(Editor’s Note. This is the last article of a three part series on executive compensation. Like the first two, (1) recent caps on executive compensation and (2) allowability of specific compensation costs, this article is based on an article by Karen Manos of the law firm of Hourey & Simon and also incorporates some of our experience as former DCAA auditors.)
In addition to specific caps imposed in recent years, five general criteria of allowabililty and pronouncements on specific elements of compensation we discussed in prior articles, the government requires compensation for personal services to be "reasonable". We will address what government considers "reasonable" and how their assertions may be disputed.
Reasonable Factors
For compensation cost to be considered reasonable, (1) compensation "in total" must be reasonable and (2) each of the allowable elements of the compensation package must also be reasonable.
In general, the Federal Acquisition Regulation provides the prudent person rule: "if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business." Reasonableness is to be determined on a case-by-case basis and factors to be considered include: (1) whether the cost is recognized to be "ordinary and necessary" " for conduct of its business (2) results from sound business practices conducted at arm-length and (3) does not significantly deviate from contractors' established practices.
In addition to the above general factors COs are instructed to consider "other relevant factors" such as (1) general conformity with the compensation practices of other firms of the same size (2) firms in the same industry (3) firms in the same geographic area (4) firms engaged in predominately non-government work and (5) cost of comparable services that are obtainable from outside sources.
Though the regulations give the contractor the discretion to determine which of the above factors are relevant, FAR 31.205-6(b)(1) states the "appropriate factors are representative of the labor market for the job being evaluated". Therefore, for example, if the firms competing for a contractor’s top executives are larger, national corporations in the same industry, the compensation practices of those firms might be more relevant than comparable practices of companies of the same size or in the same geographic areas.
Government Scrutiny
The cognizant ACO is generally responsible for reviewing compensation and usually delegates this task to audit agencies, most notably the Defense Contract Audit Agency. Whereas DCAA used to have dedicated compensation teams where auditors were trained to analyze and evaluate compensation, budget cots have eliminated these teams. The result is that auditors now evaluate compensation along with other costs and we find highly divergent skills, opinions and findings not only across DCAA offices but often within offices depending on a particular auditor’s judgement.
Generally scrutiny is heightened when (1) compensation is paid to individuals whose decisions are not subject to much control because of their position in the company such as closely-held corporations, partners, sole proprietors and members of immediate families (2) major revisions are made to existing compensation plans (3) compensation levels are not subject to normal competitive constraints (e.g. contractor is a sole source supplier) and (4) compensation is in excess of the amount deductible under IRS rules.
For large businesses (previous years negotiated government sales exceeded $50 million) DCAA’s policy is to conduct separate compensation system reviews on a periodic basis. For smaller contractors, DCAA will usually include review of compensation as part of their incurred cost or forward pricing audit. In either review, DCAA will evaluate both the reasonableness of total compensation as well as each element of the compensation package. If either exceeds 10% of what is considered reasonable, DCAA will disallow the cost without adequate justification. Once questioned, it becomes the burden of the contractor to demonstrate the reasonableness of the item(s) in question.
Use of Salary Surveys
Salary surveys are, by far, the most commonly used method of determining reasonableness of compensation. Surveys are a double-edged sword – just as government can use them to challenge reasonableness so can contractors use them to defend against such challenges. There are three sources of salary surveys that can be used: (1) published commercial surveys (2) private surveys available to participating companies and (3) contractor self-conducted surveys.
A recent case (Techplan Corp., ASBCA 41470) has provided a primer on use of surveys:
1. Determine the position to be evaluated.
2. Identify survey(s) of compensation for the position which matches the company in terms of the revenue, industry, geographic location and other relevant factors.
3. Update the survey to common data point for each year through use of escalation factors.
4. Array the data such as average, mean or selected percentiles.
5. Determine which of the numbers to use for purposes of making comparisons.
6. Apply a range of reasonableness such as 10% to the numbers being compared.
7. Adjust the actual total cash compensation for lower than normal elements of the executive’s compensation package.
8. Compare the adjusted compensation to the range of reasonableness.
If the government deviates from this guidance they should be reminded of this recent case.
Common Disputed Areas
Identification of Position. It is important to consider not only the position title but also the executive’s duties and responsibilities. In the case cited above, it was decided the CEO was responsible for a wide range of duties closer to that of an owner-officer.
Selecting Appropriate Survey. You should be careful to select the most appropriate factors – such as size, revenue, industry, geographic area, private vs. publicly held – that are relevant to your organization’s labor market. If a contractor competes for executives with other firms in the same geographic area then the same geographic area surveys should be used. Cases have established or rejected certain criteria such as (1) rejecting companies’ compensation in different years than those in dispute (2) rejecting local university wages when it was determined the firm competed against nationwide diversified companies and (3) a survey comparing primarily government contractors was of "dubious" value to a contractor whose business was primarily commercial.
The absence of skilled compensation auditors we discussed above frequently results in quite unusual findings that must then be disputed. For example, one of our non-profit clients competing for highly skilled technical professional executives in Silicon Valley had their compensation levels significantly questioned by auditors that used a general "Not-for-Profit" organizations survey that was heavily based on lower paying social services organizations. Lack of available resources by government often take unrelated surveys (for example only large firms) and creatively "project" down a linear curve the appropriate salary for a small firm. Though questionable, such assertions put the burden on the contractor to refute.
Appropriate Percentile. Selection of appropriate percentile often significantly affects the result. In the Techplan case mentioned above, it was decided the 75th percentile rather than average or mean was appropriate because of the high growth rate of the organization. Similarly, in another case, the Board held it was inappropriate to arbitrarily assign a midpoint without considering such factors as growth and financial performance of the firm. Interestingly, DCAA recognizes that a "superior performance" in terms of financial performance can justify a higher percentile with the understanding DCAA expects a lower level if performance falls below average.
Range of Reasonableness. DCAA recognizes a fixed range of 10% and contractors can expect them to question the excess. In spite of DCAA, the Boards have ruled evaluation of compensation is "not an exact science" indicating the range can vary. In one case, 30% above average was permitted while in another a 70% range was rejected.
{TAG_FORM_TITLE}
To discuss your needs, contact Bill Lennett, Principal, at 1-925-362-0712 or email him at
This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
.
