Employee Compensation Caps - Here We Go Again

Joseph G Jordan, the Administrator for Federal Procurement Policy (and also the CAS Board Chair) posted a comment on the OFPP (Office of Federal Procurement Policy) website yesterday announcing that next week, the Administration will be transmitting to Congress a legislative proposal to stop excessive payments to Federal contractors by limiting what the Government is willing to reimburse for employee compensation. This, Jordan says, is an important step in the Administration's ongoing effort to buy smarter and end wasteful, fiscally imprudent contract spending.

Under current law, the compensation cap is $763 thousand for 2011. But that cap is set it increase significantly to $950 thousand for 2012 if Congress doesn't do something about it. There were some attempts last year to reduce the cap. There was one proposal for $400 thousand and another that set the cap at the Vice President's level, around $230 thousand. Ultimately, the only change made was to extend the cap from the top five executives of a company to all employees.

The Administration's proposal would replace the current formula with one that caps it at the President's salary (currently $400 thousand). According to OFPP, "Tying the cap to the President's salary provides a reasonable level of compensation for high value Federal contractors while ensuring taxpayers are not saddled with paying excessive compensation costs." It would also apply to all Government contractors, not just Defense contractors like previous proposals.

The proposal will also provide for exemptions if an agency determines such additional payment is necessary to ensure it has access to the specialized skills required to support mission requirements, such as for certain key scientists or engineers.

Finally, OFPP was clear to point out that nothing in the proposal limits what a contractor can pay its employees. It only limits the amount that the Government will reimburse contractors. OFPP estimates that this proposal will save taxpayers hundreds of millions of dollars over what they would have to pay if the cap remains unchanged. We don't know how these savings were computed - whether they represent a single year or multiple year savings. "Hundreds of millions" seems rather large for a one year period. (When asked at a press conference how the amount was computed, Jordan declined to be more specific).

Something is bound to happen this year. With the 2012 cap approaching $1 million, a lot of people are going to take notice.

Employee Morale - Guidance Given to Contract Auditors

Audit guidance relative to employee morale costs are contained in DCAA's Contract Audit Manual at Chapter 7, Section 2103. When reading through this guidance, three things stand out. First, DCAA wants its auditors to look for reasonableness of costs. Secondly, the Agency wants its auditors to determine whether employee morale costs are more accurately classified as entertainment costs. Entertainment costs are specifically unallowable while some judgment has to be applied to determine whether employee morale costs are allowable or not. Thirdly, DCAA wants to ensure that whenever a cost is challenged, it becomes the contractor's burden of proof to satisfy the allowability criteria.

Here then are some of the audit procedures that might be applied in determining whether employee morale costs are allowable.

Reasonableness

In applying the provisions of FAR 31.201-3, Reasonableness, the auditor should consider whether the expenditure is reasonable in nature and amount both for the contractor as a whole and for the employee(s) benefited by the expenditure. The implication here is that overall costs might be reasonable but when averaged over the employee population, might be unreasonable.

Costs relating to welfare and morale activities, if significant, should be subjected to the test of reasonableness as to purpose and amount. When reasonableness as to purpose has been established, reasonableness of amount should ordinarily be applied to overall amounts and not to individual items of costs, provided the items are not made specifically unallowable by FAR Part 31. This guidance is based on the word "aggregate"  used in the cost principle.

Examining the Books and Records of Employee Associations

If a contractor has an arrangement permitting an employee association to retain the income from vending machines, such income should be considered in evaluating the total cost of the employee welfare and morale program as if the contractor...The auditor should examine the records of the employee association to ascertain that the income was reasonably expended for the purposes intended and that there is no undue accumulation of unspent funds. Any such accumulation should accrue to the Government by treating it as a deduction from otherwise allowable overhead.

Cafeteria Losses

Losses from operating cafeterias may be included as costs only if the contractor's objective is to operate such services on a break-even basis. One factor to consider is whether the prices charged are comparable to those available in commercial establishments. Losses sustained because these services are furnished without charge or at unreasonably low prices obviously would not be conducive to the accomplishment of the above objective and are not allowable. However, a loss may be allowable, provided the contractor can demonstrate that unusual circumstances exist such that even with efficient management, operating the service on a break-even basis would require charging inordinately high prices, or prices higher than those charged by commercial establishments. Examples of unusual circumstances are:

• adequate commercial facilities are not available, or
• reasonable prices are a necessary incentive to keep employees onsite to avoid the more significant costs of lost productive time due to longer lunch periods if the services were not provided.

When cafeteria losses are claimed by the contractor, it is the contractor's responsibility to demonstrate that unusual circumstances exist and to provide supporting documentation such as price comparisons with similar commercial establishments, or the distance of restaurants. The auditor should determine the validity of the contractor's justifications on a case-by-case basis. If the contractor fails to provide adequate documentation justifying the allowability of such losses, the auditor should question the costs.

Gifts, Recreation, and Entertainment

If the Government challenges the allowability of claimed recreation costs, it is the contractor’s responsibility to establish that the cost claimed meets the following criteria:

• The cost is for employee participation in a sports team or employee organization.
• The team or organization is company sponsored.
• The team’s or organization’s activity is designed to improve company loyalty, team work, or physical fitness.

Relationship to the Entertainment Cost Principle

Entertainment costs are expressly unallowable, without exception. Therefore, even if the principal purpose for incurring an entertainment cost is other than for entertainment, the entertainment cost is unallowable. For example, while the cost of a contractor open house for employee families is generally allowable, the cost of entertainment provided as part of the open house is unallowable.

