Defense Industrial Capability
Each year the Department of Defense issues a report to Congress analyzing the defense industrial base. Here is a link to the 2017 report, released in April 2018. What does the report tell us?
Workforce
61% of the aerospace/defense workforce is over the age of 45. About half the workforce is at traditional retirement age. However, “there is incredible competition to find qualified candidates with the required skills in engineering, manufacturing, and other STEM proficiencies in the market. A&D companies are being faced with a shortage of qualified workers to meet current demands as well as needing to integrate a younger workforce with the ‘right skills, aptitude, experience, and interest to step into the jobs vacated by senior-level engineers and skilled technicians’ as they exit the workforce.” Despite those challenges, the DoD continues to put unreasonable caps on the amount of compensation contractor employees may be paid.
Sector Analysis
The report addressed 10 industrial sectors. We summarize the report into a stoplight chart, based on our interpretation of the sector analyses.
Aircraft Primes: GREEN Lower-Tiers: YELLOW
C4 Primes: GREEN Lower-Tiers: GREEN
ElectronicsPrimes: GREEN Lower-Tiers: N/A
Ground VehiclesPrimes: YELLOW Lower-Tiers: YELLOW
MaterialsPrimes: GREEN Lower-Tiers: N/A
Munitions and MissilesPrimes: RED Lower-Tiers: RED
Radar and Electronic WarfarePrimes: YELLOW Lower-Tiers: RED
ShipbuildingPrimes: GREEN Lower-Tiers: GREEN
SpacePrimes: YELLOW Lower-Tiers: YELLOW
Organic IndustryPrimes: RED Lower-Tiers: N/A
Details can be found in the report (Section 8).
S2T2
We were interested (but not surprised) to note that the Sector-by-Sector, Tier-by-Tier (S2T2) analytical framework has been dropped from the annual report. Once touted as a breakthrough analytical approach, it appears that S2T2 has been relegated to the trash heap of failed bureaucratic initiatives.
Conclusion
If this annual report were not issued, would anything change? We think not.
It Used to Be Called Executive Compensation
It used to be called “executive compensation” and the FAR prescribed limits (at 31.205-6) on how much compensation government contractors could claim as being allowable for the top 5 most highly paid executives at each business segment. The rationale for those allowability limits being, of course, that the government didn’t want taxpayers to fund exorbitant executive salaries.
That notion was turned on its head a few years ago, when the limits on the top 5 executives were applied to all contractor employees. Now the “executive compensation cap” is simply called “contractor compensation cap.” The rationale for applying the limits to all contractor employees is less clear. To the extent there is a rationale, it appears to be along the lines of “nobody should ever think that they will get rich contracting with the Federal government.”
Of course, as defenders of the compensation cap are quick to point out, contractors are free to pay employees whatever amounts they choose; the rules simply limit the amount of such payments that are reimbursable by government customers. If you want to pay more, that’s on you. Which is fine—to some extent—because business owners often choose to reduce profits in order to win business. But we think legislating and regulating compensation limits flies in the face of free market principles—principles upon which this country was allegedly founded. (We don’t know for sure; we weren’t there.)
When a contracting officer determines that a proposed price is fair and reasonable, the “normal” expectation is that, somewhere along the line, that CO is comparing the proposed price to another price. Hopefully there was adequate price competition so multiple bidders’ (“offerors’”) prices can be compared. But that’s not the only price analysis technique; the FAR and agency guidance provides for other methods. The point is: who cares what the contractor is paying its employees if the bottom-line price is fair and reasonable? If the contractor is the low-bidder and wins a cost-type contract—and stays within the original contract price—then why should the government be permitted to force after-the-fact price reductions through a claim that certain elements of cost within that contract price were unallowable? But that’s the way it works.
The statutory and regulatory compensation caps also ignore the competition for top talent. We all know that STEM talent is in high demand. Believe it: contractors start hunting for talent early in a student’s undergraduate engineering career. Engineers and scientists who have the right clearances are in even more demand. The right individual can make or break a multi-billion-dollar development program; why would a contractor think twice about making a huge offer to that person? You’re right: it would be a smart investment.
