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Congratulations! You survived the request for proposal (RFP) requirements and have been awarded a government contract. Now it's time to perform on that contract.
While providing the service or product is a large part of the performance on the contract, you may have also agreed to have an adequate compensation system (check the terms of your contract). In this case, it’s important to know what is required to keep your system functioning properly.
For those who have not memorized FAR 31.205-6 and don't have our article on pre-award compensation bookmarked, here's a quick reminder of what is considered compensation. According to the regulation, compensation means: “the total amount of wages, salary, bonuses, deferred compensation, and employer contributions to defined contribution pension plans, for the fiscal year, whether paid, earned, or otherwise accruing, as recorded in the contractor’s cost accounting records for the fiscal year.”
For purposes of post-award requirements, we refer to FAR 31.205-6 (the holy grail of compensation rules). FAR 31.205-6(a) states that compensation must be for work performed by the employee in the current year, reasonable, based upon, and conform to, the terms and conditions of an established compensation plan or practice.
Adequate compensation system
Policies and procedures
A common theme you'll discover with government contracts is that policies and procedures are a must. When we say policies and procedures, we always mean well-documented and adequate policies and procedures. FAR requires that compensation must be based upon, and conform to, the terms and conditions of the contractor’s established compensation plan or practice for the cost to be allowable. This means that if you don't have a defined compensation plan or an established practice in place, auditors may determine the costs to be unallowable. This is where having a trusted advisor on board to help you create a compensation plan or practice, as well as help you navigate the audit process, is key. Furthermore, when you're drafting or significantly revising compensation policies and procedures, it is important that, either prior to implementation or within a reasonable period after it, you provide the cognizant administrative contracting officer (ACO) with an opportunity to review the plan. We know it must be exhausting always getting approval for everything you do, but that’s the path you chose when you got into a long-term relationship with the government.
Job levels and descriptions
Another part of an adequate compensation system is job levels and job descriptions. Depending on the size of your company, this may not be an easy task. For each job role, there should be a written job description (and, yes, it needs to be in writing). A good job description should include the role's responsibilities, and general level of education and experience requirements. Not everyone in the position may fit the job description; and for those who don’t quite fit, there should be supporting documentation.
The next question to address is: How much should I pay someone? We can't pull figures out of thin air or assess our worth higher than appropriate. Instead, we need to rely upon research that demonstrates compensation being provided is reasonable according to the current market. Thankfully, there are tools to help determine reasonable salaries.
Whether you decide to rely upon benchmarking established by salary survey data or choose to do your own research (Bureau of Labor Statistics is a great place to start) and benchmark based off similar job openings, you must document your practice of establishing reasonable salaries. For comparable salaries to be considered an appropriate benchmark, industry/NAICS (North American Industrial Classification System) code, company revenue/size, and the position's roles and responsibilities, rather than just the job title as detailed in FAR 31.205-6(b)(2), should be taken into consideration. Once you have the salary data gathered, you need to apply professional judgment for the final compensation decision and make sure any increases or decreases are documented appropriately. Look out for the next article where we go in-depth on performing benchmarking and provide examples of using professional judgment to make salary decisions.
Bonuses and incentive compensation
Bonuses or incentive compensation are a great way to retain good employees and the government recognizes that, which is why they allow government contractors to claim bonus costs. FAR 31.205-6(f) states that bonuses are allowable if:
(i) Awards are paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered or pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such payment
(ii) Basis for the award is supported
In other words, before you start paying out bonuses, it’s a best practice to have a written bonus plan or incentive compensation policy. And again, you must document the reason for the award. This is not the Oprah Winfrey Show where everyone gets a car.
Bonus plans should address the types of bonuses or incentive compensation you offer. You may choose to offer an annual bonus, on-the-spot bonuses, significant contribution bonuses, etc. We recommend identifying and defining each bonus type in your plan. It's important to include how often the bonus is paid and how the bonus is earned; as well as a range for the bonus. You should also address instances in which you may need to go outside of the planned payment range and what that process will require.
When it comes time to determine the bonus amount, writing "John Smith is a hard worker" may not suffice in a future audit. There also needs to be enough documentation to support that an employee is actually a hard worker and not your best friend who you want to give a bonus to. One best practice we have seen in action with our auditees and clients is to ensure documentation includes an annual performance review and rating from the employee's supervisor. The performance review should include any notable contributions the employee made during the year. It's worth noting that being in a position for an extended period is not a basis for a bonus but could be the basis for a raise. A bonus is a payment made in addition to an employee's regular earnings and, as such, raises and bonuses should be treated separately. As always it is important to note that an employee’s overall compensation, including bonuses, will be evaluated for reasonableness in an audit.
Offering a pension plan is another way employers can retain employees. Remember, pension costs are included as part of compensation per FAR 31.205-6 and the FAR is specific on what types of pension costs are allowable and unallowable. As such, it is important to make sure contractors have adequate policies and procedures that are in line with the requirements of FAR 31.205-6, including reasonableness of pension costs.
