Feasibility of Treating Contractors' Independent Research and Development Costs as a Budget Line Item

Published by the Government Accountability Office on 1971-03-08.

Below is a raw (and likely hideous) rendition of the original report. (PDF)


Feasibility -Of Tre.ating Contractors’
Independent Research
And Development
Costs As A Budget Line hem       E.-1649i2

Department of Defense


                                                        I ',,.
                                                            ,.-   ‘#

   OF THE UNITED,STATES                                   i,,''

           w            MARCH   8,1971
                             COMPTROLLER         GENERAL     OF      THE    UNITED   STATES
                                               WASHINGTON.    D.C.     20548

         Dear Senator$&?%Y                 :

              Reference  ia made to your letter  of October 5,
         our views as to the feasibility   of converting  contractors
         dent research  and development  to a budget line item.

                We have given this matter                serious consideration.           Haseli on our
        analysis     we believe       that a line-item           control     of independent        research
        and development          payments to major defense contractors                   can be developed
        using estimates          based on historical            data, together       with the Department
        of Defense's        estimate      of the amount of research               and development          and
        procurement       activity      to be contracted.             However, we suggest t'nat no
        further     legislative       controls       be imposed pending evaluation                of the
        effect    of the legislative            restrictions        that became effective            Jan-
        uary 1, 1971.
                As you know, the recently                enacted Section 203 of Public Law
   GI$@ 91-441 requires          the Department          of Defense to establish          certain         con-
PG      trols    over the payments for independent                    research     and development
        to its major contractors               and to provide the Congress with annual
        reports     on the payments made. Although this law does not contain
        all of the limitations              on independent         research      and development          that
        were embodied in your bill                or in the Senate procurement              bill,      it
        does contain        certain     restrictions         on payments for independent              re-
        search and development              that may achieve results              comparable to those
        sought to be obtained             through a line-item            control    mechanism.

                   For example, tnc.law    now requires   that a report     he made to the
          Congress by March 15 of each year showing statistics              for companies
          that received       payments from the Department     of Defense,for    indepen-
          dent research       and development  (and bid and proposal)       of more than
          $2 million.        Thus, the Congress for the first     time will be provided
          visibility      of the extent of the Department's      expenditures,   for inde-
          pendent research and development         costs of major contractors,       and
          therefore     will    have the means for deciding    whether more or less
          restrictions       are required.

               In view of the recency of this legislation                                     we ‘believe     it would
          be desirabie to allow  sul’K.cient time --at  least                                 one yccir,    preferably

                                   SOTH ANNIVERSARY                        1921- 1971                          -
two--for     evaluating     the law's impact teI'ore    considering         introauction
of legislation        to establisn   additio-nal controls.

       In this connection,      we have been informed by officials        of the
Department    of Defense that preliminary       reports    show that expenditures
by ;aajor defense contractors       for independent     research   and development
declined    during the past year.       Comparison of the report       to be sub-
mitted to the Congress by Narch 15, 1971, with data for previous                years
should show the trend of expenditures          and should assist     in determining
whether additional     controls    may be necessary.

       During our study of this matter we prepared a paper (appendix                       I)
describing    (1) the present      system for allowing         independent      research
and development      as a contract     cost and (2) a system which we believe
would enable line-item      control.       We asked officials         of the Office      of
the Secretary     of Defense for their         views on our proposal.           In a letter
dated December 19, lij70 (appendix          II),    the Assistant       Secretary    of
Defense (Installations      and Logistics)         objected    vigorously     to the
suggested system.       He described     several problems which he believes
would be created by imposition          of such a system and he contended
that implementation      of a line-item        control    could have a serious
adverse impact on the technological              base of this country.

        Although      we agree with his positio;l      that line-item      control      of
irideptndent      researcn    and development 'cioulci lead to additional          admin-
istrative      burden, we believe        such control    can be established.         If
such control        is determined    to ‘be necessary,     we suggest t;hat a system
change of this magnitude be tested on a trial                basis before legislation
is proposed reciuiring         its ifilplementation    on a broad scale.         Our
analysis      of the views expressed by t'he Assistant           Secretary     is inciuded
in appendix III.