The compensation caps also ignore the fact that government contractors are in competition with non-government contractors in private industry for that same talent. Google and Apple and Facebook (just to name three) do not have to deal with taking certain portions of compensation out of their profits. (Granted, their pricing isn’t cost-based, but you get the point.) They can easily afford to pay the right person twice the current compensation cap amount—and they do. Reportedly, “Angela Ahrendts, Apple’s senior vice-president of retail and online stores, … took home US$24.2 million in 2017, according to Apple company filings.” That’s salary, not total compensation. With stock thrown in, you can triple that amount. How can government contractors compete with that level of compensation? You’re right; they can’t.
And do not forget that simply paying employees less than the compensation caps is no guarantee that the compensation will be found to be allowable. Government auditors tend to examine compensation for “reasonableness.” If they determine that your compensation—at whatever level—is unreasonable, then they will question it and ask the CO to disallow it. The audit methodology is often flawed and the results are often similarly flawed; but it frequently costs more to litigate than the issue is worth. Contractors that choose to litigate tend to win, but most choose to settle.
The Bipartisan Budget Act (BBA) established a compensation cap of $487,000—as applied to all employees. But that law didn’t (and couldn’t) retroactively apply the cap to contracts awarded before it went into effect. Thus, contractors have had to contend with implementing multiple caps on multiple groups of employees for some time. They have been calculating “blended” caps in an effort to have one set of rates for all government customers.
Critically, the BBA also required that the ceiling be escalated annually, based on changes in the Employment Cost Index for all workers as calculated by the Bureau of Labor Statistics (BLS). But the Federal government didn’t follow the law’s requirements: no escalated values were ever published. Savvy contractors have been escalating the cap on their own, using the appropriate BLS index. But many upon many contractors are not so savvy or well-informed, and they’ve been using the $487,000 cap for years—leaving money on the table.
Recently, the White House published escalated compensation caps. You can find the link here. Here’s a summary of the cap to be applied to each calendar year. If your fiscal year is other than a calendar year, you will need to “blend” the caps appropriately.
CY 2015: $487,000
CY 2016: $500,000
CY 2017: $512,000
CY 2018: $525,000
If you want to know some of the historical caps (because you have contracts awarded before June, 2014) then follow this link.
In summary, the whole idea of hobbling government contractors by forcing them to choose between either underpaying employees when compared to the marketplace or paying the going rate but taking the difference from profit is a bad idea. It ignores free market principles and the power of competition to shape contract prices.
But until something changes, then this is the compensation compliance regime that government contractors have to live with. If you have to comply, you should know the details and be prepared to support your claimed compensation amounts in an audit.
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GFY 2017 DCAA Report to Congress
Dated March 31, 2018, DCAA’s annual report to Congress was released for publication on May 27, 2018. No word on why it took two months to approve release to the taxpayers, the people that DCAA ostensibly serves.
And that’s about as snarky as we want to be. Let’s try reporting the rest of the story by sticking to the facts.
Facts:
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Audit sustention rate (incurred cost audits) = 28.7%
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Audit sustention rate (forward priced proposals) = 66.2%
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Audit sustention rate (all other audits) = 42.4%
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Incurred cost backlog now at 2,860, which DCAA estimates to be a 14.3 month backlog. Based on GFY 2017 progress, DCAA estimates that it will have eliminated the backlog completely by the close of GFY 2018. As part of closing-out incurred cost years, DCAA disposed of 3,358 contractor proposals by "memo;" while 1,901 years were closed for "other reasons"--which included contracting-out of audits by non-DoD agencies.
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DCAA estimates that it will have eliminated the incurred cost backlog by GFY 2018, even though it is taking (on average) 808 days to complete an incurred cost audit and issue a report. But that metric is old math; in the old math scenario the clock starts ticking when the contractor’s proposal is received. Using the new math metric, it only takes DCAA 143 days from the time the audit starts to the time the audit report is issued. So: 143 days it is. That’s much faster.
Nothing more to report about the annual report.
LOGCAP Oversight Lacking?
 The proximate cause for many of DCAA’s audit-related problems are the audits of the LOGCAP (Logistics Civil Augmentation Program) contracts in 2007 and 2008. DCAA showed up late to the party and made up for it by taking a hard line with LOGCAP contractors (primarily KBR but also others), questioning millions (if not hundreds of millions) of costs incurred and also asserting that the majority of those contractors’ business systems were inadequate—allegedly leading to fraud, waste, and abuse.
