

Now, although manufacturing cost computation is suggested to cover the cost of such, 'service'

departments as factory administration, industrial engineering, production planning, maintenance

of factory buildings plant and machinery, stores, inspection, quality control, purchase department

(part) and timekeeping, the name of the Research & Development activity is not a part of this list.

Thus, following the ICMA definitions, the ICWAI Guidelines states that Research costs will not be

included in manufacturing costs. However, Development costs may be included only to the extent

they are traceable to the specific end-product. This seems to imply that such D costs shall not

constitute a part of general production overhead for computing the overhead absorption rate, but

will be a direct product cost.

In those cases where quality control and R&D are combined into one department, and our survey

has revealed a number of such instances, it is obvious that costs of the quality control activity

have to be suitably identified from those of R&D for inclusion in manufacturing cost. It also implies

that separate costing for Research and Development have also to be done, since only a part of

latter is eligible for inclusion in manufacturing cost.

Incidentally, this Guidelines should prompt enterprises to interpret as much of R&D costs as

Research costs so that the excise duty tax base is lower to that extent. However, given the nature

of R&D work done in most Indian enterprises today, it should be very difficult to justify such

outlays as R, and not D. It is also a moot question as to how the enterprise-tax authority duel is

resolved where there is a separate and geographically isolated Research Centre, complemented


by Development Cells in various manufacturing sites.

Thus, in the case of the firm cited in (E) in Section I above, in a recent year Research outlay was

Rs. 3.5 crores, and an equal amount was spent on Development. And these two activities were

carried out by distinct people in distinct locations. We were informed by the enterprise that all

Development costs formed a part of manufacturing cost. Probably the decision would be more

complex where there are single R&D centres on the manufacturing sites themselves. Of course,

there is an increasing trend to construct new R&D centres in separate premises, even if they are

adjacent to or near the production sites.

As a point in passing, after scrutinising the list of expense items included under financing,

marketing and general administration costs one finds that Research is included nowhere in the

Guidelines. One may legitimately ask: where is the fugitive Research cost going to find its home?

We shall now take a look at the provisions of the Cost Accounting Records Rules issued by the

Department of Company Affairs for a few industries insofar as they relate to R&D costs. Thus, the

relevant rules for Sulphuric Acid (1980) speak about R&D Expenses in the following manner:

"Proper records showing the details of expenses if any incurred by the company for the research

and development of sulphuric acid according to the nature viz., development of products-existing

and new, processes of manufacture-existing and new, design and development of new plant

facilities, market research for the existing and new products etc., shall be maintained separately.

Where the utility of such research extends over more than one financial year, such expenses

shall be treated as deferred expenses and charged to cost of production of sulphuric acid and

other products on a reasonable basis and applied consistently".

The following salient points emerge from the above excerpt:

(a) No distinction is drawn between Research and Development as in the case of

manufacturing cost Guidelines referred to earlier.

(b) Deferred or otherwise, such R&D costs are to be charged to 'cost of production', which is

the same as cost of manufacture. Thus, the implications for costing of R&D into products

in terms of excise duty regulations and in terms of cost accounting record rules are not

identical.

(c) Market research is included within R&D, and is thus made a part of cost of production. In


the manufacturing cost Guidelines, although not separately listed under 'Marketing

Costs', market research cost could most reasonably be supposed to be included under

this heading. Once again there is divergence of product costing under the two sets of

rules-so far as market research cost falls within or outside R&D outlay.

While the record rules provide explicitly for deferred treatment of R&D costs, they do not

distinguish between Research costs and Development costs-in fact it is clearly stated that R costs

can be deferred: It is worthwhile to emphasise here that the International Accounting Standards

Committee Guideline in this matter expressly disallows deferment of Research costs. Only

Development costs can be deferred provided:

(a) the product or process in clearly defined, and the costs attributable to the product or

process can be separately identified;

(b) the technical feasibility of the product or process has been demonstrated;

(c) the management of the enterprise has indicated its intention to produce and market, or

use the product or process;

(d) there is a clear indication of a future market for the product or process or, if it is to be

used internally rather than sold, its usefulness to the enterprise can be demonstrated;

(e) adequate resources exist, or are reasonably expected to be available, to complete the

project and market the product or process.

While our survey amongst Indian enterprises indicates that the major bulk of their R&D outlay is

really for existing products or processes, usually manufactured under collaboration agreements

with foreign companies, and that, therefore, they should usually be all able to satisfy the aforesaid

criteria, this is no reason why the future Cost Accounting Record Rules should not expressly take

note of this distinction and provide for it.