       We hope this information      will    ser-ce the purposes of your request.
If we can be of further      assistance      to you in this matter,         please let
us know.     We plan "Lo make no i'urther       distribution       of this letter   unless
specifically    requested,   and then copies will            be distributed    only after
your approval     has been obtained       or public     announcement has been made
by you concerning      the contents   of this letter.

The Honorable      William    Proxmire
United States      Senate
.   ’

                                                                                                     APPENDIX I
                                                                                                     Page 1

                                             GAOVIEWS ON
                 In this paper,        "line     item"      is   intended to mean a congressionally
        approved aggregate limitation                    or limitations       that may not be exceeded
        by the agency or agencies responsible                        for controlling        the applicable
        appropriated          funds.    Also, the term "independent                research and develop-

        ment (II&D)"          is construed in its broadest                 sense--it      includes     bid and
        proposal       (B&P) costs and costs of other technical                        efforts      that are
        closely       related     to either      JR&D or B&P costs.
              At the present           time     IR&D is considered by the Department of Defense
        (DOD) as an indirect                cost (overhead item).            ContrEictors doing business
        with DODaccumulate IR&D costs in various                          overhead accounts and allocate
        them by various methods to the work they perform for both Government
        and commercial clients.                 DODgenerally          allows such costs td be charged
        to its     contracts        if properly          allocated    and reasonable        in amount.
                 In determining        reasonableness            of these overhead costs for contrac-

        tors.or       their     divisions      whose work is predominantly                or substantially
        with the Government, DODhas for many years attempted to negotiate
        advance agreements setting out the maximum amount of IR8& to be
        recognized        as an overhead cost allocable                   to all   of the contractor's
        activities.           Section 203, Public Law 91-441,                  requires     that,     beginning
        January 1, 1971, such advance agreements shall be negotiated                                   for
                                                                                        AFFENDIX I
                                                                                        Page 2
companies which received               from DODmore than $2 million of I&D and
B&P during the preceding               year, or for product divisions of such
companies which received              more than $250,000 during the preceding

fiscal     year.      DOD is planning        to expand this            requirement    to cover
the top 100 Defense contractors.                   DODestimates           that this will       cover
over 85 percent of the total               amount of III&D costs absorbed under DOD
         In preparation      for advance agreements, the contractors                     are
required     to submit brochures           describing       the IUD work planned.
Section 203 requires              that DODmake a technical               evaluation    of the
contractor's        II&D plans.        Such evaluation          will     also serve to deter-
mine whether there is a potential                  relationship          of the II&D project
to a military         Ifunction     or operation      as required         under Section 203.
         We believe     that a line-item          control       for IR&D would be feasible
if the limitation          is restricted         to payments to the larger             companies,
and if for      these same companies IR&,D is paid directly                      under a special
contract     rather     than as an allocated           overhead charge under various
contracts.         It would be extremely           difficult,          if not impossible,       to
adequately      administer         a line-item     limitation          for any segment of

overhead because some type of control                    would have to be developed
to accumulate data on costs allocated                    to each of thousands of pro-
curement contracts.
         In lieu of the overhead advance agreements described                         above,
annual special         oontractual       agreements could be negotiated               with the
                                                                                        Page 3

larger      companies providing       for direct       payment (up to a ceiling)             of
the appropriate        share of the contractor's            IR&D. The special             agree-
ment for IR&D would be negotiated                 in a manner similar         to the present

advance agreements with major contractors                   and would continue            to permit
the contractor        to conduct U&D in the manner and to the extent                        he
deems advisable.          However, the special          agreements would provide             far

direct    payments by DODto the contractor                 for up to the agreed amount,
rather      than establishing       an amount acceptable           for inclusion         in the
contractor's        overhead allocable      to all      of his customers which then
must be distributed            to all of his contracts.            The special      agreements
also would provide         that IR&D would be excluded from charges for
costs under the contractor's             regular      negotiated     contracts      with DOD.
         The agreement for IR&D would, in effect,                  provide     for payment of
a proportionate        share of the actual          costs of the contractor's              IE&D
program not in excess of the agreed ceiling.                       The agreement also
would provide        that the payment may not exceed the total                   costs of
IRi3.Dwork which,        in the opinion      of the Secretary         of Defense, has a
potential       relationship      to a military       function     or operation.
         The DOD share of the contractor's              JR&D program would be based