Employee Morale - Recreation

Costs of recreation are unallowable, except for the costs of employees' participation in company sponsored sports teams or employee organizations designed to improve company loyalty, team work, or physical fitness. The three questions that contractors must ask themselves in order to determine cost allowability are:

1. Is the cost for employee participation in a sports team or employee organization?
2. Is the team or organization sponsored by the company?
3. Is the team or organization's activity designed to improve 
• company loyalty, 
• team work, or 
• physical fitness?

The expenditure must satisfy all three conditions - two out of three won't do it. Therefore, for example, it would be difficult under these standards to justify expenditures of recreational trips or even company picnics.

Sometimes, contractors will have an arrangement with employee associations whereby the associations can provide or operate certain services in the contractor's plant and retain the profits. Vending machines would be a good example of such a service. These profits must be treated in the same manner as if the contractor were providing the service. In other words, the profits cannot be used for employee morale costs that would be unallowable under this cost principle.

Contributions by the contractor to an employee organization, including funds from vending machine receipts or similar sources, are allowable only to the extent that the contractor demonstrates that an equivalent amount of the costs incurred by the employee organization would be allowable if directly incurred by the contractor.

Next: DCAA Guidance for Auditors Reviewing Employee Morale Costs.

Employee Morale - Food and Dormitory Costs

Contractors who operate cafeterias for their employees need to be aware of the "food and dormitory  provisions of the Employee Morale cost principle (FAR 31.205-13) because often times, these cafeterias operate at a loss and charging off those losses to Government contracts is not always possible.

The allowability of food and dormitory losses are determined by the following three factors.

1. Losses from operating food and dormitory services are allowable only if the contractor's objective is to operate such services on a break-even basis.
2. Losses sustained because food services or lodging accommodations are furnished without charge or at prices or rates which obviously would not be conducive to the accomplishment of breaking even, are not allowable.
3. A loss may be allowed to the extent that the contractor can demonstrate that unusual circumstances exist such that even with efficient management, operating the services on a break-even basis would require charging inordinately high prices, or prices or rates higher than those charged by commercial establishments offering the same services in the same geographical areas. The following are examples of unusual circumstances.

• A contractor must provide food or dormitory services at remote locations where adequate commercial facilities are not reasonably available.
• The contractor's charged (but unproductive) labor costs would be excessive if the services were not available.
• If cessation or reduction of food or dormitory operations will not otherwise yield net cost savings.

When calculating the cost of food and dormitory services, contractors must include an allocable share of indirect expenses pertaining to these activities. If contractors fail to do it, the auditors certainly will. That policy was settled back in 1969 under a General Dynamics Board Case (ASBCA No. 12761).

Also, under that same Board case, the ASBCA ruled that offsets were allowable because of the word "aggregate". GD was losing money on its cafeteria but income from vending machines more than offset the losses. The Government challenged the cafeteria losses but the Board ruled that all forms of income and expenses must be considered in the aggregate.

Next: Employee Recreation

Employee Morale - Overview

Today we begin a short series on the FAR (Federal Acquisition Regulation) Cost Principle that regulates employee morale costs (FAR 31.205-13).

The full title is "Employee Morale, Health, Welfare, Food Service, and Dormitory Costs and Credits" but everyone refers to the cost principle as simply "Employee Morale". Subject to certain limitations, employee morale costs are allowable. However, while employee morale tends to be allowable, entertainment is not allowable (FAR 31.205-14) and these two overlapping cost principles have been the source of constant friction between contractors and contract administration, Congress and GAO. See, for example, Entertainment vs. Employee Morale. Some costs do not fall neatly into either employee morale or entertainment definitions. Contractors tend to classify those grey areas into employee morale and make them allowable while the Government tends to classify them into entertainment so that they become unallowable.

The cost principle states that aggregate costs (at one time it stated "reasonable costs") incurred on activities designed to improve working conditions, employer-employee relations, employee morale, and employee performance (less income generated by these activities) are allowable subject to certain limitations. The cost principle then goes on to define some examples of allowable activities, including:

• House publications (most likely to be electronic media these days)
• Health clinics
• Wellness/fitness centers;
• Employee counseling services; and
• Food and dormitory services for the contractor's employees at or near the contractor's facilities. 

There are a lot of costs that, in the abstract, will improve employee morale. That's how contractors justify the cost of private clubs, concert and sports tickets, flowers, and Christmas parties. Of course, these costs could just as easily be entertainment as well. 

Costs of gifts are unallowable. Gifts do not include performance awards. Performance awards are covered under FAR 31.205-6(f). Also, gifts do not include awards made in recognition of employee achievements pursuant to an established contractor plan or policy. There is no cost threshold in this cost principle regarding the value of gifts. Thus, under this standard, even "de minimis" gifts would be unallowable.

Next: Food and Dormitory Costs

Political Campaign Activities at Contractor Facilities

You've seen it on TV. Perhaps you've experienced it first hand. Some politician is touring a plant, looking at a production line, shaking hands, answering questions, getting photographed and filmed, making a speech. It could be a campaign stop or a visit to support and endorse new technology. These visits cost money, right? They also take away from the productive work that employees are engaged in. Who pays for those costs? Who absorbs the downtime?