For example, if the industry standard for a 401(k) match is 6%, it may be unreasonable for a company to claim 401k match expenses up to 25%. Note: The contractor is allowed to match 401(k) expenses up to 25% but all those match expenses may not be reasonable, and, as such, not allowable. For defined benefit pension plans, actuarial costs should be used and have relevant supporting documentation. Many defined benefit plans may have specific requirements from the associated government agency as well, so contractors should be sure to review pension requirements per the related contract when developing policies and procedures.
Pensions are the most complicated compensation costs and we’ve discussed it here in a simplified manner.
Salary increases policies and procedures
An appropriate compensation system requires adequate policies and procedures regarding the salary increase process (of course!). Unfortunately, you can’t just think of a number and hope it’s correct. Salary increases can be categorized into the following main types:
1. Market-related increases
2. Merit-related increases
Market-related increases involve assessing compensation for employees in each job position to ensure they are being paid in line with what the market is offering. The process usually involves determining a mid-point salary for employees in each job position. This may then increase or decrease based on each individual employee’s education, job experience, and overall job duties. Fingers crossed you don’t have to ever decrease an employee’s pay due to market adjustments. That means you were overbilling the government for quite some time and both the government and the employee won’t be happy once that information has been communicated.
For market-related increases, companies should have a documented process of performing market surveys that are uniform across all types of positions. Without a uniform process, the company may risk appearing biased in terms of compensation for certain positions which may lead to unreasonable compensation (and this can only lead to poor outcomes).
Merit-related increases are usually based on a process that’s in place for the purpose of documenting and demonstrating that the employee is actually performing as well as on an individual employee’s performance. Companies will generally assign a pay increase percent range based on the results of an annual review rating. The annual reviews should be appropriately documented, and a process should be in place to help ensure they are being completed consistently across all levels. If appropriate reasons are not documented for annual review ratings, then the resulting compensation increase may be considered unsupported and, as such, unallowable.
Annually, management should also review the merit percentage increases and ensure they are in line with market increases. As such, the overall merit process should be appropriately documented including the process for if/when merit guidelines are not adhered to. If you don’t follow the rules you put in place, you must explain why and you can’t make up the rules as you go.
Promotion-related increases should be based on a documented process that is uniform across all positions. The reasoning for a promotion should be documented in an annual review and/or a separate promotion evaluation. Many companies have a process of holding roundtables when discussing promotions and evaluations. This is generally fine with the caveat that all decisions should be documented. If it’s not in writing, future auditors may treat these events as if they never happened.
Incurred cost submission preparation
Luckily not much needs to be done compensation-wise when preparing the annual Incurred Cost Submission (ICS). The main compensation-related schedule is Supplemental Schedule B, which requires a listing of compensation for executives. While the Supplemental Schedule B is not required, many cognizant agencies require this schedule as part of contract requirements. Make sure you read the fine print before submitting. Furthermore, the auditors will ask for it anyway, so it is much easier to have it completed beforehand. Also, completing the schedule prior to ICS submission will allow companies to move any executive compensation above the statutory cap to unallowable accounts.
We also recommend that companies perform a reasonableness analysis on these salaries while prepping the Supplemental Schedule B.
For non-executive compensation, we recommend performing an analysis of all salaries to help ensure none are above the statutory cap as well as identifying any outliers. If this is confusing, we can help.
If you do happen to be one of those unlucky contractors that are undergoing a compensation audit, you’ll first want to make sure your compensation policies are complete and up to date. You’ll also want to make sure your salary benchmarking and annual review documentation is in order and readily available. A compensation system or compensation incurred cost audit will likely also require a review of timesheets. Of course, when in doubt: document, document, document. Trust us, when the auditors are asking those hard-hitting questions – like why John Smith is being paid 25% more than Jane Doe who is in the same position – you will be very happy with your past self for having kept documentation; such as an additional degree, more years of experience, or documented additional job duties. If this is not properly documented, you’ll have some explaining to do.
In addition, auditors may specifically check whether funds used for increases were appropriately utilized in accordance with what they were earmarked for. For example, funds set aside for market-related increases cannot be used for merit and promotion-related salary increases. If you’re giving a market-related increase, the documentation for the increase cannot be performance-related.
There are many considerations related to the post-award compensation process due to FAR requirements. CohnReznick has a variety of compensation consultants to assist with any pre-award and/or post-award requirements that you may encounter. Look out for our upcoming article in which we go even more in-depth on compensation reasonableness analyses and will use examples related to determining reasonable salaries using salary surveys. In addition, make sure you also check out our article related to compensation requirements during the pre-award process. If you take nothing else away from this article, make sure you have adequate documentation for all compensation costs.
Subject matter expertise
CPA, Manager, Government Contracting
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