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Tangents - Thought Leadership and News from Trig

News and blog articles from the Trig team

Depreciation of a Design

Ty

Changing best practices in accounting to value intangibles

By Ty Hagler

The design community has a natural blind spot in understanding the language of accounting and finance.  When launching new products in the marketplace, hitting design trends in a timely fashion should count for more, while inefficiencies and delays should count for less. Companies should be able to treat industrial design expenditures as they would capital investments on their balance sheets.

In 1999, designers first started converting repurposed furniture cabinets into bath vanities.  By 2005, the trend had exploded to the point that industrial designers were developing vanities built to look like furniture pieces. 

Homeowners were replacing traditional cabinet sinks during bathroom remodels as an easy way to improve the value of their homes.  By 2009, bath vanities had become the dominant design for new bathrooms, reaching a point where even competing cabinet sink designs featured baseboard holes, mimicking the bath vanity design to a point.

Back in 2006, I worked on a family of bath vanities. Our product development group had targeted this particular line for getting in front of the emerging design trend. We created specifications for a multi-vendor request for proposal.  Each vendor had to meet the specifications and submit their designs with sample prototypes.

We received the expected range of quality and pricing, resulting in three rounds of revisions and eventually culling the vendors down to two finalists.  Our process proved cumbersome, however, and the bitter irony proved that industry trends moved faster than our ability to get the design to market.   By the time shelf space was available for consideration, the leading trend had moved from the conservative box-like vanity we had started with to elegant curves and open, wall-mounted units that you see in stores today. 

Several lessons emerged from this experience, but perhaps the most important concept I took on board during this time was that of depreciating a design. Companies ideally target their designs to hit a trend in timely fashion by the product hits the market.  With a typical development time of six months, the designer needs to correctly predict the finishes, shapes, and functions that will move the market six months out.  If the product launch faces a delay, then the value of the design expenditure (assuming the designer has initially hit the trend in timely fashion) decreases as the launch is pushed out.  

Current accounting practices require that financial officers account for intangible expenses such as branding, marketing, research and development, and design by expensing them at their time of purchase.  The company then realizes the value of the intangible asset through a change in sales over a period of time, until the particular asset no longer has market relevance. In a study of the impact of industrial design effectiveness on corporate financial performance, Dr. Julie Hertenstein, accounting professor at Northeastern University, and her colleagues, proposed the following:

“If one accepts that effective industrial design leads to better financial performance, then the robustness of these findings suggests that expenditures on industrial design should be considered investments similar to capital equipment.”   

In case you missed it, this is a huge idea: if industrial design is to be taken seriously, we need to improve the accounting tools used to measure our work.  As the saying goes, “You can only manage what you can measure.”  The financial community measures industrial design as an expense with few tools to understand if there is a return on the investment. 

Let’s suppose a company spends $150,000 to develop the vanities in the example over the last two quarters of 2006, with an expected launch for the first quarter of 2007.  We can further suppose that forecasted net sales will be an estimated $15 million for the first year, and they will subsequently decline over three years until removed from the market.  Under current accounting systems, the data appears as follows:

 

Y0

Y1

Y2

Y3

Y4

Design Expense

$(150,000)

 

 

 

 

Revenues

 

$15 M

$10 M

$5 M

 

Operating Costs

 

$(9 M)

$(6 M)

$(3 M)

 

Income

 

$6 M

$4 M

$2 M

 

Net Present Value

$9.2 M

 

 

 

 

 

By viewing the Design Expense as an asset to be depreciated over the life of the product, the Net Present Value improves by 10%, or in this case, close to a million dollars.

 

Y0

Y1

Y2

Y3

Y4

Design Expense

-

 

 

 

 

EBDT Income

 

$6 M

$4 M

$2 M

 

MARCS 3Y

 

33%

45%

15%

7%

Depreciation

 

$(49,000)

$(67,000)

$(22,000)

$(10,500)

EBT Income

 

$5.9 M

$3.9 M

$1.9 M

$(10,500)

Net Present Value

$10.1 M

 

 

 

 

 

Observant managers will note that, in this scenario, half of the value of the design disappears if the project is delayed by a year, or an NPV of $4.2 million.  Further analysis shows the NPV recovers to $8.2 million with an additional $150,000 outlay to redesign the product to meet the latest trend in Y2.

What this stylized example proves is that the current language of finance and accounting has a bias against design that can profoundly impact managerial decision-making.  By defining design as a capital expenditure, we gain better clarity to the shifting value of a specific product design, as trends may sometimes dictate where industrial designers must land in the market.  Dr. Hertenstein and her colleague’s thought leadership on this subject presents a significant opportunity to better explain our value as designers.   Taken seriously, their work is a call-to-arms for the design community to lobby for a change in the GAAP (Generally Accepted Accounting Practices) rules.   “Depreciate My Design!” does have a fun ring to it.