Aerospace is a nonprofit mutual benefit corporation that provides scientific and technical support, principally general systems engineering and integration services, for the Air Force and other government agencies. Aerospace is headquartered in El Segundo, California, and has offices throughout the United States. The corporation, established in 1960, is governed by a 19-member Board of Trustees in accordance with its articles of incorporation and bylaws. FFRDCs are funded solely or substantially by federal agencies to meet special long-term research or development needs that cannot be met as effectively by existing in-house or contracting resources. One federal agency serves as the primary sponsor 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 of the continued use and need for the FFRDC. Federal regulations regarding FFRDC policy encourage long-term relationships between the federal government and FFRDCs to provide the continuity that will attract high-quality personnel. Aerospace’s primary sponsor is the Assistant Secretary of the Air Force for Acquisition. The Air Force Space and Missile Systems Center (SMC), located adjacent to Aerospace in El Segundo, has day-to-day management responsibility. SMC negotiates annual cost plus fixed-fee contracts with Aerospace. The DOD funding ceiling for Aerospace in fiscal year 1994 was $365.8 million. Aerospace employed 3,335 personnel at the end of fiscal year 1994 and had an annual payroll of about $208 million. Aerospace’s typical practice in establishing compensation levels is to recommend an annual salary adjustment to the Board of Trustees for final approval. According to company policy, such recommendations are to be based on an assessment of competitive salary positions, increases and rate structure adjustments at other aerospace industry firms, and other economic considerations. Compensation to Aerospace employees is primarily paid from government contracts, which represent over 99 percent of the company’s total business revenue. A small portion is paid out of government contract fees, nongovernment contracts and fees, interest income, and other sources. Aerospace compensation is reviewed by the Air Force for reasonableness during its annual contract negotiations. The Air Force routinely requests that DCAA review Aerospace’s proposed compensation costs and uses its recommendations during contract negotiations. Aerospace corporate officers, in addition to their annual salary, receive the standard benefit package that is available to all employees and several additional benefits that are available only to them. Standard benefits include social security contributions, a retirement plan, medical insurance, dental insurance, long-term disability insurance, and life insurance. Additional corporate officer benefits are a supplemental corporate officers’ retirement plan; personal use of a company automobile; airline upgrade coupons; and, in the case of two officers, a home security system. Table 1 summarizes the total fiscal year 1994 compensation provided to Aerospace’s 12 corporate officers and 20 senior managers based on actual benefits paid and salaries as of September 30, 1994. (See app. I for a further breakdown.) From September 1991 to September 1994, the average annual salary for all Aerospace executives (corporate officers and senior management personnel) increased by 23 percent, from about $125,000 to about $153,300. The average salary for corporate officers increased from about $135,100 to about $176,400, or 31 percent, and the average salary for senior managers increased from about $115,000 to about $139,500, or 21 percent. During those 3 years, the total cost of salaries for Aerospace executives increased by 78 percent, from about $2.75 million to about $4.91 million, primarily due to salary increases of up to 29 percent for individual executives during 1992 and a 45-percent increase in the number of executives from 22 to 32. Salaries included paid absences, such as vacations, holidays, and sick leave. Table 2 shows the number and total salaries of Aerospace executives as of September 1991 and September 1994 and the percent increase for both. Aerospace increased the average salary of its executives by about 18 percent in 1992, from about $132,900 to about $156,600. Most of this increase occurred by implementing a special, one-time increase in June 1992 that averaged 13 percent and by giving a merit pay increase in December 1992. (See app. II for more details.) Aerospace justified the June 1992 pay increase based on the need to bring its salaries more in line with industry salaries and resolve a pay compression problem that had developed between technical staff managers and their subordinates. Although Aerospace notified the Air Force 3 weeks before implementing the increase, the Air Force expressed concern that Aerospace did not present the salary increase and supporting documentation to the government in time to allow the Air Force to review the increase and determine its reasonableness. According to the Air Force, the salary increase represented a major change to Aerospace’s compensation package and the process used by Aerospace was inconsistent with SMC’s environment of trust and teamwork. Even though the Air Force allowed the salary increase, it requested a DCAA audit of Aerospace’s