Defense Contractors: Information on the Impact of Reducing the Cap on Employee Compensation Costs
Published: 2013-06-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since the 1990s, federal law has placed a limitation, or cap, on the amount of employee compensation that contractors can charge to federal contracts. The cap increased by 63 percent in real terms since first use of the current approach in 1998. The cap was set at $693,951 in 2010 and $763,029 for 2011 and 2012.
The National Defense Authorization Act for Fiscal Year 2013 directed GAO to provide information on the effect of reducing the cap to the salary of the U.S. President or Vice President. GAO identified, among other things, (1) estimates of the number of employees of a sample of DOD contractors whose compensation would have exceeded a cap set at the salaries of either the U.S. President or Vice President and the amount of compensation that would not have been allowable and (2) the views of government and contractor representatives on potential effects of a reduction in the cap. GAO collected data from a nongeneralizable, stratified random sample of 10 large-tier, 10 mid-tier, and 10 small-tier contractors; reviewed relevant laws and regulations, and interviewed government and contractor representatives. Data on the number of employees affected by the cap was received from 27 of the 30 contractors; the three largest contractors in GAO's sample did not provide these data.
section_title: What GAO Found
paragraphs: Reducing the cap to the President's salary ($400,000) or the Vice President's salary ($230,700) would have substantially increased the number of employees with compensation costs exceeding the cap in 2010-2012.
For 2010-2012, contractors identified over $180 million per year in compensation costs that would have exceeded a cap set at the President's salary, and at least $440 million per year if set at the Vice President's salary. Most affected employees were at large-tier companies; few small-tier companies had employees exceeding these caps. While employees with compensation costs in excess of the existing cap were all identified as executives by the contractors, reducing the cap would have increasingly affected compensation costs for individuals below the executive level.
Government representatives generally supported reducing the cap as a means to reduce the costs of Department of Defense (DOD) contracts, whereas industry representatives and most contractors identified negative effects that could result from reducing the cap. The Office of Management and Budget noted the growth in the cap has outpaced inflation and the rate of growth of federal salaries. DOD noted that it fully supported the principle of paying only reasonable compensation costs and some DOD officials supported reducing the cap, though DOD cautioned that there are limited data on the potential impacts of doing so and that the impact on the defense industry would need to be carefully monitored and assessed. Industry associations and contractors representatives noted that the compensation they offer to their employees is generally based on market surveys of compensation paid by private sector companies. While acknowledging that a reduced cap would not preclude them from compensating their employees above the cap, contractor representatives noted that doing so would come at the expense of company profits, which in turn may result in challenges in attracting capital from the financial markets. They also noted that reducing the cap may affect companies' ability to attract and retain top talent and, over the long term, lead companies to reassess their business and staffing models and potentially shift work or personnel from government business to their commercial sector.
section_title: What GAO Recommends
paragraphs: GAO is not making any recommendations in this report. DOD and OMB commented on a draft, noting the need to pay reasonable compensation costs. DOD also cited the need for more research given GAO's sample size. GAO believes this analysis provides valuable insights into potential effects of cap changes.

section_title: Letter
paragraphs: Since the 1990s, federal law has placed a limitation, or cap, on the  amount of contractor employees’ compensation costs that is allowed to  be charged on federal government contracts. Compensation costs can  include many elements, such as salary, bonuses, stock options, and  employer contributions to pension plans, although under federal law and  the Federal Acquisition Regulation (FAR), contractors are only allowed to  charge some elements of compensation to federal government contracts.  The Administrator for Federal Procurement Policy within the Office of  Management and Budget (OMB) is responsible for determining the cap,  which is calculated based on an analysis of the compensation of senior  executives at large, publicly traded companies. This cap, currently set at  $763,029, has increased in real terms by 63 percent since this approach  was first used in 1998. The cap had only applied to certain senior  contractor executives, but in 2012, legislation expanded the cap’s  applicability to all contractor employees performing under contracts  awarded by the Department of Defense (DOD), the Coast Guard, and the  National Aeronautics and Space Administration (NASA).legislation permits the Secretary of Defense to establish narrowly targeted  exceptions to the cap for scientists and engineers, as needed.
Section 864 of the National Defense Authorization Act for Fiscal Year  2013 directed GAO to report to Congress on the effect of reducing the  allowable costs of compensation to the salary of the U.S. President or  that of the U.S. Vice President, which are currently $400,000 and  $230,700, respectively. of employees of a sample of DOD contractors whose compensation  would have exceeded a cap set at the salaries of either the U.S.  President or Vice President, and the amount of compensation that would  not have been allowable; (2) the status of DOD’s efforts to establish an  exception for scientists and engineers and the extent to which scientists  and engineers would be affected by reducing the cap; and (3) the views  of government and contractor representatives on potential effects of a  reduction in the cap. In addition, in response to a matter identified in  Section 864 of the National Defense Authorization Act of 2013, appendix  II includes information on the extent to which employees of DOD  contractors included in this review received compensation in the form of  vested or unvested stock options.
