Compensation for Personal Services - Part 1

The compensation cost principle, FAR 31.205-6, is by far the longest and most often revised of all the cost principles found in the acquisition regulations. It is easily the most technical for its highly detailed coverage of pension costs, employee stock options, and compensation based on changes in the prices of corporate securities. It takes a lot of time and effort to truly understand all of it. Some people in the Government make a career in specializing in this one cost principle.

The first thing to understand when discussing compensation is the definition of the term "compensation" in the context of the discussion. There are multiple definitions. The general definition is found in FAR 31.001 which states that compensation for personal services means all remuneration paid currently or accrued, in whatever form and whether paid immediately or deferred, for services rendered by employees to a Government contractor. It is generally believed that the term "remuneration" includes fringe benefits but some contractors do not agree. The overarching allowability for remuneration is that it be reasonable for the services performed. Meanwhile, if you're discussing the statutory limitation applied to executive compensation, the definition of compensation means the total amount of wages, salary, bonuses, deferred compensation and employer contribution to defined contribution pension plans ... whether paid, earned, or otherwise accruing, as recorded in the contractor's cost accounting records for the fiscal year." (see FAR 31.205-6(p). This definition is different from the former definition and includes far fewer elements that the broader definition at FAR 31.001.

Beginning today, we will begin unpacking the compensation cost principle and explain its basic and essential requirements focusing primarily on its application to smaller contractors. To begin with, we provide you this listing of the various sections included in the cost principle. In all, there are 16 sections within the cost principle. The first three are sections covering general information and the remaining 13 are specific to particular components of the "compensation package". Here are the 16 sections.

     (a) General
     (b) Reasonableness
     (c) [Reserved]
     (d) Form of payment
     (e) Income tax differential pay
     (f) Bonuses and incentive compensation
     (g) Severance pay
     (h) Backpay
     (i) Compensation based on changes in the prices of corporate securities
     (j) Pension costs
     (k) Deferred compensation other than pensions
     (l) Compensation incidental to business acquisitions
     (m) Fringe benefits
     (n) Employee rebate and purchase discount plans
     (o) Postretirement benefits other than pensions
     (p) Limitation on allowability of compensation for certain contractor personnel
     (q) Employee stock ownership plans (ESOPs)

Next: Section (a), general principles.

Prenegotiation Objectives

"Prenegotiation objectives" establishes the Government's initial negotiation position. These objectives assist in the contracting officer's determination of fair and reasonable prices. They take into account the results of the contracting officer's analysis of the offeror's proposal including all pertinent information (e.g. field pricing assistance, audit reports, and technical evaluations, fact-finding results, the independent Government cost estimate if there is one, and price histories). They also include profit objectives when cost analysis is required.

FAR 15.406-1 requires the contracting officer to establish prenegotiation objectives before the negotiation of any pricing action but allows discretion to the extent that the scope and depth of the analysis supporting the objectives be commensurate with the dollar value, importance, and complexity of the pricing action. These prenegotiation objectives are always in writing and in most cases, approved by a supervisor or manager before negotiations commence. The written memorandum is often referred to as a POM (Prenegotiation Objective Memorandum).

Most Governmental procuring agencies have specific instructions or manuals guiding the preparation of the POM. Most of these contain detailed instructions that go beyond the generalities of FAR 15.406 but are entirely consistent with those basic requirements.

POMs are never shared with contractors before negotiations and rarely afterwards. In some cases, contractors are able to acquire them in connection with appeals or litigation.

POMs include both factual matters and judgmental factors. Generally speaking, the more judgment involved, the more flexible the negotiating position becomes. Price/cost analysis reports and audit reports are usually pretty factual. Labor rates and material costs are usually based on contractor history so the only thing to discuss in negotiation is escalation percentages. Quantities (e.g. hours per assembly) are sometimes based on history but could include judgmental aspects as well (e.g. complexity factors).

Contractors also develop prenegotiation strategies, though for small companies, there is not a lot of formality to it. Contractors have the advantage of having prepared the proposal and will usually have a better grasp of the inherent facts and judgments than would the Government. Contractors must ensure that they do not run afoul of the Truth in Negotiations Act (TINA) when negotiating contracts. Penalties for violating TINA can be severe.