More than a decade later, we still feel the ripples from those stones thrown in the government contracting pond. The Contractor Business Systems oversight regime sprung from that source. The backlog of unaudited contractor final billing rate proposals sprung from that source. DCAA’s relative lack of CAS-related audits and post-award (defective pricing) audits sprung from that source. DCAA’s “risk-based” audit approach (designed to “risk away” small dollar value audits in favor of larger dollar value audits) sprung from that source. Putting DCMA in charge of reviewing contractor Disclosure Statements sprung from that source.
It all started with LOGCAP contractors and it continues to this day.
The DoD Office of Inspector General (DoD OIG) released an audit report on May 11, 2018 that reminded us of the old days of DCAA LOGCAP audits. In audit report DODIG-2018-119, the DoD OIG reported several headline-worthy assertions, including:
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Army Contracting Command and Defense Contract Audit Agency (DCAA) officials did not adequately monitor all 128 LOGCAP IV vouchers submitted from 2015 to 2017 for questionable and potentially unallowable costs
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DoD policy established DCAA prepayment reviews as the sole method of voucher oversight prior to payment; however, prepayment reviews are cursory reviews not sufficient for preventing reimbursement to the contractor for all potentially unallowable costs
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The Army paid all 128 LOGCAP vouchers the LOGCAP contractors submitted from 2015 to 2017, valued at $2.4 billion, with little or no examination of the supporting documentation. We [DoD OIG] identified at least $536 million of the $2.4 billion billed on vouchers that were supported by questionable documentation that warranted further analysis
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We also identified $422,825 in costs that, based on the description of the costs in contractor’s accounting data, may not be allowable
Wow. That’s a whole lot of assertions, right?
Well, not really. Much like the DCAA assertions from a decade ago, when examined more closely the DoD OIG audit findings are more headline material than anything else. Let’s look closer:
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Worst case: contractors submitted $2,400,000,000 in costs for reimbursement, of which $536,000,000 “warranted further analysis.” Not that the costs were improper or unallowable, just that somebody should have looked harder at them. That’s about 22 percent of all costs incurred—a very high number.
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When looking at the $536,000,000 value, DoD OIG admits the truth: the value is comprised of 2,531 individual transactions that “did not contain sufficient detail for us to determine how the contractor calculated the costs.”
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In fact, DCAA had already reviewed those costs and understood them, even though the DoD OIG auditors did not. The report stated “According to DCAA officials, the contractor did not intend these line items to be literal representations of the costs claimed in the contractor’s voucher. DCAA officials stated that the contractor clustered these line items, and thousands of similar line items in the contractor’s billing support, under one employee identification number. DCAA officials explained that the contractor billed in this manner to reduce the number of files attached to the vouchers. However, the contractor’s presentation of cost data in such a manner lacks transparency and reduces contracting and auditing officials’ ability to determine whether costs are allowable.” So the 2,531 transactions were in fact summaries of thousands upon thousands of other accounting transactions, summarized for ease of reviewing.
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As readers likely know, contracts contain billing instructions. Indeed, DCAA has an entire audit program (17390) dedicated to “contractor compliance with billing instructions.” Had the contracting activity wanted the contractors to provide additional detail for certain contractor costs, it had ample opportunity to do so. If those contractors were now to be asked to comply with modified billing instructions, in our view those contractors would be entitled to an equitable adjustment of the contract price (including fee) for doing so.
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But modifying the contracts is exactly what the DoD OIG recommended be done. The report stated, “To ensure that future vouchers include supporting documentation that accurately represents the nature of the claimed cost, ACC-RI should modify the LOGCAP IV contract to require contractors to submit transaction-level accounting data that accurately represents the costs billed on vouchers in iRAPT.”
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With respect to the $422,825 in potentially unallowable costs, the report stated, “The Defense Contract Audit Agency Director … stated that the Defense Contract Audit Agency did not find any significant unallowable costs during its review of the $422,825 in costs we identified as potentially unallowable.”
Thus, much like the DCAA audit reports and testimony of a decade ago, the DoD OIG audit report is full of attention-grabbing headlines, but not much else.
Left unstated in the report is the fact that these were all interim payment vouchers. In other words, they were not final payments; they were interim payments and subject to subsequent review. In fact, in addition to the 17390 audit mentioned above, DCAA has the 10100 (audit of incurred costs) and the 10180 (Iraq direct cost testing) and the 11015 (testing of paid vouchers) audit programs available to be used on these contractor vouchers.
The DoD OIG didn’t mention the additional controls available to the contracting officer and contracting activity, possibly because doing so would have detracted from the headline-worthiness of the findings.
It feels like déjà vu all over again.
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