Contract Pricing: Reviews of Defense Contractor Compensation Costs

Published by the Government Accountability Office on 1990-08-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                                                                                                 .._”   ...__”   . ..--   _.   ..-   --
_   _....._           _.,..“.   _   .I-   __.-..._.   __-        ._..-._   -_   .._   -.”   _.

Arlppst                                   19!FO
                                                                                                                                          CONTRACT PRICING
                                                                                                                                          Rev iew s of Defense
                                                                                                                                          Contrac tor
                                                                                                                                          Compensation Cos ts

        ---....?---                                         -I

         (;hO/NSIAI)-!)O-241!)PS                                                                                    -
                     United States
GAO                  General Accounting Office
                     Washington, D.C. 20648

                     National Security and
                     International Affairs Division


                     August 29,199O

                     The Honorable William V. Roth, Jr.
                     United States Senate

                     Dear Senator Roth:

                     In response to your request, we have developed information on Defense
                     Contract Audit Agency (DCXA) reviews of contractor compensation costs.
                     Specifically, this fact sheet provides information on the number of com-
                     pensation reviews conducted by DCAA,the amount of unreasonable com-
                     pensation identified by DCAA, and the status of the government’s efforts
                     to reduce unreasonable compensation,

                     We found that:
Results in Brief
                   . Between October 1, 1987, and December 31, 1989, DCAA completed 361
                     reviews of defense contractors’ compensation costs.
                   q In 123 of these reviews, DCAAidentified about $340 million in what it
                     viewed as unreasonable compensation,
                   . As of December 31,1989, action had been completed on 39 of these
                     reviews which had identified about $63 million in unreasonable compen-
                     sation, In negotiations with the government, contractors agreed to con-
                     tract and rate agreement reductions based on approximately $17
                     million of the $63 million.

                     Compensation is one of the largest components of costs incurred under
Background           government contracts. The Federal Acquisition Regulation (FAR)
                     31.206-6 (a) defines compensation as
                          .all remuneration paid currently or accrued, in whatever form and whether paid
                              .   .

                     immediately or deferred, for services rendered by employees to the contractor
                     during the period of contract performance. . . . It includes, but is not limited to,
                     salaries; wages; directors’ and executive committee members’ fees; bonuses
                     (including stock bonuses); incentive awards; employee stock options, stock apprecia-
                     tion rights, and stock ownership plans; employee insurance; fringe benefits; contri-
                     butions to pension, annuity, and management employee incentive compensation
                     plans; and allowances for off-site pay, incentive pay, location allowances, hardship
                     pay, severance pay, and cost of living differential.”

                     Responsibility for determining the reasonableness of contractors’ com-
                     pensation costs rests with the government administrative contracting

                     Page 1                                                     GAO/NSIAIMO-249FS   DCAA

                      officers. Until October 1, 1987, both the Defense Contract Administra-
                      tion Services, an organization within the Defense Logistics Agency, and
                      DCAA jointly reviewed defense contractors’ compensation costs and made
                      recommendations to administrative contracting officers regarding
                      unreasonable compensation. Effective October 1, 1987, the Department
                      of Defense (DOD) gave DCAA sole responsibility for reviewing contractor
                      compensation costs.

                      FAR  requires that negotiated contracts include employee compensation
                      costs-such as salaries, bonuses, and fringe benefits-only to the extent
                      that they are “reasonable.” According to FAR, “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.”

                      DCAA reviews defense contractors’ compensation costs under its Con-
DCAA’s Contractor     tractor Employee Compensation System Review program. DCAA selects
Employee              contractors for review based on selection criteria that take into account
CompensationSystem    the government’s risk of accepting excessive compensation in govern-
                      ment contracts.
Review Program
                      In determining which contractors to review, DCM considers conducting
                      reviews every 2 years on contractors who have annual government sales
                      of $10 million or greater and receive at least 10 percent of their business
                      from government sales. DCAA also considers the amount of compensation
                      included in the contractor’s government sales, previous compensation
                      review findings regarding that contractor, and the expiration date of the
                      contractor’s collective bargaining agreements.

                      Scheduling reviews to coincide with the expiration date of bargaining
                      agreements allows DCAA’Sfindings to be considered in renewing those
                      agreements. DCAA also conducts special purpose reviews that focus on
                      specific groups of employees and follow-up reviews to determine what
                      action the contractor has taken regarding the findings. The availability
                      of DCM staff is another consideration in planning the number of com-
                      pensation reviews each year.

How DCAA Determines   Before April 1986, FAR required that compensation be considered rea-
Reasonableness        sonable if total compensation generally conformed to compensation paid
                      by other firms of the same size, in the same industry, or in the same
                      geographic area for similar services or work performed. Under the total
                      compensation approach, the government had little success in challenging

                      Page 2                                              GAO/NSIAD-99-249FS DCAA


                  the reasonableness of compensation costs because there were no widely
                  acceptable measurements of total compensation.

