What Is Return on Research Capital?
Return on research capital (RORC) is a calculation used to assess the revenue a company brings in as a result of expenditures made on research and development (R&D) activities.
Return on research capital is a component of productivity and growth since research and development is one of the ways companies develop new products and services for sale. This metric is commonly used in industries that rely heavily on R&D, such as the pharmaceutical industry.
Understanding Return on Research Capital (RORC)
Companies face an opportunity cost when examining the use of their funds. They can spend money on tangible assets, real estate, capital improvements, or they can invest in R&D. Investments made in research may take many years before tangible results are realized, and the return typically varies between industries and even within sectors of a particular industry.
In theory, if an enterprise has promising prospects, it should forgo returning capital and plow back retained earnings into the business. Investing in research and development is one popular method to develop future innovation capabilities. Analysts and investors monitor R&D levels to gauge future competitiveness. Many industries have come under fire for shrinking R&D budgets, while stock buybacks are at all-time highs.
Research and development initiatives are very difficult to manage since the defining feature of the research is that the researchers do not know in advance exactly how to accomplish any given desired result. In larger businesses, monitoring R&D spending presents a problem. As a result, higher R&D spending does not guarantee more creativity, higher profits, or more market share. Thus, at times, managers struggle to effectively prove the return on research capital.
Recent breakthroughs in big data, analytics, and enterprise risk management methodologies help demonstrate, with evidence-based proof, that investment in research and development adds enterprise value. In business, money follows success. As business leaders further demonstrate return on research efforts, budgets will grow as well.
- Return on research capital (RORC) measures a firm's revenues generated from R&D activities.
- Return on research capital (RORC) is calculated by dividing current gross profits by the prior year's R&D expenditures.
- It usually takes more than one year to realize the return on R&D; sometimes, it may be realized over more than one year.
Example of Return on Research Capital
The return on research capital is the amount of profit earned for each dollar spent on research and development within a given period (usually a year). It is calculated as current gross profits (typically found on the current year's income statement) divided by the prior year's R&D expenses.
The prior year's R&D expenses are used because the payoff is not typically realized immediately. Rather, it is often realized in some future point in time. For example, Rx Pharmaceutical Company earned $100 million in gross profits for 2018. In the previous year, it spent $50 million on research and development. It's return on research capital is $2 ($100 million / $50 million). So for every $1 spent on research and development, the company earned $2 in gross profit. One can reasonably assume that higher returns mean that the company has spent wisely in terms of research and development and is reaping the rewards from its efforts.
Large and complex research and development projects may not produce profits for years after completion, rendering this analysis faulty.