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Based on a sample of UK manufacturing small- and medium-sized firms in the engineering and electronics industry, the study identifies firm- and industry-specific factors that stimulate R&D outsourcing and assesses the impact of R&D investment and outsourcing on firms' profitability. The findings indicate that (1) R&D investment fosters profitability, (2) firms with a lower turnover spend less on R&D, (3) current R&D does not explain innovation measured by revenues from new products and patents, (4) smaller firms with lower R&D investment levels tend to outsource R&D and (5) outsourcing is not inferior in terms of product innovation. Hence, outsourcing can enhance profitability – albeit the benefit of outsourcing decreases with firm size. Managers of small firms should consider outsourcing R&D, as this can reduce R&D expenditure and lead to the more effective use of resources as well as achieving a similar degree of product innovation with resultant increases in profitability.