Development costs: Overview, definition, and example
What are development costs?
Development costs refer to the expenses incurred by a company during the process of developing a new product, service, or asset. These costs typically include research and design, testing, prototyping, and other activities that are necessary to bring a new idea or concept to market. Development costs can be capitalized (recorded as assets) or expensed (recorded as costs in the period they occur) depending on the nature of the costs and the accounting standards followed. These costs are essential for innovation and growth, as they directly contribute to the creation of new products, technologies, or services.
Why are development costs important?
Development costs are important because they represent the investment a company makes in creating new products or improving existing ones. Tracking and properly accounting for these costs helps businesses understand the financial resources allocated to innovation and product development. Proper management of development costs also plays a key role in profitability, as these costs often influence the pricing and cost structures of new products or services. For companies, capitalizing certain development costs can provide financial advantages, such as spreading costs over the useful life of a product rather than taking a full charge in the year they are incurred. This can affect the company’s balance sheet, income statement, and tax liabilities.
Understanding development costs through an example
Let’s say a technology company, TechCo, is developing a new software application. During the development process, TechCo incurs several costs, such as paying for research, hiring developers, and conducting beta tests. According to accounting standards, some of these costs may be capitalized, meaning they will be recorded as an asset on the balance sheet, as they represent the future economic benefit that the software is expected to provide. For example, the costs related to the software’s development, such as programming and design work, could be capitalized, whereas ongoing research or testing costs might be expensed as they occur.
In another example, a pharmaceutical company is developing a new drug. The company incurs costs related to clinical trials, regulatory approvals, and scientific research. Depending on the accounting treatment, these development costs may be capitalized if they meet specific criteria, such as demonstrating a probable future economic benefit from the drug’s success. Once the drug is approved and ready for sale, the capitalized costs would then be amortized over the product’s expected useful life.
An example of development costs clause
Here’s how a clause related to development costs might look in a contract or financial document:
“The Parties agree that the costs incurred in the development of the new software, including programming, design, and testing, will be capitalized as development costs and amortized over a period of five years. Any research and marketing expenses incurred during the development phase shall be expensed as incurred in accordance with generally accepted accounting principles (GAAP).”
Conclusion
Development costs are a critical component of business investment in new products, services, or technologies. Properly accounting for these costs ensures that companies accurately reflect the financial resources used in their innovation efforts and can make informed decisions about pricing, budgeting, and financial strategy. Whether capitalized or expensed, development costs contribute to a company’s overall financial health and its ability to bring new offerings to market successfully. By understanding and managing development costs, businesses can maintain sustainable growth and profitability while pursuing innovation.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.