As we examine Proforma A-I for showing 'The Cost of Production of Sulphuric Acid' we observe

no separate mention of R&D costs as an element of the cost records. Apart from entries for cost

of sulphur dioxide, catalysts, salaries and wages, utilities, repairs, depreciation, adjustment for

cost variance, there are two more entries, namely, 'Other Works Overheads' and 'Share of

Administration Overheads'. Where would R&D costs be included? There is no clarification on this


point either in the footnotes to the proforma, or in the main body of the rules.

When we scrutinise the relevant guideline for R&D in the Cost Accounting Record Rules (Dyes),

19761, exactly the same sentences as for Sulphuric Acid occur, except on one point. Regarding

the charging of deferred R&D expenses the Dyes rule states that they should be 'charged to the

cost of the products'. If we go strictly by this wording then it has a different implication from that

for charging to 'cost of production'. This is manufacturing cost, and nothing more. But 'cost of

product' could be the cost of sales and thus R&D could become here a non-manufacturing cost.

However, it seems that this was a loose usage, for in the very next sentence we hear about the

'method followed for charging these expenses to the cost - of production .'.

In the case of Dyes too the sheet proformae accompanying the rules do not show R&D

separately. Nor do they make it clear as to which of the cost categories overhead or otherwise-

such costs would belong to.

In the same month of April 1976, the Department of Company Affairs had issued another set of

Cost Accounting Record rules for Rayon . The distinctiveness of the statement on R&D in this

case merits full reproduction of the relevant paragraph:

"Adequate records showing the details of expenses incurred by the company for the development

of existing products or processes, if any shall be maintained separately. Such records sball

indicate the expenses incurred on generic research and brand promotion separately. Expenses

incurred on brand promotion shall be excluded from costs and charged to profit directly. If the

R&D department is also engaged in the design and development of plant facilities, the

appropriate share thereof shall be capitalised. The method of charging R&D expenses to the cost

of production shall be indicated in the cost records, . . . . . . . . . . . . . . . . Wherever the utility of

such research extends over more than one financial year such expenses shall be treated as

deferred expenses and charged to cost of production on some reasonable basis which is to be

followed consistently.

"Expenses incurred by the R&D Department for furnishing technical knowhow to outsiders shall

be recorded separately and excluded from the cost of rayon products. . . . . . . . The amounts

recovered for providing technical knowhow to outsiders shall also be indicated separately." (All

italics ours).

The distinguishing elements of the provisions for Rayon, from those for Sulphuric acid, are as

follows:


(a) Market research does not appear in the wordings anywhere.

(b) Generic research is asked to be demarcated from brand promotion expenses. The latter are

not to be considered as R.& D, and are excluded from cost computations.

(c) Cost of design and development of new plant facilities is not mentioned in the same breath as

R&D for products/processes. The capitatisation treatment of former costs is also a distinct

feature.

(d) R&D work for outsiders at a fee is separately recognised and guidelines offered for its

treatment.

We cannot venture to suggest too strongly as to whether such distinctiveness in the Rayon rules

followed from the nature of this industry, or from the greater thoroughness of approach amongst

the set of people in the Department who framed the provisions for this industry. In fact, this

tendency for precision is also in evidence in Proformae A and A-III for cost of production of

Viscose Staple Fibre and Acetate Yarn respectively. In both cases R&D expense is shown as a

separate item in the proformae. It is only logical that if the rules devote a separate paragraph to

R&D costs, as for repairs and maintenance, and others, the corresponding proformae should also

mention R&D separately as is done for the rest.

To sum up then, allowing for inter-se variations amongst various cost accounting record rules,

they all envisage R&D costs without any distinction between R and D to be a part of cost of

production. But so far as manufacturing cost computation for excise duty purposes is concerned,

the preceding cost-of-production figures have to be adjusted to exclude Research cost, market

research costs, and non-product traceable Development costs.

It is important to note in this respect that the International Accounting Standard 9 has pronounced

in clause 8 that market research activities undertaken prier to the start of commercial production

to establish the usefulness of a product, or of the existence of a potential market are similar to

Development activities. In these cases the related costs are sometimes treated in the same way

as D cost and are written off or deferred on the same considerations. And clause 7 of the same

standard expressly excludes cost of sales promotion of existing products and related market

research activities.


