Cost Reasonableness and Compensation Cost Update

McKenna Government Contracts, continuing excellence at Dentons

PCI Financial Forum

Cost Reasonableness and Compensation Cost Update

September 8, 2015

Steven M. Masiello

Gale R. Monahan


Agenda

• Cost Reasonableness

• Overview

• Trends and Issues

• Best Practices

• Compensation Cost Reasonableness

• Compensation Costs Generally

• Trends and Issues

• Select Compensation-Related Rules

• Fair Labor Standards Act

• Service Contracts Act

• Davis Bacon Act

• Executive Orders

2


Cost Reasonableness Overview

• Why is cost reasonableness important?

• Reasonableness is a component of cost allowability

• Under cost reimbursement contracts, government only pays allowable costs

• If a fixed price solicitation requires certified cost or pricing data, only allowable costs

may be used to develop/support price

• Including unallowable costs in vouchers or certain proposals may:

• Result in cost disallowances

• Result in system disapproval

• Subject contractors to penalties for expressly unallowable costs

• Cause fraud allegations

3


Cost Reasonableness Overview (cont.)

• What makes a cost reasonable?

• “A cost is reasonable 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” – FAR § 31.201-3

• Reasonableness considerations

• Is the cost ordinary and necessary for the conduct of the contractor’s

business or contract performance?

• Is the transaction consistent with:

• Generally accepted sound business practices

• Arm’s-length bargaining, and

• Federal and state laws and regulations

• What are the contractor’s responsibilities to the government, other customers,

the owners of the business, employees, and the public?

• Has the contractor significantly deviated from established practices?

4


Cost Reasonableness Overview (cont.)

• What makes a cost reasonable (cont.)?

• No presumption of reasonableness for costs incurred

• Subject-specific guidance contained in cost principles; e.g.,

• FAR § 31.205-6 (compensation)

• FAR § 31.205-46 (travel)

• Historically, the government has focused on contractor processes/

procedures

• Methods of contractor performance and business decisions (and resulting costs)

typically not second guessed

5


Trends and Issues in Cost Reasonableness

• Government Evaluation of Contractor Cost Reasonableness

• Kellogg Brown & Root Servs., Inc. v. United States, 728 F.3d 1348 (Fed. Cir.

2013); Kellogg Brown & Root Servs., Inc. v. United States, 742 F.3d 967, (Fed.

Cir. 2013), cert. denied, 135 S. Ct. 167 (Oct. 6, 2014)

• Contractor Discretion

• Old Rule (e.g., Boeing Aerospace Operations, Inc., ASBCA Nos. 46274,

46275, 94-2 BCA ¶ 26,802)

• “Costs may not be disallowed on the basis of unreasonableness if the contractor has

acted within the scope of its discretion in a nonarbitrary manner.”

• Government may not substitute its judgment for that of the contractor

• KBR Decisions

• Courts are permitted to evaluate not only the process, but also employee decisions

made implementing the process

6


Trends and Issues in Cost Reasonableness (cont.)


• KBR (cont.)

• Standard of Performance

• Old rule (e.g. Best Foam Fabricators, Inc. v. United States, 38 Fed Cl. 627

(1997))

• Under cost-type contracts, contractors provided their best efforts

• Costs recoverable absent misconduct/gross negligence

• Supported by over 70 years of decisional law

• KBR Decisions

• Strict application of FAR § 31.201-3

• “The words ‘arbitrary,’ ‘gross negligence,’ and ‘willful misconduct’ do not appear in

[FAR § 31.201-3’s] text.”

7




• KBR (cont.)