on the ratio        of the contractor's       negotiated         contract    activity      for
DOD compared to the contractor's              total     workload.          Inasmuch as the
actual      ratio   cannot be determined until           the end of the year, the
proportionate        share could be determined on the basis of the ratio
for the most recent year completed at the time the contractor's                              pro-
posed IX&D program is submitted for evaluation.                        To avoid additional
                                                                                         Page 4
administrative       effort        and to enable orderly           planning        by the contractor,
the proportionate          share so determined should not be changed even
though the actual          ratio     may differ      from the ratio           used in determining
this   share. If the actual            ratio     differs      substantially,         DODmight

consider      its effect      as a factor         in negotiating          the special    agreement
for the following          year.
       Those contractors           who do not come within                the category of "major
defense contractors"           would continue to be reimbursed for the allocable
share of their       JR&D costs through distribution                      of overhead costs,       as
is presently       done.      Because of the smaller amounts involved,                      the lR&D
programs of these contractors                  are not subject           to technical    evaluation
by D3D. Those "major"               contractors      who prefer          similar    treatment   could
be offered       the option of limiting             their     allocable       E&D charges to
iX)D contracts      to a stipulated            maximum (perhaps $2 million              as the law
presently      indicates      for other than major contractors).                      Otherwise,
"major"      contractors      would be required             to enter into the special
contract      agreements for IR&D. As a practical                        matter,    it is unlikely
t'nat many major contractors             would refuse to enter into the special
agreements in view of the significant                       difference       in cost recovery.

       In its annual budget request,                 DODwould set out the amount or

amounts for the proposed payments of I&D to its major contractors.
The budget line-item           proposal would be developed based in part on
historical       data.     Section 203, Public Law 91-441, requires                      annual

reporting      of the latest         available      Defense Contract Audit Agency
                                                                                      Page 5

statistics          on II&D or R&P payments to major defense contractors.
Similar          data is available         for the past seven years.            Such data,
together         with DOD's estimate           for the amount of researchand            develop-
ment and procurement activity                   to be contracted      for,     should provide       a

realistic          basis to DODfor estimating             the amount to be set out as a
line    item for the IR&D of major contractors.                      The budget back-up
would explain           any significant         changes anticipated          by DOD in the
ratio     of the JR&D estimate               to tne contract    work estimate.
        At present,        IR&D is included without            identification       in the budget
as a part of the appropriations                   for research,      development,     t&t    and
evaluation          (RDl!&E), procurement,          and operations     and maintenance for
each of the military              services      and the Defense agencies.           To facilitate
control          and to eliminate          the work involved    in making extensive          cost
allocations          to the numerous appropriations,              it would be preferable
to include          the amount authorized           for lR&D of major contractors            as
a prt        of only one of these appropriations.                  This appropriation        would
be used to fund the payments to each major contractor                            for the agreed
share of his JR&D, as distinguished                     from payments made from the
various          appropriations      for     contract   work performed.
        A reduction         in the amounts otherwise           requested to be appropriated
for DODwould, of course, be warranted                      corresponding        to ,-the amount(s)
specifically           requested to be appropriated            for II&D.
        The data presented by DOD in its budget submission,                         as explained
above, should provide the Congress with good visibility                            of the basis
                                                                                    APPENDIX I
                                                                                    Page 4
for the estimated IR&D costs for major contractors.    This should enable
the Congress to be in a position to judge the propriety of the requested
line-item       amount.
       The proposed line-item          amount should,           in our opinion,     be considered

by the Congress in conjunction               with the total           of the RDT&Eappropriations.
The activities          carried   out bjr contractors          under their      IR&D programs are
closely       related    in nature to research and development work performed
under Government contracts            or in Government laboratories.                 If DOD's
costs for participating            in JR&D programs and its              costs for direct
RiYlSE activities         are considered as a package, the Congress would ob-
tain a clearer          picture   of the total       current     expenditures     authorized
for research and development.
                     BY DOD
       Tne total        amount of the planned IF&D programs for major contractors
which DOD can determine to be reasonable                     and potentially      relevant     to
a military       function     or operation       obviously     will     not be known until
all of the programs have 'oeen received                    and evaluated by DOD. When
such determination           has been made, the DODwould be in a position                    to
gauge whether its           share of such amount would be wSthin the line-item
limitation,        or whether reductions          will     be needed.      Consequently,     it
would be necessary for DODto arrange for early                          submission and
evaluation       of major contractorsV           IR&D programs.
       In order to permit continuation                   of II&D efforts     at the level

