The allowability of contractor executive compensation is a complex, tricky, thing—made more tricky by recent statutory and regulatory changes. We have written about some of those recent changes before.

At this point, the average contractor must handle three separate rules that each establish separate limits on allowable compensation. Some contracts are subject to the “old” executive compensation ceiling of $952,308, as applied to the Top 5 most highly compensated individuals in each segment. Other contracts are subject to the “old” ceiling as applied to all contractor employees (not just the Top 5). Still other (newer) contracts are subject to a lower compensation ceiling of $487,000, as applied to all contractor employees. The ceiling on allowable compensation depends on when the contract was issued and its effective date, because it is the FAR Part 31 cost principle language in effect on that effective date that establishes the applicable ceiling.

Based on the foregoing, it would seem logical that each contractor must establish three different sets of billing rates, based on those three different sets of allowability rules, and then apply the appropriate set of billing rates to the appropriate contract, based on establishing each individual contract’s effective date.

That seems to be a problematic approach, right? Think about it:

Three compensation allowability calculations.

Three sets of provisional billing rates.

Three sets of final billing rates.

And then you have to know which set applies to which contract. The forward pricing part might seem to be relatively easy to handle, because all new contracts will be subject to the most restrictive (lowest) compensation ceiling. Even so, the interim (provisional) billing rates for 2014 and beyond will have to account for the fact that there are several groups of contracts, each with its own allowability criteria. The same is true for the final (actual) billing rates for 2014 and beyond.

Think that’s tough to implement? Maybe so. In fact, we’ll assert that it is so. But that’s what seems to be called for by the regulations.

The whole situation seems more than a little risky. You had better not make any mistakes. At a minimum, DCAA might allege that you billed expressly unallowable compensation costs, or that you included expressly unallowable compensation costs in your proposal to establish final billing rates. There are penalties and interest payments associated with expressly unallowable costs.

If you prepare your forward pricing rates (or calculate estimated indirect rates in your cost proposals) and you don’t exclude the right amount of executive compensation, then you might be accused of submitting certified cost or pricing data that was not accurate – which would be a violation of what used to be called “TINA”.

It’s possible (though perhaps unlikely) that somebody might allege some kind of violation of the False Claims Act – i.e., that the contractor intentionally or negligently overbilled the government). That would be a bad thing, very bad.

This situation cannot be what the lawmakers intended when they lowered the allowable executive compensation ceilings, can it? Is this really what government contractors have to do in order to comply with the regulatory requirements?

Sure, over time the issue will take care of itself, as the proportion of contracts subject to the various (higher) compensation ceilings work themselves out (i.e., you burn off your backlog). But that could take years, depending on the contracts’ various periods of performance. In the meantime, contractors seeking to comply with the cost principle are going to have a challenge, to say the least. It’s going to take additional resources and take additional time to calculate indirect cost rates. It’s going to take additional resources and take additional time to support those calculations through the inevitable audit. It’s going to cost contractors money at a time when budget concerns are in the forefront of the minds of the buying activities. It’s going to cost contractors money at a time in which Congress and Pentagon leaders are trying to reduce the regulatory burden imposed on contractors in order to reduce unnecessary overhead costs and make doing business with the DOD more enticing.

It’s the wrong thing at the wrong time, but there’s nothing to be done about it … is there? Is there anything a contractor can do to comply with the spirit of the cost principle without having to comply with its literal compliance requirements? It would seem not.

It is what it is.

A contractor has to comply and that’s going to be a pain and there’s nothing that can be done about it.

Unless …

Unless DOD comes up with an acceptable approach that minimizes the bureaucratic burdens while permitting contractors to demonstrate compliance with the requirements of the cost principle.

Unless there is some mathematical means of blending all those individual compensation disallowances together, so as to create a single weighted average rate that, when applied to all active contracts, would be acceptable to both contractors and to the DOD.

Oh, wait. There is such a methodology and DOD has endorsed it.

Here’s a link to the official endorsement.