Well, if the company happens to be a Defense contractor, the Department of Defense wants to make sure that none of the costs are being passed off, charged to, or allocated to its contracts. DoD has taken the position that political candidate appearances at contractor facilities are tantamount to lobbying costs and therefore unallowable under FAR 31.205-22(a)(1). That particular FAR section states that costs associated with attempts to influence the outcomes of any Federal, State, or local election, referendum, initiative, or similar procedure, through in kind or cash contributions, endorsements, publicity, or similar activities are unallowable. That might seem like a stretch to you but not to DoD.

DoD's auditors, if they find out about contractors hosting political events, will be asking you a lot of questions. They will be trying to build a case to demonstrate that the activities are "clearly an attempt by the contractor to influence the outcome of an election by soliciting votes."

The auditors have been told to determine how the candidate is portrayed by the contractor and the subject matter of the candidate's speech. They can learn a lot from news articles and broadcasts. Most likely, they will conduct interviews of organizers and attendees.

Not only will auditors question the costs associated with the event, but they will also pad the amount by finding directly associated costs. Additionally, we are aware of a case where auditors questioned the salaries and wages of contractor employees attending the event.

This is one of those situations where contractors really need to weigh the costs against the benefits. If you think a candidate's appearance is disruptive, just wait until the auditors come in and ask their questions. You'll really experience disruption.

New Audit Guidance on Access to Contractor Internal Audits

The National Defense Authorization Act (NDAA) of 2013, signed into law on January 3, 2013 included a provision related to DCAA's access to contractor internal audits. The Senate version of the NDAA, which did not survive, included a provision that would have required contractors to grant access to their internal audits or face potential billing withholds. The version that was signed into law was much more benign. It does not require contractors to grant the Government access to internal audits. It requires DCAA to document requests for access to defense contractor internal audit reports. The documentation must include

• Written determination that access to such reports is necessary to complete required evaluations of contractor business systems
• A copy of any request from DCAA to a contractor for access to such reports
• A record of response received from the contractor, including the contractor's rationale or justification if access to requested reports was not granted.

The NDAA also provides that DCAA shall set up procedures to ensure that contractor internal audit reports, when and if granted, cannot be used by DCAA for any purpose other than evaluating and testing the efficacy of contractor internal controls and the reliability of associated contractor business systems.

Finally, the NDAA requires the GAO to review DCAA's documentation after a year and submit to congressional defense committees a report on the results of the review, with findings and recommendations for improving the audit process of the DCAA.

We don't see anything in this law that requires contractors to provide DCAA access to its internal audits. Its still voluntary on the contractor's part. If it were not voluntary, the original wording would have been retained and there would be no need for DCAA to document contractor rationale or justification when access was not granted.

DCAA recently issued guidance to its audit staff on access to contractor internal audit reports and made corresponding changes to its Contract Audit Manual (CAM). Most of the guidance mirrors the NDAA provisions but there is one troubling aspect to both the guidance and the revised CAM. DCAA guidance now implies that contractors must turn over their internal audits. DCAA states that "... the Law not only allows us to use the internal audits to assess the contractor's business systems; it allows us to use the internal audits to understand the efficiency of the contractor's internal controls..".  What DCAA should have stated in their guidance is that there is no requirement that contractors provide copies of their audit reports but if they voluntarily decide to do so, DCAA can only use those reports in limited circumstances.

Just saying.

Documenting Lowest Priced Airfares

Since January 2010, the FAR travel cost principle (FAR 31.205-46) has limited airfare costs to the lowest priced airfare available to the contractor during normal business hours. There are some exceptions including where circuitous routing would be required, travel during unreasonable hours, excessively prolonged travel, or to meet the medical needs of the traveler.

Many companies, including Government contractors allow certain employees to fly business class or even first class. The excess over the lowest priced airfare is unallowable and should be removed from any billing to the Government or the annual incurred cost submission. A problem arises however in determining what the lowest priced airfare was at the time the travel literary was arranged and paid for.

Contractors need to set up a process for contemporaneously documenting the lowest priced airfare when reservations are made. That way, its easy to apportion the business class or first class airfare between allowable and unallowable amounts. Barring that, what is a contractor to do after the fact - like when it is preparing its annual incurred cost submission?

One resource for determining the lowest priced available airfares in effect at the time of travel is to utilize the Department of Transportation's "Domestic Airline Consumer Airfare Report". DOT's Office of Aviation analysis collects air fare data and prepares them in compliance with public law, to be used in the development of Airport Competition Plans, not for determining the lowest priced airfare at a particular time. The quarterly report shows the average airfares between two cities, average airfare by the largest carrier and average airfare by the lowest priced carrier. For example, in the 4th quarter 2012, the average one way ticket from Seattle to Boston was $300, the average for the largest carrier in the market (Alaska Airlines) was $293, and the average for the lowest cost carrier (Jet Blue) was $242.

Using this information source should be a last resort - the best method is to set up a system that documents the lowest available airfare at the time reservations are made. However, using this method has some very good precedence - DCAA is utilizing the method to question costs when auditing annual incurred cost submissions.

Depreciation - The Basics

Depreciation is allowable under Government contracts, subject to a few limitations.

Contractors subject to Cost Accounting Standards (CAS), must, of course, follow CAS 409, Depreciation of Tangible Capital Assets. They may also elect to apply CAS 409 to non-CAS covered contracts

For contracts to which CAS 409 does not apply, allowable depreciation cannot exceed the amount used for financial accounting purposes and must be determined in a manner consistent with the depreciation policies and procedures followed in the same segment on non-Government business. This means that it is unlikely that the accelerated depreciation methods used for tax purposes (e.g. ACRS/MACRS) can be used.


