What Are Research and Development (R&D) Expenses?

What Are Research and Development (R&D) Expenses?

Let me explain to you what research and development (R&D) expenses really are. These are the costs a company racks up when it's pushing for innovation and bettering its products, services, technologies, or processes. You'll see R&D as a standard operating expense. Most of the time, you have to record these costs as expenses right when they happen, but if the R&D has some alternative future use, you might capitalize them instead.

Understanding Research and Development (R&D) Expenses

R&D is a structured process that mixes basic and applied research to solve new or ongoing problems, or to create or refine goods and services. It breaks down into two main stages. First, there's the research stage, where you investigate and examine ways to develop something new or significantly improve what's already there. Then comes the development phase, where you turn that research into reality through designing, manufacturing, and testing.

Reasons to Conduct R&D

You conduct R&D to improve your business operations and what you offer to customers. These efforts can increase profitability, keep you ahead of competitors, and are vital for survival in certain industries. R&D often targets new products. Before launching anything, it goes through extensive phases covering market opportunity, costs, and production timelines. Once researched, the product moves to development, where you build it based on the initial concepts.

Companies also use R&D to update existing products or perform quality checks. In these, you evaluate if the product still meets standards and consider improvements. If those changes make financial sense, you implement them in the development phase.

R&D Expenses

R&D isn't free, and the payoffs aren't always quick. It might take years for your investments to show results, and some research could lead nowhere or produce underwhelming outcomes. The aim with most investments is a higher return, and R&D follows that logic, though without guarantees.

These expenses can be small or run into billions. Sectors like industrial, technological, healthcare, and pharmaceuticals see the highest R&D spending. Some companies, especially in tech, plow a big chunk of profits back into R&D to fuel ongoing growth. As a fast fact, the top R&D spenders in 2022 were in hardware, software, internet, and health industries.

R&D Expense Accounting

Under generally accepted accounting principles (GAAP), you must recognize R&D costs as expenses in the year they're incurred. These show up on the income statement and cut into your net income. Generally, you expense them because R&D doesn't guarantee immediate benefits, and future gains aren't certain. But there are exceptions where you can capitalize them and report on the balance sheet, delaying full expense recognition—which looks better on your financials.

You might capitalize R&D costs for intangible assets from acquisitions, when they create materials or fixed assets with estimable value and life, or for software that has uses beyond one project. Remember, R&D expenses usually appear on the income statement in the year incurred. Importantly, the IRS provides tax breaks for these expenses.

Real World Example of R&D Expenses

Tech companies depend on R&D, leading to high expenses in this area. In a fast-evolving field, staying innovative is key. Take Meta, formerly Facebook—they pour money into R&D for virtual reality and AI chatbots. This helps them diversify and chase new growth as tech advances. For the three months ending June 30, 2024, Meta spent $10.54 billion on AI R&D, over a quarter of its sales that period.

Note that acquisitions can count as R&D expenses too. Meta's 2014 buy of Oculus Rift is a case in point. They had the resources to build virtual reality internally, but acquiring it sped up the process.

Are Research and Development Expenses Tax Deductible?

In the past, you could deduct R&D expenses fully in the year you made them. But the TCJA changed that—starting in 2022, you amortize domestic costs over five years and foreign ones over 15 years.

What Are the Three Types of R&D?

There are three types: basic research, applied research, and experimental development.

How Much Do Companies Spend on R&D?

It varies by industry. Pharma and tech firms spend heavily—for instance, Meta spent 29% of revenue on R&D in 2023. Energy companies spend far less, like Chevron's 0.2% of revenue that year.

The Bottom Line

Innovation drives many businesses, and R&D is often the key to surviving and outpacing rivals. It can be expensive to research, test, and roll out, with no sure success, and it's usually expensed rather than capitalized. For some companies, their future depends on R&D, but it can drag on profitability while you wait for returns.