COUNCIL ON GOVERNMENTAL RELATIONS

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November 5, 2003

## A NEW BUSINESS RESEARCH MODEL: INCENTIVIZING UNIVERSITIES

**[Executive Summary:]{.underline}**

In previous communications, COGR has addressed the management of
federally funded research primarily from the perspective of research
faculty and their administrative support staff, involved in research
projects. As a contribution to the discussion about new business
research models, this paper presents the financial perspective of the
institution, as the business manager for its faculty.

With the help of five examples, this paper illustrates some of the
difficult choices, which universities have to make in view of the
existing cost policy expressed by federal agencies and by OMB. In turn,
each example illustrates a particular situation: the effect of
restrictions on legitimate cost recovery by agency or type of award; the
cap on administrative cost recovery; the lack of commitment to life
cycle recovery costs for capital projects and the requirement to invest
capital recoveries; the artificial distinction between internal and
external interests costs; and the exclusion of certain universities from
equitable energy cost recovery.

The government imposes many of these restrictions with the goal of
realizing savings for the taxpayer. The examples suggest that the
opposite may be true. The resulting costs to the public are partly
financial and partly a loss of national research capacity. Taken either
in isolation or labeled a short term mandate, any one of these
restrictions may appear innocuous to the outside observer. However,
their negative impact is obvious to the business officer and would not
likely be acceptable if universities were making business decisions like
commercial entities.

Taken together, the examples illustrate the dilemmas universities face
when sound business decisions are not equivalent to sound research
decisions. Unless the government changes its policies, it will be
operating at cross-purposes with sound research business models. Such
models anticipate that the government's academic business partner is
expected to manage itself and the federal investment in research in
prudent and cost effective manner.

# Case \# 1: The Effect of Restricted Cost Recovery by Agency or Type of Award

A tenured professor retires and the 30-year old laboratory has been
renovated to accommodate a new occupant. In deciding how to allocate the
new space, the university has to weigh the risk that a junior faculty's
research support may come in form of awards, which do not pay the full
negotiated Facilities and Administrative (F&A) rate. An example might be
the NIH career development awards under which the F&A cost recovery is
limited to 8%, similar to a training grant. Although the government has
clearly stated its intent to support young academic researchers, in
recognition of the national priority to assure a professional workforce,
its failure to provide the requisite support costs diminishes the impact
of such career development programs.

Alternately, a faculty member might try to claim the renovated space,
whose high-risk research is so novel that federal funding has not yet
been obtained. For how long can the university afford to cost share the
support costs for his laboratory? Some universities have begun to
recognize faculty who are successful grantees and who bring in the full
negotiated F&A rate, by assigning them the prime research space in newly
renovated buildings. Other universities might consider prioritizing the
renovation of buildings that will house successful grant applicants, at
the expense of other disciplines that are not as likely to be "winners".

It becomes obvious that academic and financial arguments are likely to
clash as important research decisions are made. Financial
considerations, of course, may not be the final determining factor in
academic decisions. From a strictly "business" perspective, the odds
favors the more senior appointment in high priority research areas,
whose grants include F&A payment at the negotiated rate.

# Case \# 2: Effect of the Cap on Administrative Cost Recovery

The university determines that investment in a state-of-the-art
purchasing system will substantially drive down the costs of material
and supply purchases, most of which are consumed by its federal research
programs. The institution's administrative costs already exceed the 26%
cap imposed in Circular A-21. The university has to calculate how it can
pay for the investment in infrastructure systems costs and how it will
cover the payroll costs for the clerical staff to handle the complicated
data entry needed to achieve the net lowering of its direct research
costs.

The benefits of upgraded or newly installed management systems, e.g. for
payroll, human resources or accounting purposes, invariably extend to
the research activities of the university. Among those exclusively
benefiting research are the systems now required to handle electronic
grants administration (e-Gov), human subjects protection and animal use
and safety. By limiting universities from recovering the legitimate
portion of their investment in systems and personnel, the government
creates negative incentives to the realization of cost savings that in
the long run will benefit not only the individual university but its
regional environment and its research sponsors. In the clinical research
areas, the impact of the cap on administrative costs is particularly
strongly felt and hard to explain, when institutions are committing
significant resources to meet new and expanded regulatory requirements
for protection of human research participants.