authorized       by Congress, it may be desirable                to stipulate      in each
agreement that the amount payable by DODmay be increased                            at DOD's
option,       under specified      conditions,       to the extent funds are available
within     the line-item       lL.mitation.      F'or example, if because of the
appropriation      limitation,       DOD is unable to agree to support its                    full
proportionate      share of a contractor's           IR&D program even though tech-
nical     evaluation     shows that the program is considered                desirable        and

COD-oriented,      upward adjustment          of the ceiling      may be warranted            if
DOD determines that the full              amount authorized       for II&D under the
appropriation      line-item      will    not otherwise       be spent.      This may pro-
vide an incentive          to the contractor       to continue     IR&D efforts      beyond
the amount that DODhas agreed to support,                     but would assure that the
amount of DGDfunds spent for IF&D would remain within                         the limitation.

         The implementation       of line-item      control     of IR&D applicable            to
DODwould probably           create some additional        burden on other Government
agencies which negotiate            contracts    with major defense contractors,
particularly      the National       Aeronautics     and Space Administration             (NASA).
         At present ZASA participates           with DOD in the negotiation              of
advance agreements on IR&D, and such agreements are considered                            to be
applicable      to BASA, as well as DOD contracts.                If special      agreements
are negotiated         by DOD for direct        payment of JR&D such agreements
would not have any effect            on NASA, and separate agreements would be

required.       Inasmuch as the negotiations           leading     to the lR&D special

agreements would be similar              to those presently       used for     advance
agreements, it does not seem that the execution                    of separate agree-

ments for NASA's participation                in IR&D should require         extensive
time and effort.
                                                                        Page 8
     NASA was asked to review our proposal        for line-item    control     and
to comnzent on problems it might present.        A NASA official    replied

@formally   that his agency felt   that a line     item control    would cause
them problems that they do not now have, but until          they know what
DOD's procedures would be they could not reasonably          evaluate    the
                                   ASSlSTANT   SECRETARY       OF DEFENSE
                                          WASHINGTQN,   D.C.   20201

                                                                            19 DEC 1970

    Honorable   Elmer    B. Staats
    Comptroller    General    of the United         States
    U, S. General    Accounting     Office
    Washington,    D. G. 20548

    Dear   k&r,   Staats:

    Recent&y,       members        of your staff furnished       to us draft copies of a GAO Study
    titled    “Feasibility      of Line-Item      Control    of IR&D.”       I understand     that this
     study was prepared           at the request      of Senator   Proxmire.         The paper de-
    scribes      a method      df establishing      budget line-item       control   which requires
    very sigriificant        changes from past practices           that have been followed            by the
    Government           and Industry.      There is no evidence         that any in-depth       study
    has been made of the impact.                 Yet, the report     gives the impression           that
    the approach          is simple to administer,         assures     equitable   treatment      to con-
    tractors,      provides      good visibility      of IR&D and B&P costs and, in the opinion
    of the GAO, is feasible.              There    is no evidence     that the detailed      analysis
     required     to support      these claims       has been undertaken.

    In the short time we have had to consider   this proposal   we have found                        g
    number   of problems.  I would like to touch briefly   on some of these.

                    Budget    Planning

            The GAO paper expresses                  the view that a realistic       line item amount
    could be established          for IR&D and B&P using historical                 data on payments
    to contractors         and relating     this to the procurement          budget.      Such an ap-
    proach     is no more than a projection              of historical    costs without       consideration
    of the value of the effort that is to be supported.                    Xn addition,     for budget
    purposesI        our latest data would have to be projected                two years in advance.
    We believe        that it is unrealistic        to expect Congress       to approve       such a line
    item without         some detail as to the projects            that are to be supported.           At
    the same time,           we believe    it is unrealistic       to expect that contractors          can
    furnish     valid information        two years in advance           on IR&D projects        to be per-
    formed.       If they are required          to do so, it is inevitable       that they will find it
    increasingly         more difficult     to depart from “approved”            projects     and contrac-
    tor initiative       will disappear.        With respect       to B&P projects,        advance
    information         could not possibly        be furnished.

