United States: The Cost Corner Government Contracts Cost And Pricing: Compensation For Personal Services—Part I

Welcome back to the Cost Corner, where we provide practical insight into the complex cost and pricing requirements that apply to government contractors. The current topic is Federal Acquisition Regulation (FAR) Cost Principles applicable to contracts with commercial organizations. Previous columns addressed the Cost Principles pertaining to the general criteria for determining the allowability of costs, direct and indirect costs, accounting for unallowable costs, and penalties for unallowable costs. This column begins coverage of FAR 31.205, Selected Costs, which includes forty-seven Cost Principles, each of which governs the allowability of a particular type of cost. The Cost Corner will not address all of the Cost Principles in FAR 31.205 but instead will focus on those that have, in our experience, generated the most significant questioned and disallowed costs.

FAR 31.205-6, Compensation for Personal Services (the Compensation Cost Principle), is the lengthiest and arguably most complex Cost Principle. The Compensation Cost Principle establishes: (1) six general criteria, including reasonableness, for determining the allowability of compensation costs, and (2) additional limitations on the allowability of more than a dozen elements of compensation.

This column analyzes the six general criteria for allowability of compensation costs, with a particular emphasis on reasonableness, including relevant guidance from the Defense Contract Audit Agency (DCAA) Contract Audit Manual (DCAM). The next Cost Corner will address some of the most commonly encountered "additional limitations" on specific compensation costs.

DEFINITION OF COMPENSATION

The FAR defines compensation for personal services to mean "all remuneration paid currently or accrued, in whatever form and whether paid immediately or deferred, for services rendered by employees to the contractor."¹ This definition is quite broad. It includes compensation in the form of cash, corporate securities (e.g., stocks, bonds, and other financial instruments), and any other assets, products, or services provided in exchange for services rendered by employees.²

Examples of compensation include salaries and wages, bonuses and incentive compensation, fringe benefits, income tax differential pay, "golden parachute" and "golden handcuff " payments, backpay, severance pay, pension costs and other postretirement benefits, deferred compensation other than pensions, and employee stock ownership plans (ESOPs).³

GENERAL CRITERIA FOR ALLOWABILITY

The Compensation Cost Principle establishes six general criteria for the allowability of compensation costs and specific requirements for reasonableness of compensation.⁴

First, subject to certain exceptions, compensation for personal services must be for work performed by the employee in the current year and must not represent a retroactive adjustment of prior years' salaries or wages.⁵ The exceptions to this rule include certain severance pay, allowable backpay, pension costs, other deferred compensation, fringe benefits, and post-retirement benefits other than pensions.⁶ The exceptions are subject to additional limitations on allowability that will be addressed in the next Cost Corner column. The primary effect of the first criterion for the allowability of compensation is to render unallowable most types of backpay and retroactive adjustments for work performed in prior years.⁷ It does not impact the allowability of backpay and retroactive adjustments for work performed in the current year.⁸

Second, the total compensation for individual employees or job classes of employees must be reasonable for the work performed.⁹ The government typically analyzes reasonableness by individual employee for owners, executives, and other "high risk compensation categories" and by job class for other employees. The standard for reasonableness depends on whether the compensation is paid in accordance with an "arm's length" labor-management agreement negotiated pursuant to the Federal Labor Relations Act or similar state statutes.¹⁰

Costs of compensation established under covered labor-management agreements are deemed reasonable unless the costs are "unwarranted" by the character and circumstances of the work or "discriminatory" against the government.¹¹ The application of a labor-management agreement intended to apply to a given set of circumstances and terms and conditions of employment, such as work involving extremely hazardous activities or work not requiring recurrent use of overtime, would be considered "unwarranted" when applied to a government contract involving significantly different circumstances and terms and conditions of employment, such as work involving less hazardous activities or work continually requiring the use of overtime.¹²

The application of a labor management agreement is "discriminatory" against the government if it results in employee compensation in excess of that being paid for similar non-government work under comparable circumstances.¹³ For example, a union agreement that provided for higher wage rates for construction work on a government installation than for rates applicable to commercial construction in the same area under similar circumstances would be discriminatory.¹⁴ On the other hand, the application of a labor-management agreement is not "discriminatory" against the government simply because the government pays more than commercial customers if the circumstances are different. For example, a union agreement that provided for higher wage rates for construction work on hazardous sites would not be discriminatory against the government if the government paid higher rates for work performed on a hazardous government site.

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* Keith Szeliga is a partner and Emily Theriault is a special counsel in the Government Contracts Practice in the Washington, D.C., office of Sheppard, Mullin, Richter & Hampton LLP. They may be contacted at kszeliga@sheppardmullin.com and etheriault@sheppardmullin.com, respectively.

Footnotes

1 FAR 31.001.

2 FAR 31.205-6(d)(1).

3 FAR 31.205-6(d)–(q).

4 FAR 31.205-6(a), (b).

5 FAR 31.205-6(a)(1).

6 Id.; FAR 31.205-6(g), (h), (j), (k), (m), (o).

7 FAR 31.205-6(a)(2).

8 Id.

9 FAR 31.205-6(a)(2).

10 FAR 31.205-6(b). The FAR does not define what constitutes an "arm's length" labor-management agreement. The DCAA interprets the term to mean "agreements between independently organized labor groups, such as labor unions, and contractor management for the purpose of establishing wage increases, hours, benefits, and working conditions." DCAA, DCAM ¶ 6-413.1.c.

11 FAR 31.205-6(b)(1).

12 Id.

13 Id.

14 DCAA, DCAM ¶ 6-413.1(e).

Originally published in Pratt's Government Contracting Law Report

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.