                  In April 1986, FAR was revised to permit the government to challenge
                  any single element of compensation, such as fringe benefits. When an
                  element is challenged, the burden is placed on the contractor to either
                  defend the reasonableness of the element or show that lower costs for
                  other elements of the compensation package offset the “unreasonable”
                  costs. According to the FAR, a government contractor’s compensation
                  costs will be considered reasonable, if each of the allowable elements of
                  the employee’s compensation package is reasonable. Consideration
                  should be given to all potentially relevant facts, such as, whether the
                  elements of the compensation package are in general conformity with
                  the compensation practices of other firms of the same size, the compen-
                  sation practices of other firms in the same industry, the compensation
                  practices of other firms in the same geographic area, and the compensa-
                  tion practices of other firms engaged in predominately nongovernment
                  work. The cost of comparable services obtainable from outside sources
                  is another reasonableness criterion identified in FAR.

                  To determine whether a contractor’s compensation is reasonable, DCU
                  compares it to comparable data from compensation surveys. Compensa-
                  tion surveys are prepared by private companies (as well as defense con-
                  tractors) using compensation data collected from various firms. D&U
                  considers a contractor’s compensation reasonable if it is within 14 per-
                  cent of appropriate survey compensation (within 26 percent for execu-
                  tives). DCAAallows the 14 and 26 percent variances because of an Armed
                  Services Board of Contract Appeals decision that reasonableness of com-
                  pensation is better represented by a range than by a precise figure. A
                  range also allows for variations in surveys based on the way employees
                  doing comparable work are paid in different firms.

Results of DCAA   compensation reviews, some of which are for different divisions of the
Compensation      same parent companies. The DCAACompensation Program Manager said
Reviews           that most major contractors (those with over $40 million in government
                  sales) have had at least one compensation review.

                  DCU initially identified about $460 million in unreasonable compensa-
                  tion in 140 of the 361 reviews. As of December 31,1989, DCAAhad made
                  about $110 million in reductions to the unreasonable compensation find-
                  ings in these reports, based on such things as additional contractor data

                  Page 2                                              GAO/NSIAD-90-249Fs DC4A

                           or changes in DCAAaudit guidance. These revisions reduced the number
                           of reviews with findings of unreasonable compensation to 123 and the
                           total amount of those findings to approximately $340 million.

                           If DCAAdetermines that a contractor’s employee compensation is more
Government’s Success       than 14 percent above the appropriate wage survey average (25 percent
in Reducing                above for executives), it requests the contractor to either justify the
Unreasonable               compensation or submit an action plan to reduce the compensation to a
                           reasonable level. DCAAthen submits a report of its findings and the con-
Compensation               tractor’s response to the cognizant administrative contracting officer.

                           According to the Office of the   DOD   Inspector General, the administrative
                           contracting officer may

                       . negotiate a settlement or other agreement to reduce the contractor’s
                         unreasonable compensation,
                       . issue a formal notice of intention to disallow unreasonable compensation
                         included in future contract costs, or
                       l take no action if it is determined that the contractor’s compensation is
                         not unreasonable.

                           Of the approximately $340 million in unreasonable compensation identi-
                           fied in the 123 reviews, the DCU Compensation Program Manager said
                           that action has been completed on 39 DCU reviews with identified
                           unreasonable compensation of about $63 million. The program manager
                           said that in negotiations with the government, contractors agreed to
                           contract and rate agreement reductions based on approximately $17 mil-
                           lion of the $63 million in unreasonable compensation identified in the 39

Scopeand                   DCAAstatus reports of compensation reviews, and made a limited anal-
Methodology                ysis of 10 IXXA reviews that reported large dollar amounts of unreason-
                           able contractor employee compensation. We validated selected data by
                           examining the relevant individual compensation review reports.

                           We also interviewed DUA officials at their Washington headquarters
                           office and several regional offices and met with DOD Inspector General
                           officials who were conducting a related review. Our work on this assign-
                           ment did not include discussions with government contracting officers
                           or contractor representatives, As agreed with your staff, we will, in a

                           Page 4                                                 GAO/NSIAD-90-249FS DCAA

separate review, evaluate whether certain DC~Acompensation findings
and recommendations were supportable and convincing and why DOD
contracting officers have not acted on them.

Our review was performed from August 1989 to May 1990. We did not
obtain official agency comments on a draft of this report, but we dis-
cussed our findings with DCAA officials and have incorporated their com-
ments where appropriate.

Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 30 days from the date of this letter. At
that time, we will send copies to the Secretary of Defense and the
Director, DCAA,and make copies available to other interested parties on

The major contributors to this fact sheet are David E. Cooper, Assistant
Director, and John L. Carter, Assignment Manager, from headquarters;
and Joe D. Quicksall, Evaluator-in-Charge, Ronald M . Haun, Site Senior,
and Jerilyn Green, Staff Evaluator, Dallas Regional Office.

Please contact me at (202) 2758400 if you or your staff have any ques-
tions concerning this fact sheet.

Sincerely yours,
._   ..I.._   ll.“,l   .-_.   -_l-..-.ll--..“.---   -