Residual values must be taken into account unless those residual values are less than 10 percent of the capitalized cost of the asset or where declining balance or class life asset depreciation is used.

Contractors cannot depreciate assets acquired from the Government at no cost by it or by any division, subsidiary, or affiliate under common control.

Contractors cannot depreciate property that is already fully depreciated by it or any division, subsidiary, or organization under common control. However, a reasonable use charge for fully depreciated property may be agreed upon and allowed. Contractors will need an advance agreement if they want to do this.

Contractors cannot call their assets "impaired" and write them off immediately. Depreciation on impaired assets cannot exceed that which would have been allowable had the assets not been impaired.

Depreciation on sales and lease-backs cannot exceed that which would have been allowable had the contractor retained title.

Depreciation is one of those "pay me now, pay me later" type transactions. Contractors will eventually recover their investment. There is incentive to accelerate depreciation by selecting an accelerated depreciation method or tinkering around with useful lives but eventually, contractors will recover their investments in property, plant and equipment. The promulgation of CAS 414 and FAR 31.205-10, Facilities Capital Cost of Money, where contractors can claim imputed interest on their undepreciated asset investments, has rendered arguments over depreciation methods almost moot.

Bid Shopping and Bid Peddling

It is a commonly held belief among contracting professionals, both in and out of the Government, that contractor practices of "bid shopping" and "bid peddling" lead to poor quality contract performance.

Bid shopping occurs when a successful prime contract low bidder, after project award, uses the successful subcontract low bids as the beginning point for a post-award auction to the same or other subcontractors to agree to perform the subcontract work at an even lower price. Assuming the prime contract is fixed price, the savings accrue only for the benefit of the low-bid prime contractor, not the Agency, the project, or the taxpayer.

Bid peddling occurs when other subcontractors approach the successful prime contractor bidder after award of the prime contract and offer to perform the subcontract work at a lower price than submitted by the subcontractor whose sub-bid price was relied on by the successful prime contractor (and ultimately the Government). As in bid shopping, any savings from this practice accrue to the prime contractor.

These practices seem to occur most often in fixed price contract types; service, manufacturing, construction, and engineering but the one that is getting the most attention these days is construction projects. It is especially hard on subcontractors who have put their heart and soul into a bid and have it used by a prime contractor to justify its bid, only to have the prime contractor go out and shop or peddle the work.

At one time, sealed bidding where low cost was rewarded was the norm. Today, many of these solicitations use other factors upon which award is made (e.g. past performance). According to the Quality Construction Alliance, there has been a precipitous decline in use of low-bid selection in recent years and this decline can be attributed to one glaring defect in the low bid system - bid shopping and bid peddling. In low-bid selection, the agency awards the prime contract on the basis of the successful bidders' single low bid for the project as a whole. However, after the award, the prime contractor and subcontractors can engage in bid shopping or bid peddling. From there almost invariably, negative consequences for the project ensue, such as undisclosed change work orders, substituted materials, lower quality, delays, and claims. Contracting officers want to avoid this and for this reason, have moved away from sealed bids.

Recently, legislation was introduced in the House (H.R. 1942) that would prevent bid shopping and bid peddling on construction contracts over $1 million. This isn't the first time such legislation was introduced. It was introduced back in 2011 but died in committee. The proposed legislation would require bidders to list subcontractors in their bids and then would have to use them during performance. There's a little bit of wiggle room in the proposed legislation but not much. Contractors that violate the law will be subject to suspension and debarment proceedings.

Another DoD Checklist - This Time For Forward Pricing Rates

Back in March, the DoD published a final rule in its FAR Supplement (DFARS) to require contractors to complete and submit a proposal adequacy checklist whenever a solicitation requires the submission of certified cost or pricing data. You can read more about this 37 item checklist by following this link.

Yesterday, May 16th, DoD published another checklist, this time as a proposed rule. This 27 item proposal adequacy checklist will be required of contractors submitting forward pricing rate proposals (FPRPs) to the Government. FPRPs are the precursor to FPRAs (Forward Pricing Rate Agreements). FPRAs greatly facilitate contract negotiations because the parties do not have to haggle over the indirect rates. FPRAs are most beneficial at contractors with a significant number of pricing actions every year. Refer to FAR 42.1701 for more information concerning FPRAs.

One of the greatest challenges in forecasting indirect expense rates is trying to reasonably estimate future workload or volume. Indirect rates can swing significantly depending upon future events (e.g. winning a particular bid) where there is some uncertainty. One of the checklist questions tries to pin that down. It asks:

Does the proposal disclose known or anticipated changes in business activities or processes that could materially impact the costs? For example

• Management initiatives to reduce costs;

• Changes in management objectives as a result of economic conditions and increased competitiveness;

• Changes in accounting policies, procedures, and practices including:

• reclassification of expenses from direct to indirect or vice versa;

• new methods of accumulating and allocating indirect costs and the related impact and

• advance agreements;

• Company reorganizations (including acquisitions or divestitures);

• Shutdown of facilities

• Changes in business volume and/or contract mix/type.

Contractors need to take special care when answering these questions. Failure to disclose anticipated changes in business activities could lead to allegations of defective pricing.

A Case Where Late Proposals Were Okay

We've written from time to time of the importance, when responding to a Government solicitation, of ensuring bids are received on time. FAR 15.208 makes it clear that it is the offeror's responsibility to deliver its proposal to the proper place at the proper time. Late delivery generally requires rejection of the proposal.

