(Editor’s Note. Since the recent Newport News case addressing allocability of certain research and development costs was issued, our consulting firm has received numerous requests from clients to help them determine how the case affects their independent research and development expenditures. In most cases, they have been developing new product lines and services and want to know if they receive a contract related to the new products and services (in some cases they already have) can they continue charging the costs for development to IR&D. The following is a summary of a white paper our firm in partnership with Len Birnbaum of Birnbaum and Associates prepared for a client. We hope this article is instructive for understanding the impact of the Newport News case and how contractors can best continue charging development costs to IR&D while working on a funded contract. In order to maintain confidentiality, we refer to our client as "Contractor" and have changed the name of the product and services provided to the universally recognized term of "widgets".)
The purpose of this memorandum is to provide our opinion as to whether it would be appropriate to charge certain development costs associated with the new line of widgets to the IR&D account and, include those costs in the G&A cost pool for the fiscal years 2002 and 2003 as well as future costs incurred in 2004 and beyond. Resolution of this issue depends (1) on the proper interpretation of FAR 31.205-18(a)(2), which provides in part "the term does not include the costs of effort sponsored by a grant or required in the performance of a contract" and (2) the effect of the Newport News Shipbuilding, Inc. (NNS) decision where the District Court has interpreted the words "required in the performance of a contract" to include not only specific costs (i.e. deliverables and work separately identified in the statement of work) but also implicit costs (i.e. work not identified but necessary to the completion of the contract).
The resolution of these issues is of paramount concern because if the costs claimed as IR&D are subsequently deemed to be expressly unallowable, it could result in penalties. Moreover, there is also concern that claiming expressly unallowable costs could subject the company to the civil False Claims Act and possibly the criminal False Claims Act. The latter can be avoided by providing an adequate disclosure and/or entering into an advance agreement with an authorized government representative such as a contracting officer (CO) or administrative contracting officer (ACO).
In April 2001, Contractor made a decision to pursue the development of a new widget product line, which was a scaled down version of two earlier versions of the widget. Contractor was going to utilize the experience under these two earlier product lines by modifying the software, adapting certain hardware features and modifying other features. Five configurations (C-1, C-2, C-3, C-4 and C-5) were planned. The differences primarily involve the type components used.
However, little or no work was expended on the new widget line until Contractor began discussions in February 2002 with Customer to build the version C-3. Contractor anticipated that the total cost for development would be approximately $4M dollars. Customer, however, advised that they did not have sufficient funding available to pay for the entire development. Therefore, in order to proceed Contractor agreed to absorb approximately 50% of the estimated development costs which amounted to approximately $2M dollars. The development work which would be paid for by Contractor would benefit the entire new widget product line, not just the version C-3. Customer stated it was willing to pay approximately $2M in nonrecurring engineering costs in order to underwrite part of the development costs. In March, 2002, Contractor established specific job numbers to account for those costs which were specifically related to the development of the C-3 unit and work order numbers that would be applicable to the entire widget product line. In May 2002 Contractor received a letter contract to proceed. Notwithstanding the fact that separate job orders were established at the outset a portion of costs that were initially charged to IR&D were transferred to the contract job order.
In July 2002, Customer issued a purchase order for five C-3 widgets. The units were delivered in 2003. In August, 2003, Customer placed an order for another two units and in February 2004 ordered eight additional units.
Both the relevant FAR cost principles and cost accounting standards do not appear to prohibit allocation of the costs in question to IR&D.
1.FAR 31.205-18
The exclusionary language of costs noted in FAR 31.205-18(2) has been subject to several regulation changes. Prior to 1971 the cost principle defined IR&D to exclude only R&D effort that was "sponsored by a contract, grant or other arrangement". The phase "or required in the performance of the contract" was added to the cost principle by Defense Procurement Circular No. 90 (DPC-90 that was published in September 1971). The term "sponsored by" was not defined, but the Armed Services Board of Contract Appeals did observe that it was intended to prohibit a contractor from being paid twice for its same effort. The regulatory definition of IR&D remained unchanged until 1992. The definition was then reorganized and changed from "sponsored by, or required in the performance of a contract or grant" to "sponsored by a grant or required in the performance of a contract". There was no explanation for the change in promulgating comments.
