I N SI G H T S
into AUTOMATION & MATERIAL HANDLING
The Intelligent Warehouse:
Where Software Reigns – How to Pay for It
Automation and material handling equipment
suppliers can capitalize the investment in software
development making the investment essentially
free. What’s the catch?
The rate at which sophisticated software within the
automated material handling industry is increasing is,
to put it mildly, breathtaking. From advanced controls
and data communications supporting highly configurable
systems to predictive maintenance and yield management
systems—underpinning all of this is software. Coupled
with the undeniably rapid proliferation of automated
material handling equipment in manufacturing and
across the supply chain, you have the makings of a
level shift in the expectations of an entire sector of
the economy. With this shift come real problems for
equipment companies – how do I pay for all this software?
Among the solutions required to outfit a 21st Century
warehouse are automated storage and retrieval systems,
automatic guided vehicles, robots, sortation equipment,
order picking equipment, automated identification
systems, packaging machinery, automated inspection
equipment and palletizing equipment. While the physical
attributes of these solutions are the key to getting the
job done with less reliance on manual labor, it is the
software systems that enable and control the hardware
and drive the intelligence to maximize productivity
and efficiency.
This influx of software technology with its obvious
technical complexity poses a challenge for companies
that have focused on mechanical and electrical disciplines
almost exclusively in the past. More importantly, it requires
companies to address the financial complexity inherent
with a massive software investment.
The potential negative impact on the financials (and
business models) of automation companies requires
adoption of new approaches to both product development
and its accounting. Luckily, the financial community
has a solution, but it comes with a catch.
Accounting for Software Development
Costs: Capitalization
In 1985, citing the increasing importance for standardization of accounting for software development activities,
the Financial Accounting Standards Board (FASB), the
designated private sector organization in the U.S. that
establishes financial accounting and reporting standards,
created a financial treatment of software development
costs that allows for capitalization of the investment.
FASB Statement No. 86 (FASB 86 or FAS 86): Accounting
for the Costs of Computer Software to Be Sold, Leased,
or Otherwise Marketed clarifies the rules for categorizing
software development costs. In certain controlled instances,
FAS 86 allows coding and testing (“production”) costs
related to product development to be capitalized.
This rule has been broadly used by equipment manufacturers in other industries where the impact of large
complex software systems was felt earlier than in the
automated material handling industry. In application
over the past 30 years, it has been determined that
this rule can be applied to software “…sold as a separate
product or as part of a product or process.” This means,
the investment in software embedded in a hardware
product or controlling a hardware product can be
INSIGHTS into AUTOMATION & MATERIAL HANDLING
capitalized. The rule clearly applies to new products,
but additionally, can apply to significant enhancements
to existing products.
design. At this point, a brief FAS 86 Summary document
is created to describe the development approach and
why the criteria for ‘technological feasibility’ have been met.
The process by which FAS 86 can be applied requires a
controlled development process in which the “technological
feasibility be demonstrated” before any capitalization
of costs can begin. This technological feasibility is a
critical point. Understanding how it is demonstrated
requires strong software understanding at the outset
of the development effort. Demonstrating technological
feasibility that minimizes potential financial and development risk requires the right approach.
The second method for demonstrating technological
feasibility has a much higher level of financial and often
development risk. It requires designing the product
and a working model. Executives should exercise extreme
caution because this method requires that the majority
of the development effort be completed before capitalization
begins. At this point, the returns for capitalizing costs
are vastly diminished.
The most beneficial approach to prove technological
feasibility from both a financial and development perspective
is through completion of product and software design,
identification of key skills and technology, and resolution
of high risk issues. Essentially, we’re talking about
organizations following a strong software development
process that employs best practices within their software
groups.
These practices are designed to remove both product
and development risks while providing the project with
a foundation for success. Proficient development
organizations accomplish this by providing strong
“Definition Phase” work products: product and software
requirements, development planning documents along
with a software architecture document with detailed
Sophisticated
software systems
enable and control
the hardware
and drive the
intelligence—
maximizing
productivity
and efficiency.
Irrespective of approach, once technological feasibility
has been established, all costs and expenses associated
with software development, integration and testing
can be capitalized. These costs, capturing all internal
and any external development costs, are capitalized
for the duration of the development effort. It is only
after general product release that capitalization ends
and amortization begins. The amortization period
must be aligned to the “expected life of the product.”
For automation and material handling systems this life
expectancy is often as much as 15 years.
Determining the life expectancy of the product is an
exercise that requires some prudence. In most cases,
a lengthy amortization period can be expected, minimizing the annualized impact of the software development
costs to the financials.