Looking through GAO archives, there was a case where a proposal was rejected because it was one hour late and another rejected because FedEx delivered it to the wrong building and still another because the Government's computer system crashed and electronic delivery was not made on time. In each of these, the CG (Comptroller General) ruled that it was the offeror's responsibility to ensure on-time delivery - the excuse was not one of the exceptions listed in FAR 15.208..

A recent Court of Federal Claims decision is about to change that thinking.

Last November, two companies submitted bids to USAID (Agency for International Development). The Government requested that those bids be sent electronically. Both companies submitted their proposals well before the 5:00 P.M. deadline however because of "computer" issues that were attributable to the Government's systems, those proposals were not delivered to the contracting officer until after the 5:00 P.M deadline. The USAID contracting officer rejected both bids as late. Both companies filed an appeal with the US. Court of Federal Claims.

The Judge didn't buy USAID's position. In fact, the Judge said that it "...makes little sense".

If defendant (the Government) is correct, one must conclude that the drafters of the FAR decided to impose on contractors the risk that, without warning, an agency computer could fail, causing a proposal electronically transmitted with reasonable time for it to be received to instead be declared late and out of the competition. The only way for a contractor to avoid this risk, according to the defendant, is for it to file its proposal by 5:00 P.M on the day before the submission is due - essentially, suggesting that whenever a solicitation or its equivalent requires electronic transmission, the due date should be viewed as being a day earlier than actually stated.

And, in a somewhat snarky summary comments, the Judge stated,

These cases somewhat painfully illustrate the thorny issues that can arise when the outmoded provisions in the Federal Acquisition Regulations (FAR) governing the delivery of electronic proposals - which date back to the last century - are applied to modern computer technology. As this deficiency is well-documented, and because, notwithstanding it, Federal agencies continue, in the name of electronic commerce, to exhort offerors to submit their proposals electronically, one might think that those same agencies would be hesitant to construe the FAR in a way that springs technological traps on their contracting partners - but, then again, perhaps not.

We don't know whether the Comptroller General will adopt this position in its decision making process. They should. In the meantime, contractors might as well take their appeals to the Federal Claims court instead of the of GAO.

Does DCAA Target Contractors?

A few days ago, the IRS disclosed that some rogue employees in Ohio had been "targeting" conservative groups. Since then, there have been more disclosures and a full-blown scandal is brewing. There have also been numerous accounts by individuals and groups suspecting they have also been targeted for one reason or another. Obviously, this story is not going away soon.

This got us discussing among ourselves whether contract auditors or administrators (e.g. DCAA, DCMA, GAO, DoD-IG, etc.) have ever been part of a orchestrated effort to target particular contractors or segments of the contractor community.

Happily, not one person in our Consulting Group had ever been a part of such an endeavor. Moreover, we have never heard of it happening nor could we imagine that it could even occur. DCAA auditors, first and foremost, are independent. Independence is required by GAGAS (Generally Accepted Government Auditing Standards) and any impediments to independence will disqualify an auditor on any given audit. Secondly, auditors are driven by risk, not by politics. Auditors spend their time in areas that seem to be of highest risk to taxpayers -  getting the most bang for the buck, so to speak.

When we were auditors, contractors sometimes asked us why we were picking on them. We weren't. We just had some audits to perform and after taking them through our risk assessments, they understood our purposes better. We were never there for nefarious reasons. There may be cases where auditors stayed a little longer and dug a little deeper than was justified by the risk assessment because he/she was ticked off at someone or something. Sometimes its difficult to suppress the human element when two sides collide. These situations however are "one-off" cases, not something orchestrated by management.

Our advice to contractors undergoing any audit is to ensure that the audit scope and the risk assessments are fully understood before the audit begins. We've given this advice several times in this blog. If the auditor seems to go astray, ask him/her what they are doing. It you don't get a satisfactory answer, talk to their supervisor or manager.

Penalties on Unallowable Costs - Part V

Today we will conclude our series on penalties on unallowable costs by with one last look at the guidance that DCAA (Defense Contract Audit Agency) has given its auditors for computing penalties and interest on unallowable costs. If you missed the previous segments, read them here: Part I, Part II, Part III, and Part IV. Most of this information can be found in more detail in DCAA's Contract Audit Manual (DCAM) Section 6-609.

Contract clause. Auditors are directed to request that contractors identify all contracts that contain the "penalty clause" (i.e. FAR 52.242-3). Usually this information is contained on Schedule I of the Annual Incurred Cost proposal required by FAR 52.216-7. However, DCAA points out that the absence of the penalty clause in a contract does not prevent the Government from assessing the penalty. "A contractor is bound by the required clause even though the clause is inadvertently omitted, because the statutes make it a mandatory clause." Some clauses are required by Statute and some by regulation. Those that are required by statute, apply even if they have been inadvertently omitted. This is the substance of the so-called Christian Doctrine.

Reporting requirements. The amount of detail required in an audit report to identify, support, and calculate penalties is rather extensive and time consuming for the auditor. Although the auditor has no authority to waive penalties, when it is clear that the penalties will be less than $10 thousand (requiring the contracting officer to waive them), there is a greatly truncated version of the information required in the audit report.

Statistical Sampling. Often times, auditors will utilize statistical sampling techniques to sample transactions and project the results to a larger population. Audit guidance requires that the portion of the sample subject to penalty shall be projected to determined the total recommended costs subject to penalty. Any such projections made by the auditor should be closely scrutinized by contractors as DCAA's track record in applying statistical sampling techniques has been less than stellar.