• Potential significance for contractors

• DCAA and contracting officers may attempt to substitute their post hoc judgment for

that of the contractor

• Increases need to fully explain both reasonableness determinations and the context in

which the determinations were made

• Disagreements will likely occur regardless

• Documentation is critical

• KBR decisions significantly increases the risk of cost disallowance on the basis of

reasonableness under cost-type contracts

• Contractor’s bear the burden of proof

• Business Judgment Rule is not a safe harbor

8



• Cost Reasonableness Disputes are Fact Intensive

• BAE Sys. S.F. Ship Repair, ASBCA No. 58809, 14-1 BCA ¶ 35,642,

BAE Sys. S.F. Ship Repair, ASBCA No. 58810, 14-1 BCA ¶ 35,667

• CO, not DCAA, has the final say on cost reasonableness

• DCAA’s verification or acceptance of costs does not mean the costs are

reasonable

• Decision was a denial of BAE’s MSJ

• Bottom line: disputes regarding cost reasonableness are very likely to

require a discovery and a hearing due to their factual nature

9


Cost Reasonableness Best Practices

• Establish and Consistently Apply Processes

• A key element of demonstrating cost reasonableness is establishing,

maintaining, and consistently applying policies/procedures

• Compensation

• Subcontractor cost/price analysis

• Related determinations (e.g., commerciality)

• Internal approvals and audits integrated into processes to ensure that

documentation of business decisions is complete

• Reinforce Processes with Training

• Regular training should occur on all policies/procedures

• Document and retain records of attendance

10


Best Practices (cont.)

• Document (fully) all Significant Procurement or Business Expenditure

Decisions

• DCAA/DCMA take the position that if an action is not documented, it did not

happen

• Use checklists to ensure that cost/price analysis occurs and is fully and

consistently documented

• Checklists should generally track FAR Part 15 guidance for cost/price analysis

• Use pre- and post-negotiation memos to record and explain decisions,

particularly when a cost/technical tradeoff is made

• For large expenditures, employ a review process to evaluate and approve the

commitment and amount expended (including cost/price analysis)

• Employ a Record Retention Policy

• Ensures documentation will be available to support cost reasonableness

11


Best Practices (cont.)

• Anticipate Challenges to Cost Reasonableness

• All policies and practices should be designed with the expectation that

DCAA will question the reasonableness of any significant expenditures

(particularly direct costs)

• Challenges are becoming more common

12


Compensation Cost Reasonableness

• Compensation costs

• FAR § 31.001: all remuneration paid currently or accrued, in whatever

form and whether paid immediately or deferred, for services rendered

by employees to the contractor

• FAR § 31.205-6(d): includes compensation paid, or to be paid in the

future, to employees in the form of:

• Cash

• Corporate securities

• Other assets, products, or services

• While generally allowable, the FAR contains detailed guidance and

limitations on the allowability of specific forms of compensation

13


Compensation Cost Reasonableness (cont.)

• General criteria for allowable compensation

• Must be for work performed in the current year

• Total compensation for individual employees must be reasonable for the work

performed

• Must be based upon/conform to contractor’s established compensation plan or

practice

• Must comply with other cost principles

14


Compensation Cost Reasonableness (cont.)

• General criteria for allowable compensation (cont.)

• Compensation costs subject to both:

• General test for reasonableness (FAR § 31.201-3)

• Specific reasonableness requirements (FAR § 31.205-6)

• Reasonableness factors include, but not limited to, conformity to practices

of other firms of

• Same size

• Same industry and

• Same geographic area

• If requirements of FAR § 31.205-6 are met, requirements of FAR

§ 31.201-3 should be satisfied as well

15


Current Issues in Compensation Costs

• Government review of contractor compensation

• Compensation cap of $487K from Bipartisan Budget Act applies to all

contractor employees, not just executives

• Contractors are now likely required to provide DCAA total compensation

breakdown for all employees, not just executives

• Compensation is reasonable if the aggregate of each element amounts

to reasonable total (FAR § 31.205-6(b)(2))

• DCAAM 6-413.7 acknowledges that offsets are permitted

• A compensation element may be unreasonable, but total compensation may

still be reasonable

• Unreasonable compensation elements are still high risk

• DCAA relies on 10% “range of reasonableness” test

• Rejected in recent decisions (Metron, Inc., ASBCA No. 56015, 12-1 BCA

¶ 34,920; J. F. Taylor, Inc., ASBCA No. 56624, 12-2 BCA ¶ 35,066)

• DCAA continues to apply this test

16


Current Issues in Compensation Costs (cont.)