        Comparison         of an IR&D     and B&P line item with          the Defense
procure&ent       budget      is also   an inappropriate approach               because such a
 comparison       is. not valid.     Items in the Defense budget               will be placed on
 colitracts    to be performed          over a period of several            years*    The IR&D/
B&P line item is to be expended in the fiscal                      year for which it ib appro-
priated.       The propo&d         comparison        should therefore         be made with
contractors”        sales to the DOD in an appropriate                fiscal year.      This figure
is not readily       available     until the year is near its end.               Even if it were
proper      to compare      the IR&D/B&P          line item to the procurement              budget
we would have the problem                of determining        that portion      of new procure-
ment dollars        that would be awarded            to contractors        who had been selected
for negotiation        of advance agreements             and we would need to know the
dollar amount of their new contracts                   that would be performed           in house
and the amount to be performed                 by subcontractors           who were not on the
advance agreement            list.   The difficulty        of this task is apparent        when you
consider      that at this point in time we would not know what oontractors
would be successful            in capturing     the new awards.

                Advance      Agreement      Negotiations

        The fiscal year used by most contractors                 is the calendar     year.       The
Government’s         fiscal year begins with July.           The GAO plan provides           for
the IR&D/B&P           line item to be expended during the Government’s                 fiscal
year.     This would require          advance agreements        to be negotiated      with two
six-month      ceilings.       The problems      this may cause require        investigation.
Advance     agreements         would have to provide       for after the fact negotiation
to adjust for changes in the business               mix between DOD and other customers
 since this can only be estimated            at the outset,     This would substantially
increase     administrative        effort.

                Other      Administrative     Problems

       Present      contracts   have all been negotiated         under existing    law and
the ASPR,      These contracts       would still recover        IR&D and B&P costs in
overhead.      Until they phased out over a period of several               years they would
not be affected      by the proposed       line item approach.       .This *would present
problems    in budgeting,      negotiating      ceilings    and segregation    of costs.  None
of these problems         have been considered          in the GAO proposal.

         The impact     of the proposed    plan on competitive     awards  presents  a
major     problem    that would have to be resolved     before such an approach
could    be considered.       Payment   of IR&D.  and B&P     as a direct cost removes

these costs from the overhead          accounts   of those contractors      subject to the
proposed   control.      This means that in competitive       situations,     these con-
tractors  would be relieved       of this burden and. would be able to quote lower
prices than companies        who do not have advance agreements;            or, conversely,
would receive     duplicate   recovery     of IR&D and B&P costs.         The.proposal
does not indicate     how this would be handled,

 IR&D plays an important           part in maintaining         the technological         base of this
‘country    and careful     consideration       is imperative       before any revolutionary
 changes are made that could have a serious                   adverse      impact.      There is no
 indication    that the GAO proposal          is supported       by anything       approaching    the
 type of in-depth      study required.         Yet it infers     that the proposed, line item
  approach    is feasible    and desirable.        I urge that a report         of this nature,
 with its inferences,       not be furnished        the Congress        or’anyone      else.   I would
  also suggest that a complete          in-depth      study of this vitally        important    matter
 be conducted      before any conclusions          or recommendations              are made.

                                                         Since rely,

                                                           BARRY@.         SHILLITO
                                                    Assistant       Secretary    of Defense
                                                      (Installations       and Logi,stic s)
                                                                                           APPmDJx III

       The Assistant        Secretary      refers    to mar line-item          prqmsal       a8 being
a, revolutionary       change, and suggests that a mmplete in-depth                          study be
made before considering            it for i~~&~~~tation.            BB also -tea                     on
severalproblemstbatbe                  feltmmldresultfmne8tabli8hing                        aline-
iten   control     on'IRw3.