Final comments

Just because an auditor identifies an unallowable cost as "expressly unallowable" does not make it so. Often times, judgment is required and auditors will err on the aggressive side. Additionally, the Agency is not always correct in identifying what is and is not expressly unallowable. Consider recently where DCAA directed its auditors to classify medical payments/insurance for "unauthorized" dependents as expressly unallowable. It was only after DoD stepped in and told them that such a position was nonsense that DCAA had to revise its guidance.

The auditors' calculations of penalties and interest should be an iterative process where both parties finally agree on the numbers. The parties don't need to agree on the substance, but the impact should be factual. Auditors are going to need help to make accurate calculations, especially in determining interest. Contractors should help them as much as possible, thereby preventing subsequent and avoidable arguments.


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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance

Penalties on Unallowable Costs - Part IV

For the past few days, we have been discussing penalties levied by the Government when contractors include unallowable costs in their final incurred cost submissions. These are not inconsequential penalties and contractors should give attention to their internal controls for identifying and excluding unallowable costs. In the first three segments, we have discussed the FAR coverage (FAR 42.709) on penalties. Today, we want to focus on the guidance that DCAA has prepared for its audit staff on what they should do when they encounter unallowable costs during the course of their audits.

The first thing that the audit guidance underscores is the term "expressly unallowable". The FAR coverage uses the term "expressly unallowable" without further explaining or defining what is or is not "expressly unallowable. The DCAA guidance provides a definition that comes out of FAR 31.001. According to that definition, "expressly unallowable" includes only those costs that are expressly unallowable under FAR 31.2. It does not include any costs that are unallowable because they violate any other regulatory requirement or contract term, unless such regulation or contract term is also included in the cost principle. In addition, expressly unallowable costs do not include costs which are unallowable solely because they are unreasonable or unallocable. Later in this series we will provide some examples of costs that are expressly unallowable.

The other aspect of FAR 42.709 that DCAA emphasizes the date that the audit commences. Since the regulations allow the contractor to withdraw an overhead submission before formal initiation of the audit in an effort to avoid penalties, audit guidance requires the auditor to establish verifiable evidence that tthe contractor is aware when the audit begins.

So, what is the responsibilities of the auditor in assessing penalties. In short, the auditor provides an advisory role to the contracting officer. Specifically, the auditor is responsible for

• reporting all unallowable costs subject to penalties identified during the audit, regardless of dollar amount (recall, the penalty can be waived if less than $10,000 but the auditor will report amounts lower than that).
• making recommendations concerning the appropriateness of penalties when the contracting officer specifically requests that assessment, and
• providing assistance in computation of simple interest due the Government.

The auditor has no authority to impose the penalty, recover it against subsequent public vouchers, recommend the supplemental penalty, or waive the penalty. This authority rests solely with the contracting officer.

Flowdowns to subcontractors - the pertinent audit guidance points out that the penalty statutes and implementing regulations do not flow down to subcontracts and reminds auditors to not recommend penalties for subcontracts, even though they might have been passed along to the Government by way of the prime contract.

Inter-company transfers and work orders. Many contractors include allocations from a group office or a home office as part of their indirect rates. These allocations are subject to penalty. The same goes for work performed by an affiliated organization.

Voluntary management reductions. While it doesn't seem quite fair, audit guidance states that a contractor may not avoid a penalty by applying a voluntary management reduction that does not specifically identify the unallowable costs excluded from the final incurred cost proposal. DCAA theorizes that such a reduction is used because the contractor has a poor internal control system for identifying unallowable costs. This provision of the audit guidance seems extra-regulatory to us and should be open to challenge. We are not aware of any appeals of such a position.


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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance

Penalties on Unallowable Costs - Part III

This is the third installment on our discussion of penalties levied on contractors who unwittingly, inadvertently  or otherwise, included expressly unallowable costs in their annual incurred cost submissions. You can read Part 1 here and Part 2 here. Today's discussion deals with potentially available waivers of the penalties.

The FAR coverage of waivers is discussed in 42.709-5. There are three conditions that require the contracting officer to waive penalties. The regulatory language reads "shall waive" meaning that if one of the following conditions is present, the contracting officer must waive the penalty - its not left to his/her discretion. Here are the conditions:

1. The contractor withdraws the proposal before the Government formally initiates an audit of the proposal and the contractor submits a revised proposal. Note that an audit is formally initiated when the Government provides the contractor with written notice, or holds an entrance conference, indicating that audit work on a specific final indirect cost proposal has begun.

2. The amount of the unallowable costs under the proposal which are subject to the penalty is $10,000 or less. That is not $10,000 of expressly unallowable or previously determined unallowable costs but $10,000 allocated to Government flexibly-priced contracts. Also, the $10,000 figure is cumulative, not individual items. The ASBCA (Armed Services Board of Contract Appeals) went back and forth on whether the $10,000 figure was cumulative or individual but eventually decided on "cumulative" - the regulatory wording is not clear (see Appeal of Thomas Associates, ASBCA No 57126)

3. The contractor can demonstrate, to the contracting officer's satisfaction, that:

     a. It has a good system for identifying and excluding unallowable costs. The contractor has established policies and personnel training and an internal control and review system that provide assurance that unallowable costs subject to penalties are precluded from being included in the contractor's final indirect cost rate proposals, and

     b. The unallowable costs subject to the penalty were inadvertently incorporated into the proposal (i.e. their inclusion resulted from an unintentional error, notwithstanding the exercise of due care.

