In fiscal year 2007, the federal government obligated nearly $27 billion for basic research, with DOD obligations accounting for $1.5 billion of that total. As shown in figure 1, more than half of DOD basic research funding was provided to schools in the form of research grants and contracts. “Other” includes Federally Funded Research and Development Centers and foreign performers. OMB Circular A-21, Cost Principles for Educational Institutions, establishes principles on how schools charge costs to federally funded research. Circular A-21 requires all costs for reimbursement to be allowable, allocable, and reasonable, and provides that the federal government bear its fair share of total costs, determined in accordance with generally accepted accounting principles, except where restricted or prohibited by law. While the federal government and schools share certain research goals, there is debate on what constitutes the federal government’s fair share of research costs. The federal government reimburses both direct and indirect costs associated with federally funded research. Direct costs can be specifically identified with individual research projects and are relatively easy to define and measure. They include, for example, the researcher’s salary, subawards, equipment, and travel. Indirect costs represent a school’s general support expenses and cannot be specifically identified with individual research projects or institutional activities. They include, for example, building utilities, administrative staff salaries, and library operations (see fig. 2). As shown in figure 2, indirect costs are divided into two main components, facilities costs and administrative costs. Facilities costs include operations and maintenance expenses, building use or depreciation costs, equipment use or depreciation costs, and library expenses. Administrative costs include general administration expenses, such as the costs associated with executive functions like financial management; departmental administration expenses, including clerical staff and supplies for academic departments; sponsored projects administration expenses, that is the costs associated with the office responsible for administering projects and awards funded by external sources; and student administration and services expenses, such as the administration of the student health clinic. Circular A-21 outlines the process for establishing an indirect cost rate for schools performing federally funded research. The indirect cost rate is the mechanism for determining the proportion of indirect costs that may be charged to federally funded research awards. The rate is established based on a historical fiscal year of cost data from a school, and is applied to individual research awards. The indirect cost rate is applied to a modified set of direct costs referred to as “modified total direct costs” (MTDC) (see figs. 3 and 4). MTDC includes the salaries and wages of those conducting the research, fringe benefits (e.g., pensions), materials and supplies, travel, and the first $25,000 of each subaward. MTDC excludes costs such as equipment costs, capital expenditures, tuition remission, equipment or space rental costs, and the portion of each subaward in excess of $25,000 (see fig. 4). The indirect cost rate is developed as follows: Each subcomponent of the facilities component of the indirect cost rate (e.g., building use, depreciation, operations and maintenance) is divided by MTDC and added together to derive the facilities component of the rate. Similarly, each subcomponent of the administrative component of the indirect cost rate (e.g., general administration, sponsored administration) is divided by MTDC and then added together to derive the administrative component of the rate. Then, the facilities component and the administrative component are added together to equal the indirect cost rate. A school’s indirect cost rate is negotiated between the school and the federal government. A school can establish three types of indirect cost rates (see table 1). Circular A-21 assigns rate-setting responsibility to either HHS or DOD, as the cognizant rate-setting agency. The Division of Cost Allocation (DCA) handles this responsibility within HHS and the Indirect Cost Branch within the Office of Naval Research (ONR) does so for DOD. Currently, HHS, with 50 rate negotiators in four field offices and headquarters, is the cognizant rate-setting agency for more than 1,000 schools, while DOD, with four negotiators and a director in one location, is responsible for 44 schools. As shown in figure 5, a school establishes its indirect cost rate by submitting a proposal to its cognizant rate-setting agency using a base year that represents a historical fiscal year of costs. HHS reviews the proposal while DOD generally sends the proposal to the Defense Contract Audit Agency (DCAA) to be audited. After the proposal has been reviewed or audited, the cognizant rate-setting agency and the school negotiate, and come to agreement on the rate. The rate is then documented in a formal indirect cost rate agreement. Across the federal government, there are limitations, or caps, placed on the reimbursement of indirect costs. Two related to DOD-funded research at schools are