When you are sitting at the table negotiating a contract, you should be alert for positions proffered by contracting officers that are not factual or realistic. While these positions may be part of his/her negotiation objective, they may not always be practical, viable, reasonable, or realistic. In a recent negotiation, it became obvious to us that the Government had made a significant error in calculating the hourly rate for one of the proposed labor categories. Bringing that fact up to the negotiator, allowed him to revise his negotiation strategy and ultimately it expedited the negotiation process.

Falsifying (or Embellishing) Your Small Business Status

We've reported here a number of times over the years how Government contractors get themselves in hot water by claiming a small or disadvantaged business status to which they were not entitled. Although it can be tempting to do so in order to secure a Government contract, the risks are not worth it. Challenges by competing bidders to a successful bidder's representations are now common. Insiders, with varying motives have been "blowing the whistle" with increasing frequency. Last week, the Wall Street Journal reported on a "misrepresentation" case where someone went to jail.

A New York businessman posed as a disabled veteran to qualify and win more than $16 million in Government contracts between 2007 and 2010. The problem was, this individual had never even served in the military. He was convicted by a jury and will now spend the next three plus years in the slammer.

The fraud was made known to investigators through a "confidential informant". We don't know who this person was but it was obviously someone who knew the contracts were restricted to companies run by small disabled veteran owned businesses and also knew that this individual was not one of those but owned and managed the company nevertheless. It could have been a competitor or an employee.

Once the investigation began, this guy knew he was in trouble. He found one of his construction workers who was a disabled veteran and coerced him, under threat of losing his job, to tell the investigators that he was a 51 percent owner of the company and was also responsible for the day-to-day operations of the company. The problem was that this employee was not a very good liar and his story quickly fell apart under interrogation. .

The days where contractors could play loose with their certifications are gone. There's no longer enough "businessf" to go around. There are more competitors chasing fewer dollars and those companies are doing a lot of the policing for the Government. Also, the Qui Tam provisions of the False Claims Act provide the lure of untold riches for employees or persons with inside knowledge of a situation to blow the whistle and share in the Government's recovery of ill-gotten gains.

David Koeltzow Joins PNWC

Pacific Northwest Consultants is very pleased to announce that David Koeltzow ("Kelso") has joined the firm. David most recently worked as a Compliance Manager for a Defense contractor in Oregon. Prior to that, he spent 24 years with the Defense Contract Audit Agency in the Portland, OR area. Mr. Koeltzow's other work experience includes CPA firm staff accountant and several years with the Bureau of Land Management. Education wise, David holds a Bachelor of Science from Michigan Technical University and an MBA from the University of Oregon.

Mr. Koeltzow is well known and respected in the Government contracting community. While with DCAA, contractors knew him for his strong sense of firmness, fairness, ethics, knowledge, and willingness to offer guidance. The Government relied on him for his keen technical knowledge and skills including some significant litigative support work. David has also worked extensively to streamline and simplify the process of preparing annual incurred cost submissions with an update of DCAA's Excel model (called "ICE").

Mr. Koeltzow will be based in the Portland, OR area. According to Terry Nuzzo, PNWC's Chief Executive Member, "The addition of David gives us a tremendous boost in Government contracting experience and will better equip the firm to support clients in Oregon and Southern Washington".

David can be reached at dkoeltzow@pacificnwc.com.

Limits Placed on Dollars Available for Contracted Services - Part 2

Last Friday, we highlighted a new DoD policy that limits labor rates and overhead rates for service contracts awarded in 2012 and 2013 to those rates in effect under similar contracts in 2010. The Defense Contract Audit Agency (DCAA) has been assigned a role in implementing this new policy. Its not an "audit" role however but a information provider role. DCAA is going to poke around in its files for information from 2010 such as final indirect rates, historical decrements of unallowable costs, and any other information it might have that will help the contracting officer in implementing this new policy. DCAA is also telling its audit staff that it may need to obtain year end direct labor rates from the contractor, if not already int he permanent file.

