“How would you forecast quarterly R&D expense?”

Forecasting R&D and SG&A expenses

“How would you forecast quarterly R&D expense?” He asked,10 minutes into the interview.

“As a percentage of revenues.”

“What if the business is seasonal? Your R&D expense will fluctuate with revenues.”

I blanked out and tried to make something up. The interview ended early as we both knew I wasn’t going forward to second round. That was me six years ago.

So how do you forecast research and development (R&D) expense and sales, general and administrative (SG&A) expense?

Start by analysing the following:

Is the business seasonal? For example, Q1 is15% of revenues, Q2 is20%, Q3 (back to school season) is25% and Q4 (holiday season) is40%.

When is the bonus paid? Is it paid annually, at the end of the fiscal year, or quarterly? How about the sales commission? Is it paid quarterly or every6 months?

Also keep in mind the following:

R&D expense doesn’t drop as fast as revenues in a slow environment because the majority of that expense is wages. Companies don’t layoff engineers and developers when revenues drop for a quarter or two. After all they are investing for the future.

Sales expense might drop faster than R&D as most of the sales expense is commission and a smaller part is salary.

Depending on the business, you might not get significant operating leverage from R&D and sales expenses. As revenues grow, companies invest in R&D to add new products and update old products. They also invest in expanding the sales staff to reach more customers, domestically and internationally.

G&A expense tends to be somewhat fixed because it includes senior management and support staff like HR and finance departments. So you could get some operating leverage from the G&A expense.

There are two ways to forecast R&D and SG&A expenses:

You could forecast R&D or SG&A as a percentage of revenues for the annual forecast, and then divide that annual forecast by4 to arrive at the quarterly forecast. If the expense is higher in Q4 because of a bonus or commission, then add some seasonality. For example, assume Q1, Q2 and Q3 are23% of the annual forecast each, and the rest of31% of the annual forecast is spent in Q4. Again, look at the historical trend for the appropriate seasonality.

The second method is to grow the expenses by some number, usually lower than the q/q growth in revenues because companies can’t hire people as fast as revenues grow (it just takes time to interview, make an offer, accept the offer, give notice, etc…). Also, when revenues drop, the expenses could be flat q/q before they drop because it takes time for companies to lay off people and when that happen non-operating restructuring charges are reported for severance costs.

Make some assumptions when you answer the interview questions. For example, assume R&D is equal for the first three quarters then it rises in Q4 because of the bonus. Also, you could assume the sales commission is paid on a quarterly basis which makes forecasting the sales expense a bit simpler. Tell the interviewer that you could identify the best forecast method by looking at historical trends in sales and expenses.