Now the thing is, this DOD-approved methodology is not a panacea. It only applies to DOD contracts and it requires an advance agreement. So contractors may have to have a DOD set of blended rates and a non-DOD set of multiple rates to apply to each civilian agency contract. That still kind of sucks. But if you are a Pentagon contractor and DCAA is your audit agency, this newly approved approach provides an opportunity for you to streamline your rate calculation processes.

But it requires an advance agreement.

We were tempted to opine that the advance agreement is unnecessary, because why would you need an advance agreement to follow the methodology that DOD has already approved? But then we did some research, and we noticed that DCAA does not approve of the “blended rate” approach to excluding unallowable executive compensation. In point of fact, the DCAA CAM (October 2014 edition) states:

Under the blended rate method, the blended rate is applied to both cap-covered and noncovered contract work. This is in violation of Title 31 of the United States Code, section 1301(a), herein referred to as the Purpose Statute, and section 1341(a)(1), herein referred to as the Anti-Deficiency Act. Section 1301(a) (Purpose Statute) requires that appropriations shall be applied to the objects for which the appropriations were made. Section 1341(a)(1) (Anti-Deficiency Act) places limitations on officers or employees of the United States Government expending and obligating amounts exceeding amounts available in the appropriation. Both sections would be violated at most contractor locations since use of a blended rate would result in a predominant misallocation of the unallowable compensation credit to the contract work that is not subject to the cap or authorized by the appropriation.

If contractors do not carry out or expand their blended rate calculation to an appropriate number of decimal places, the impact of the unallowable compensation may not be significant enough to lower the G&A rate. As a result, unallowable compensation costs will not be recovered by the Government.

[CAM Ref. 6-414.9]

Based on the foregoing – and unless DCAA changes its position in response to the official Pentagon policy change – your DCAA auditors are going to question your use of the blended rate methodology and they are going to assert those costs are expressly unallowable. Your executed advance agreement should act to ensure that those questioned costs are not sustained by your cognizant ACO. Consequently, it seems very prudent indeed to execute that advance agreement called-for by the DOD guidance.

Assuming you are going to go forward with the approved blended rate methodology, it is going to be a complicated calculation. As we see it, here are the key steps inherent in the process endorsed by DOD:

1. Establish a list of all employees whose total compensation, as defined by 31.205-6(p), exceeds the compensation cap of $487,000. Determine the aggregate total amount of unallowable compensation in accordance with the cost principle. Hopefully the unallowable compensation will be limited to the G&A expense pool. If not, apportion the unallowable compensation between all affected indirect cost pools.

2. Establish a list of all employees whose total compensation, as defined by 31.205-6(p), exceeds $952.308. Determine the aggregate total amount of unallowable compensation for those individuals. Hopefully you will have less than five such individuals. If not, you will have to develop two pools of unallowable compensation costs: one pool for the “Top 5” individuals and another pool for the total population. Hopefully the unallowable compensation will be limited to the G&A expense pool. If not, see Step 1.

3. Identify all cost-reimbursement contracts that were (or will be) awarded after June 24, 2014, It is expected that the vast majority of those contracts affecting 2014 have already been bid (i.e., they are near-firm backlog). These contracts are subject to the compensation limits you identified in Step 1.

4. Identify all cost-reimbursement contracts awarded prior to June 24, 2014. (These are firm backlog contracts as of that date.) Those contracts are subject to the compensation limits you identified in Step 2. (Remember you may have two groups based on those contracts that are subject to “Top 5” limits and those for which all employees’ compensation must be evaluated.)

5. For all contracts, estimate G&A expense allocation base dollars to be incurred for those contracts. (If another indirect cost pool is affected, you may need to identify the allocation base dollars (e.g., direct labor dollars) of all affected indirect cost pools.) Extend those values out, year-by-year, for the length of those contracts’ periods of performance, as backlog is burned to zero. Adjust for expected contract modifications (e.g., authorized but currently unpriced work). Where necessary, use out-year Business Development forecasts to estimate the G&A allocation base dollars by contract. As before, if other indirect cost pools are affected, then you will have to identify the affected allocation bases of those pools, year-by-year.

