I was tipped off recently that there’s a weird loophole in contractor independent research and development (IRAD) that gives them a significant advantage when it comes to competing for Other Transactions (OT) awards.
First, a little background. Defense contractors that are compliant with the Cost Accounting Standards are allowed to perform IRAD on promising tech/system areas that are not currently funded by the government. Lockheed Martin, for example, spent $1.5 billion in IRAD in 2021.
These costs can be deferred to future periods to be an allowable cost when the future product is sold, but usually contractors expense IRAD costs to their indirect rates (specifically, General & Administrative). In other words, when Lockheed spends $1.5 billion on IRAD in 2021 to posture their technology to compete on future contracts, that $1.5 billion goes to an indirect cost pool, and then gets spread across all their government contracts as an allowable expense as though it were facilities or business IT investment. Government pays for contractor IRAD.
Second, startups and non-traditionals do not have the luxury of IRAD. They could be spending millions on product development, but only have a couple small contracts with government. Even if they did have the cost accounting systems to separately identify and allocate IRAD, they couldn’t expense it against current contract efforts because it would unfairly burden their rates and make them non-competitive.
OK — defense primes get IRAD reimbursed by government while nontraditionals do not. That gives the primes “free money” to do R&D, and position themselves for future contract competitions.
Now how does this get even more wonky in the case of Other Transactions, which are non-FAR agreements?
Basically, defense primes can perform IRAD, compete for an OT, and if they win, they can move those costs out of IRAD and into the Direct base — i.e., those costs can be billed against the specific OT contract as a direct cost and no longer burden the G&A rate. Here’s the explanation from an IRAD Guide.
[Cost Accounting Standard] CAS 402 requires that costs incurred for like purposes in similar circumstances be accounted for consistently, so that the relevant costs are either direct or indirect. From that conclusion, DCAA sometimes will state that if a contractor classifies costs of performing an “other transaction” or a cooperative arrangement as direct costs to the extent reimbursed and as indirect IR&D costs to the extent not reimbursed, the contractor is in violation of CAS 402.
DCAA’s conclusion is incorrect because it is founded upon an incorrect assumption. Under FAR § 31.205 18, contractors may classify the cost of all effort under “other transactions” and cooperative arrangements as IR&D costs, assuming the effort is of a type to be IR&D, and then reduce that cost (i.e., credit project costs) for any reimbursement. A contractor accounting for its “other transactions” and cooperative arrangements in this manner complies with CAS 402 because the costs are IR&D costs, which are subject to reduction due to reimbursement.
It’s not clear if the contractor must credit IRAD to the OT project, or whether they have the option. If the contractor directly charges the IRAD to the OT vehicle, then it can dramatically accelerate the project schedule since some of the work is already done. If the contractor does not directly charge the IRAD, then it can reduce the price it will bid, the remainder being paid for through G&A rates on other projects.
Remember, a defense prime can compete for OT awards if they contribute self-funded effort (not IRAD) or if they have at least one nontraditional supplier.
Here’s just a little more food for thought….
Let’s say a defense company charges $1M to IRAD and it gets included in the forward pricing rate agreement with DCMA. So that $1M contributes to higher G&A rate, which bumps up their proposed price on all contracts just a little. If that $1M reverts to direct work on a OT vehicle, then it no longer needs to be reimbursed through G&A. All cost-plus contracts are reimbursed using actual expenses, so there’s no issue there. But the fixed price contracts the company bid on are just that — fixed price. The slightly higher G&A rate based on $1M IRAD then gets turned into profit. If the company has 50% of its contracts coming via fixed price, then it might be able to expect a $500K boost in profits.
These are some reasons nontraditionals should want to have a robust, government compliant cost accounting system. Of course, those systems also come with baggage that could make them non-competitive in commercial markets. And like IRAD, new entrants cannot get investments in cost accounting systems reimbursed by government. Defense primes can spend hundreds of millions of their cost systems — fully reimbursed by government as an allowable overhead expense.
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