FFRDCs are private sector organizations funded primarily by federal agencies to meet a special long-term research and development need that cannot be met as effectively by existing in-house or contractor resources. One federal agency serves as the primary sponsor of the FFRDC and signs an agreement specifying the purpose, terms, and other provisions for the FFRDC’s existence. Agreement terms cannot exceed 5 years but can be extended after a review by the sponsor of the continued use and need for the FFRDC. Federal regulations state that an FFRDC is required to conduct its business in a manner befitting its special relationship with the government, operate in the public interest with objectivity and independence, be free from organizational conflicts of interest, and have full disclosure of its affairs to the sponsoring agency. The Aerospace Corporation is a private, nonprofit mutual benefit corporation created in 1960. Aerospace’s primary purpose is to provide scientific and engineering support for the U.S. military space program. Aerospace operates an FFRDC in support of U.S. national security space programs pursuant to the Federal Acquisition Regulation (FAR), and its primary sponsor is the Air Force. Aerospace is governed by a 16-member Board of Trustees in accordance with its articles of incorporation and bylaws. The Air Force Space and Missile Systems Center (SMC), a part of the Air Force Materiel Command, has day-to-day management responsibility over the FFRDC. Through fiscal year 1994, SMC negotiated annual cost-plus-fixed-fee contracts with Aerospace. In fiscal year 1995, it began operating under a cost-plus-award-fee contract where the amount of fee is based on Aerospace’s performance. Table 1 shows the contract costs and fees awarded to Aerospace between fiscal years 1989 and 1994. Although SMC is the primary customer, Aerospace also performs work for other U.S. government agencies, international organizations, and foreign governments. In fiscal year 1993, for example, Aerospace’s reported revenues totaled $422.2 million, of which 97.4 percent came from the Air Force and other DOD agencies; 2.2 percent from other federal agencies, such as the National Aeronautics and Space Administration; and 0.4 percent from nonfederal government sources, such as universities and foreign governments. The Office of Federal Procurement Policy Letter 84-1, dated April 1984, established governmentwide policies for the establishment, use, review, and termination of the sponsorship of FFRDCs. It provides that the conditions affecting the negotiation of fee should be identified in the contract, sponsoring agreement with the FFRDC, or the sponsoring agency’s policies and procedures, as appropriate. The FAR also requires that the sponsoring agreement or the sponsoring agency’s policies and procedures identify the considerations that will affect the negotiation of fee when fee is determined to be appropriate. The Defense Acquisition Regulation Supplement (DFARS) provides more specific guidance for determining whether a fee is appropriate and how the fee is to be determined. Since FFRDCs may incur expenses that are unreimbursable under federal regulations, the DFARS allows for a fee to cover unreimbursed expenses if they are deemed ordinary and necessary to the FFRDC. An SMC contracting office instruction provides the fee determination procedures to be used on the Aerospace contract. It states that the fee is to be based on a need that must be justified and that the fee must be used for the purposes awarded. In fiscal year 1993, Aerospace reported that it used about $11.5 million of the $15.5 million Air Force contract fee to sponsor research. It used the remainder of the fee, along with other corporate resources, for capital equipment purchases, real and leasehold property improvements, and other unreimbursed expenditures. According to Aerospace officials, the fee from Air Force contracts is combined with funds from other sources in Aerospace’s accounting records. Therefore, it is not possible to link each specific use of Aerospace’s funds to the specific funding source. However, Aerospace and SMC have a general understanding that sponsored research is to be paid from the Air Force contract fee. Also, the accounting standards and principles governing Aerospace do not require it to match funding use with funding source. Table 2 shows Aerospace’s actual sources and applications of funds in fiscal year 1993. Aerospace used the Air Force fee primarily to sponsor research with broader and longer term goals than the more immediate, direct goals of individual Air Force program offices. In fiscal year 1993, Aerospace spent about $11.5 million, or 74 percent, of the Air Force fee for sponsored research. According to Aerospace officials, these funds were used for research in such areas as electronic device technology, surveillance, and information sciences. They added that sponsored research has resulted in cost savings for the Air Force space program. For example, Aerospace attributed to such research a 50-percent increase in the life expectancy of satellite sensors in the Defense Meteorological Satellite Program. It credited such research with