Thursday, May 27, 2010

Compensation: Reasonableness Considerations for Smaller Contractors

This is the third and final part of our brief overview of "reasonableness" as it pertains to employee compensation. In Part I, we discussed the regulatory requirements of FAR 31.205-6 and in Part II, we discussed the different levels of audit coverage for major and non-major Government contractors and why major contractors are expected to have robust compensation systems. You can read these posts here and here. Today we are going to conclude this series with some considerations for smaller contractors (non-major contractors). As we noted before, contractors always have an affirmative duty to ensure the reasonableness of their compensation levels. Government contractors need to have some level of certainty that the compensation levels used in pricing and for claiming reimbursement under cost-type contracts is reasonable. And, there are a number of ways to support reasonableness, depending upon circumstances.

Significant Commercial Work. There is a presumption of reasonableness when a contractor has a significant amount of commercial and/or fixed price work. The theory is that market forces will keep salaries and wages in line with other firms in the area, industry, and similar sized. Just don't deviate from those practices on your Government contract(s).

Employee Turnover. Excessive employee turnover can indicate that pay scales are low relative to the competition. Conversely, low turnover might suggest that salaries and wages are too high. Of course, there are many other economic and internal factors that contribute to turnover levels but the Government might look at employee turnover as an indicator of compensation reasonableness. You should be prepared to answer the question if asked.

Surveys. External pay surveys provide detailed data regarding market pay levels for specific jobs and are used extensively to establish benchmarks for comparative purposes. There are several sources of surveys available to contractors - published surveys that are available for the general public to purchase regardless of participation in the survey, private surveys based upon data from survey company clientele and which only participants may purchase, contractor self-conducted surveys, and a variety of free Internet surveys. The Government does not like the Internet data because of valid concerns over the accuracy of the data. It may not be statistically valid and some of the information provided could be self-serving. The pay surveys tend to be expensive and not cost effective for small companies to purchase. That leaves self-conducted surveys as the primary source of benchmarking for small companies. There have been stories that certain Government offices have been coercing small contractors to purchase expensive survey data. You need to be aware however that there is no regulatory requirement for contractors to purchase salary survey data and salary survey data is not the only method of determining reasonableness.

Use of Historical Data for Pricing. A common estimating technique is to base future costs on historical data, adjusted for inflation, learning curves, and other factors. Using historical data, when appropriate, will avoid having to justify individual wages and salaries.

There is a significant subjective element to determining reasonableness. The Government recognizes this and allows 10 percent over a benchmark amount before asking contractors for additional justification. They also take into account offsets. For example, if base salary seems excessive but the contractor does not contribute to a 401k plan for example, the reduced fringe benefit will offset the higher base salary. The best defense against a Government challenge is to have your own solid basis for determining reasonableness prepared beforehand.

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