During the later half of the twentieth century, the federal government of the United States invested heavily in research. Unlike other countries, such as Russia and Japan, which produce research within governmental laboratories, the research supported by the U.S. government primarily takes place within universities. To entice universities and their researchers to conduct the government’s desired research projects, the federal government traditionally promises to cover much of the costs. The government pays the university the estimated cost of the project and allows the school to keep all funds whose occurrence can be documented.

This policy of cost-reimbursement is easy to implement for the expenses that are definitively associated with the particular project. These costs, often called direct costs, include such items as the equipment, materials, and personnel used during the project, and are relatively easy to measure and can be fully assigned to that project. Hence, the governmental policy toward direct costs receives little notice despite these expenditures accounting for 70 percent of the cost of research grants on average.

The other source of expenses in research grants are items that benefit other activities in the university, such as education or extension, as well as federally funded research. These costs, usually called indirect or overhead costs, are partially assigned to several activities and include items such as building maintenance, library materials, utility costs, and central administrative staff. Unfortunately, deciding which portion of these costs should be assigned to federally funded research grants is not a straightforward task. The complexity of indirect costs ensures that any method used to allocate them among activities is likely to receive some criticism, explaining why much of the debate over governmental policy for research funding focuses on overhead.

The system used in the United States to measure the costs of research grants has not changed in principle since 1958. For each grant, the direct costs are estimated and then multiplied by the indirect cost rate of the university to compute the total indirect costs. The method used to determine the indirect cost rate contains the complexity and controversy of the policy. Before 1958, the same rate was used for all universities, but this simple policy was abandoned because it ignored the varying character and resources among schools. To better account for these differences, the revised policy computes a unique indirect cost rate for each institution in two steps. First, each university estimates the level of indirect costs due to federal grants for the next year by conducting elaborate and complicated costing studies. Then, this total is divided by their expected level of direct costs (excluding some categories) to compute that year’s rate. The average indirect cost rate in 1997 was 56 percent for private institutions and 47 percent for public institutions. The lower rate for public schools is partially due to weaker incentives for aggressive cost recovery caused by state policies that require public institutions to return indirect cost payments to the states.

Although the theory of cost-reimbursement guides the policy for research funding, the federal government uses alternative methods to purchase other products such as office furniture. For these other goods, the government selects a producer through a competitive bidding process and then pays the company by their level of output. This method is not used for research because it is impossible to accurately measure the output of research. Although one can measure the quantity and quality of furniture in an objectively verifiable fashion, one cannot do the same for most types of research.

Therefore, payment for research is based on inputs, which can be objectively measured, as opposed to outputs. As just discussed, measuring inputs is complicated because some inputs simultaneously benefit other activities in the university, such as education. It is important, however, for research grants to include these indirect costs because overhead reimbursement encourages quality research in the universities in two ways. First, the funds provide universities with the resources necessary to maintain a strong research infrastructure. Second, the extra compensation increases the value of research grants to universities, and subsequently, provides incentives for universities to devote their efforts toward building a strong reputation for quality research.

Partly for these reasons, most agree that indirect costs should be covered in research grants, but no similar consensus exists on the proper method of indirect cost measurement. Critics of the current system have several grievances; the most prominent criticism suggests that inappropriate items are sometimes included in research grants as overhead. Politicians wishing to lower governmental spending usually voice this complaint, or researchers concerned that high indirect cost rates at their university limit their ability to win grant funding. This grievance received much attention in the press in the early 1990s when federal auditors questioned some of the indirect costs claimed by Stanford University. While the costs questioned by auditors are only a small part of the total level of federally funded research, the publicity from the case caused the federal government to more closely scrutinize the costs suggested by universities and to enact additional regulations that more specifically outlined which costs are acceptable.

To much less fanfare, the method utilized in the early twenty-first century for measuring indirect costs is also criticized for encouraging cost increases in institutions of higher education. Universities incur large administrative costs when they determine their indirect cost rate because the computation requires periodic costing studies that are expensive. Because these rates vary little across institutions of similar types, the information obtained from the studies may not justify the costs. In addition to creating additional costs, the system may also not adequately encourage universities to limit other costs. Universities are not rewarded for cost containment and are sometimes penalized for frugal behavior through lower indirect cost rates. To minimize these weaknesses in the system, economists Roger Noll and William Rogerson suggest a more simple approach where universities of the same type use a fixed indirect cost rate that is based on an audit of a sample of peer universities.

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