We have examined above how for excise duty purposes enterprises could be tempted not to

include as much of R&D outlays in manufacturing cost as possible. But the same enterprises,

especially in the drugs and pharmaceutical industry, could be seen to make efforts to include as

much of R&D costs as possible in the cost of 'bulk drugs' category for the purpose of price fixation

under the Drug (Prices Control) Order, 1979 of the Government of India. Let us examine some of

the relevant provisions of the said DPCO in this regard.

Para 3 of DPCO : Vide clause (2) it is stated that while fixing the maximum price of a bulk drug

the government may take into account the average cost of production of such bulk drug

manufactured by an efficient manufacturer, and allow a reasonable return on net worth. (An

efficient manufacturer means one whose share in the total production of the drug in the country is

large, or one who employs efficient technology in the production of such drug).

No definitions or clarifications about 'Average' and 'cost of production' are provided anywhere in

the Order. Moreover, the computation of net worth attributable to bulk drugs in a bulk-drug-cum-

formulations enterprise would pose practical problems. The Order does not offer any hint or clue

on this matter either.

Para 10 of DPCO : The retail price of formulation is to be computed according to the following

formula:

R.P ::_ (MC + CC + PM + PC) x ( I + MU/100 ) + ED, where:

R.P = retail price

MC = material cost and includes cost of drugs etc.

CC = conversion cost

PM = cost of packing material

PC = packing charges

MU = mark-up

ED = excise duty


So far as MC, CC, PM and PC are concerned, they are all to be worked out according to such

norms as may be specified by the Government from time to time by notification in the Official

Gazette.

Thus, neither in para 3 nor in para 10 do we find any express mention about the treatment of R&D costs for either bulk drug or formulation pricing.

Now, a typical large enterprise in this industry (with annual sales turnover exceeding Rs. 6 crores)

is a combination of drug and formulation manufacture, the former being used as captive raw

material for the latter in a large measure. The formulation mark-ups today range from 40% to

100%, depending on the category, to which formulations belong. Let us suppose on a given date

a certain enterprise employs 50 per cent of its net worth in producing a bulk drug, and the rest in

making formulations in the 100% mark up category. Let us assume that revenue R&D expense

during a year is Rs. 1 crore. Also, the whole of the bulk drug is consumed internally. Suppose

also that the enterprise succeeds in getting the whole of R&D outlay of Rs. 1 crore accepted as

being for bulk drugs. In that case this cost is included in cost of production for computing return

on net worth, and yielding a price for the bulk drug. This price then, in turn, becomes the MC cost

of formulations, over which a 100 % mark up is available. Thus, through product pricing the firm

may be able to recoup twice the amount of actual R&D outlay. However, if, say, only 50 per cent

of the R&D outlay were allowed as being for bulk drug, and the balance for formulations covered

in CC (assumed) for the retail price formula, then product pricing would recover only 1.5 times the

amount of R&D outlay (Rs. 0.50 crores at bulk drug pricing stage + Rs. 0.50 crores as 100%

mark-up on bulk drug material cost + Rs. 0.50 crores as 100% mark-up on CC for formulation

which is assumed to include R&D cost)

But nowhere is it stated whether CC for formulations is to include R&D costs, nor as to how R&D

costs are to be split between the drugs and formulations segments of the business. Section 6 of

proforma 6 (pp. 47-48) of the DPCO provides a Table for the allocation of income and expenses

between these two segments. R&D appears therein as a separate expense item. But the last

column of the proforma is headed as 'basis for allocation'. It this basis then left to the choice of

each enterprise for each item of expense?

Government officials face the policy dilemma that apparently unconscionably large sums of R&D

outlay are attempted to be pushed into the bulk drugs category of current production, whereas

most such research might actually be on items non relevant to the needs of India, or for future

products for which current product costs are unduly inflated, leading to unreasonably higher

prices for the consumer. Such dilemmas seem to be inevitable when one moves away from the

concept of what the market will bear to the normative realm of what an average Indian should pay


for the medicine he buys.

At least a part of this problem could be tackled by inducing the drugs firms to maintain separate

and distinct cost records for each R&D project under the two categories of bulk drugs and

formulations. The R&D organisation could also be structured accordingly. These two steps should

then avoid the need for arbitrary apportionments of R&D between bulk drugs and formulations.

And then the task of resolving which bulk-drug R&D outlays are for the remote future, or which

are not quite relevant to India (especially in the case of foreign drug companies) may be handled

a little more systematically. But subjective wrangles in this respect will always persist.

In sum, the DPCO needs to incorporate the accumulated experience of coping with R&D costs in

pricing decisions in fresh and more specific terms in a revised and updated version of the 1979

order.