Its not at all difficult to make accounting changes that make it look like one is holding labor rates and indirect rates to 2010 levels without really doing so. Moving elements of compensation from direct to indirect, changing the number of estimated "work days", increasing the indirect expense allocation bases, are all ways of manipulating rates without changing the underlying costs. DCAA will be on the alert for this risk area. Its guidance states:

Auditors should be alert for accounting changes, subsequent to 2010, that may impact the use of 2010 actual rates. Auditors should explain these changes, and if practical, furnish calculations to make rate information comparable.

This is a polite way of saying that DCAA believes that contractors are going to be tempted to make accounting changes, not to improve the allocation of costs to final cost objectives, but to manipulate data in such a way to show compliance with the new DoD guidance. Although not stated in the guidance, we suspect that if the audit agency uncovers instances where a contractor has made "accounting changes" for the purpose of showing their 2012 and 2013 rates match their 2010 rates, a Form 2000, Suspected Irregular Conduct, may be considered.

This policy is going to be challenging for those service contractors that are affected by it. Contractors should keep those contracting officer lines of communication open. Notify the contracting officer any pending accounting changes, or the planned adoption of new compensation policies/elements.

New Limits Placed on Dollars Available for Contracted Services

DoD issued a new policy last Summer that attempts to put the brakes on increases in the cost of contracted services. This new policy implements Section 808 of the Fiscal Year 2012 National Defense Authorization Act.

The new policy, issued by the Director, Defense Procurement and Acquisition Policy, provides that contracts, task orders, and delivery orders in excess of $10 million, awarded to contractors in fiscal years 2012 and 2013, shall not exceed labor rates and overhead rates paid to the contractor for the same or similar contract services performed under contract in fiscal year 2010.

There is an escape clause however. If for some reason the Government cannot negotiate 2012 and 2013 prices down to the 2010 level, the Secretary of the Military Department or Head of the Defense Agency can approve the higher prices, but the approval must be in writing and must be issued prior to award. That's a fairly high level of approval and not something that most contracting officers would want to have to justify.

This will undoubtedly place a hardship on many contractors providing services to the Defense Department. Its one thing to hold down overhead rates but its very difficult to hold down labor rates to levels paid two or three years ago.

Contractors should be wary of trying to "game the system" by, for example, moving costs from direct to indirect as the auditors are going to be looking for that very thing. We'll discuss that matter, and the related DCAA guidance, next.

Business Base Forecasting

We described in yesterday's post the difficulty that both contractors and the Government have in estimating future business - business that should be considered in establishing indirect rates for forward pricing purposes. Ultimately, its a contractor's responsibility to prepare and support those estimates but estimating future work is such a fuzzy area that the Government often seeks outside or third party assurance to help them assess whether contractors have fully considered all potential future business in their allocation bases. The larger the business base, the lower the indirect rates is the way it works.

Often times, contractors don't even attempt to project rates for anything beyond one or two years. Beyond that, contractor's tend to "straight-line" the rates to cover whatever period of performance they are proposing. Auditors began throwing these straight-line estimates back at the contractor, telling them to prepare discrete estimates for each year of proposed costs. Of course this was a ridiculous audit position because it was impossible for a contractor to have such a fine crystal ball.  DoD eliminated that "audit" problem by taking away the responsibility for determining forward pricing rates from DCAA (the auditors) and turning it over to DCMA (the contracting officer). DCMA's expectations were much more pragmatic but even that organization was not satisfied that contractors were telling the whole truth and nothing but the truth.

Earlier this month, DoD's Director of Defense Pricing issued a new directive designed to provide better insight into the purchasing plans by DoD's many buying commands. Each buying command must designate a point of contact that DCMA can easily reach out to for assistance in evaluating contractor business base forecasts. These contacts must be able to facilitate the business base evaluation requests and ensure that they are assigned, completed, and returned to DCMA in a timely fashion.

There's more. The second part of DoD's new directive will require that the buying commands share their POMs (Program Objective Memorandums, or, the final product of the budgetary process within DoD) with DCMA. This information will provide DCMA with business base data ahead of the indirect rate review process and perhaps facilitate negotiations of forward pricing rate agreements.

Contractors should not hesitate to ask for this same information concurrent with DCMA's receipt. Could help corroborate what the contractor is hearing from its own sources.