Ever since DPC-90 altered the rule identifying the relationship between IR&D and contract R&D efforts there have been problems and numerous commentators have recommended regulatory reform to unambiguously allow the recovery of implicit IR&D costs. As more fully discussed below, the government has recently construed the term "required in the performance of the contract" very broadly taking the position that FAR 31.205-18(2) excludes from allowable IR&D all "costs required by a contract" (both specific and implicit). Under this interpretation a contractor who accepts a single order for the next generation of a product prior to completion of development can no longer treat the continuing development effort as IR&D.
2. CAS 420
Although Contractor’s contracts are only subject to modified CAS coverage (i.e. 401, 402, 405 and 406), the allocation provisions in CAS 420, with minor exceptions, are incorporated by the reference in FAR 31.205-18. The purpose of CAS 420 is to insure that IR&D is allocated to cost objectives based on the beneficial or causal relationship between such costs and cost objectives, and that the allocation is consistent. The definitions in CAS 420, in part, provides:
"Independent Research and Development means the cost of effort which is neither sponsored by a grant, nor required in the performance of the contract."
(The same definition as provided in FAR 31.205-18).
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"Indirect cost means any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or with at least one intermediate cost objective."
The CAS Board in its preamble to CAS 420 states that "the definitions of IR&D costs and B&P costs are not intended to include allocation requirements." It further stated that "CAS 420-50(a) (1) of the Standard provides guidance on what costs are to be charged directly to IR&D and B&P projects." The latter in part provides:
The IR&D and B&P project costs shall include (1) costs, which were incurred in like circumstances for a final cost objectives would be treated as direct costs of the final cost objective. What constitutes "like circumstances "is addressed in CAS 402.
3. CAS 402
"The purpose of this standard is to require that each type of cost is allocated only once and only one basis to any contract or other cost objective. Costs identified specifically with the contract are direct costs of that contract." The standard defines indirect cost as
"Indirect cost means any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or at least one intermediate cost objective".
In illustrating what constitutes like circumstances the standard provides an illustration, CAS 402-60(b)(2).
Contractor proposes to perform a contract which will require 3 firemen on 24 hour duty at a fixed post to provide protection against damage to a highly inflammable material used in the contract. In addition, the contractor has a fire fighting force of 10 employees for general protection of the plant. The contractor’ costs for these firemen are treated as indirect costs and allocated to contracts. The illustration concludes that it would be proper to charge the three fixed-post fireman directly to the contract and the other 10 firefighters as an indirect cost, provided the contractor adequately discloses its practices, for the classes of fireman.
By way of analogy with respect to Contractor, certain work benefits the entire widget product line while certain specific activities only benefit a particular contract. In other words, a generic benefit and a specific benefit exists.
4. CAS 418
Although Contractor is not subject to full CAS coverage (which would include CAS 418) at the present time, this standard provides criteria to distinguish between direct costs and indirect costs. Contractors that are subject to this standard are required to have a written statement of accounting policies and procedures for classifying costs as direct or indirect which shall be consistently applied. CAS 418-30(a)(3) provides " Indirect cost means any cost not directly identified with a single final cost objective [i.e. a contract], but identified with two or more final cost objectives or at least one intermediate cost objective".
Clearly, development costs which are applicable to more than one contract should be allocated to the contracts which benefit. The allocation process is accomplished by pooling all development costs into a single pool for allocation purposes. CAS 418 requires contractors to develop their own criteria with respect to distinguishing direct costs and indirect costs. Most certainly, the government would not permit a contractor to charge one hundred percent of costs which benefit more than one contract to a flexibly priced (i.e. cost reimbursement) government contract.
Accounting for Government Contracts, Federal Aquisition Regulation, edited by Lane Anderson is widely considered to be an authoritative text. It squarely addresses the issue of what constitutes IR&D or contract research and suggests criteria to distinguish between IR&D and contract work when a contractor establishes its written policy and procedure. An abstract from his book follows:
An issue that arises with regularity is whether development effort as a part of generic IR&D is to be characterized as an IR&D cost or a contract research cost. Generic IR&D is usually characterized as development effort that (1) is not specifically required by any one contract, and (2) benefits an overall business line with potential application to a number of contracts, none of which explicitly requires the IR&D, but all of which may derive some benefit from the effort. Part of the problem is that CAS 420 only permits a direct cost treatment (in a sense, contracted research) when the effort is specifically required by a contract. The issue comes to a head for firm fixed-price contracts where a direct cost may in fact exceed the firm fixed-price and the contractor cannot recover the cost but an indirect cost can be recovered on multiple contracts.