INSIGHTS into AUTOMATION & MATERIAL HANDLING
Technology Giants Gaining P&L Benefit
This method of capitalizing software development
costs has two significant impacts on the P&L of
automation companies. In the near term, during the
product development period, the impact to the P&L
is positive as significant fixed costs are pulled out of
expenses. After reaching the technological feasibility
point, costs that would normally show as software R&D
costs are no longer shown as expenses on the P&L.
This has the effect of actually improving EBIT while
simultaneously investing in advanced software systems.
As mentioned earlier, this continues to the point of
product release. All on-going maintenance costs associated
with the product must be captured as expenses.
Recapture of the capitalized costs occurs over the usable
life of the software system—presumably, coincident
with revenue generated by product sales.
Leading technology companies—Google, Phillips, and
HP to name a few—have been capitalizing investment
in product software development for years. And Apple,
in their 2014 annual report stated, “Development costs
of computer software to be sold, leased, or otherwise
marketed are subject to capitalization beginning when
a product’s technological feasibility has been established
and ending when a product is available for general release
to customers.” These companies have realized significant
P&L and competitive advantages through capitalization
of software costs.
Remember, we mentioned a catch. Let’s look at the
potential downsides of this approach.
The Catch
There are several scenarios that could result in a
significant financial reporting issue. As we all know,
the development of sophisticated software can be extremely
challenging. The number of software development
projects that fail to deliver on expectations or fail outright
and get cancelled is large–especially within organizations
that do not have deep expertise in software systems.
Using the approach in which technological feasibility
has been met – and risks have been identified and
mitigated – helps to minimize the risk associated with
capitalization of the costs. However, it is not an assurance
that there won’t be problems. As an example, if a project
is cancelled after capitalization has begun, the useful
life has suddenly gone to zero and all the capitalized
costs will hit the P&L immediately. That could certainly
have a strong impact and make for a very bad quarter.
There is also an impairment test that must be done
periodically during the amortization period. For example,
if the net realizable value of the product is below the
unamortized value, perhaps because the product is not
generating the revenue that was expected, then the
difference between the unamortized value and the net
realizable value needs to be expensed immediately.
Additionally, there is ambiguity associated with some
modern software development processes. FAS 86
matches up well with the normal “waterfall” method for
software development, but using it in “agile” software
development is more complex and has implications
on how the development is managed. In the case of
“agile” development, there is a requirement for more
detailed time and activity tracking in order to sort out
the activities post-technological feasibility. There are
also other solutions for capitalization with an agile/
incremental development process that involve initial
planning activities, incremental architecture and design
tracked separately from the remainder of the coding
and testing activities.
Make a Move. How Quickly?
The demand for much more sophisticated software
solutions embedded within automation and material
handling products represents a significant opportunity
for equipment suppliers. This pull from the market is
unprecedented and will continue to accelerate, with
a rapid separation between winners and losers in the
marketplace.
The risks of not moving quickly are obvious. However,
the risks of moving quickly, while maybe less obvious,
are no less dire. The development of complex software
is a complex task. Moving into this discipline quickly is
fraught with product and corporate risk. Dealing with
the costs associated with the development of complex
software is also fraught with corporate risk. Both need
to be mitigated in order to be successful.
FAS 86 provides a pathway to reduce the financial
risk—as long as you have the proper experience and
skillset to fully characterize technological feasibility
and risks within your new product concept. Partnering
with an organization that has both the software experience
and expertise successfully utilizing FAS 86 may well be
the most effective way to reduce the overall risks associated
with meeting the needs of such a rapidly evolving market.
About the Author – Tom Mariano
As Executive Vice President and General Manager, Tom provides strategic oversight and technical expertise
to Foliage’s Industrial Equipment practice. He has over 25 years of experience in software development,
engineering and marketing management. Tom’s focus during his career includes semiconductor and automotive
manufacturing automation; robotics and material handling for warehouse and distribution solutions. He holds
a Master of Science in Robotics and Control Systems from MIT, and a Bachelor of Science in Mechanical Engineering
from Northeastern University.
Are you interested in learning how to leverage FAS 86 for your next software development effort?
Contact Tom at tmariano@foliage.com
About Foliage
Foliage, part of the Altran Group, is a global product development company partnering with clients to address
the business and technical challenges inherent in developing, manufacturing and supporting complex,
connected systems. Providing a full complement of technology consulting and engineering services, Foliage
ensures clients deliver innovative solutions to market while reducing total cost of ownership over the lifecycle
of their products. Visit foliage.com
Foliage | 20 North Avenue, Burlington, MA 01803 | +1.781.993.5500 | foliage.com
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