Forward Pricing Rates

One of the major problems faced by contractors and the Government alike when establishing and negotiating  forward pricing rates (indirect rates used to price future work) is the inability to accurately forecast workload beyond the next year. Many contracts have periods of performance that extends three to five years and contractors must try to forecast what their indirect rates will be out in those years. If the contract is fixed price, failure to accurately estimate rates can lead to significant losses or windfall profit. If the contract is cost-type, failure to accurate estimate indirect rates can lead to funding issues or earlier than desired contract completion.

One certainty in Government contracting is the uncertainty over which programs will continue to receive funding. Will the Government buy 12 aircraft per year, or 20, or 25? That makes a big difference for contractors and their supply chains. Or, what about decisions to in-source work that is being contracted. How does one account for that possibility in their indirect rate build-ups? How about the looming potential of sequestration where, if it happens, significant cuts will be made to existing contracts? Was that information known a year ago? Those questions and concerns makes a big difference to a contractor's estimate of the business base used to allocate indirect costs.

Contractors' inclination is to be conservative in estimating future workload. The risk in missing workload estimates has a huge downside; monetary loss. The Government's inclination is that contractors are deliberately understating future workload in order to increase its indirect rates thereby enhancing corporate profits. The reality is that if the Government could be more accurate and certain and provide more assurance to contractors of its purchasing plans, contractors could provide better estimates of their forward pricing indirect rates and feel more comfortable in doing so.

Tomorrow we will discuss one step that DoD is taking to help contractors and its contracting officers to get a better handle on future DoD workload.

Some Contractors Try to be a Little Too Cute

"Hey, these gloves are tools, not articles of clothing".

DLA (Defense Logistics Agency) needed to purchase some electrical gloves to protect workers from electrical shock. The Government solicitation included the "Berry Amendment" clause that require articles of clothing, including "hand wear" be produced in the United States.

Integrity Supply, one of six offerors submitting bids, proposed gloves produced in Malaysia. DLA informed Integrity that its proposal was unacceptable because the end items proposed would not be produced in the United States.

Integrity appealed to the Comptroller General (CG), arguing that these gloves were not clothing but were worn solely to protect the worker from electrical shock and therefore should be considered tools, not clothing.

The CG ruled that the protester's emphasis on the protective nature of the gloves was misplaced. The term "clothing" as used in the Berry Amendment, is understood to include a wide variety of items including items worn for the purpose of protection. The CG found no basis to conclude that DLA acted unreasonably when it rejected Integrity's bid.

Integrity's sophomoric logic might be something to "try on" an unwitting contracting officer but to make a formal appeal of it to the Comptroller General is, in our opinion, misguided and a waste of everyone's time.

NAICS Codes - Part 2

We're continuing our discussion on NAICS codes (National American Industry Classification System) from Friday. When the Government issues a solicitation, it specifies the NAICS code and size standard associated with the procurement. For example, a recent solicitation reads as follows:

The solicitation number is xxxxx and is issued as an invitation for bids ... The solicitation document and incorporated provisions and clauses are those in effect through Federal Acquisition Circular FAC 2005-60. The associated North American Industrial Classification System (NAICS) code for this procurement is 332312 with a small business size standard of 500 employees. This requirement is a small business set aside and only qualified offerors may submit bids.

So in this case, if your company has this particular NAICS code, 332312 and fewer than 500 employees, you are qualified to bid for the contract.

Businesses can have more than one NAICS code. The U.S. Census Bureau assigns and maintains only one NAICS code for each establishment based on its primary activity (generally the activity that generates the most revenue for the establishment). However, the Central Contractors Registration (CCR), where business register to become federal contractors, will accept up to 5 or 10 classification codes per establishment. The U.S. Census Bureau is not a central Government agency with the role of assigning, monitoring, or approving NAICS codes for establishments. Individual establishments are assigned NAICS codes by various agencies for various purposes using a variety of methods. There is no formal role for an arbitrator of NAICS classifications.

There is an appeal process for the contracting officer's NAICS code designation and applicable size standard. Appeals must be filed within 10 calendar days after the issuance of the initial solicitation. SBA's Office of Hearings and Appeals (OHA) will usually dismiss summarily an untimely NAICS code appeal. There is no proscribed format for an appeal but it must contain at least:

• The solicitation or contract number and the name, address, and telephone number of the contracting officer
• A full and specific statement as to why the size determination or NAICS code designation is allegedly erroneous and argument support the allegation 
• The name, address, telephone number and signature of the appellant or its attorney.