Because various court cases have differing views on the issues, contractors can help themselves by evaluating each case separately and individually. In so doing, a contractor should determine answers to the following questions.
When was the IR&D project established? Establishing an IR&D project prior to the award of one or more benefiting contracts usually means there is a bona fide general business purpose for the effort. It also validates the propriety of accumulating the costs of these efforts as indirect costs to be allocated according to CAS 420. On the other hand, if an IR&D project is established after the award but during performance of a benefiting contract, this suggests the effort is really contract related and should be charged to the benefiting contract.
Which cost objectives was the IR&D project intended to benefit? The contractor's intent and purpose in establishing an IR&D project are relevant to determining whether the costs should be allocated directly to one or more specific contracts or indirectly across the contractor's work. If the IR&D project was established to benefit a new product, product line, or other line of business, the project costs are properly IR&D costs to be indirectly allocated. Hopefully, the contractor can document this intent with business plans, strategic plans, forward pricing rates, and so forth. On the other hand, an IR&D project established for collecting research and development costs for a single fixed-price contract suggests a direct cost to that contract.
What technical objectives did the IR&D project fund? An analysis is necessary to determine whether the generic technical effort was identical to the technical effort under the contract. If a meaningful and principled distinction can be made between the contract effort and the IR&D effort, cost allocations can easily follow an appropriate course. The contract effort will be allocated directly to the contract and the IR&D effort is to be allocated indirectly across the contractor's work. However, in many cases, contractors cannot make the meaningful and principled distinction.
Were the contract requirements well-defined? Many contracts require the contractor to accomplish a particular objective but leave the means of accomplishing that objective to the contractor. Where the requirements are not specific, the contractor will have more difficulty trying to justify a direct cost treatment of research and development effort. Consequently, the IR&D project costs should flow to indirect cost pools. However, if a contract contains explicit, well-defined specifications requiring the contractor to use or develop a certain technology, the contractor can more easily justify treating the project costs as direct costs.
Which cost objectives actually benefited from the IR&D effort? If the costs of an IR&D project can be identified with one or more specific cost objectives, the suggestion is that the project costs are direct costs. If subsequent development of new products, product lines, or other lines of business occurs, or the performance of multiple contracts that benefit from the technical effort exists, there is evidence that the contractor is unable to identify the project costs with specific cost objectives at the time the costs were incurred.
This case may have a profound impact on the interpretation as to what constitutes "required in the performance of the contract". NNS was charged with violating the False Claims Act because NNS included the total IR&D cost for the development of a double hull tanker for the commercial shipping market as IR&D expense in spite of receiving two commercial contracts for tankers. The court, before addressing the False Claim matter, had to make a determination as to whether FAR 31.205-18 expressly excluded the IR&D costs which had been claimed. The Court concluded that the term "required in performance of a contract" clearly and unambiguously includes implicit work requirements. Further, the court concluded that both the FAR’s plain language and the regulatory history precluded the contractor’s interpretation that the development effort was not explicitly required in the two contracts with commercial customers.
The Court issued a summary opinion in favor of the government concerning the unallowability of the costs under FAR, but did not reach a definitive conclusion with respect to violation of the False Claim Act because the record had not been fully developed to support same. The Court, however, opined that while NNS’ general practice violated FAR, charges to IR&D prior to finalizing contracts for commercial products could be allowable.
In summary, the Court concluded the term "required in the performance of the contract" must be read to include efforts which are not explicitly stated in the contract, but are nonetheless required. Further, the plain language in the cost principle does not allow the charging of IR&D simply because the costs may benefit more then one existing contracts. The Court went on to point out that the dividing line between IR&D and other work is not whether the work is explicitly or implicitly required, but rather based on whether the work is performed before or after a contract is signed.
The impact of this decision is unknown because there have been no subsequent published decisions dealing with this issue. As a general rule, U.S. Federal District Courts do not become involved in the interpretation of FAR Cost Principles. It is uncertain as to whether the Boards of Contract Appeals and/or the U.S. Federal Claims Court will adopt the District Court’s interpretation. The NNS decision, however, will certainly be considered, but we believe, based on the particular circumstances and facts, that decisions will be made on a case by case basis.
DCAA guidance on FAR 31.205-18 and CAS 420 is, interestingly, silent on the issue of whether costs are appropriately allocable to contracts or IR&D.