6. Aggregate the G&A base dollars by contract groups. Do a check to make sure that, when you add the G&A allocation base dollars together and then look at the G&A allocation base dollars from all other contract types (e.g., FFP or T&M), you get your total forecasted G&A allocation base. If you don’t, then figure out where you went wrong and do the math again. Note that if you have a high percentage of T&M contract work, you may want to add that type to the cost-reimbursable contracts, because the “M” part of the T&M contract may be absorbing a material amount of your allocated G&A expense dollars.)

7. Calculate a ratio of each contract group’s G&A allocation base dollars to the total G&A allocation base dollars. (Do the same for other affected indirect cost pools, if you have any.) Assuming the G&A expense pool is the only pool where you have unallowable executive compensation, you should have three ratios.

   1. Ratio of cost-type contracts subject to the high limit, Top 5 population.

   2. Ratio of cost-type contracts subject to the high limit, total employee population.

   3. Ratio of cost-type contracts subject to the low limit, total employee population.

8. Multiply the ratios you calculated in Step 7 to the appropriate pool of unallowable costs you identified Steps 1 and 2. The results of that multiplication will be your unallowable executive compensation costs.

9. Add the three results together and credit your G&A expense pool.

10. Calculate your DOD G&A expense rate (total claimed G&A expense pool over total G&A allocation base).

Or you can just have three sets of rates and apply them to the appropriate contracts, based on each contract’s effective date. It’s your choice.

But if you are one of those contractors whose ERP system does not easily support multiple billing rate tables, you may have less of a choice than you think.

There are many reasons to criticize the process by which the Defense Contract Management Agency establishes what it considers to be acceptable Forward Pricing Rates for defense contractors to use in bidding contract awards. There are many reasons to use as the basis of criticism, and we’ve not been shy about offering them on this blog.

The process is too bureaucratic. It has too many layers of oversight and review. It takes too long. By the time the government’s position is issued, the contractor has often already submitted a new set of Forward Pricing Rates. The process often results in rates that are arbitrarily – some might say punitively – low, with insufficient justification for the ACO’s position. The differences between the contractor’s position and the government’s position often leads to protracted and adversarial negotiations between the contractor and the buying activity.

As you can see, there are many reasons to criticize DCMA’s existing process. And now the Department of Defense Office of the Inspector General has found a couple more reasons to criticize the process.

The thing is, we believe the DOD IG’s criticisms are inapt. We believe that the IG’s recommended process improvements, if implemented by DCMA, would tend to exacerbate the existing issues in the problematic process rather than improve the process. The DOD IG’s recommendations will neither streamline the process nor result in issuance of more timely Forward Pricing Rates. The DOD IG’s recommendations will neither reduce costs nor increase efficiency. Quite the contrary, actually.

As we see it, the DOD IG would like to take the existing process with all its problems, and make those problems worse. The DOD IG would like to slow down the process and make it more bureaucratic. The DOD IG would like the ACO’s to “paper the file” more so as to aid in more management oversight and review.

What are we talking about?

Allow is to quote from the DOD IG summary of findings, pulled from the audit report summary—

[Current] DCMA policy does not adequately address Federal Acquisition Regulation (FAR) requirements to (1) perform cost analysis to establish fair and reasonable forward pricing rates, (2) tailor the requests for audit services, and (3) document a contract case file.

Let’s take those three findings (and concomitant recommendations) one at a time, shall we?

1. Current DCMA Forward Pricing Rate policy does not adequately address the FAR requirement to perform cost analysis so as to ensure that the indirect rates established are “fair and reasonable.” We do agree that “fair and reasonable” is the goal, though of course we rarely experience achieving that goal. Instead, we too often see Forward Pricing Rates established lower than the contractor would like, so as to “protect the Government’s interest.” Regardless, the IG would like DCMA ACO’s to perform cost analysis on the contractor’s Forward Pricing Rate Proposal (FPRP) because performing that cost analysis is better than not performing it.