There are quite a few NAICS code appeals. For example, in August there were six, in July there were nine and in June there were two. Many are successful. Sometimes appeals attempt to change a NAICS code to one that has a higher size standard, allowing the appellant to bid on a contract. Other times an appellant wants to lower the size standard in order to reduce competition.

NAICS Codes - In General

The North American Industry Classification System (NAICS) is the standard used by Federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing, and publishing statistical data related to the U.S. business economy. It is also used by the Federal Government for contracting purposes. The official NAICS website can be found here.

NAICS was developed under the auspices of the Office of Management and Budget (OMB), and adopted in 1997 to replace the Standard Industrial Classification (SIC) system. Every five years, the Economic Classification Policy Committee (ECPC), an inter-agency committee established by the OMB. During its review, the ECPC determines the feasibility and adherence to the underlying principles of NAICS, determines if the proposed changes are acceptable, and makes final recommendations to OMB for additions and changes to the NAICS manual. The ECPC recently completed its five year review and has published its 2012 NAICS manual.

The Small Business Administration (SBA) is responsible for developing size standards for each NAICS category on an industry by industry basis. Before a size standard is made available for use by industry, the SBA must solicit comments from the public through the rule-making process and then coordinate with the General Services Administration to update the associated acquisition systems, to reflect industry size standars that have been adopted for new NAICS codes. SBA publishes the corresponding industry size standards on their website.

Contracting officers must identify, in the solicitation or request for proposal, both the NAICS code that best describes the principal nature of the product or service being acquired and the size standard that has been established by the SBA for the NAICS code so that offerors can correctly represent themselves as a large or small business concern.

The process used by OMB/ECPC for developing new NAICS codes and the process used by SBA to approve size standards for new NAICS codes, are not performed simultaneously. Therefore, it is important to note that new NAICS codes are not available for use in Federal contracting until SBA publishes corresponding industry size standards.

What's a Bid Protester to Do?

Elmendorf Support Services (ESS) provided base supply services to the Air Froce at Joint Base Elmendorf-Richardson AFB in Alaska. The contract became effective on October 1, 2005. ESS provided general supply services, inventory control, customer and training services, contingency planning, and other support activities. The contract provided for a base year plus nine option years.

In March 2010, the Air Force conducted a cost comparison between ESS performing those services versus what it would cost to have the work performed by Government civilian employees. This study was performed pursuant to the 2011 National Defense Authorization Act. The Air Force study concluded that performance by Government civilian employees would be more cost-effective, saving the Air Force $5.4 million or 18 percent of the contract value over a five-year period. On February 2, 2011, the Air Force notified ESS of its intent to "in-source"  the contract services at the end of the sixth option year, or September 30, 2012.

The Air Force ran into some hiring issues in bringing on the number of civilians necessary to perform the work. As an interim step, it used a mix of military and civilian personnel to perform the services during a transition period.

ESS filed a complaint with the U.S. Court of Federal Claims stating that the Air Force cost analysis did not contemplate the use of military personnel and that a military workforce is likely to involve costs above and beyond those associated with in-sourcing the services to a Government civilian workforce.

The Air Force filed a motion to dismiss ESS's bid protest. The Judge denied the motion for a variety of reasons but mainly the fact that at the time, June 2012, ESS was still under contract. The Air Force filed another motion to dismiss ESS's bid protest this month, September 2012. This time, the Judge sided with the Air Force since ESS's contract was over and ESS no longer had "standing" to protest a decision by the Air Force to "in-source" the work. The Judge granted the Air Force's motion to dismiss the complaint for lack of jurisdiction. Additionally, ESS was not able to recoup legal costs associated with the bid protest.

The Court never had to rule on the merits of the case. They simply waited three months and threw it out on a technicality.