       DODbelie~~ that prerentinga                   budgetitembase~on                hiatorGa,l

ds,ta wmld not take into consideration                   the value of the IR&D effort
tobe       8upporGed;tbattbe            C%mgresewo&Ldn~ta~ro~                  alineitem            with-
out 8oae detail        of the pqjects          to be worked on byttbe            contractors;
that the contmtors              could not rmlistically           predict       in advance the
content      of prqjects       to be per-f-d          &ring    the b&get        year; that if
required te subwit swh dsts, contractors                      would hecritate to'depart
from their planned IRU? program,                    and thus would lose their              initiative;
and that a&awe           information       on bid aad progosd          projects'could              not
possibly      be fmnished.
       MB recognize        that a line       fimn in DOD’8budget covering                  the IR&D
costs Ia be reinibursed           to    contractors     must aeceeaar5l.y        be    based on
esttites        aml cannot be 8upported by a detailed                listing       of contractors
showing the precise            tasmnts to be paid each contractor.                    ISowever, we
                                                                                   APPENDIX III
                                                                                   Page 2

believe     that the historical           data now available         showing the total     costs

to DODfor supporting              IR&D programs of major contractors              during the
past seven years should serve as a realistic                     base for projecting       the
line-item        estimate   for the next budget year.             While such back-up sup-
port may not be as detailed               as the normal support for budget line             items,
we believe         the information      would be useful       to the Congress inasmuch as
it   should present an understandable                 and verifiable      basis for the amount
proposed.          Although we cannot predict           that such information        would be
acceptable         to the Congress as support for the budget line                 item, we be-
lieve     It may suffice       under the circumstances.
        DODalso questions            the validity      of comparing a proposed line-item
amount for IR&D with the Defense procurement budget.                         Although many of
the problems and points              discussed by DODin raising            this   question appear
to be valid,         it seems to us that DOD is suggesting                that we are proposing
much more preciseness             in justifying       an IR89 line     item than exists     in
justifications         for other      portions      of the Defense budget.        There obvi-
ously is a relationship              between IR&O and the procurement'budget              and all
we are suggesting           is that the best information             available    and the best
esti&es          of contractual       activity      that can be made, using historical
and other data, be presented to the Congress for use in its                          deliberations.

        DOD says that because most contractors                 use the calendar year as

their     fiscal     year, whereas the Government fiscal               year begins with July,
                                                                                      APPENDIX III
                                                                                      Pw3e 3

the special       IR&D contractual      agreements would have to be negotiated
with two 6-month ceilings.

          If the special     IR&D contractual       agreements were to be negotiated
on the basis of the contractor's               fiscal      year (apparently         the calendar
year for most contractors)            DOD's comment would appear to be valid.
Under such circumstances,            DOD could not enter into a contract                     covering
the contractor's         IR@ program for the second half                    of the calendar       year
until      funds covering     that period of time had been appropriated                        by the
Congress.       While the special       contractual         agreements would be similar
in many respects         to the advance agreements presently                    negotiated     with
major contractors,          a significant       difference        would be that they would
cover the contractor's           IR8GDprogram to be conducted during the Gorern-
merit's,     rather    than the contractor's,           fiscal     year.       This would preclude
the need for two B-month ceilings.
          We belfeve    that the contractors        would be able to prepare a proposed
program to be implemented during the Government's fiscal                             year even though
their      planning    in the past may have been on a calendar-year                     basis.        Ac-
tually,      IR@ programs are generally            planned by contractors              on a long-range
basis--two       or more years--and,         therefore,      the contractors          should not have

great difficulty         in preparing       a plan for the Government's               fiscal     year.
          DODalso says that increased            administrative            effort   would be required

by the need for after-the-fact               negotiation         to adjust      for changes in the
contractor's          business mix between DODand other customers.                      This comment

was prompted by the draft            proposal     reviewed by DODwhich suggested that
                                                                                            APPENDIX III
                                                                                            Page 4
the proportionate          share of a contractor's             IR&D program         to be paid         by