[Case \# 3: Uncertainty about Facility Policies & the Requirement of
Invest Capital Recoveries]{.underline}

The university determines that a research building dating from the 1930s
has outlived its usefulness and that it would be most cost-effective to
raze the building and to build all new space. However, the federal
government has in the past considered imposing limitations on cost
recoveries for buildings used as research space. While these plans were
eventually discarded, universities are reluctant to invest in new
research facilities based on existing federal cost policies that might
be subject to change. Further, the government has for years failed to
include a well-funded facilities support program in the federal agency
research program budget. To date there exists no federal policy that
commits the government to participate in its share of debt service over
the life of the loan. It would make good business sense to provide
incentives, since the research to be performed is in the government's
and the nation's interest. Such incentives have been proposed and could
range from including a reasonable facilities funding program in the
federal budget, offering universities a federal sharing in loans, or a
federal loan guarantee program. The common denominator in all these
would be removing the uncertainty that universities currently experience
under the given federal policy.

Business decisions for the university are further exacerbated by the
federal government's requirement that for every dollar of depreciation
that is recovered on the new building, a dollar must be spent on some
future project. This means in effect that the university will never
recover the cost of its investment, and may be committed to new
construction at times when it is not in a sound financial position to do
so.

[Case \# 4: Artificial Distinction between External and Internal
Interest Costs]{.underline}

The university's bond rating is in jeopardy due to depressed financial
markets and reduced state support. Because of this, it would be less
expensive, on a gross basis, to allocate internal capital funds to pay
for a new science building. However, the university knows that there is
no option for recovery from the government of the university's internal
cost of capital. Under these circumstances, the university may make a
rational business decision to borrow at a higher external rate because
it then can recover a fraction of the interest costs from the federal
government, thereby lowering its net cost of interest.

It would clearly be in the taxpayers' interest to provide incentives for
the university to use its own money, possibly by sharing some of the
investment costs, so that the federal contribution does not go towards
defraying avoidable higher interest costs.

# Case \# 5: Inequitable Policies for Recovery of Energy Related Costs

A space vacancy occurs in the cancer research center. The university
could make the space available for a number of equally worthy projects.
One of them is a large laboratory where the research project requires
constant air changes. Unfortunately such a laboratory would entail high
energy use. Since the university had not undertaken an energy study
prior to 1996, it is now prevented from receiving appropriate
compensation through the F&A rate for its higher energy research
consumption. When the government put new energy studies on hold in 1996,
it promised to develop a fair formula for all academic energy consumers,
but has failed to do so. As a result, more than one hundred universities
are now prevented from recovering the costs for higher energy use which
they consume, which they could easily document, and which their peers
who had done prior energy studies now enjoy.

For the university faced with this choice, the uncompensated energy
costs inject an artificial economic factor into a determination, which
should be based solely on academic and scientific needs. This may
influence the university to make a decision not in the best interests of
science.

**[Conclusion]{.underline}**

The unique nature of universities precludes their being treated as
business partners just like commercial business partners. The government
can justifiably expect to get the best results from federally funded
research with the least appropriate investment, and with the expectation
of cost sharing. But when the government fails to recognize the
universities' legitimate business constraints, and the result are
increased research costs that are shifted to the university research
partner, then it is time for new business research models, which
recognize these constraints and offer incentives.

The government's current cost polices do not deprive universities of the
freedom to make choices but the choices are increasingly narrow. It
seems logical that universities will best serve the nation if they are
free to make their best academic judgments about future research
directions and graduate education. Furthermore, universities are not
risk averse. Universities have always had to face the risk that the
areas of research on which they focus could suddenly change either
because a redirection is called for by the nature of the science, or
because the federal government changes its priorities. However, at this
time the risks for universities have increased because artificial limits
and prescriptions are built into the maze of applicable government
policy and individual agency regulations that govern research. The
result are financial disincentives for universities, which may force
decisions that are not consistent with the country's overall goals and
expectations.