Board Decision Becomes Treatise on FAR 31.201-3 - Reasonableness

In 2001, the Army awarded a contract to Brown & Root Services, Inc (KBR) for support services during military operations in Iraq (commonly referred to as the LOGCAP III contract). KBR. Two of KBR's subcontractors filed REA's (Requests for Equitable Adjustment) with KBR. KBR paid the subcontractors and then in turn, requested reimbursement from the Army. The Army denied the cost so KBR appealed to the ASBCA.

The ASBCA also denied the appeal because it found the KBR's actions and the resulting costs to be unreasonable.

First, KBR agreed to the validity of its subcontractor's REA after concluding that performance delays were the Government's fault. However, after examining the facts and the contract language, the Board found that it was not reasonable for KBR to conclude the the Government failed to perform the prime contract.

Second, KBR did nothing to analyze the propriety of its subcontractor's claimed costs. Although KBR recognized that its subcontractor could only seek its actual costs, it did not require evidence of actual cost before paying out a $25 million settlement. Instead of determining the actual number of delay days, KBR relied on its subcontractor's unrealistic model of estimating delay days.

This is a lengthy ASBCA decision but is highly instructive for someone trying to understand how the Board might apply the FAR 31.201-3 "reasonableness" standard.

Incurred and Claimed Does Not Prove Reasonableness

BAE Systems San Francisco Ship Repair was awarded a task order under a multiple-award, task order contract (MATOC) for programmed maintenance of a Logistics Support Vessel. During performance, BAE discovered significant differences between the drawings for potable water and drain piping systems and those that actually existed on the vessel. BAE filed a equitable adjustment claim for $904 thousand.

Eventually, DCAA (Defense Contract Audit Agency) was requested to audit the claim. In its report, DCAA reported that BAE had submitted adequate data to support its claim and considered the claim to be acceptable as a basis for negotiation of a fair and reasonable settlement. Of the $904 thousand claimed, DCAA took exception to a very insignificant $566 - almost not worth reporting upon.

The contracting officer evidently did not like the DCAA audit report because she dismissed it entirely and rendered a decision that BAE was entitled to recover only $351 thousand. She wrote:

Defense Contract Audit Agency (DCAA) ... did not question the amounts of your proposed claim. All DCAA did, unfortunately, was verify the addition of the claim without verifying any of the underlying facts. DCAA did not have any of the oroginal time cards or any other information beyond the summary you provided. DCAA took no exception to the proposed material costs. DCAA specifically did not examine entitlement, but only looked at quantum. DCAA had no knowledge of the actual facts and did not look beyond the information offered by BAE.

BAE appealed the contracting officer's final decision to the ASBCA (Armed Services Board of Contract Appeals. As the case progressed, BAE, at one point, moved for a summary judgment, asking whether its claim be based on its actual, recorded costs of performing additional work as confirmed by Government auditors, or should the amount be based on an estimate by Government personnel. BAE stated that its proposed costs are actual costs and DCAA confirmed them by tracing to books and records. The Government should not be heard to impeach or contradict its own auditors.

The ASBCA denied BAE's request for summary judgment. The ASBCA did not agree that BAE's costs were automatically allowable simply because those costs were recorded in the books and records and because DCAA had reconciled those costs to the books and records. It further stated that the contractor has the burden of proof, unaided by a presumption of reasonableness, to establish that the costs it incurred were reasonable. Therefore, BAE's claim does not meet the requirement, imposed by law, that it had met its initial burden of establishing that the costs it claimed are reasonable.

What Would the Government Do?

We frequently come across what we consider goofy audit positions. Of course, one of the things we do is to help contractors implement internal controls to reduce the occurrence of potentially unallowable costs and when a particular cost is challenged by the Government, provide advice and guidance on how to respond. 

Sometimes the allowability of a particular cost is not black and white. There may be no FAR cost principle that discusses the allowability of the item. When there is no specific cost principle to apply and the contract is otherwise silent on the matter, contractors and the Government usually decide on "reasonableness". 

Recently, we came across a situation where the Government questioned a contractor's purchase of bottled water. In this case, the cumulative cost turned out to be rather significant - evidently contractor employees were guzzling a lot of water. There being no specific cost principle that addresses the purchase of bottled water, the Government questioned the amount based on reasonableness. The city water supply was perfectly safe for drinking, therefore the cost to purchase bottled water was unreasonable and therefore unallowable under Government contracts.

Sometimes it is interesting, informative, and instructive to know the Government's policy in similar situations. In this case, given the same set of circumstances, would the Government purchase bottled water for its employees? Probably not. Back in 1961, the GAO ruled that a Government agency could not use appropriated funds to purchase bottled water. They ruled that bottled water generally does not materially contribute to an agency's mission accomplishment, and is ordinarily considered a personal expense. The decision did allow for some exceptions however. Where water is unhealthy or unpotable, agencies may buy bottled water.

There is also a DoD Regulation (FMR vol. 10, chapter 12, paragraph 120203) that governs the purchase of bottled water. Essentially, the regulation permits the purchase of water where the public water is unsafe or unavailable.

Note, the GAO decision and the DoD regulation do not apply directly to contracts. However, these can be and have been used by the Government to support a position of "unreasonableness". If the Government does not allow it for their own employees, is it reasonable to expect that contractors should be allowed to purchase it for their employees?    

Allowability of Incurred Costs due to Contractor Errors

The Department of Energy (DoE) issued a new Acquisition Letter (No. AL-2012-03) this week concerning the allowability of incurred costs due to contractor errors. Acquisition Letters (ALs) from DoE are issued to provide specific guidance for implementing FAR and DEAR (the DoE FAR Supplement). AL's from DoE function similar to PPGs (Policies, Procedures, and Guidance) issued by the Department of Defense. 

