Return on research capital (RORC) is a metric that describes the revenue generated by a company as a result of capital spent on research and development. It compares the revenue made with the initial amount spent on research. The ratio shows how much the company can make per unit of expenditure on research.
Return on research investment is vital to accountants and executives of companies because it helps them gauge the successes of the investments in research and aids them in making future research investment decisions. This considerable interest from policymakers, company executives and economists, in general, is fuelled by the high cost of research and development.
These efforts are intended to improve the company and usher in increased profit. The research might be focused on improving the current production processes, or developing new ones entirely. It might also be aimed at finding groundbreaking and innovative new products that the company can produce.
For most companies, the competitive edge comes from their constant research and development which enables them to either produce superior goods and services or cut costs such to beat competitors. The process of tracking and monitoring returns on research is complex, since most of the time, the benefits of the research are not immediate. Some take years before they are matured enough to be commercialised. Depending on the nature of the research, the company might do it in-house, or partner with schools or other research institutions.
Return on Research Capital Ratio Formula
Estimating the exact profits that a company makes as a direct result of investment in research is difficult. However, accountants and other financial analysts over the years have agreed on the following formula as a means to calculate the return on research capital ratio.
The return on research capital ratio is the result of the current year’s gross profit divided by the previous year’s expenditure on research and development.
The current year’s gross profit is total revenue for the year minus the cost of goods or services sold. From the formula, the larger the expenditure on research and development, the smaller the RORC. However, an increase in the current year’s gross profit will translate to an increase in return on research capital ratio. As a result, to increase the return on research capital ratio, the expenditure on research and development should be reduced while the current year’s gross profit should be increased.
Return on Research Capital Ratio Example
An herbal soap manufacturing company, Greendal, has a total sales revenue of $700,000 for this fiscal year. The cost of production of the soaps for this year was $380,000. The administrative cost for the year is $110,000.
Greendal made an investment of $120,000 in research and development in the last fiscal year. The soap company wants to know the return on research capital ratio to gauge if last year’s investment in research and development was a wise decision.
Let us gather the data that is required to calculate the return on research capital ratio. To calculate the return on research capital ratio, we need to calculate the current year’s gross profit. We already know that the gross profit is given by the difference between the total sales revenue ($700,000) and the cost of goods or services sold ($380,000).
From the question, we can see the following:
- Current year’s gross profit = $320,000
- Previous year’s research and development expenses = $120,000
We can use the formula and substitute the values for the variables:
So the return on research capital ratio for Greendal for this fiscal year is 2.67. This means that for each dollar spent on research and development, the company made a return of 2.67 dollars.
The ratio clearly shows that there is a positive return on investment in research and development. The management of Greendal will most likely invest more in research and development, seeing that they have produced positive results.
It should be noted that while calculating the gross profit for Greendal, the administrative costs were not included. This is because all such expenses are not attached to the production and will be paid for from the profit made.
Return on Research Capital Ratio Analysis
The return on research capital ratio is used to measure the profitability of an investment in research and development. The higher the return on research capital ratio, the more the company is making profits from its investments in research and development.
The ratio enables management and investors to make informed decisions on the status of research and development. Its contributions to the financial success of the company, and future plans on maintaining the investment in research and development. For most companies, there are options to invest in other tangible assets, therefore, investing in research and development will come with an opportunity cost.
The company will have to forgo the option of investing in other profitable assets. This is why investors need to measure and know if the research and development is profitable enough to maintain.
The major downside of research and development, and also a reason why it is necessary to monitor RORC is that most times, the return on research may take a long time. Other research may not bring any profitable information, especially for big companies that spend to create innovative products. Sometimes, simple research results can result in a breakthrough that will bring exponential growth, while complex and expensive research could end up fruitless.
Return on Research Capital Ratio Conclusion
- Return on research capital describes the revenue generated by a company as a result of expenditures on research and development.
- It is used by companies to guide their decisions regarding research and development spending.
- This formula requires two variables: the current year’s gross profit and the previous year’s expenditure on research and development.
- A high RORC ratio is an indication that the company is making profits from its investment in research.
Return on Research Capital Ratio Calculator
You can use the return on research capital ratio calculator to quickly calculate the return on research capital ratio by entering the required numbers.
FAQs
1. What is a return on research capital?
The return on research capital is used to measure the profitability of an investment in research and development. It compares the revenue generated in the current year against that in the previous period.
2. How do you calculate the return on research capital ratio?
RORC ratio can be calculated by using the following formula: RORC = Current Year Gross Profit / Previous Year R&D Expenditure
3. What is a good return on research capital ratio?
In general, a good RORC should be above 3. If it is below, there may be a problem with the research and development department that will need to be addressed.
4. What does the return on research capital ratio show you?
The RORC ratio can be used to find out whether an investment in research and development is worthwhile. It shows the profitability of the company's research and development expenses. It also helps the management and investors to make informed decisions on the status of research and development.
5. What is an example of a return on research capital?
The best example would be Tesla's RORC. In 2017, the company recorded a gross profit of $1284 million against their spending on research and development which amounted to $1,386 million. This means that they have an RORC of 12%.