compensation and warned Aerospace that the government would request full reimbursement of any costs determined to be unreasonable. Aerospace told us that it believes that SMC’s environment of trust and teamwork has continued throughout this period and that it notified the Air Force immediately after its Board of Trustees approved the salary adjustment, which was based on a sound business position and the best information available at the time. Aerospace also noted that the FAR does not mandate prior contracting officer review; it only mandates that there will be no presumption of allowability when a contractor introduces major revisions of existing compensation plans and has not notified the contracting officer either before implementation or within a reasonable period after implementation. Aerospace maintained that the salary increase did not represent a major revision to its existing compensation plan. Further, Aerospace advised us that the salary adjustment occurred during fiscal years 1992-93, when it was confidently looking toward an increased budget and workload. Even though an unanticipated downturn in Aerospace employment occurred, the increase only restored salaries to market levels, in Aerospace’s view. However, Aerospace records provided to us showed that, before the June 1992 salary increase, Aerospace reduced its employment by 423 (272 technical staff and 151 nontechnical staff) through a reduction in force in November 1990 and a retirement incentive program in November 1991. No merit salary increases were given in December 1993, but 13 executives received additional salary increases since December 1992 through 13 promotions. From September 1991 to September 1994, Aerospace increased the number of its executives by 45 percent, from 22 to 32. During the same period, Aerospace nonexecutive employment decreased by about 17 percent, from 3,973 to 3,303. As a result, the ratio of executives to nonexecutive employment decreased from 1 per 181 employees to 1 per 103 employees. Aerospace did not, and is not required by the past or current contracts to, obtain Air Force approval for changing the number of executives. Table 3 compares the number of executives and the total number of employees since September 1991. Aerospace gave us many reasons for increasing the number of executives, including satisfying customer requirements and customer reorganizations and its continuing efforts to improve customer support. For example, when the SMC chief engineer position was expanded to emphasize horizontal engineering and integrated product teams, Aerospace said it added a corporate chief engineer to interface with SMC’s chief engineer. Also, it said that a general manager position was created in its Colorado division to improve support to the U.S. Space Command and the Air Force Space Command and consolidate seven different Aerospace organizational units at that division. Aerospace cited other factors, such as more robust succession planning and creating a senior manager position to better distinguish FFRDC and non-FFRDC activities, in response to recent congressional focus on FFRDC activities. It also concluded that increasing the number of senior managers would increase the leverage of the corporate officers. Aerospace noted that, even though the number of executives increased, the total number of managers decreased and the cost per member of the technical staff decreased. Aerospace further concluded that the pressure to downsize programs required adding some higher level managers with a broader perspective to support the Air Force and that the total number of employees decreased because of funding ceilings, not workload. In 1993, Aerospace paid two executives hiring bonuses of $30,000 each. Aerospace informed us that the hiring bonuses were needed, over and above an initial annual salary of $155,000, to hire these two individuals and that the special circumstances of each offer were reviewed and approved by Aerospace’s Board of Trustees. Aerospace initially reported these two hiring bonuses as government-reimbursable costs in June and October 1993. Subsequently, Aerospace reclassified these costs as nonreimbursable expenses in accordance with the FAR in July 1994 and December 1993, respectively. Aerospace commented that these were one-time bonuses that were paid in only two special cases for employees that had successfully discharged important responsibilities. After the Air Force’s request in June 1992, DCAA initiated a review of Aerospace’s compensation. On December 9, 1993, DCAA issued its report, which was subsequently revised three times. DCAA compared Aerospace positions with comparable compensation market survey data and used FAR criteria to initially conclude that Aerospace had provided $616,846 and $4,092,954 in unreasonable compensation for fiscal years 1992 and 1993, respectively. The FAR criteria call for general conformity with compensation practices of other firms of the same size, in the same industry, and in the same geographic area that are engaged in predominantly nongovernment business. Aerospace objected to the comparable compensation market survey DCAA used because it included a number of industries and corporations that Aerospace judged had no comparability to the technical education and experience of the FFRDC staff.