DOD beeadjusted          to conform to the actual            ratio      of Defense work to all
of the contractor's          work, in the same manner as presently                         followed.
       In view of the administrative   problems involved and to facilitate
effective    programming by the contractors,   we have revised the suggested
proposal      to provide that once a special                II&D agreement has been nego-
tiated,      the contractor        will    be paid for the work performed using the
proportionate          share considered in negotiating                 the agreement.          No adjust-
ments of the share would be made if the mix of business                              changes during
the year, but DOD should give consideration                      to the effects             of such a
change in negotiating          the agreement for the following                     year.
          DOD states     that there would be problems in budgeting,                         negotiating
ceilings,      and segregating            costs due to the fact that present procure-
ment contracts         would continue to recover JR&D costs in overhead.
          There undoubtedly        will    be problems encountered           in converting             from
the present       system to another,           but such problems should be eliminated
once the conversion           is completed.            In making the conversion,              we believe
the problems mentioned by DODmay be minimized through amendments to
major contractors'          current        contracts     eliminating      amounts equivalent                to
the II&D costs to be included                 in the special         agreements.           These contrac-
tors will      probably     find     it essential        to continue to receive              substantial
funds for II&D from DODin order to sustain                        their    technological          capability,
                                                                                      mP 5

and should, therefore,            be willing      to adjust     their     current     contracts    in

consideration       of DOD's guarantee of additional                financing.
      M3D contends that contractors                receiving     direct     payments of IR&9
from DODwould have a competitive                  advantage as they would be able to
quote lower prices           than companies not having special               IR&D agreements;

or, conversely,       such contractors           receiving     direct     payments of IR&D
could obtain duplicate            recovery of IR&D.
      We recognize          that additional       safemrds       would be needed to preclude
con-rpetitive     advantages in bidding           for Defense contracts.             However, we
believe     the problems cited         by DOD can be substantially               avosded.     IR&D
costs generally       represent      a very small portion           of 8 contractor's         costs
and, therefore,       a small portion           of his bid price.          To the extent that
the share of IR&D paid by DOD (which is based on the business mix of
the preceding       year)     is greater       than the aotual DOD share, the contractor
may have a sligbt           competitive     advantage.        However, the share paid by
DOD also could he lower than the actual.                      In any event, we believe            that
any competitive       advantage      would      probably     be minor.
      Nevertheless,          we agree that       steps will     he required         to reduce or
eliminate       such advantage wherever possible.                We believe         there are ways
to do this,       but we doubt that it will            be possible        to ensure that companies
are always bidding           ou precisely       equal terms.
                                                                                                                    APPENDIX III:
                                                                                                                    Page 6

          One procedure              that      could        be adopted               as a means of offsetting                   such

competitive           advantage              so far        as Government               business       is     concerned         would

be to add a factor                   to the maJor contractor's                            bids     to offset          the amount

of IR&D paid             directly            by DOD.         This       factor         could      be derived          from the

special       IR&D agreement                  as it        would     be based on the ratio                     of the maximum

DUD      payment      to the total                  estimated        sales;           fn fact,       to minimize          adminis-

trative       effort,         it     might          be advisable           to include             in the special              agree-

ment the agreed               factor          for     use in evaluating                   any bids         presented          by the

contractor           during         the following               year.

          While      use of a factor                  to enable           equitable            comparison           of bids     would

entail      some additional                   administrative               effort,         we believe          it     should      not

be too difficult                   inasmuch          as a similar              technique          is used by DOD in other

situations,             such as in evaluating                       bids       of companies,            some of which             have

Government-owned                   property          or equipment              at their          disposal.

          In the last              paragraph          of his        letter,           the Assistant           Secretary         states

that      "IX&D plays              an important             part     in maintaining                the technological               base

of this       country         and careful               consideration                 is imperative           before      any revo-

lutionary          changes are made that                        could         have a serious               adverse     impact."

          We understand               that     the basis            for       this     statement           is DOD's concern

that      through        the line-item                method Congress                  would      gradually          impose fur-

ther      controls        that        would         lead    to the elimination                    of the independence                  of
                                                                         APPENDIX III
                                                                         Page 7

contractors      in selecting   work projects   and eventually   cause a drying up
of this   source of new technology.
      We cannot, of course, predict        what the Congress may do in the
future.       It is our view that a budget line-item      method as suggested
would not affect      the contractor's    independence in selecting       work projects
to any greater      degree than the advance agreement method required          under
Section 203 of Public Law 91-441. Under current            procedures,     the con-
tractor   determines the research and development projects          he wishes to
pursue in his IR&D program.          This procedure would not be affected        under
the suggested line-item         method.