Foreign Taxes

When a contractor performs Government contracts in foreign countries, whether under Foreign Military Sales (FMS) contracts or for domestic requirements, certain host countries impose taxes on the contractor. FAR 31.205-41(a)(1) specifically addresses the allowability of Federal, state, and local taxes but does not address the allowability of foreign taxes. According to DCAA's Contract Audit Manual (CAM), foreign taxes are analogous to state or local taxes and are therefore considered to be allowable contract costs (see CAM 7-1408a). That's the good news. Now for the not so good news.

Contractors may have to pay some or all of these foreign taxes back to the Government. When a contractor has paid income taxes to a host country, it may be able to claim a foreign tax credit against its Federal income tax. If so, the contractor would be duplicating the recovery of foreign income tax expenditures - first as a contract cost and second as a reduction in its Federal income tax liability.

To preclude this windfall, FAR requires that the contractor repay the amount of the tax credit. For fixed price contracts, the reduction must be paid or credited to the U.S. Government as directed by the contracting officer (see FAR 52.229-6(h)). For cost type contracts, the same procedure applies except in cases where the foreign government is reimbursing the contractor's costs. In that case, FAR 52.229-9 specifically requires the payment to the Treasury and prohibits credit to a contract.

Equitable Estoppel

The following is not legal advice. It is only to familiarize readers with the concept of "equitable estoppel". If after reading this post, you think that it may have applicability to a situation that you are facing, we suggest you contact your legal counsel.

Back in 1987, the Department of Transportation eliminated Rocky Mountain Trading Company from the competitive range in a procurement for IT (Information Technology) equipment because Rocky Mountain failed to submit a timely revised proposal to a contract amendment. Rocky Mountain argued that its proposal was excusably late because its proposal was misdelivered due to an unknown verbal agreement between the United Parcel Service (UPS) and the Government. Under this agreement, all UPS deliveries, regardless of address on the label, were made to DOT's shipping and receiving center which was located in a different building from the delivery location specified in the solicitation for proposals. The Board of Contract Appeals found for the contractor and estopped the Government from asserting that the contractor's revised proposal was late. The Board stated that the Government certainly knew that vendors which selected UPS to deliver bids and proposals are unable to deliver those bids and proposals directly to the depository for sealed offers. The Government knew yet failed to divulge that contractors using UPS could not have their proposals delivered directly to the bid depository as required by the solicitation. The Government knew this because it had a delivery arrangement between itself and UPS. Equitable estoppel was appropriate because the contractor was ignorant of this arrangement and relied upon it to its detriment.

The idea that the Government can be estopped from asserting certain positions has many applications in contract law and in particular, the ultimate allowability of contract costs being challenged by the Government. We foresee many applications of this concept as DCAA begins working off its incurred cost backlog.


Courts and boards have identified four fundamental elements which must always be present for a party to establish a prima facie case of equitable estoppel against the Government.

1. The Government must know the facts
2. The Government must intend that its conduct shall be acted on or must so act that the contractor has a right to believe it is so intended
3. The party asserting the estoppel must be ignorant of the true facts, and
4. The part asserting the estoppel must rely on the Government's conduct to its detriment.

The Government must know the facts

In broad terms, equitable estoppel requires conduct which amounts to a false representation or concealment of material facts, or at least, which is calculated to give the impression that the facts are otherwise than those which the party subsequently attempts to assert. Such a misrepresentation or concealment can be made by one’s words, conduct, silence or acquiescence. A contractor must establish that the Government knew or should have known the truth about the material fact which it misrepresented or concealed and upon which the contractor relied to its detriment.

The Government must intend that its conduct be acted upon

The second element requires that the Government intend that its conduct be acted on in a manner that the contractor could reasonably believe it so intended. Governmental conduct must be of a character as would induce a reasonable and prudent person to believe that the Government intended its conduct to be acted upon. 

The contractor must be ignorant of the true facts.

The third element requires that the party asserting estoppel must actually rely upon the conduct or statements of the Government. This is another way of stating that the contractor must be ignorant of the true facts. Sometimes, a contractors reliance is considered unreasonable because of provisions in the underlying contract.

The contractor must have relied on the Government's conduct to its detriment.

Finally, a contractor must also prove that its reliance has caused it to suffer an injury. A party must establish that their reliance has placed them in a worse position than they would have been in otherwise. 

