In this post, we’re continuing our foray into the Income Statement, focusing on expenses. Our dive into expenses will include Research and Development (R&D) expenses, near and dear to any scientist.
Let’s return once again to the now quite familiar BioTechne Income Statement:
The second block of items in the Income Statement enumerates Operating Expenses. These are broken down into ‘Sales, General, and Administrative’ (sometimes you see this referred to as SG&A or G&A) and ‘Research and Development.’ Note that the line items here can change depending on the type of business you are in. If sales is a large part of your business, you may choose to have Sales as its own line, and G&A kept separate. Some business sectors may not pull out R&D as a separate line item, but this would be highly unusual for Life Science businesses, as R&D is a crucial part of our business models.
An important aspect of G&A for R&D leaders to understand is depreciation and amortization. How these expenses are handled can GREATLY impact the profit seen in an income statement. And while we’ll talk more about profit in the next section, I do want to pause briefly on the depreciation and amortization handling here.
Depreciation and amortization
First, some definitions. If you are like me, depreciation already feels like a somewhat familiar concept. Depreciation refers to both (1) the decrease in the value of assets over time and (2) the method used to reallocate, or “write down” the cost of a tangible asset (such as equipment) over its useful life span. In accounting, we are referring to the second of those definitions. Amortization is the same basic concept as depreciation, except it applies to intangible assets like patents, copyrights, and trade secrets.
To really understand depreciation and amortization, we need to resurrect ‘The Matching Principle’ referenced in the first post on the income statement. The matching principle seeks to match the cost with its associated revenue to determine profits in a given time period. For instance: you buy a fancy new Illumina Sequencer this year, but the expectation is that it will help to bring in revenue for the next 5+ years, so some percentage of that initial cost of the sequencer needs to be recorded in future income statements. But how long exactly will this sequencer be (1) functional and (2) part of your clinical workflow? What the accountants decide can have a huge impact on the profit in the income statement.
Here’s a worked example. Let’s say you bought a NovaSeqX recently that put you back a cool $1M. Now let’s consider three different ways of approaching depreciation and see how it impacts profit for an imaginary CRO business in which you generate $900K in revenue and incur $500K in direct costs (technician salaries, reagents, etc) and $300K in overhead (rent, marketing, etc) in a given quarter. Scenario 1: we assume the sequencer will last us 5 years, so we depreciate it by $50K per quarter (cost – salvage value) / useful life; for simplicity I am assuming a $0 salvage value). Scenario 2: we assume the sequencer will last us 2 years, which then gives us $125K per quarter depreciation. Scenario 3: we assume we’ll be using this sequencer for the next 10 years, which puts quarterly depreciation at $25K per quarter. In the table below, you can see that in scenario 2, this business is now operating in the red, whereas things look pretty rosy in scenario 3.
| (in $1000) | Scenario 1 | Scenario 2 | Scenario 3 |
|---|---|---|---|
| Revenue | 900 | 900 | 900 |
| Cost of goods sold | 500 | 500 | 500 |
| Gross Profit | 400 | 400 | 400 |
| Expenses | 300 | 300 | 300 |
| Depreciation | 50 | 125 | 25 |
| Net Profit | 50 | -25 | 75 |
There are two things to take away from this example: (1) profit can be significantly influenced by the assumptions you make in depreciation and amortization and (2) these assumptions should be part of considerations to make significant capital investments. So next time you argue for a capital investment, keep in mind how it will impact your company’s income statement, financial health, and, ultimately, also the stock price.
In the next part of this series, we’ll take a more complete look at a company’s profitability. In the meantime, you can sign up to the mailing list to be updated when the next installment is out.
