Defense contractors spend considerable amounts on “independent” research and development (IR&D or IRAD) efforts. They need to, if they are going to compete for next generation-type defense programs. As our readers likely know, defense contractors’ IR&D expenditures are largely (if not entirely) reimbursed by the U.S. Federal government through payment of indirect costs allocated to direct contract costs—generally in the General & Administrative (G&A) expense rate.

Accounting for IR&D costs can be tricky, as we discussed in this article that covered the Appellate decision in the matter of ATK Thiokol, which so far is the leading precedent regarding how to account (and allocate) IR&D expenses. As we commented in the ATK article—

The Court had to interpret the FAR 31.205-18 cost principle, CAS 402, and CAS 420 in arriving at its decision. The parties’ contentions turned on the meaning of the phrase ‘required in the performance of a contract.’ Allowable IR&D costs are those that are not required in the performance of a contract, but the issue was whether the words meant ‘specifically’ or ‘expressly’ required, or whether they meant ‘implicitly’ required. 

As you can see, properly accounting for IR&D costs involves inter-leaving the FAR Cost Principles and at least one (and likely more than one) Cost Accounting Standard. It’s not easy, especially for defense contractors, who also need to look the supplemental Cost Principles in the DFARS.

Another emerging challenge for defense contractors has been the Pentagon’s heightened sensitivity to its reimbursement of contractors’ IR&D expenditures. Like most everything involving Federal funds these days, DOD has been looking at how it can maximize the bang it receives for contractors’ IR&D bucks. We first mentioned the issue in July, 2010, right here, where we wrote that two of Dr. Carter’s “Better Buying Power Initiative” objectives were:

• Identify and eliminate non-value-added overhead and G&A charged to contracts.

• Limit B&P allowable costs in sole source contracts and encourage effective use of IRAD.

A few months later, Dr. Carter clarified what he meant by the phrase, “encourage effective use of IRAD.” He wrote that the goal was to increase the Pentagon’s focus on contractor IR&D expenditures, so as “to improve the return on IRAD investments for industry and government.”

Dr. Carter’s goal was to be implemented through revisions to the DFARS (the Defense Federal Acquisition Regulation Supplement). We wrote about the proposed revisions, and commented on the additional conditions they would create for many defense contractors. The rule was finalized recently so that, for the large defense contractors (i.e., those that have more than $11 million in reimbursed IR&D costs), in order to have their IR&D costs be allowable, they must submit annual reports to the Defense Technical Information Center (DTIC). And the project information (and associated costs) will be reviewed by DOD oversight officials to ensure that they are “of potential interest to DoD.”

And, unsurprisingly, those reviews are creating some challenges for defense contractors.

Reports are beginning to emerge from several large contractors that the reviews are not going as smoothly as one might have hoped.

The first issue is that DOD reviewers seem to be taking a narrow view of what types of IR&D projects might be “of potential interest” to the Pentagon. Contractors have been provided with an April, 2011, letter from then-Secretary of Defense Robert Gates that lists seven “Science and Technology Priorities” for the Defense Department. The worry is that these seven “strategic investment priorities” define and limit the types of R&D projects that the Pentagon wants to pay for, such that any project that cannot be shoehorned into one of the seven priorities will have its costs disallowed by DCAA and/or DCMA.

Issues that have received negative comments from reviewers include—

• Projects that were started but were subsequently abandoned, especially those that were of a higher dollar value or a large percentage of total IR&D expenditures

• “Shoestring” projects that were started but given insufficient budgets, given the project objectives

• Projects clearly outside the current capability and/or expertise of the contractor (i.e., attempts to enter new technology markets)

• Projects that have incomplete, unclear, or insufficient cost data

In addition, contractors being reviewed are expressing concerns (privately and without attribution) regarding the qualifications of the reviewers. They wonder whether the DOD reviewers have sufficient technical expertise to understand the projects they are reviewing, which are—by definition—state of the art or even just beyond state of the art efforts.

As a practical matter, large defense contractors who qualify for IR&D reviews might want to assess where they are against DOD’s expectations. They should be prepared to defend why their efforts (a) fit into the Technology Roadmap, and (b) why the Technology Roadmap ties to the Pentagon’s strategic science and technology priorities.

Looking at the bigger picture, we wonder if naysayers weren’t correct in worrying that the Defense Department’s renewed focus on contractor IR&D expenses wouldn’t tend to stifle innovation and technology development. If the Pentagon’s vision is an implementation of centralized planning and control that will act to channel contractors’ technology development efforts into only approved channels, then we don’t think that’s going to work out in the long run.

Just ask the former Soviet Union how that centralized planning and control thingee worked out for them.