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By Mark Roberts

Mark Roberts

A federal rule finalized in January requires defense contractors to document how they spend money on independent research and development (IR&D) projects that are reimbursed to the tune of about $4 billion annually by the U.S. Federal Government.

For nearly 80 years, U.S. government contractors have been able to recover a portion of IR&D and bid and proposal costs through indirect cost allocations, similar to general and administrative expenses charged to existing U.S. Department of Defense (DoD) contracts.

In the 1990s following a series of defense spending cuts, the DoD relaxed funding limitations for IR&D expenditures so that the IR&D money flowed more freely, with minimal specific and in-process  documentation required for how the contractor was using federal funds. The idea was to encourage contractors to expand their businesses with new products and technical capabilities, to meet DoD needs and to promote the technical prowess of the industry. It was also hoped that the resulting increases in the business base would lower indirect rates and costs overall.

But the problem, as the U.S. government saw it, was that too many companies were engaging in IR&D projects that did not have a technical benefit to meet DoD needs. Currently, the DoD claims to be unable to maximize the value of IR&D funds that it disperses.

Also, the IR&D projects weren’t always clearly consistent with a company’s corporate strategies or the U.S. government’s interests. As the final rule published on January 30, 2012, in the Federal Register says: “The result has been a loss of linkage between funding and technological purpose.”

The government is now saying, in effect, “If you’re going to charge us for an IR&D project, we want to make sure it’s going to have a benefit to us.”

What does this mean for defense contractors? So far, it’s requiring them to fill out a standard   online form to the U.S. Defense Technical Information Center describing the IR&D project and its goals. In our experience, the new requirement hasn’t been particularly onerous, and we have not heard of any proposals being denied.

In the immediate future, contractors should expect more scrutiny around their IR&D projects by the U.S. government. Contractors must demonstrate a technical benefit, and the IR&D project goals should be aligned with corporate strategies meant to expand the business base and effectively compete in the Aerospace & Defense marketplace.

The rule applies primarily to companies that have sought annual reimbursement of more than $11 million for IR&D and bid and proposal costs. Smaller companies are also encouraged to report IR&D projects to the U.S. Defense Technical Information Center.

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The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.