• Executive compensation

• New compensation ceiling ($487K) effective on June 24, 2014

• Final rule will likely be issued in 2015

• Multiple ceilings may apply to a contractor depending on date of

contract award and agency of award

• FY 2012, executive compensation cap = $952,308

• Effective June 2013, cap for all employees = $952,308

• Effective June 2014, cap for all employees = $487,000

• DOD issued guidance stating that use of a “blended rate” approach is a

practical and cost efficient solution for contractors to implement FAR

requirements

• DCAA disagrees: DCAAM § 6-414.9 describes blended rate method as

unacceptable and in violation of Anti-Deficiency Act

• Contractors should seek advance agreements prior to using a blended rate

method

17


Select Compensation-Related Rules

• Cost reasonableness and compensation cost principles govern maximum

allowable compensation costs the government will pay

• FLSA, SCA, DBA, and Executive Orders govern minimum compensation

and other benefits contractors must provide employees

• Failure to adhere to applicable statutes and rules can have serious

consequences, including suspension and debarment

• Labor and employment issues are an area of emphasis for the current

Administration

18


Fair Labor Standards Act (“FLSA”)

• FLSA establishes minimum employment standards for employees of

government contractors

• Minimum wage – Exec. Order 13658/DOL regulations established the minimum

wage at $10.10 for contracts awarded after Jan. 1, 2015

• If applicable state minimum wage exceeds FLSA, employer must payer higher wage

• Overtime pay – employees who work in excess of 40 hours per week must be

paid 1.5 time their hourly wage unless exempted (executive, administrative and

professional employees)

• Proposed DOL regulations may reduce scope of exemption by raising minimum salary

($50K) and require exempt employees to meet a “duty” test (high-level work only)

• Record keeping – requires employers to keep employee time and pay records

• Three years for payroll records, collective bargaining agreements, sales and purchase

records

• Two years for time cards, work/time schedules, records of wage additions/deductions

• Also requires employers to display FLSA poster in workplace

19


The Service Contract Act (“SCA”)

• McNamara-O’Hara Service Contract Act of 1965, codified at 41 U.S.C.

§§ 351-358

• Service Contract Act of 1965, as Amended (FAR § 52.222-41)

• Statement of Equivalent Rates for Federal Hires

(FAR § 52.222-42)

• Fair Labor Standards Act and Service Contract Act - Price Adjustment

(Multiple Year and Option Contracts)

(FAR §§ 52.222-43, -44, -46, -48, -49)

• Regulations describing the labor standards (29 C.F.R. Pt. 4)

• Department of Labor (“DOL”) guidance:

www.dol.gov/compliance/laws/comp-sca.htm#applicable_laws

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What is the SCA?

• According to DOL, intent of the SCA is to remove wages as a competition

factor in government service contracts

• Establish minimum compensation for federal service employees

• “Close the gap” in labor standards

• Basic requirement: pay wages and fringe benefits at rates set forth in

Wage Determination (“WD”) incorporated into federal contracts

• Applies to service contracts

• Wages and fringe in WD based on corresponding classes of laborers employed

on similar projects in the area

• Administered by DOL Wage and Hour Division

21


Applicability

• SCA applies to all government service contracts in excess of $2,500

• Includes any subcontract at any tier and must be flowed down

• When performing as a subcontractor, be aware of potential SCA requirements

• A service contract is any contract, the principal purpose of which is to

furnish services through “service employees”

• Service employee = any person engaged in the performance of a service

contract other than one employed in a bona fide executive, administrative, or

professional capacity

22


Exemptions

• Contracts

• Performed outside the U.S.

