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Research and development (R&D) refers to the part of a company's operations that seeks knowledge to develop, design and enhance that company's products, services, technologies or processes. Along with creating new and innovative products and adding features to old ones, R&D connects various parts of a company's strategy and business plan, such as marketing and cost reduction.

Some advantages of research and development are clear, such as the possibility for increased productivity or new product lines. The Internal Revenue Service offers an R&D tax credit for businesses. Some kinds of investors look for firms with aggressive R&D efforts. It's also not uncommon for small business owners to make a lot of money by being bought out by a larger firm in the industry that wants to use their R&D.

Defining Research and Development

Research and development consists of the investigative activities that a person or business chooses to do with the desired result of a discovery that will either create an entirely new product, product line or service, or strengthen an existing product or service with additional features.

Research refers to any new science or thinking that will result in a new product or new features for an existing product. Research can be broken down into either basic research or applied research. Basic research seeks to delve into scientific principles from an academic standpoint, while applied research seeks to use that basic research in a real-world setting.

The development portion refers to the actual application of the new science or thinking so that a new or increasingly better product or service can begin to take shape.

Research and development is essentially the first step in developing a new product, but product development is not exclusively research and development. An offshoot of R&D, it can refer to the entire product life cycle, from conception to sale to renovation to retirement.

Productivity and Product Differentiation

Firms gain a competitive advantage by performing in some way that their rivals cannot easily replicate. If R&D efforts lead to an improved type of business process – cutting marginal costs or increasing marginal productivity – it is easier to outpace competitors.

R&D often leads to a new type of product or service. According to the Small Business Administration, this is most common in sectors such as industrial machinery, trucks and tractors, semiconductors, computing technology and pharmaceuticals (see "How Much of a Drug Company's Spending Is Allocated to Research and Development on Average?")

The R&D Tax Credit

In 1981, the IRS started offering tax breaks for companies to spend money and hire employees for the purpose of research and development.

Qualifying companies include startups and other small ventures with qualified research expenses. Such expenses can be used to offset tax liabilities, along with an impressive 20-year carry-forward provision for the credit.

Buyouts and Mergers

Many entrepreneurs and small businesses have made a large sum of money in a short time by selling good ideas to established firms with many resources. Buyouts are particularly common with internet companies, but they can be seen wherever there is a lot of incentive to innovate.

Advertising and Marketing

Advertising is full of claims about revolutionary new techniques or never-before-seen products and technologies. Consumers demand new and improved products, sometimes simply because they are new. R&D departments can act as advertising wings in the right market.

R&D strategies let companies create highly effective marketing strategies around releasing a new product or an existing product with new features. A company can create innovative marketing campaigns that match the inventive products and increase market participation. Innovative new products or features can increase market share by giving customers something they've never seen before.

The Bottom Line

Increased market participation, cost management benefits, advancements in marketing abilities and trend-matching – these are all reasons companies invest in R&D. R&D can help a company follow or stay ahead of market trends and keep the company relevant. Although resources must be allocated to R&D, the innovations gained through this research can actually work to reduce costs through more efficient production processes or more efficient products. R&D efforts can also reduce corporate income tax, thanks to the deductions and credits they generate.

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