This last condition is where contractors might have the best case for getting penalties waived.


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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance

Penalties on Unallowable Costs - Part II

We began a short series yesterday on penalties imposed on contractors who claim costs that are unallowable under FAR cost principles (and also under Agency supplements like the DoD FAR Supplement or NASA FAR Supplement). If you missed that segment, you can read it here. These penalties have a statutory basis meaning Congress passed a law and the President signed it.

As discussed yesterday, there are two different penalties, one for specifically unallowable costs and a double penalty for costs that were determined to be unallowable before the incurred cost claim was submitted. Although not specifically mentioned in the Regulations as such, these two penalties are commonly referred to as Level 1 and Level 2 penalties respectively.

Only the contracting officer has the authority to assess penalties (see FAR 42.709-3). Usually however the contracting officer is relying on someone else (e.g. DCAA) to make the recommendation. To assess a Level 2 penalty, the contracting officer must have some evidence that the costs were determined unallowable prior to submission. The kinds of evidence listed in the Regulations include;

1. A DCAA Form 1, Notice of Contract Costs Suspended and/or Disapproved (or similar notice) that was not appealed and was not withdrawn.
2. A contracting officer final decision which was not appealed
3. A prior executive agency Board of Contract Appeals or court decision involving the contractor, which upheld the cost disallowance; or
4. A determination or agreement of unallowability under 31.201-6 (Accounting for Unallowable Costs).

After making the assessment, the contracting officer must issue a final decision which includes a demand for payment of any penalty. The demand shall state that the determination is a final decision under the Disputes clause of the contract. This demand is separate from demanding repayment of any paid portion of the disallowed cost.

Interest

In addition to the penalties, there is also the interest component. The contracting office will compute interest on the paid portion of the disallowed cost from the midpoint of the contractors' fiscal year to the date of the demand letter. The regulations do provide some flexibility on the duration if the costs were not paid evenly during the year. The interest rate to be used is the Treasury Rate, currently set at 1.75 percent.

The contracting officer wouldn't normally have the information necessary to ascertain the paid portion of unallowable costs so he/she would need to request assistance from the contract auditor.


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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance

Penalties on Unallowable Costs - Part I

Now that the Government is starting to audit and clear out its backlog of old contractor incurred cost submissions, some contractors are finding out first-hand, some for the first time, the FAR provisions regarding penalties on specifically unallowable costs included in their submissions.

FAR 42.709 covers the assessment of penalties against contractors who include unallowable indirect costs in final indirect cost rate proposals or the final statement of costs incurred or estimated to be incurred under a fixed-price incentive contract. It applies to flexibly priced contracts greater than $700 thousand.

The penalties are pretty stiff. If the indirect cost is "expressly unallowable" under a cost principle (e.g. advertising, alcoholic beverages), the penalty is equal to the amount of the disallowed costs allocated to contracts subject to this provision plus interest on the paid portion. The penalty is applicable and assessed whether the Government actually paid the costs.

It gets worse. If the indirect cost was determined to be unallowable for that contractor before proposal submission, the penalty is double. So, for example, if a contractor persists in claiming a cost that was determined to be unallowable as a result of an earlier audit, the penalty is two times whatever was claimed.

In the next few days, we look further at this issue, who's responsible for calculating and assessing the penalty and whether or not their are any waivers available to contractors who inadvertently or not, has included unallowable costs in their incurred cost submissions.

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Read our complete series on penalties for unallowable costs by following these links.
Part I - Regulatory Authority
Part II - Levels I and II Penalties, and interest
Part III - Waivers
Part IV - Calculating
Part V - Audit Guidance

No More Caps on Contracts Awarded to Women-Owned Small Businesses

SBA just amended its regulations to remove the limitation on the dollar amount of a contract that women-owned small business can compete for under the Women-Owned Small Business (WOSB) Program. As a result, contracting officers may now set-aside contracts at any dollar level, as long as the other requirements for a set-aside under the program are met.

This policy change was required by Section 1697 of the National Defense Authorization Act (NDAA) for Fiscal Year 2013. Previously, the cap had been set at $5 million for manufacturing contracts and $3 million for all other contracts.

In Fiscal Year 2011, the Federal Government awarded only 4 percent of its contracts to WOSBs. This is short of the 5 percent statutory goal for such awards. Removing the cap should help Federal agencies reach the goal.

If a contracting officer has a reasonable expectation based on market research that two or more WOSBs will submit offers (including economically disadvantaged WOSBs or EDWOSBs) and that an ensuing contract award can be made at a fair and reasonable price, he/she may restrict competition to those firms that are so designated (see 13 CFR 127.503).

Past Performance as an Evaluation Factor

Here's a recent GAO bid protest decision that illustrates the importance of submitting your best, most relevant "past performance" data, when "past performance" is a factor in the award of a Government contract.

The GAO (Government Accountability Office) denied a protest where the past performance information the protestor claims should have been considered was not provided in the protestor's proposal. An offeror bears the responsibility to identify relevant past performance information and an agency is not required to investigate and consider matters not referenced in the proposal.

In this case, the solicitation rated past performance as more important than price and price was significantly more important that small business participation. The RFP required offerors to submit information for up to three recent and relevant contracts or delivery orders. The information was to include quantities, monthly delivery rate and maximum monthly delivery rate. Additionally, the offerors were required to have the contracting officers of these past performances to complete a questionnaire.