• Transportation where published tariff rates are in effect

• Furnishing services by radio, telegraph, or cable companies subject to the

Communications Act of 1934

• Public utility services

• Contracts for delivery of goods subject to the Walsh-Healey Public

Contracts Act (42 U.S.C. §§ 35-45)

• Construction contracts subject to the Davis-Bacon Act

(40 U.S.C. §§ 3141-3148)

23


Wage Determinations (“WD”)

• Each WD identifies:

• Classes of “service employees” with corresponding wage rates

• Fringe benefit requirements

• Health and Welfare

• Holidays

• Vacations

• Wages and fringe required by WD generally are based on either:

• Wages and fringe that “prevail in the locality”

• Collective Bargaining Agreements

• In the absence of a WD, must pay federal minimum wage (FLSA)

• Usually included in RFP, if not included, ask CO for the WD

• CO may periodically provide revised WD

• Based on DOL determination that prevailing wages have increased

• May require increase in employee wages

• Revised WD can trigger right to equitable adjustment

24


Davis Bacon Act (“DBA”)

• Very similar to SCA

• Applies to government contracts in excess of $2,000 for the construction,

alteration, or repair (including painting and decorating) of public buildings

or public works

• Requires contractors to pay laborers and mechanics prevailing wages

and fringe benefits listed in the applicable WD

• Related acts

• Many federal laws authorize federal assistance for construction through grants,

loans, loan guarantees, and insurance

• Require application of DBA labor standards to most federally assisted

construction projects

• Examples: Federal Aid Highway Acts, the Housing and Community

Development Act of 1974, and the Federal Water Pollution Control Act

25


Consequences of Noncompliance

• Failure to comply with FLSA, SCA or DBA may result in

• Rejection of a proposal

• Breach of contract

• Potential grounds for termination for default

• Liability for deductions, rebates, refunds or underpayments (including nonpayment) of compensation

• CO may withhold the corresponding amounts needed to compensate such underpaid employees from accrued payments due

• CO may withhold from subject contracts or any other prime contract

• Government may sue for any remaining underpayments

• Suspension or debarment

• No government contract may be awarded for three years

• Debarment penalties apply to both the prime contractor and to any of its violating subcontractors

• Violators may appear in List of Parties Excluded from Federal Procurement and Nonprocurement Programs

26


Fair Pay and Safe Workplaces Executive Order

• Executive Order 13673 (July 2014)

• Requires agencies to consider contractors’ history of compliance with labor laws and state law equivalents when determining contractor responsibility

• DOL proposed regulations published in May 2015

• Prior to Award

• Contractors bidding on procurement contracts in excess of $500K required to “represent, to the best of the [their] knowledge and belief, whether there has been any administrative merits determination, arbitral award or decision, or civil judgment” rendered against the contractor within the preceding three-year period for violations of the FLSA, SCA, DBA, ADA, ADEA, FMLA, NLRA, OSHA, Title VII of the Civil Rights Act and others, as well as equivalent state laws

• This information factored into the CO’s responsibility determination

• Contractors required to disclose similar information for subcontractors on subcontracts (other than COTS items) valued over $500K

• Contractors required to include provisions in their subcontracts requiring subcontractors to disclose and update such information.

27


Fair Pay and Safe Workplaces E.O. (cont.)

• Post Award

• Contractors and subcontractors performing work on covered contracts must provide updated information every six months

• Information brought to the attention of the CO or the Labor Compliance Advisor may result in government action:

• Appropriate remedial measures

• Compliance assistance to avoid future violations

• Contract remedies, including government not exercising contract option, contract termination, or referral to the agency suspension and debarment official

• Dispute Resolution

• For contracts in excess of $1M, contractors cannot force employees to arbitrate employment disputes

• Applies to subcontracts exceeding $1M threshold

• Public comment period for proposed DOL regulation ended on Aug. 28

• ABA cautioned against increased costs/burdened on contractors

• Council of Defense and Space Industry Associations advocated for withdrawal

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Questions?

Steven M. Masiello

Partner

Government Contracts

303.634.4355

[email protected]

Gale R. Monahan

Managing Associate

Government Contracts

303.634.4311

[email protected]

29

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Documents

Cost Reasonableness and Compensation Cost Update