The FAR Cost Principles and federal cost reimbursement contracts provide that only reasonable allowable costs are recoverable, including costs for executive compensation. A January 18, 2012 decision of the Armed Services Board of Contract Appeals rejected a government challenge to the reasonableness of compensation one contractor paid to executives and rejected the DCAA’s methodology for determining the reasonableness of the compensation. See J.F. Taylor, Inc., ASBCA Nos. 56105, 56322 (Jan. 18, 2012) [pdf].

Appellant J.F. Taylor, Inc. had performed cost-type contracts to provide flight simulator training and other services to the Navy for over 30 years. All agreed that the company was exceptionally successful and well managed. The dispute concerned the reasonableness of compensation paid to the CEO-founder and his four Vice Presidents—the founder’s three sons and one family friend. In 2002, the company paid the President $375,000 and the VPs $260,000 each, and other amounts thereafter. DCAA auditors challenged the payments as unreasonable.  Taylor filed a claim disputing DCAA’s finding, which the contracting officer denied.

The Board decided the case under FAR 31.205-6, Compensation for Personal Services, which says that factors relevant to the reasonableness of compensation include “general conformity with the compensation practices of other firms of the same size, the compensation practices of other firms in the same industry, the compensation practices of firms in the same geographic area, the compensation practices of firms engaged in predominantly non-Government work and the cost of comparable services obtainable from outside sources.” It also provides for special consideration of owners of closely held corporations like J.F. Taylor. 

The Government offered proof that the DCAA auditors’ determination of reasonableness was based on averaging of amounts found in several statistical studies of executive compensation and adding a 10 percent “range of reasonableness.” The Board rejected that method because it failed to consider relevant factors set forth in Techplan Corp, ASBCA No. 41470 et al., 96-2 BCA ¶ 28,426.  In J.F. Taylor, the Board held that DCAA’s method was invalid because it:

  • ignored data and used an arbitrary 10 percent range of reasonableness;
  • ignored differences in the sizes of the surveys on which it relied;
  • incorrectly failed to consider the revenue base of the whole company;
  • failed to consider the financial success of the company;
  • failed to consider unique challenges in Appellant’s industry, such as the requirement for employees to hold active security clearances; and
  • made other statistical and analytical errors.

The Board held that DCAA’s method was statistically incorrect and fatally flawed because it failed to consider individual circumstances relevant to Taylor’s industry, Taylor’s success in that industry, and the company’s management success. Without getting into accounting details, a company’s success or the lack of it should be a large factor in setting executive compensation. It seems remarkable that DCAA’s methodology in this case gave so little consideration to these factors, according to the Board’s decision.

The reasonableness of executive compensation is a matter to be determined on a case-by-case basis.  But this decision casts doubt on DCAA’s continued use of the methodology discussed in this decision. The Board’s rejection of the DCAA’s method should result in either an appeal to the Federal Circuit or a modification of DCAA’s willingness to continue the methods rejected by the Board.