known as the administrative cap and the DOD basic research cap. In 1991, Circular A-21 incorporated an administrative cap limiting the administrative costs for which a school may be reimbursed to 26 percent of the MTDC for research awards. This cap is applied during the rate- setting process. This limitation only applies to higher education institutions, as stated in OMB Circular No. A-21. Despite the circular’s administrative cap, DOD regulations, which implement a statutory mandate, provide that for DOD contracts, versus grants or cooperative agreements, schools have the option to negotiate a separate rate that is not subject to the administrative cap. The Department of Defense Appropriations Act, 2008 incorporated a cap limiting the indirect costs for which a research performer (including a school) may be reimbursed to 35 percent of a DOD basic research award’s total costs. This cap, which applies to all nonfederal research performers, that is, schools, nonprofits, and private sector companies performing on contracts, grants, and cooperative agreements, was also included in the fiscal year 2009 and fiscal year 2010 defense appropriations acts. In contrast to the administrative cap, which is applied to the negotiated rate applicable to all of a school’s federal research awards, the DOD basic research cap is applied to individual DOD basic research awards, and while the school can monitor whether the charges have exceeded the 35 percent limitation as it performs the research, the school (or other performer) ultimately ensures government reimbursement does not exceed the cap once all costs are known. The DOD basic research cap is calculated with different cost bases than either the school’s indirect cost rate or the administrative cap. As previously discussed, a school’s indirect cost rate is applied to a modified set of total direct costs to arrive at the dollar amount of indirect costs applicable to a specific research award. In contrast, the 35 percent cap on DOD basic research awards limits indirect costs as a proportion of total costs. Total costs include all allowable direct and indirect costs on an individual award. Because of the different cost basis, the 35 percent DOD basic research cap does not mean that an institution with an indirect cost rate higher than 35 percent will be limited by the cap. The threshold for a school to be limited by the 35 percent DOD basic research cap is a negotiated indirect cost rate of 53.8 percent. This is demonstrated through the following example: if a school receives a DOD basic research award for $100,000, the maximum amount of the award that may be reimbursed as indirect costs is $35,000. This threshold holds true in situations where no direct costs are excluded from total direct costs. In this circumstance, total direct costs are equivalent to modified total direct costs. This allows us to use the formula for an indirect cost rate to calculate the threshold (see fig. 7 below). If a school has an indirect cost rate below this 53.8 percent threshold, it will not be affected by the DOD basic research cap on indirect costs at 35 percent of total award costs. If a school has an indirect cost rate above this threshold, it may not be reimbursed for all its indirect costs, depending on each award’s costs. We identified multiple types of variation in indirect cost rates for schools performing DOD basic research, driven by several different factors (see appendix III for detailed information on the factors and variations we identified). Across all schools, wide variation was identified in proposed rates, negotiated rates, and in the difference between the proposed and negotiated rates at schools receiving DOD research funding in fiscal year 2007. The difference between the proposed and negotiated rates was significantly larger for schools that negotiate with HHS than for those that negotiate with DOD. Differing policies and procedures employed by the two cognizant rate-setting agencies, including, for example, different approaches and differing use of rate types, may explain some of this variation. Another source of variation was that schools eligible for a rate increase of 1.3 percent to account for the cost of utilities, known as the utility cost adjustment, both proposed and negotiated higher rates than those not receiving the adjustment. The increase for the costs of utilities is received by a fixed list of schools that are listed in OMB Circular A-21. OMB has not reexamined the list of those receiving the adjustment since 1998 and DOD and HHS officials responsible for rate-setting were unclear on what the process should be for receiving and approving applications for use of the utility cost adjustment. The proposed and negotiated indirect cost rates at schools performing DOD research varied widely from one school to another. Figure 8 summarizes the distribution of schools with various levels of proposed and negotiated rates. For example, whereas about 14 percent of schools proposed a rate of less than 45 percent, about 17 percent of schools proposed a rate of 60 percent or higher. Similarly, while about 24 percent of schools negotiated rates that were less than 45 percent, about 7 percent of schools negotiated a rate of 60 percent or higher.