The DOD IG provides a beautiful example of circular logic in its rationale. According to the IG, FAR 42.1701(b) “requires that the ACO shall obtain the contractor’s forward pricing rate proposal and require that it includes cost or pricing data that are accurate, complete, and current as of the date of submission.” Because the contractor is submitting cost or pricing data, FAR 15.404-1(a)(3) “requires that ‘cost analysis shall be used to evaluate the reasonableness of individual cost elements when certified cost or pricing data are required.’”

Basically, the IG said that because the DCMA required contractors to provide cost or pricing data in support of their FPRPs that meant that DCMA was required to use cost analysis to evaluate the contractors’ submissions. Had the DCMA not required cost or pricing data, then no cost analysis would have been required. Had the DCMA not required cost or pricing data then it would have been free to evaluate the FPRPs in any which way it chose to do so. Forget the purpose of Forward Pricing Rates; forget why cost analysis is to be used: if you have cost or pricing data then you are negligent unless you use cost analysis to evaluate the data. That was the DOD IG’s position on the matter.

Now the first problem we have with the IG’s position is that FAR Part 15 does not apply to contractors’ FPRPs. The scope of FAR Part 15 (which is established at 48 CFR § 15.000) clearly states that “This part prescribes policies and procedures governing competitive and noncompetitive negotiated acquisitions. A contract awarded using other than sealed bidding procedures is a negotiated contract (see 14.101).” A proposal to establish a Forward Pricing Rate Agreement (FPRA) is not an acquisition.

It’s not an acquisition because the FAR defines the term “acquisition” at 2.101.

‘Acquisition’ means the acquiring by contract with appropriated funds of supplies or services (including construction) by and for the use of the Federal Government through purchase or lease, whether the supplies or services are already in existence or must be created, developed, demonstrated, and evaluated. Acquisition begins at the point when agency needs are established and includes the description of requirements to satisfy agency needs, solicitation and selection of sources, award of contracts, contract financing, contract performance, contract administration, and those technical and management functions directly related to the process of fulfilling agency needs by contract.

Since no appropriated funds are being used to acquire goods or services when an FPRP is being evaluated and negotiated, the process is not an “acquisition” as that term is used in the FAR. And since the process by which an FPRP is turned into a FPRA (or FPRR) is not an acquisition, you can’t apply the policies and procedures for evaluation of an acquisition to that process.

It doesn’t matter what FAR 15.404-1(a)(3) says because FAR 15.000 says it’s not applicable. The DOD IG’s position is illogical. It doesn’t parse. So right off the bat, we have a problem with the IG’s findings and recommendations.

Because the DOD IG starts off from an inapposite premise, its further discussions of the analysis of detailed “elements of cost” are worthless.

That didn’t stop the Director, DCMA, from concurring with them.

That’s right. Instead of pushing back, the Director of the Defense Contract Management Agency agreed with the DOD IG’s inapt reading of the FAR and the circular reasoning it used. According to the IG report, DCMA revised Instruction 130 to “address the requirement to perform cost analysis.” In addition, the revised Instruction “also includes the mandatory use of two checklists that were developed in order to incorporate the DoDIG findings: the FPRP Adequacy Checklist and the FPRA Review Checklist.”

2. According to the DOD IG, if DCMA ACOs would only “tailor” their requests for DCAA field pricing assistance, then DCAA could provide more timely and better input into the FPR negotiation process.

As the DOD IG noted, current DCMA policy establishes that FPRRs are to be established within 30 days of receipt of a contractor’s FPRP, and that FPRAs are to be established within 60 days of receipt. Those deadlines are—shall we say?—difficult to meet. Extremely difficult. When DCAA performs an audit of a contractor’s FPRP, those deadlines become impossible to meet.