The solicitation estimated a production rate of 4,000 units per month. The protestor submitted the required three past performance reports. One of the three had a production rate of 4,000 per  month but the other two had only 2,000 per month. The contracting officer noted that there was a partial overlap on the two performances of 2,000 per month so gave credit for that. In order to ensure that the agency evaluated recent and relevant information regarding past performance, the Government looked for additional delivery information. They identified some contracts but were unable to verify actual delivery under those additional orders.

Unable to verify actual deliver information, the Government rated two of the past performances as "very relevant" and the third as "relevant". The competitor's received three "very relevant" appraisals and won the award.

The losing bidder essentially argued that the Government should have done more work to determine actual delivery quantities. GAO disagreed. GAO stated:

Once again, however, FNM asks that we shift responsibility to the agency for finding information about another contract that FNM could have identified in its proposal, but did not. For the reasons above, we see no basis for concluding that the agency was required to search for information that FNM did not refer to in its proposal. 

GAO concluded that the agency reasonably evaluated past performance. Had the offeror provided adequate past performance data, both offerors would have been rated the same as far as past performance was concerned and award would have been made based on other factors, perhaps price.

Plant Reconversion Costs

Plant reconversion costs are those incurred in restoring or rehabilitating facilities to approximately the same condition existing immediately before the start of the Government contract, fair wear and tear excepted. Reconversion costs are unallowable except for the cost of removing Government property and the restoration or rehabilitation costs caused by such removal (see FAR 31.205-38).

FAR does provide one exception. In special circumstances where equity so dictates, additional costs may be allowed to the extent agreed upon before costs are incurred. Note this important qualification - agreed upon before the cost were incurred. FAR also cautions that "care should be exercised to avoid duplication through allowance as contingencies, additional profit or fee, or in other contracts.

This particular cost principle has not changed since it was first published in 1959 but at the time it was published, there was a bit of controversy. Contractors felt that reconversion costs should be allowable while the Government took the opposite position - that costs should be charged to future work.

Back in 1975, there was a case involving a terminated contract where the contractor claimed the costs of tearing down its production line which included sewing machines and tables. The ASBCA (Armed Services Board of Contract Appeals) ruled that moving the sewing machines represented allowable repair and maintenance while moving the tables represented unallowable plant reconversion costs. The sewing machines, you see, hand to be cleaned and drained of their oil carriages prior to storage while there was no reason why the tables could not remain in-place pending future work.

Even though this cost principle contains a provision that might allow plant reconversion costs in special circumstances so long as it is agreed upon before the costs were incurred, it seems unlikely to us that a contracting officer is going to entertain such a request. The cost principle does not define or identify "special circumstances" it would take an extremely convincing argument to move a contracting officer toward such an agreement.

RFPs, RFQs ... Whatever

We sometimes toss around phrases and acronyms expecting everyone to understand what we're talking about. Sometimes we get things mixed up ourselves - its easy. It is very common to confuse RFPs and RFQs. Some people use the terms synonymously.

The best place to look for definitions of terms used in Government contracting is in FAR 2.101. There are many definitions elsewhere in FAR but Section 2.101 is a fairly comprehensive and a good place to start.

Lets begin with the term "solicitation". "Solicitation" is a generic term used to describe any request to submit offers or quotations to the Government. There are several types of solicitations,

• RFQ - Request for Quotations - Solicitations under Simplified Acquisition Procedures are called RFQs.
• RFP - Request for Proposals - Solicitations under competitive or negotiated procedures are called RFPs.
• IFB - Invitation for Bids - Solicitations under sealed bid procedures are called IFBs.

Contractors (or prospective contractors) make offers to RFQs, RFPs, and IFBs. An offer is a response to a solicitation that, in the case of IFBs and RFPs, if accepted, binds the offeror to perform the resultant contract.

• Responses to IFBs are called bids or sealed bids
• Responses to RFPs are called proposals
• Responses to RFQs are called quotes.

RFPs are used in negotiated acquisitions to communicate Government requirements, anticipated terms and conditions that will apply, information required to be included in the offeror's proposal and factors and significant sub-factors that willbe used to evaluate the proposal and their relative importance.

Allocability and Records Retention

FAR 31.201-4, Allocability, provides that a cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits, received or other equitable relationship. Here's a Board case that touches on this concept.

The U.S. Agency for International Development (AID) issued a cost reimbursable contract to Bearing Point, Inc. for for economic recovery, reform and sustained growth in Iraq. Bearing Point in turn, subcontracted security services from Custer Battles. Custer Battles lost its contemporaneous records related to labor and transportation costs incurred under the subcontract so the AID contracting officer disallowed about $3.85 million based on lack of adequate supporting documentation, concluding that the costs were not allocable to the contract/subcontract because there was no evidence that they were incurred in support of the AID contract.

Bearing Point appealed the decision relying on testimony from three employees who were present in Iraq, personally knew the Custer Battles security forces, and reviewed the Custer Battles invoices. Bearing Point argued that the contract did not specify any particular documentation to support the invoices, and that it had "adduced" credible evidence of allocability of the disputed costs.

AID countered that Bearing Point was required to maintain records or other sufficient evidence of costs to obtain reimbursement and argued that the disputed costs were not allocable to the contract because they do not meet the contractual standard of contemporaneous documents or other supporting evidence.

The Board sided with Bearing Point. The Board ruled that the contract clauses do not impose the stringent requirements of either "nice neat little files" expected by the contracting officer or the contemporaneous records for which AID desired. The ASBCA determined that Bearing Point had met its burden of supporting claimed costs.