(Editor’s Note. In efforts to reduce proposed labor rates in price sensitive competitions, contractors often turn to a major tool – uncompensated overtime (UOT). Since there have been some recent regulations addressing uncompensated overtime we thought this would be a good time to provide an overview on the subject, how DCAA and other government organizations view it and provide alternatives in how to treat it. The basis of our information is not one authority but stems from our long time study of the subject, experience as consultants and our working knowledge of how different government agencies view it.)
Under the Fair Labor Standards Act overtime must be paid to hourly employees whenever they work more than 40 hours in a week but not to salaried executive, administrative or professional employees even though they often work more than forty hours per week. The Act refers to hourly employees as "non-exempt" and salaried employees (those not paid overtime) as "exempt. Uncompensated overtime then refers to the work exempt employees perform above and beyond forty hours per week.
Worry About "Gaming"
The government has long been concerned that improper treatment of uncompensated overtime provides the potential for "gaming" where the contractor can overcharge cost type contracts and undercharge commercial, fixed type or overfunded cost type contracts. Consider, for example, an exempt employee who earns $1,000 per week and works 50% on a cost type government contract and 50% on a commercial contract. During a normal 40 hour work week the exempt employee would likely charge $25 per hour for each contract ($1,000 divided by 40 hours equals $25 per hour).
Now consider the same exempt employee who works 50 hours during the week. The contractor may intentionally or unintentionally charge the same $25 per hour to both jobs resulting in $1,250 being allocated to direct projects while the exempt employee receives only $1,000.
"Forty-Hour" Versus "Total Time Approach"
Numerous companies require their employees to record a maximum of eight hours per day or forty hours per week. Such "forty hour" companies have employees charge only the first 8 hours to jobs or indirect functions while others permit exempt employees to select where to assign their 8 hours. Alternatively, "total time" companies have their employee identify all hours worked and assign these hours to all cost objectives (e.g. contracts, tasks, etc.) or indirect functions.
Both government agencies and industry reactions to the alternative approaches have been mixed. Many government representatives (notably DCAA and the Defense Contract Management Command) agencies point to the potential "gaming" problems inherent in forty hour companies. Assuming the same 50 hour work week in the example above a forty hour contractor may charge 25 hours to the cost type contract at $25 per hour and only 15 hours at $25 per hour to the commercial contract. In reaction to this potential, there have been many proposals, from time to time, to require total time reporting.
Some in industry that do not account for overtime argue that evaluation of contract bids or proposals on anything other than a forty hour work week places them at a competitive disadvantage since they will offer their hourly rate calculated on a forty hour work week ($25 per hour from the above example) while total time employees may use a lower rate ($20 per hour). Source selection officials and their agencies side with this argument indicating the difficulty in comparing contractors’ prices and they have, from time to time, advocated a mandatory 40 hour week/2080 hour year as the standard for evaluating all bids. Many have further argued that mandatory total time accounting will increase administrative costs for contractors who will pass on the increased costs to government contracts.
Where the Rules Fall
In practice, it is generally the determinations of the Defense Contract Audit Agency that determine whether "the government" accepts or rejects the contractor’s handling of uncompensated overtime in both bidding and costing circumstances. It is important to understand DCAA’s guidance because (1) it is, by far, the most comprehensive and (2) is, by default, the primary basis of determining proper treatment of UOT.
DCAA’s Contract Audit Manual (DCAM) Part 6-410 addresses UOT. Its stated goal is to determine (1) whether a contractor accounts for all hours worked and if not, whether the government materially suffers (2) whether the contractor is allocating an "equitable share" of labor costs to government contracts (e.g. is not "gaming" the system) and (3) whether all work such as UOT is included in the base for purposes of calculating indirect cost rates.
The DCAM does not require total time reporting unless there is a "material" inequity from the contractor’s failure to record total time. CAM refers to DFARS 252.237-7019, and instructs its auditors to request a copy of the contractor’s policy addressing UOT and make sure that that the contractor’s method of bidding UOT is consistent with the way it accounts for UOT. If the contractor records only forty hours per week, the auditor is to conduct a floorcheck and/or interview exempt emploees to determine whether they work more than 40 hours. If there is UOT, the auditor is to suggest that full time recording is preferable. If the contractor refuses, the auditor is then encouraged to expand the floorcheck/interviews to determine whether the failure to record all hours results in a "material" difference in cost allocations to contracts. If they determines that the absence of total time reporting and/or their suggested methods of treating UOT results in material overcharging the government, auditors are told to cite contractors for noncompliance with FAR 31.201-4 and when covered by cost accounting standards, also CAS 418. (Editor’s Note. In effect, all contractors must comply with CAS 418 in this instance because even when not CAS covered, they will be cited for non-compliance with the FAR if CAS 418 is violated.)
CAS 418 requires that indirect costs bear a beneficial, causal relationship to the cost objectives to which they are allocated. In addition, the allocation base selected (i.e. direct labor, total cost, value added, etc.) must be representative of the total cost activity performed by the contractor. Since direct labor is usually at least one of the factors in the base, DCAA claims that failure to record all hours worked results in the exclusion of UOT hours from the base and thus the remaining hours in the base would not "bear its fair share of indirect costs" (e.g. since the denominator is lower, the resulting indirect cost rate would be too high).