developing remedial procedures to extend the life of satellite batteries, which have historically contributed to limiting the life of the satellite. Aerospace also cited many other research benefits, such as combining missions on a single spacecraft system and using commercial parts and techniques. One long-standing FFRDC issue has been whether to fund sponsored research as a cost-reimbursable item or out of fee. A 1962 report to the President on government contracting for research and development, known as the Bell report, supported the continuation of fee payments for research because most nonprofit organizations must conduct some independent, self-initiated research if they are to attract and retain staff.On the other hand, an August 1965 congressional report on Aerospace noted that some research would normally be a reimbursable expense and therefore all of the research could be provided under reimbursement.Similarly, in December 1994, the DOD Inspector General concluded that FFRDC-sponsored research should be reimbursed as contract costs to the extent that is allowable and reasonable. Most recently, in May 1995, a DOD study, completed at the direction of the Congress, focused on ways to limit the use of fee. It recommended that all allowable and allocable costs, including research, be considered as reimbursable costs rather than paid from fee. Although Aerospace believes that either funding approach is correct, it believes that research is best funded using fee rather than being reimbursed as a cost item. It said that making research a cost-reimbursable item would decrease the responsibility of Aerospace management and the Board of Trustees over independent research and increase administrative burden. Also, Aerospace expressed concern that Air Force program managers may not want to fund certain research because these managers may have more immediate goals than those for Aerospace’s research program. Air Force officials said they acknowledged Aerospace’s expertise and plan to use it to the maximum extent possible regardless of the funding mechanism. Reimbursing research as a cost item would not necessarily reduce total Air Force contract costs, according to DOD. However, it would subject all research to the FAR cost principles applicable to cost-reimbursable items. Regardless of how Aerospace’s research program is funded, Air Force and Aerospace officials acknowledged that the program’s effectiveness in meeting Air Force needs could be improved. Air Force officials said that the benefits from research could be increased by strengthening Air Force and Aerospace coordination on project selection. According to Aerospace, the effectiveness of the program will be improved as a result of recent steps taken to improve the research selection process. These include (1) a formal collection of prioritized Air Force Technology Need Statements, (2) Air Force participation on Aerospace’s Technical Program Committee, and (3) a formal briefing by Aerospace to the Air Force demonstrating the relationship between selected research projects and the Air Force’s prioritized technology needs. In fiscal year 1993, Aerospace spent $18.1 million of its working capital funds for capital equipment ($14.3 million) and for real and leased property improvements ($3.8 million). Aerospace officials said these expenditures were funded from reimbursements for depreciation and amortization ($14.5 million) and the Air Force contract fee ($3.6 million). The FAR allows as reimbursable costs depreciation of capital equipment and amortization of real property and leasehold improvements. SMC defines capital equipment as an asset that has an estimated useful life of over 2 years and a cost of $1,500 or more. It includes those items that Aerospace generally uses to support Air Force contracts but are not purchased in direct support of an individual project, such as computer hardware and bundled software and laboratory diagnostic and test tools. Capital equipment used in direct support of an individual Air Force project is charged as other direct costs in the year acquired rather than depreciated. DOD’s May 1995 report to the Congress recommended requiring FFRDCs to submit an annual 5-year capital acquisition plan. According to Aerospace, such a plan may be impracticable due to rapid changes in personnel, technology, and equipment. Real and leasehold property improvements include building rehabilitation projects, building equipment replacement, security and safety requirements, new operational requirements, and seismic upgrades to meet earthquake protection standards. On the Aerospace contract, leasehold amortization has been a reimbursable cost, whereas building depreciation has been funded primarily through the Air Force contract fee and other corporate funds. In fiscal year 1993, Aerospace spent $1.9 million from fee and other corporate funds on unreimbursed costs, that it considered ordinary and necessary to the FFRDC. Some of these expenses were for contributions, travel in excess of per diem, spouse and guest meals, personal use of company-furnished automobiles, and advertising. Table 3 summarizes Aerospace’s unreimbursed expenditures in fiscal year 1993.