The Department of Defense (DoD) issued a final rule amending the DoD FAR Supplement (DFARS), making certain fringe benefit costs expressly unallowable, thus subjecting defense contractors to possible penalties for charging these costs to defense contracts and noncompliance with Cost Accounting Standard (CAS) 405. At the same time, the new White House compensation cap increase allows for additional reimbursement for highly compensated employees, but comes with increased calls to reform and limit compensation. Contractors should be aware of both changes to ensure accurate cost reimbursements and to maintain compliance with cost principles.

Unallowable Fringe Benefit Costs

What started as a policy memorandum addressing narrow concerns about unallowable health care benefits costs for contractor employees’ ineligible dependants1 has ended with a final rule amending DFARS provisions concerning fringe benefits generally, including sick leave, vacations, and holidays. Under the new rule issued on Dec. 6, 2013: “Fringe benefit costs that are contrary to law, employer-employee agreement, or an established policy of the contractor are unallowable.”2

Although DoD asserts that the change simply clarifies that these fringe benefits costs are unallowable, the acknowledged consequence of the new provision is to make such costs “expressly unallowable.” This change to making the costs “expressly unallowable” opens defense contractors to possible penalties if they include such costs in indirect cost proposals.3 Further, defense contractors subject to CAS could be at risk of CAS 405 noncompliance allegations. Given the vague language it employs, the rule is destined for controversy. As one commenter on the proposed rule noted, the CAS Board Preamble for CAS 405 explains that the cost must be unallowable in “direct and unmistakable terms” to be an expressly unallowable cost.4 As used by the rule, however, the general phrase “contrary to law” falls far short of “direct and unmistakable.” Establishing allowability on general compliance with law, agreement or policy hardly tends to the degree of particularity that an expressly unallowable cost contemplates. The final rule may make compliance with cost principles subject to underlying disputes about the proper interpretation of such laws, agreements and policies. Earlier this year, the Defense Contract Audit Agency (DCAA) released guidance that, under the previous procurement rules, unallowable fringe benefits costs were not “expressly unallowable,” correcting its prior erroneous stance that such cost were expressly unallowable and thus subject to penalties.5 This new provision is an attempt to match the procurement rules with DCAA’s initial erroneous view.

DoD removed the phase “incurred or estimated” after receiving comments asserting that making estimated costs expressly unallowable goes beyond the limits for applying penalties to unallowable costs in indirect cost proposals. Although DoD challenged the commenter’s view that FAR 42.709-1 did not apply to estimated costs, DoD did remove the phrase from the final rule.

In light of this change, contractors subject to DFARS should maintain keen awareness of the laws, agreements and policies governing costs submitted for reimbursement on government contracts. The Final Rule became effective December 6, 2013.6

White House Increases Compensation Cap While Urging Reform

On Dec. 4, 2013, the White House’s Office of Federal Procurement Policy (OFPP) announced that the compensation cap for certain government contractor executives and employees is set at US$952,308 for FY2012, an increase of US$189,279 over FY2011.7 Although the cap does not prevent contractors from providing covered employees higher compensation, the cap limits the compensation that contractors can use in determining cost reimbursement for certain employees. To set the cap, OFPP applied the statutorily proscribed method, which uses the median compensation among certain highly compensated employees at all publicly-owned U.S. companies with annual sales exceeding US$50 million.

In the announcement, OFPP continued urging Congress to consider the White House’s proposal to replace the statutory formula with a compensation cap linked to the President’s salary. Some Members of Congress appear open to the White House’s calls for reforming allowable compensation. Drafts of the National Defense Authorization Act for FY2014 replace the formula with a reduced index-linked cap that would apply to almost all contract employees under either defense or civilian contracts.8 Most recently, Congress announced that the proposed Bipartisan Budget Act of 2013 caps the allowable compensation for a contractor employee at US$487,000, the lowest level since FY2005.9 In the age of sequestration and budget fights, government contractors should continue to monitor developments in this area.