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Leading indicators: R&D costs.

The proliferation of public software companies has produced a valuable side-benefit: a large base of audited, consistently-presented data about financial ratios and trends in the PC software industry. For better or worse, moreover, public software companies increasingly define competitive benchmarks for the entire industry. For instance, the 36 public firms in the current Softletter 100 rankings account for 83% of the revenue generated by all the companies on our list.

Over the next several issues, therefore, we're going to take a look at basic operating ratios that can be extracted from public company data. Our database covers 42 companies whose primary business is PC software publishing and development. (We don't include client/server companies in this database, largely because we're still exploring the business model for "enterprise" developers.) Within the general PC market, this database covers a broad range of application categories, company sizes, development platforms, and distribution channels--most of the key variables that affect spending and profitability.

Because the software business is so technology-driven, R&D spending levels tend to be one of the industry's most critical operating ratios. Early-stage companies may reinvest as much as half of their revenues in ongoing product development; the usual benchmark, however, seems to be about 11%-12% of revenues:


A few observations:

* The trendline: Despite a huge industry-wide investment in developing new Windows titles, R&D spending levels have remained remarkably constant over the past three years. In fact, the most recent median spending level is 11.8% of revenues--almost exactly equal to a three-year average of median R&D spending. However, it's worth noting that 12 of the 15 largest companies in our database report higher R&D spending ratios for their most current fiscal year; only Microsoft, Lotus, and Santa Cruz showed a decline in R&D spending.

* The FASB 86 factor: Calculating true R&D spending isn't always a simple process. According to the so-called "FASB 86" accounting rule, software companies are supposed to capitalize certain classes of R&D expenditures; however, the FASB 86 rule is so vague that there is virtually no agreement about how it should be applied (Soft.letter, 7/15/88). As a result, many companies show almost no capitalized R&D; others (which we've starred on our chart) may capitalize amounts that actually exceed their uncapitalized R&D costs. Thus, the effective investment in R&D may be substantially higher than the numbers suggest.

* Size and application category: In theory, R&D spending is a fixed cost that should benefit from economies of scale. Yet it turns out that company size has little impact on the level of R&D costs. The 22 companies in our database with revenues over $50 million spent 12.4% of revenues on R&D, while their 20 smaller counterparts spent 10.8%. Similarly, we found only relatively minor differences in spending levels across various application categories. General business, accounting/finance, consumer/entertainment, and education companies typically spent between 9.4% and 11.4% of revenues on R&D, while utility and publishing/presentations firms ended up slightly higher, in the 13.3% to 15.0% range. In short, most companies seem to behave as if R&D spending levels of 10%-15% are a natural industry benchmark.
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:research and development in software industry
Date:Oct 22, 1993
Previous Article:Microsoft unveils a new consumer strategy.
Next Article:Postscript.

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