(Editor’s Note. As consultants to contractors, we have, on occasion, successfully put forth a rebuttal to assertions of noncompliance with FAR 31,201-4 and CAS 418. Based upon an argument made by William Murphy, formerly a partner with Ernst & Whitney and Peterson Consulting, in a September 1992 article in CP&A REPORT, neither CAS 418 nor FAR 31.201-4 requires the recording of uncompensated overtime. Citing the historical promulgation of CAS 418 (too detailed to recount here), it was originally proposed to require full recording of all hours worked after which the CAS Board explicitly rejected the requirement and as a result it was not included in the standard. Thus the demand to require such recording is unfounded. Similarly, FAR 31.201-4 makes no mention of overtime, compensation, labor costs or any other statement that remotely require the recording of uncompensated overtime. It is rather, a one paragraph statement on allocation that contains a general statement that a cost is allocable to a government contract "if it is assignable or chargeable to one or more cost objectives on the basis of the relative benefits received or equitable relationship".)
DCAA, particularly recently, has emphasized that materiality must be considered when citing either a CAS 418 or FAR 31.201-4 noncompliance. Materiality, however, is not defined but is left to the auditor’s individual judgement. If materiality is asserted, DCAA is instructed to not only cite the contractor for noncompliance and require it to include all hours in its allocation base(s) but also recommends one of three methods for accounting for UOT to comply with CAS 418:
Method 1. Calculate an average rate for each pay period, based on salary paid divided by total hours worked and allocate costs to cost objectives based on that calculated rate. In the example cited above, if the pay period was bi-weekly and the exempt employee worked 100 hours rather than the standard 80 hours, the rate to be applied to each hour worked would be $20 ($2,000 salary/100 hours).
Method 2. Assign the total hours on a pro rata basis to all cost objectives worked during the pay period. In the example, the 25 hours worked on the government contract (50%) and the 25 hours worked on the commercial contract (50%) would result in applying the same percentages of salary to the respective contracts (50% of $1,000 salary or $500 to each contract).
Method 3. Allocate costs using an estimated annual rate and credit any variance to an indirect account. In our example, if the contractor expects the exempt employee to work 2,600 hours then his hourly rate will be $20 ($52,000 divided by 2,600 hours). If actual hours vary, then the difference is added to the indirect pool if less than 2,600 hours and deducted if more than 2,600 hours.
Two variations are sometimes accepted by DCAA under certain circumstances:
Alternative Method 1. Allocate employee’s hourly rate on a standard week and credit the indirect cost pool for excess hours at the same rate. In our example, charge all cost objectives at $25 per hour and if the standard work week is exceeded, credit the indirect account for each hour exceeded times the same $25 per hour.
Alternative Method 2. As a variation of Method 2 above, determine a pro rata allocation of hours worked each day and distribute the daily salary using the pro rata allocation. In a our example, if the exempt employee worked 5 hours on a government contract and 5 hours on a commercial contract today, their $200 daily salary would be apportioned 50% to each contract for that day.
In practice, DCAA’s reaction’s to these two alternative methods vary widely. We sometimes see complete acceptance of Alternative Method 1 while other auditors adamantly reject its use at similar type contractors, insisting on adoption of one of the three "acceptable" methods to avoid being cited for CAS 418. Sometimes one of the alternative methods are eventually accepted either after DCAA determines a lack of materiality or negotiations have demonstrated the difficulty and high cost of implementing one of the "acceptable" methods.
In spite of their comprehensive requirements, DCAA has resisted even more stringent proposals occasionally put forth by other government bodies. In 1996, the DOD Inspector General questioned DCAA’s policy of not requiring total time reporting of all contractors. Both DOD procurement officials and DCAA responded that such a requirement is unwarranted and that it is incorrect to assume that since a contractor does not account for all hours inequities automatically result. Their reply also pointed out that such a requirement would impose an additional administrative burden without providing a corresponding benefit. Because of the DODIG report, however, DCAA has been advised to conduct additional work regarding UOT. More in-depth audits are to be made to determine if an eight hour contractor’s allocations are materially inequitable and if this is not the case, the auditor is to fully document their conclusion.
Inclusion of uncompensated overtime frequently makes it difficult to evaluate proposals because high levels of UOT results in lower costs in the proposals but can adversely
affect the ability of contractors to attract and retain qualified personnel which puts performance at risk. There have been successful protests because government evaluators did not consider the impact of reduced wages and fringe benefits on employees’ willingness to work voluntary overtime in the future. Congress and some procurement agencies have drafted regulations requiring consideration of potential performance risk but has not taken a definitive position regarding use of UOT or mandatory total labor reporting. Rather, as of now, it leaves these issues to the individual agencies. Limited regulations include:
1. FAR 37.115-2 has been added to incorporate similar changes made earlier by DOD. No definitive stand has been taken on the use of UOT other than to state "use of uncompensated overtime is not encouraged". Because of the difficulty in evaluating proposals with UOT, procurements for technical and professional services are, to the maximum extent possible, to be acquired on the basis of task to be performed rather than on the basis of the number of hours. When hours are used, solicitations for both prime and subcontracts will require identification of UOT for direct labor personnel. A point is made that UOT charged to indirect cost pools for these direct labor personnel is to be required.
2. FAR 52.237-10, "Identification of Uncompensated Overtime" is now required on all government solicitations for services estimated at $100,000 or more if they are to be acquired on the basis of number of hours provided. The clause provides (a) a definition of UOT (b) calls for its identification (c) requires that the accounting practices used to estimate UOT for bidding purposes be consistent with those for accumulating and reporting UOT in accounting records and (d) "unrealistically low labor rates" be considered a potential risk and an assessment be made before an award.
3. A governmentwide rule has been proposed to have contracting officers make sure that UOT on contracts will not degrade the level of technical expertise required to fulfill contract requirements. They will have to conduct a risk assessment and evaluate any proposals received that reflect (1) unrealistically low labor rates and (2) unbalanced distribution of UOT among skill levels.