Administration Misses Sequestration Impact Report Deadline

As we reported here on August 13th, the President signed into law the Sequestration Transparency Act of 2012 which required the Executive Branch to provide a report to Congress by September 6th that details the programs, projects, and activities that will be impacted by $110 billion in cuts should there be no agreement on a budget.

September 6th has come and gone and there is no report yet.

Last Friday, the Administration, in its daily briefing, stated that the report would be issued this week. However, that date is not so certain based on this Washington Post editorial.

Companies that have legitimate concerns over how sequestration, if it comes to that, will impact them, will have to continue to wait.

Adequacy Determinations for Annual Incurred Cost Submissions

Yesterday, we reported on DCAA's new policy with respect to sampling low-risk incurred cost submissions and closing out the rest with a memorandum to the contracting officer. A low-risk submission is one that has been determined to be adequately prepared, and there has been no significant findings in any prior year's incurred cost audits of the particular contractor.

We mentioned DCAA's incurred cost adequacy checklist used to determine whether contractor submissions are adequate. Its a good idea for contractors to use this checklist to self-assess their own submissions prior to formal submission. What bothers us about DCAA's "adequacy" determinations however is that many auditors, when performing adequacy determinations, are requesting data from contractors that is not listed in the checklist and/or schedules that are considered "optional" or "supplemental".

Here are a couple of examples.

1. Schedule L requires contractors to reconcile labor costs to the Forms 941s that are submitted to the IRS. The checklist requires three steps

• Verify direct labor totals to totals on Schedule H
• Verify G&A labor totals to totals on Schedule B
• Verify other indirect pool labor totals to applicable pool schedules.

We have seen numerous cases where DCAA has called and asked for copies of the Forms 941; a request typically reserved for an "audit".

2. Schedule P is an optional schedule according to DCAA's Information for Contractors pamphlet, its Excel-based rendition of an incurred cost claim (ICE), and FAR 52.216-7 and requests contractors provide compensation for the five most highly compensated executives in the company.

We have seen numerous cases where DCAA has requested this schedule as a condition for considering the submission adequate.

3. Schedule S is the contract brief(s) where information from government contracts is listed in a format familiar to auditors. Again, this is an optional schedule but we have seen cases where DCAA's adequacy determination was contingent upon submitting these optional schedules.

So, just because your submission passes DCAA's adequacy checklist, does not necessarily mean that it will be considered adequate by DCAA. You may have to send them a truckload of additional data if you hope to get on their "low risk" list.

DCAA's New Policy for Sampling Low-Risk Incurred Cost Proposals

Last July 24th, The Director, Defense Procurement and Acquisition Policy (DPAP), granted a Class Deviation authorizing DCAA to modify its process for sampling low-risk incurred cost proposals. Both DCAA and DPAP stated that the new process will provide for a more effective oversight approach without significantly increasing risk to the Government. What this really provides for is a method whereby DCAA can make its significant incurred cost backlog magically disappear.

Under the new procedures, all incurred cost submissions will be evaluated upon receipt for adequacy in accordance with FAR 52.216-7, using the DCAA Incurred Cost Proposal Adequacy Checklist. Inadequate submissions will be returned to contractors. Adequate submissions will be assigned to one of five strata based on ADV (costs charged to flexibly priced contracts during the year). These strata are

• under $1 million
• $1 to $15 million
• $15 to $50 million
• $50 to $100 million
• $100 to $250 million
• greater than $250 million

Within each of these categories, submissions will be further classified as low risk or high risk. High risk submissions will be audited. Low risk submissions will be sampled. Low risk proposals must meet the following criteria:

1. There has been a prior audit of incurred costs
2. No significant audit leads or no other significant risk has been identified
3. No prior significant total exception dollar reported in the last year audited. Significant is defined as $15 thousand for the under $1 million strata, $25 thousand for the $1 - 5 million strata, etc.

Low risk proposals under $1 million received before September 30, 2011 will not be audited. DCAA will send a memorandum to the contracting officer telling him/her that everything is fine. For low risk proposals under $1 million received after September 30, 2011, DCAA will select only 1% for audit. The remaining 99% will not be audited.