According to the IG report, DCAA takes at least 163 days (5 months) to perform an audit of a FPRP, and its average turn-around time is 189 days (more than six months). (We note that the 2013 average of 189 days is up from the 2012 average of 177 days). Basically, any ACO that relies on DCAA for input into the FPRP evaluation process has just guaranteed that the agency deadlines will not be met. As a result—and as we’ve reported—DCMA has decided to move on without DCAA and has directed its ACOs to evaluate and negotiate Forward Pricing Rates without waiting for DCAA. That sounded like a pretty good decision to us.

Not so fast, according to the DOD IG.

According to the IG, the problem is not DCAA. The problem is DCMA ACOs. The ACOs are not “tailoring” their audit requests so as to permit DCAA to issue their audit reports in time to meet the DCMA deadlines. Use of tailored requests for field pricing assistance can also “help the ACO conduct cost analyses while obtaining the minimum essential supplementary information required for the job.”

We have long thought DCMA and, indeed, the DFARS and PGI, needed more guidance in the area of field pricing assistance. We told the DAR Council as much in the early days of the Proposal Adequacy Checklist. They didn’t listen to us. Accordingly, we can hardly take issue with a recommendation that guidance in that area is lacking.

Moreover, we tend to agree that ACOs should figure out where they want DCAA to help them out, and then ask for help in those areas and nowhere else. We don’t think “tailoring” the audit request will lead to audits being issued in 30 or even 60 days, but it couldn’t hurt.

The foundational premise is that DCAA will listen to the DCMA ACO and scope their audits just to the areas requested. We believe that’s a fairly large assumption. In our experience, DCAA auditors are very sensitive (or should be) to having their audit scopes “limited” or interfered with in any way. We are not optimistic that DCAA will accept the audit “tailoring” that the DOD IG advocates. This may well be a paper recommendation with little if any teeth.

In all honesty, we don’t think this recommendation is going to help, but we don’t think it’s going to hurt either. So why not go with it?

And that is the tack chosen by the Director, DCMA, in the response to the IG audit report. The report stated—

The Director, DCMA, concurred in principle. DCMA identified two obstacles that, in its opinion, could prevent implementation of FAR 15.404-2(a)(1) at this time. First, DCMA stated it cannot dictate or restrict the DCAA auditor’s scope and procedures. Second, the Director stated that DCAA will currently not agree to a tailored request if it needs to rely on work performed by DCMA. DCMA pointed out that it is conducting a pilot project involving the DCMA cost monitoring program to in part evaluate the feasibility of DCAA accepting a tailored audit request. DCMA stated it will amend its policy, as appropriate, based on the results of the pilot.

As we read the foregoing, it seems to say that DCAA cannot (or will not) rely on any cost analysis performed by DCMA. Consequently, DCAA has to perform the entirety of the audit steps its audit program calls for. As a result, DCAA will do what it wants and take as long as it needs. Until DCAA changes its policy, DCMA is stuck. DCMA needs to either wait for DCAA’s audit report or move ahead without DCAA.

Makes sense to us.

3. According to the DOD IG, the current DCMA record management policy does not require the ACO to document and include the cost analysis of contractor FPRPs in a “case file”. Similarly, the ACO is not required to retain information related to “the determination of fair and reasonable prices.” The standard Pre-Negotiation Memorandum (PNOM) does not require a reference to the cost analysis techniques and procedures performed by the ACO. And other similar stuff.

Well, assuming that a cost analysis had to be performed, it would obviously be nice to document and discuss the analytical techniques performed. Unfortunately for the DOD IG, the FAR does not require such cost analysis. So this is pretty much a very big moot point.

Regardless of our position, the Director, DCMA, concurred. DCMA Instruction 130 was revised to address the DOD IG’s concerns.

Why did the Director, DCMA, concur instead of pointing out what we pointed out?

It was probably the path of least resistance.

And so now DCMA ACOs have more work to do, work that is not required by the FAR, but is now required by DCMA Instruction 130.

Good luck with that.