Can Charging the Costs To IR&D Be Justified?
A valid case for charging the generic expenses related to developing the widget can be put forth:
First, a valid product line exists. The creation of the widget product line certainly qualifies for a new product line. Similarly to a new car line, Contractor decided to develop a brand new line and like auto companies, took orders for the new line.
Second, distinct work orders were established. Contractor established separate work orders intended to distinguish between work intended for specific contracts and generic work for the product line. Furthermore, when Contractor learned it may have incorrectly charged certain costs to the wrong work order it took decisive steps to correct it.
Third, allocating costs related to developing the widget product line across all contracts would represent a causal/beneficial relationship while charging the development costs associated with a new product line to only the first contract would not represent a causal/beneficial relationship. If that first contract was a cost type government contract, it is highly unlikely the government would accept all the costs that would be allocated to it.
Fourth, Lane Anderson’s criteria for IR&D expensing is largely met. As mentioned above, it is clear the widget was a new product line, meeting one of Anderson’s conditions for IR&D costs. As the negotiations with Customer indicated, Contractor made a distinction between direct costs related to the contract and generic costs related to the product line as a whole and agreed not to charge its client the latter. Contractor knew of no prohibition to charging these development costs to IR&D and it is only in the light of the NNS case that a question arises. Since the product was new, the initial work effort was not clearly defined. From the very beginning, Contractor made technical distinctions between work required for the Customer contract and different work required for developing the product line. The creation of the work orders and corrections of early confusion demonstrate that. As for which contracts benefited, it is also clear that subsequent contracts benefited from the early development work and future contracts work will also benefit.
Fifth, the facts of NNS are significantly different. The underlying facts in Contractor’s situation can be distinguished from the underlying facts in the NNS case and may provide a basis to assert the different facts call for a different conclusion. Firstly, NNS had expended approximately $74M in the development of the double hull tankers while Contractor charged only $780,000 of its IR&D account associated with the new widget product line in the years 2002 and 2003. Secondly, NNS’s flexibly priced government contracts represent between 85% and 99% of its yearly revenue whereas Customer’s flexibly priced contract work accounts for approximately 14% of its total revenue during the period. In NNS’s case, the high dollar level of development costs was almost totally allocable to flexibly priced government contracts while for Contractor the far lower dollar amount is mostly allocable to either fixed price government work or commercial business. Thirdly, NNS planned to sell its new product solely to commercial companies while Contractor’s product line is intended for the government. In the case of NNS, the government received little benefit from the commercial product line while for Contractor, the benefit to the government is clear. Lastly, NNS subsequently abandoned its efforts to enter the commercial market and ended any further development while Contractor’s work on the new widget line is continuing and contracts are increasing. NNS’s charging development work on a discontinued commercial product line provided no benefit to the government while for Contractor, the widget product line is continuing to generate additional business where the increases in volume of work decreases Contractor’s indirect expense rates which further benefits the government contracts.
Sixth, none of the cost accounting standards would be violated if the costs were charged to IR&D. The CAS discussed above provide general guidelines and largely leaves the question of which costs are charged direct and indirect to the contractor. Establishing a clear policy on how IR&D costs will be charged does, with the understanding that certain "generic costs" will be charged to IR&D, does not violate CAS.
Conclusion and Recommendation
Although we believe that Contractor can make a valid case for claiming its generic widget development costs it may not be practical at this time for the reasons discussed above, particularly if it will not result in the recovery of any additional costs since most of Contractor’s cost type contracts have capped rates which have been exceeded even without the costs under consideration being included in G&A. However, we would suggest that the indirect cost proposal clearly indicate that since the allocability of certain IR&D costs is unsettled and the caps on its indirect cost rates exist, Contractor is not claiming any development costs for the widget product line as IR&D at this time, but reserves its right to claim such costs in the future.
On a prospective basis, we recommend that Contractor formulate its formal accounting policies and procedures for IR&D considering the criteria outlined by Anderson, discussed above. After Contractor has developed written policies and procedures, it would be beneficial to seek advance approval of its policies and procedures from the CO or ACO. Even if the ACO decides not to approve the policies they will provide full disclosure to the government and avoid potential problems such as assertions of civil or criminal fraud and possibly avoid imposition of penalties since the allocation issue does not represent a clear, unmistakable expressly unallowable cost which is a precondition for penalties.
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