What is R&D?
Research and development is an activity that seeks to create new knowledge. Within a business context, R&D will aim to create a new product, process or service; or improve an existing one. In fact, that forms part of HMRC’s definition of R&D.
Of course, the goal of R&D will ultimately be to increase the profitability of the company. It can, however, do that either by creating a new product for sale, or by reducing the marginal cost of the firm by improving the efficiency of the production process.
Which businesses conduct R&D?
R&D is often associated with large corporates. This is likely because large corporates have departments dedicated to the task, whereas R&D happens across multiple functions at startups. The R&D of large corporates can also be more visible. When people think of R&D they’re likely to think of large vaccine trials or testing aerodynamics in wind tunnels.
However, research by the US Small Business Association shows that small businesses “are awarded 13 to 14 more times more patents per employee than large firms”. Indeed, small businesses need to innovate more in order to carve a new niche within an industry. Whereas, large companies may have the economies of scale to remain profitable off existing technologies.
Which industries conduct R&D?
While R&D is of course concentrated in high-tech industries such as manufacturing and biotech, all industries conduct R&D in some form. Even typically service-centred industries such as hospitality and the creative industries will conduct R&D.
From the data provided by HMRC on R&D relief payments, we see this split of R&D across different industries in the UK. The benefit of this data is that it shows R&D amongst both small and large companies. However, it is widely believed that less than half of eligible companies are currently claiming the R&D relief.
McKinsey also collected data from publicly listed companies globally. They looked at the % of earnings reinvested into R&D spend, as well as the gross amount of R&D investment by industry.
How to measure the benefits of R&D
R&D can have an impact across many areas of your business.
Developing new products or services
Firstly, R&D can lead to the creation of new products or services, which in turn generate new sales. The measurement for the effectiveness of this R&D is relatively straightforward. You will want to look at the value of new sales generated from the products created through R&D. You should also take the impact on your gross margin into account, as the new sales may have different rates of profitability than existing offerings. McKinsey developed an easily applicable framework for this, which is especially suitable for larger businesses.
R&D projects can also aim to improve the internal processes of your business. Most often these will be the productive processes with an aim to reducing your marginal costs. However, R&D can also aim to improve other functions within your business, such as customer service, HR or marketing.
For example, your software engineers may build a bespoke platform to link your customer service enquiries with your online content. That would count as R&D, and the outcome would be a reduction in operational cost, rather than increased revenue growth.
In the cases above, R&D will have a clear impact on the bottom line. However R&D can also have less measurable benefits for your business. For example, a failed R&D project may demonstrate that a new product line is technically unfeasible. This will then inform your product strategy and prevent excessive investment in a futile product direction in the future.
Your R&D might also inform your acquisition strategy by helping you understand where the technological future of your industry is located. Indeed the consensus is that having an R&D strategy closely aligned to your overall business strategy improves the quality of both. However, quantifying these less tangible benefits can be tricky.
Other ways R&D benefits your business
Aside from the profitability benefits of specific R&D projects, R&D can also impact your business in other ways. Here are a few:
Innovative companies are more attractive to high-quality candidates. Especially high-skill hires such as engineers and developers.
A new technology can help to establish new partnerships. These partnerships can be with businesses, academic institutions or the public sector. The UK government’s Knowledge Transfer Partnerships scheme aims to foster R&D links between the private and public sector.
Attracting External Finance
R&D can excite investors of the potential of your business to reach scale in the future. Research has shown that “R&D investments increase the number of [venture capital] deals in an industry”.
When R&D might not be suitable for your business
Not all industries benefit equally from R&D. If you’re a biotech business selling new drug types, then your business would not exist without R&D. However a service-led business such as a restaurant chain would be less likely to benefit from R&D.
Less suitable for low-tech industries
Indeed, research on German Manufacturers by the Centre for European Economic Research showed a strong relationship between firm value and R&D investment for high-tech sectors, but a negligible relationship for low-tech sectors. “For the median productivity firm, investment in R&D raises firm value by 3.0 percent in a group of high-tech industries but only 0.2 percent in low-tech industries.”
Investing the right amount into R&D
Also although R&D might be right for your business in general, getting the right amount of R&D investment is also important. Evidence from China indicates that R&D investment increases a firm’s value up to a point. After a tipping point, R&D investment provides sharply diminishing returns. Researchers describing an “inverted U shape” for the correlation between firm value and R&D investment.
Benefits to the economy
Studies have shown a clear link between R&D investment and economic growth. With an increase of R&D investment by 1% delivering a 0.61% increase in economic growth.
More specifically the advance in science or technology created by one firm also benefits other firms within the same industry. Once the technology hits the market, the secondary or late adopters can also profit from it.
In general, R&D is a value-creating activity. The outcomes of effective R&D should ultimately result in the satisfaction of consumer expectations and needs.
R&D tax credits
The government recognises that R&D benefits are often felt outside of the firm where the R&D takes place. For that reason it subsidises individual firms’ innovation. The R&D tax credit scheme allows businesses to receive up to 33% of the cost of their R&D back a cash credit or tax reduction. If you’re new to the scheme then the best place to start is our introduction to R&D tax credits.
At EmpowerRD we guide you through the process of making an R&D tax credit claim. Our industry-leading advisors include ex-HMRC inspectors who guarantee you’re claiming the most amount of credit available to you. We combine their expertise with an online claims platform which significantly speeds up the process of making a claim. Speak with one of our team to see how much you could claim.