Sampling rates for the other strata include

• $1 to $15 million - 5%
• $15 to $50 million - 5%
• $50 to $100 million - 10%
• $100 to $250 million - 20%
• greater than $250 million - 100%

While there will still be a strong emphasis for ensuring adequate incurred cost submissions, there will be significantly fewer incurred cost audits in the future. 

Improving Compliance with Timekeeping Policies

Government contractors are required to maintain timekeeping systems that provide for the accurate and complete recording of direct labor hours as well as appropriate controls to ensure corrections to labor records are accurate and authorized. The DCAA Contract Audit Manual (Chapter 5, Section 9) lists a number of attributes that timekeeping systems must possess in order to meet those requirements. Among the attributes, whether you have a manual or automated timekeeping system, is a requirement that direct labor employees record their time no less often than daily. Elsewhere, the Manual states that employees should prepare their timecards as work is performed meaning that when they perform multiple tasks in a day, they record their hours multiple times in a day.

Most contractors can attest to the difficulty in getting their employees to regularly comply with these requirements. Contractors might have great timekeeping policies and procedures. They might regularly train employees and highlight the requirements during team meetings and periodic written communications. Many contractors perform their own compliance checks to see how well employees are following procedures. But in the end, it seems like every time the auditors show up to perform "floorchecks", some yahoo is sitting there with a timecard that hasn't been completed for the previous day or days. And then, you hope that the auditor doesn't find more instances of incomplete timecards so that you can argue that the failure was an isolated case rather than a systemic problem.

More and more companies are moving to automated timekeeping systems. With so many cost-effective, scalable, web-based offerings out there, even the smallest companies can afford to automate their timekeeping practices. Google "dcaa compliant timekeeping" and you'll find plenty to evaluate and choose from. There is a feature that is becoming increasingly popular among these web-based offerings that can help improve compliance rates. This feature scans the timekeeping databases during non-work hours and identifies employees that did not complete their timecards for that day. Then, the system automatically notifies the employee by email that it found an incomplete timecard. Most systems can be configured to also send the supervisor a copy of the same message. Then, the next time the employee checks his/her email, he/she is reminded to go on-line and complete the previous day's timecard.

This process is completely automated and has been shown to significantly improve compliance rates. If you are evaluating new timekeeping systems, don't commit to one that doesn't have this feature.

Auditor Jargon Part 7 - "Low Hanging Fruit"

Its been awhile since we posted an auditor jargon definition. These are words and phrases that auditors use in their conversations with one another and sometimes with contractors. These phrases usually carry specific meanings when used by contract auditors. Today's phrase is "low hanging fruit". We heard this one in a conversation with an auditor just the other day.

Picture an apple tree with ripened fruit. Some of the fruit is low hanging and you can reach it from the ground. You walk around and fill up your sack or bucket very quickly and rather easily. Other fruit is higher up and more difficult to pick. It takes more effort. First you need a ladder, then you have to position it just so, and then you have to climb up the ladder, pluck the fruit, and then climb down. Each trip up the ladder yields only a few apples before repeating the step over and over.

When auditors use the term "low hanging fruit", they are referring to costs that they can question, disapprove, or disallow with minimal effort. The allowability is pretty black and white, no shades of grey, no research to perform, no extensive justifications and rationale to write up and usually no arguments with the contractors. Auditors love low hanging fruit because it makes them feel like they have contributed to the acquisition process without having to expend too much energy. Some contractors have been known to purposefully leave some low hanging fruit for auditors to find as a way of distracting them bigger issues. This strategy is dangerous however because most auditors can sense something amiss, it opens up potential TINA issues (truth in negotiations), may render the estimating system inadequate, and when auditors' realize they're being duped, they usually dig deeper.

Examples of low hanging fruit might include:

1. Consultant costs - FAR requires an agreement, an invoice and evidence of work performed. Many contractors do not maintain this tri-level support.
2. Escalation - Anything a contractor proposes will be replaced by forecasts from the auditors very expensive escalation subscription service.
3. Expired quotations for purchased parts.
4. Employees not posting their timecards in a timely manner.

You can read parts 1 through 6 in this series by following these links.

• Part 1 - Verifiability
• Part 2 - Defensible
• Part 3 - Full Costing
• Part 4 - Uniformity and Consistency
• Part 5 - SIC
• Part 6 - Material and Immaterial