LM095697 Feasibility -Of Tre.ating Contractors’ Independent Research And Development Costs As A Budget Line hem E.-1649i2 Department of Defense ( I ',,. ,.- ‘# BYTHECOMPTROLLER GENERAL 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 FEASIBILITYOFLINE-I~CONTROLOF INDEPERDENTRESEARCHARDDEVELOPMENT DEFINITIONS 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. PRFSENTSYSTE24FoRALI0WING IRUI AS A CONTRACTCOST 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 contracts. 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. PROPOSED SYSW 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 APPENDIX1 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 I 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 APPEXVTUX I 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 A3?PE3D1x1 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. CONGRl3SSIONAL ACTION 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 8 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. COMPLlANE AND COITTROL 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. EFFECT ON OTHEFIAGENCIES 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. APPENDIX1 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 impact. 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. 2 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 3 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 page1 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. ADVANCEAGREXMENT NEGOTIATIONS 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. OTHIBAlMINISTRATIYE PROBLEMS 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, AP!i?ENDIXIII mP 5 and should, therefore, be willing to adjust their current contracts in consideration of DOD's guarantee of additional financing. EFFEcTO8~ITIOR 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.
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)