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

Entertainment vs. Employee Morale

Yesterday we discussed a recent ASBCA (Armed Services Board of Contract Appeals) decision where the judge sided with the Government on the question of whether certain costs included in an annual incurred cost submission, were specifically unallowable under FAR cost principles. Claiming those costs resulted in the imposition of penalties and interest. There are other aspects of the decision that are instructive for contractors in identifying unallowable costs.

There were five items of cost involved in this case. Four of those were questioned by the auditors as unallowable entertainment (FAR 31.205-14). The contractor claimed that these costs were incurred to improve employee morale, fitness and teamwork and therefore unallowable under FAR 31.205-13 (Employee Morale). These expenses included executive membership to a private club, concert tickets, flowers, and a Christmas party (that included alcohol). The ASBCA did not buy these "employee morale" arguments.

These two cost principals, employee morale (FAR 31.205-13) and entertainment (FAR 31.205-14) need to be considered in concert when deciding whether costs are allowable or not. From the Government's perspective, if the cost do not meet the narrowly defined activities included in employee morale cost principle, they will be inclined to categorized the costs as unallowable entertainment.

The DCAA Contract Audit Manual (DCAM) is quite emphatic, stating it this way:

By statute, entertainment costs are expressly unallowable, without exception. Consequently, the entertainment cost principle at FAR 31.205-14 takes precedence over any other cost principle.

DCAM further states:

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.

If the Government can find a way to classify a cost as entertainment, it will do so. Sometimes, however, they are not correct in their assessment. The arguments proffered by the contractor in this case, seem sophomoric and doomed from the start. However, contractors should not be dissuaded by this case from claiming costs that are truly expenses related to employee morale.

You can read the full ASBCA decision here.