Compensation: Guidance for Determining Reasonableness

This is the second of three parts on helping Government contractors determine the reasonableness of employee compensation. Yesterday, we discussed FAR requirements and its definitions for compensation "reasonableness". If you missed that, you can read it here. Today, we look at guidance that the Government has issued for its auditors tasked with reviewing compensation reasonableness.

The Defense Contract Audit Agency (DCAA), the Governmental organization most responsible for assessing the reasonableness of contractor compensation levels, has issued very specific guidance for assessing reasonableness. The guidance differs depending on whether a contractor is considered a "major" or a non-major", certain risk factors, and the type of review needed/requested.  But remember, this is only guidance and auditors are required to adjust the scopes of their reviews based on identified risk factors. Some auditors get very "creative" in applying the guidance. Our goal here is to provide a basic understanding of the written guidance to enable you to be prepared when an auditor makes assertions about your compensation practices.

DCAA employs different audit procedures for major and non-major contractors. A major contractor is one with $100 million or more of auditable dollars per year. Auditable dollars are not the same as contract awards. Auditable dollars relate to costs incurred during the year. Auditable dollars come from flexibly priced contracts. Flexibly priced contracts are just about everything other than firm-fixed price. The most common flexibly priced contracts include CPFF, CPIF, FPI, and T&M contracts. Contractors with less than $100 million of auditable contract dollars are considered non-major.

For major contractors, the Government expects to find a very comprehensive "compensation system". A comprehensive system includes the organizational structure, established lines of authority, duties, and responsibilities, internal controls and managerial reviews, internal and external consistency, pay structures budgeting, merit and incentive pay programs, and benefit programs. When performing a compensation system review (CSR) at a major contractor, the auditor will evaluate the following:

• management reviews of the compensation system
• organization and assignment of responsibility
• policies and procedures for non-bargaining unit employee compensation
• the total compensation package
• jobs, job families and career levels
• pay grade assignments and changes to pay structure
• internal equity or consistency
• job analysis and job descriptions
• job evaluation process
• external equity and the market comparison process (benchmarking)
• employee benefit programs.
• employee merit pay program
• performance appraisal system

When the auditor has performed these procedures and determined that the contractor's system cannot be relied upon to demonstrate reasonable levels of compensation and has also documented the potential for unreasonable levels of compensation, the auditor will apply their own tests of reasonableness. At the same time, the auditor will also issue an inadequate opinion on the compensation system and in extreme cases, disallow some compensation costs.

Relatively few contractors meet the criteria for a "major" contractor. For non-major contractors, the "risks" associated with unreasonable compensation to the Government is considerably less and system expectations are correspondingly less. For example, there is no requirement for a formal compensation system - that would not be cost-effective nor would the lack of a comprehensive system impose undue risk to the Government. However, non-major contractors still have an affirmative duty to ensure that compensation costs charged to Government contracts meets the "reasonableness" criteria of FAR 31.205-6. Tomorrow we will look at ways that small contractors can demonstrate reasonableness.