IR&D Costs Now Clarified

For many decades, the definition of Independent Research and Development (“IR&D”) Costs as a direct charge or an indirect charge has been the subject of disagreement between the government and contractors. IR&D costs1 are frequently included in the General and Administrative (“G&A”) indirect cost pool because the benefit of the research costs will accrue to more than one contract, i.e., spread over many contracts. Some R&D costs may, however, be charged to a specific contract as a direct charge. The FAR combines the allowability of IR&D and B&P costs in the same cost principle2 but most confusion has occurred regarding the IR&D costs.

The cost principle defines the allowability of IR&D costs. When allowable, these costs are usually charged to a G&A cost account. For concerns subject to Cost Accounting Standards (“CAS”), the rule at CAS 4203 determines the allocability of IR&D costs to a particular contract. If, however, you are not subject to CAS, then the cost principles will determine allocability.4

This all seems straightforward, so what is the confusion? The regulation states that IR&D costs are compensable as indirect, i.e., G&A, costs unless the IR&D work is “required in the performance of a contract.”5

Generally, all contractors have interpreted the foregoing phrase to mean the specific statement of work (“sow”) in the prime contract explicitly requires performance of IR&D work. This is a narrow, contract specific, interpretation. The Government, on the other hand, has taken the position that any IR&D implicit, inferred, or necessary for performance under a contract, in addition to a specific sow requirement, is controlling. DCAA auditors have challenged IR&D in incurred costs proposals and disallowed such costs stating they should be charged directly to a contract.

The phrase “required in the performance of a contract” in the definition of R&D has been interpreted by the Government to mean R&D work that was necessary to perform the contract, not whether the SOW expressly required the R&D work. The Government maintained that such R&D was for commercial work and the cost of which should not be born by the federal government. This interpretation was accepted by district courts.6

This government position was directly challenged recently in a decision under ATK THIOKOL, Inc. v. United States, United States Court of Appeals for the Federal Circuit, No. 2009-5036, March 19, 2010. THIOKOL developed a rocket motor for Mitsubishi Heavy Industries in 1997-98. Mitsubishi did not pay for the R&D work, so THIOKOL charged the costs to G&A. The DCAA disallowed the costs.

THIOKOL filed suit to recover their IR&D costs at the Court of Federal Claims and prevailed. The Government appealed. The Appeals Court equated IR&D costs with B&P costs, since the latter costs benefit all the business of the contractor rather than a specific contract, so treating such costs as G&A is reasonable.

The Court did rely heavily on Interpretation No. 1 to CAS 4027 that “distinguishes proposal costs that are specifically required by an existing contract from those that do not result from such specific requirements. The former costs relate only to (a particular) contract while the latter costs relate to all work of the contractor.” “The effect of Interpretation No.1,” according to the Appeals Court, “is to equate B&P costs with the exclusion of costs that are required in the performance of a contract “with the category of costs that are ‘specifically required by the provisions of a contract.’”

The Appeals Court concluded that the costs required in the performance of a contract to mean, in both contexts (B&P and IR&D), that costs that are specifically required by the contract must be allocated to the contract as a direct charge. This Court agreed with an earlier decision8 that “proposal costs that are not specifically required by a contract are properly allocated as indirect B&P costs” and IR&D costs are treated in the same way as B&P costs.

The Court also approved “parallel” allocations of costs as appropriate when the R&D supports one contract while also supporting multiple costs. Hence, the R&D can be charged to an IR&D G&A account.

The moral of the story here is carefully read your contract. If the sow specifically requires R&D work, then charge the cost of the R&D to the contract. Alternatively, if there is no express requirement for R&D in the contract, and a research effort benefits the entire company, then charge the cost as IR&D to a G&A account. Be sure you treat these cost consistently and draft IR&D project descriptions to explain their benefits to multiple contracts.

Tom Petruska
Contract Unlimited Incorporated

The foregoing is not legal advice or a legal opinion.  See your attorney for legal advice.

Footnotes:

1. FAR 31.205-18

2. id

3. 48 C.F.R. §9904.420

4. FAR 31.201

5. FAR 31.205-18

6. United States v. Newport News Shipbuilding, Inc. 276F. Supp. 2d 539 (E.D.Va.2003)

7. 48c. F.R. 9904.406-61 (c)

8. Boeing Co. v. United States, 862 F.2d 290
(Fed. Cir. 1988)

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