It will be appropriate to mention here that the Cost Accounting Record Rules for Bulk Drugs were

promulgated as early as in March 1974. Para XV therein relates to R&D costs. In comparison with

later rules, this paragraph is much less substantive e.g., it does not mention anything about

deferral, leaving aside the matter of distinction between Rand D. The ICW AI pamphlet on cost

audit for bulk drugs, incorporating the above rule, devotes a para on R&D. It opens with a rather

ambiguous sentence. 'Expenses on Research and Development are recorded separately'. Does it

mean R&D as a whole separately from others, or Research and Development as distinct from

each other? Most probably the former sense is implied. But the most significant statement is :

'As regards new products, if expenses are of considerable value, these are treated as deferred

revenue expenditure and are spread over a reasonable number of years.' (Italics ours).

Without attributing to it the character of an ICWAI recommendation, the import of the practice of

deferment if expenses are of considerable value is both ambiguous and serious. If, as is most

likely, considerable value is judged in terms of high amount of expenditure only, then in the light

of current thinking, without linking it to visible D results which are proved, deferment would be

totally inadvisable. The Rolls Royce debacle (caused partly by deferring mounting excess R&D

costs resulting in widened discrepancy between the P&L A/C and cash flow) is probably a case in

point. As mentioned in a previous chapter, this is a standing temptation for losing or low profit

enterprises to treat R&D expenses as deferred cost.

IV. Summary and Recommendations


1. In most of the cases explored R&D costs do find their way into current production costs and

into product pricing.

2. This is achieved by adding R&D costs usually to administrative and at times to manufacturing

overheads.

3. We came across at least one instance where R&D costs did not percolate down to product

costing, but were directly debited to the P&L A/C.

4. Project-costing, especially for manpower costs and overheads, is being done in rather

sophisticated ways in certain very large and diversified companies having an R&D set-up. The

responsibility centre concept for overhead allocation, and standard manpower unit conversions

are employed in a few cases only.

5. The range of practices regarding project cost monitoring is also very wide. Amongst them, the

various formats illustrated above highlight the crucial aspects of R&D monitoring in some of the

organisations surveyed by us. Many R&D Heads, however believe in aggregate R&D budgeting,

but not in project wise budgeting.

6. As a sequel to the last stance mentioned above, specific tracing of R&D costs to individual

projects is rare to find (see point 2 above also). Obviously, project-budgeting and project-costing

for R&D should be implemented by all concerned.

7. Little evidence could be collected on the manner of apportioning common overhead costs of

the enterprise to the R&D centre.

8. Filling up of time spent record cards by researchers was in clear evidence (supported by

printed formats) in only two firms. Though manhour time cost is the largest single category of

R&D costs, research personnel, including their Heads, usually resent the time-logging formality.

The 1979 NAA study also concludes that while time reporting is an important area, the amount of

control in it must be weighed against a possible loss in research productivity.

9. Often the rules and regulations of the Department of Company Affairs, the Indirect Tax

Authorities, and price regulating Ministries provide conflicting motivations to enterprises in the

treatment of R&D costs for product costing and pricing. .

10. The Cost Accounting Record Rules should draw a clear distinction between Research and

Development-so far as deferred revenue expenditure treatment is permitted. Besides, the costing


formats should provide R&D costs with a separate identity, or explain under which existing head it

is to be incorporated.

11. Wherever firms draw a distinction between Research and Development, explicit policies

should be framed regarding who should bear these two types of costs-the existing consumer, or

the future consumer or the shareholder?

(Extract from “ Management and Accounting for Research and Development – The Indian

Praxis” by Prof. S.K.Chakraborty in collaboration with Mr. Bipul K.Bhaumik, and ICWAI

Publication.)

Note by the author: The discussions in the above chapter, are still relevant as the basic nature of

R & D Costs have remained the same. The cost accounting records rules (Formats) and the cost

audit report formats have undergone some basic changes, but the information on R & D costs

have remained more or less the same and same have been already covered in detail under the

earlier chapters.

REFERENCES:

1. Glossary of Management Accounting Terms – ICWAI Publication.

2. Cost Accounting Standard 1 to 4 – ICWAI Publication.

3. Terminology of Management Accounting – CIMA Publication.

4. Management and Accounting for R & D costs –Prof.S.K.Chakroborty- ICWAI

Publication.

5. Accounting Standards issued by ICAI.

6. Management Accountant Journal of ICWAI (Various Issues).

Accounting for Research and Development Cost

Documents

accounting of research

development costs monograph

treatment of research

research design

defence research

various research laboratories

industrial research

accounting treatment