Process Improvement Research & Development Tax Credits

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        Lean Six Sigma process improvement techniques have dominated manufacturing headlines over the past decade. Understanding the details of process improvement practices, such as Lean Manufacturing, Six Sigma and Kaizen, is vital to evaluating how these practices may lead to Research and Development Tax Credits, particularly when major process changes result.

The Federal Research & Development Tax Credit

        Enacted in 1981, the Federal Research and Development (R&D) Tax Credit allows a credit of up to 13 percent of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:
  • New or improved products, processes, or software
  • Technological in nature
  • Elimination of uncertainty
  • Process of experimentation
        Eligible costs include employee wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent. On January 2, 2013, President Obama signed the bill extending the R&D Tax Credit for 2012 and 2013 tax years.

Overview of Lean Six Sigma

        Lean Six Sigma is a term used to describe the combination of Lean Manufacturing concepts with the Six Sigma defect reduction process. Not all process improvement is done through the strict implementation of Lean Manufacturing or Six Sigma practices, however, Lean Six Sigma has become a commonplace improvement technique in manufacturing industries as well as health care systems.

        The DMAIC approach, Define, Measure, Analyze, Improve, and Control, is the backbone of most Six Sigma improvements . This basic methodology, combined with waste reduction at all phases of a process, creates the basis for the commonly used term Lean Six Sigma. Overall, this combination strives to maximize the value, in any form, given to the customer.

Technical Aspects
        Improving upon a complex process, whether in the manufacturing or health care industry, is technical in nature. The technical nature is enhanced when using such complicated industrial engineering techniques and hands on analyses as those found in Lean Six Sigma.

        Technical uncertainty within a process is often the driving factor for using Lean Six Sigma in process improvement. In this phase, the process or system as a whole is defined and questions are raised as to where problems such as bottlenecks, design flaws, scheduling, and inventory management can be solved. This phase is where possible paths of improvement are made.

Process of Experimentation

        Figuring out what data to determine and conducting statistical analysis to this data is included in the process of experimentation within DMAIC approach. There is often extensive testing and studying of the effect of different components within a process. These components could be the inputs and outputs of the system or the mechanical workings of different parts of the process.

        Modeling and simulation is also prevalent when studying process improvement possibilities. Modeling and simulation makes it possible for the system to be analyzed without interrupting the daily operations. By modeling and simulating a factory or hospital, engineers can understand how certain factors affect inputs, outputs, and overall performance without interrupting the real life process from functioning.

Consideration of Alternatives

        Lean manufacturing and Six Sigma approaches are rarely taken without considering multiple alternatives. The complexity of the process, how many parts or different processes there are within a system, determines the number of alternative process improvements that can be considered. In some cases there are an infinite number of changes that can be made and only several alternatives will be considered. Modeling and simulation is an effective way of comparing these alternatives with each other.

Where Does Kaizen Fit In?

        When roughly translated from Japanese, Kaizen means "continuous improvement". The purpose is to eliminate the seven kinds of waste (muda) in:
  • Overproduction
  • Unnecessary stock
  • Defects
  • Waiting
  • Transportation
  • Processing
  • Motion
        Improving all these aspects through the elimination of waste is an on-going process that strives for perfection. Companies that utilize the Kaizen philosophy are continuously testing their processes, studying relationships and outcomes, and working with new technologies to improve their processes.

R&D Example: Sustainable Foods Inc.

        This example is created by the authors but was derived from an actual process improvement example that is very similar. Sustainable Foods Inc is a high quality Asian-style frozen foods supplier in California. They began receiving surcharges from the State of California because of extremely high Biological Oxygen Demand levels in the waste water from their plant. This was a very serious problem not only because of the surcharges, but because water conservation practices are becoming growingly important due to the expectation of a serious US water shortage by 2050. These charges and Sustainable Food's support for the environment led them to determine the cause of the problem and solve it using a Six Sigma DMAIC approach.

        The first step of action was to define the problem. Understanding what BOD was, what caused the high levels, and where throughout the plant the problem was occurring are factors that Sustainable Foods had to be determine. The Sustainable Foods team attempted to measure the problem by conducting normality tests, gathering historical and current data, and developing a sample power.

        All this measured data was organized and analyzed. The analysis included gap analysis, fishbone diagramming, cause and effect matrices, benchmarking with other companies, and regression analysis. Once all the data was measured and analyzed, Sustainable Foods was able to begin to improve their process to reduce BOD levels. They developed a three tier system to rank the solutions to be made.

        The first tier of solutions was immediate; through on-sight adjustments they called "Just Do It's". These were basic improvements, cleaning, and employee training techniques. The next tier of solutions was more involved. These solutions needed further development and included the creation of a 'Waste Awareness Program Committee' and error proofing safeguards.

        The final tier of solutions, tier three solutions, were long-term, extended development solutions that would take a degree of time and careful consideration. Such solutions included adding a thickening agent that would reduce the capabilities of egg roll fillings hitting the floor and investigating green waste removal methods. Sustainable Foods Inc also employed a third party engineering firm to help them model and more technically analyze alternative solutions.

        With incredible success resulting from the three tiers of solutions, Sustainable Foods had to develop a system to control future production to build upon this success. A continued employee training program was put into effect, floor drain covers were installed, and Sustainable Foods made a long term commitment to eliminate 95% of BOD waste water contamination.

Analyzing the Three Tiers for Tax Credit

        Although all three tiers were vital to Sustainable Foods' process improvement efforts, not all the solutions may be considered Qualified Research Expenses (QREs). Because they are basic, non-technical solutions, none of the first tier activities would qualify as QREs under the R&D tax credit.

        Some of the more technical and calculation sensitive solutions in the second tier would be considered QREs. For example, the creation of a Waste Awareness Program Committee is not technical in nature and did not require a process of experimentation or consideration of alternatives, therefore it would not qualify as an eligible R&D activity.

        On the other hand, certain error proofing safeguards could qualify if there was analysis conducted to evaluate the potential benefits of such safeguards. The third tier solutions would offer the most qualifying R&D activities. These solutions often require extensive analysis and careful consideration of the possible alternatives. There is also a great deal of experimentation and testing that comes into play before a majority these solutions are decided upon. The activities contracted to the engineering firm would qualify for 65% of the cost of hiring the firm, but the rest of these third tier solutions would qualify for 100% of the labor and supply costs of these activities.


        The goal of process improvement is to reduce costs and improve product quality. Lean manufacturing and Six Sigma process improvements can help manufacturing companies and health care providers do this. Lean Six Sigma both improves throughput and can qualify for substantial R&D tax credits.

Article Citation List



Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Raymond Kumar is a CPA and Tax Manager with R&D Tax Savers.

Sean Brophy is a Tax Analyst with R&D Tax Savers.

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