This particular AL provides guidance to DoE contracting officers who need to make decisions on the allowability of costs charged to Government contracts. It first distinguishes between explicitly unallowable costs as defined in the FAR Part 31.205 and costs that are not explicitly unallowable but may not necessarily be reasonable. Determining whether costs are reasonable requires contractors and contracting officer to exercise judgment. According to the AL, contractor “errors” could fall into the “reasonableness” arena.

The example given in the AL is a situation where a contractor employee rents a car and inadvertently, but contrary to company policy, failed to decline the optional insurance. The cost of the extra insurance would be an allowable cost according to DoE.

The AL also distinguishes between “errors” that happen infrequently and those that happen all the time. If these kinds of errors happen frequently, the cost is no longer reasonable because it is obvious that the contractor does not have an adequate system of internal controls to prevent their occurrence. The AL states:

 If it were possible for a contractor to operate a zero error financial system at no cost, no incurred cost due to error would be allowable because it would be unreasonable. Since this is not possible, the cost-reimbursement contractor and the government must make prudent business judgments about the benefit versus cost of the contractor's financial system. It would not generally be prudent, for example, to spend $100,000 to save $10 in cost.

We believe this is a good policy. It should preclude some of the endless discussions between contractors and auditors/contracting officers about whether certain relatively immaterial costs can be claimed on Government contracts. Although not applicable to other Governmental agencies, it might nevertheless be useful to drag it out to buoy your position, if you find yourself in this situation.

The Importance of Documentation

Once again, we have a case where a contractor's claim for reimbursement was denied due to inadequate documentation. We bring this subject up frequently to underscore the importance of documentation. Just remember, you may be entitled to reimbursement of costs but the Government has no obligation to pay those costs if they are not adequately documented.

In this recent case, the Comptroller General denied a claim for costs where a protestor failed to adeuqately documents its claim and aggregated allowable and unallowable costs such that the allowable portion could not be determined on the basis of the record (or on the basis of avilable documentation). [GAO Decision B-401466.2 dated April 7, 2010]. This case began with an earlier bid protest. The protestor dropped its protest when the Government agreed to pay the contractor's reasonable proposal preparation costs. The GAO cautioned the protestor that costs were only recoverable to the extent that they are adequately documented and shown to be reasonable. Additionaly, the documentation must identify and support the amounts claimed for each individual expense, the purpose for which that expense was incurred , and how the expenses related to the claim.

The contractor submitted invoices for two firms that, according to an affidavit from its managing director, was related to services by the two firms in the preparation of the proposal. However, upon review of the documentation, the invoices indicated a much broader scope of work than just the proposal preparation. It included terms like market, demographic, financial, cost, and assistance. The Government asked for further details including an analysis of the work performed and the correlation between the work and the costs. The contractor was unable to provide this information. As a result, the GAO denied the claim.

GAO concluded that there might have been a portion of the cliamed costs that related to proposal preparation. However, in sutuations such as this one where a protestor has aggregated allowable and unallowable costs and provided insufficient documentation to support the allowable portion, the entire amount must be disallowed.

How to Determine Whether a Cost is Reasonable

One of the overarching criteria for deciding on whether to charge a particular cost to a government contract, either directly or indirectly, is whether it is reasonable in amount. We often mention "reasonableness" in this blog when discussing cost allowability criteria. A couple of days ago, we discussed reasonableness as it relates to bonuses and incentive compensation. Since then, we've been asked how one goes about determining whether a cost is reasonable.

As everyone soon learns, there are no hard and fast standards for determining "reasonableness". It is a highly subjective area and one in which reasonable persons can and do disagree. Contractors, of course will make a broad argument while the Government will take a more limited or restrictive view. Some contractors like to use the New York Times test; how would this look in the news? If the public disclosure of the cost would embarrass the company, they may choose not to claim it. Some situations are obvious. You wouldn't pay executive level salaries to clerical employees and you wouldn't charter a private jet to go to a negotiation conference with the Government. Most disagreements about reasonableness however are in those grey areas where neither side has the compelling argument. Publically held, heavily commercial or fixed price oriented contractors are less risky from the Government's perspective than are contractors with mostly cost-type contracts. The "market place" adds a level of restraint on how a company expends its funds. Closely held companies with mostly cost-reimbursable contracts are higher risk for incurring unreasonable costs because the market forces are not in play. So, what does FAR have to say about "reasonableness"?

FAR 31.201-3 states that a cost is reasonable if in its nature and amount, it does not exceeds that which would be incurred by a prudent person in the conduct of a competitive business. From the Government's perspective, it is the contractor's responsibility to establish that each cost is reasonable. There is never a presumption that a cost is reasonable.

As general guidance, we recommend that contractors consider four questions when deciding whether a cost is reasonable.

1. Is the type of cost generally recognized as necessary in conducting business? The purchase and up-keep of an ocean-going yacht for exclusive use of the company president is not a necessary cost of doing business.
2. Is the cost consistent with sound business practice, law, and regulation, and are purchases conducted on an "arms-length" basis? To pay a premium price for materials on a Government contract while receiving a bargain price for the same materials on a commercial job may not be consistent with sound business practices.
3. Do your actions reflect a responsible attitude toward the Government, other customers, owners, employees, and public at large? Excessive salaries to executives and unconscionable retainers for retired executives as consultants are not acting responsibly toward owners and employees.
4. Are your actions consistent with established practices? If your established practice has always been to perform design work in-house but for some reason you decide to out-source it at a higher cost (and you had available capacity), it would be unreasonable to out-source it.

As you consider these matters, it would also be a good practice to prepare documentation to support your decision making process. If challenged, contemporaneous documentation prepared before the incurrence of the cost will carry much more credibility than documentation prepared at a later date.