Pub. L. No. 112-239, § 864. items. Because the cap is concerned with cost-based contracts, we  excluded commercial item contracts, as well as contractors that only had  obligations on firm fixed price contracts and/or fixed-price with economic  price adjustment contracts. We based our selection of contractors on data  from USAspending.gov. We selected contractors from four strata based  primarily on fiscal year 2012 contract obligations: (1) contractors with  obligations greater than $25 billion (2 contractors selected); (2)  contractors with obligations between $2 billion and $25 billion (8  contractors selected); (3) contractors with obligations between $15 million  and $2 billion (10 contractors selected); and (4) contractors with  obligations between $1 million and $15 million (10 contractors selected).  This sample is not generalizable, but is designed to illustrate the potential  impact that reducing the cap would have on contractors of varying sizes.  For the purposes of this report, we refer to contractors from the first two  selection groups as large-tier contractors, the third group as mid-tier  contractors, and the fourth group as small-tier contractors. The 30  contractors received about 25 percent of all fiscal year 2012 DOD  contract obligations.
We requested data on a number of items, including the estimated number  of employees with compensation costs that would have been allowable  but for the cap and exceeded the contractor fiscal year 2010 cap of  $693,951; the fiscal year 2011 cap of $763,029; and, for fiscal year 2012,  the amount of $763,029. contractors included data on the estimated number of employees whose  compensation would have exceeded the cap had it been set at the  salaries of the President and Vice President in fiscal years 2010-2012,  the estimated number of contractor employees performing under  government contracts who were granted stock options or restricted stock,  and the potential effects of reducing the cap. In our data request, we  asked for data on most questions for fiscal years 2010, 2011, and 2012.
USAspending.gov is a free, publicly accessible website established by the Office of  The cap of $763,029 is for fiscal year 2011 and subsequent contractor fiscal years,  unless and until revised by the Office of Federal Procurement Policy. At the time of this  review it had not published a revised cap amount for 2012. Therefore, for the purposes of  this review, we used the 2011 cap for analysis of 2012 data.
To simplify the data request, we collected for fiscal year 2011 information  on some questions where we determined one year of information was  sufficient to provide useful insights, such as questions related to the  number of employees at different management levels and a question  about employee job titles. In these instances, we chose fiscal year 2011  rather than fiscal year 2012 to ensure that contractors would have the  information available at the time of our request.
While we did not independently verify the contractor-reported data, we did  take a number of steps to assess the reliability of the data. Specifically,  we reviewed written responses provided by the contractors on the source  of the data, when that data source was last reviewed or audited, steps  taken by the contractor to ensure the accuracy and completeness of the  data provided, critical assumptions made, and any known limitations on  the reported data. We also looked for inconsistencies in the data, and  followed up as necessary to resolve these inconsistencies. From these  efforts, we believe the information is sufficiently reliable for the purposes  of this report. Appendix I provides additional details on our scope and  methodology.
We conducted this performance audit from January 2013 to June 2013 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives, with one limitation. We  received complete responses to our data request from 27 of the 30  contractors in our sample—7 large-tier, 10 mid-tier, and 10 small-tier. The  three largest contractors from which we requested data—The Boeing  Company, Lockheed Martin Corporation, and Northrop Grumman  Corporation—provided responses to our questions regarding company  size, revenue, compensation practices and the potential impact of  reducing the cap to the salaries of the U.S. President or Vice President.  However, these contractors did not provide data on the number of  employees with compensation costs greater than the salaries of the U.S.  President or Vice President or on the estimated amount of total  compensation that would no longer be allowable at these cap levels.  These three contractors collectively accounted for about 18 percent of all  DOD obligations in fiscal year 2012. Without the data from these three  contractors, our findings with regard to the first objective do not fully  reflect the impact on the large-tier contractors. For the purposes of this  report, data presented on our entire sample reflect responses of the 27  contractors that provided us with complete data; these contractors  accounted for 7 percent of DOD’s contract obligations in fiscal year 2012.  Of the 27, data on large-tier contractors reflects responses from 7  contractors.
subsections: section_title: Background
paragraphs: In fiscal year 2012, DOD obligated approximately $360 billion on  contracts for goods and services, such as major weapon systems,  information technology, professional and administrative support, weapon  system and base maintenance, and office supplies. DOD contracts with  companies of varying size, structure, and type of business. For example,  in terms of size, in 2012, the total number of U.S.-based employees at the  30 companies selected for this review ranged between 10 and more than  150,000. Some of these companies provide goods and services primarily  to DOD, and some also provide goods and services to other federal  agencies or the private sector. For example, the percentage of total  revenues received from the government in 2012 among the companies  included in this review ranged between 4 percent and 100 percent, with  24 of the 30 contractors reporting at least half of their revenues were  received from the federal government.
Contractors can allocate and charge a number of costs to federal  government contracts, including certain types and levels of compensation  costs. The FAR identifies many elements of compensation, including  salaries and wages, bonus and incentive compensation, pension costs,  and fringe benefits such as sick leave, holidays, and employee insurance.  Some compensation costs are considered allowable under government  contracts, while others are considered unallowable. For example,  compensation in the form of bonuses and incentives are allowable under  certain conditions, such as that the basis for the award for a bonus or  incentive payment is supported. Similarly, according to a DCAA official, in  most cases, restricted stock (a form of long-term incentive that includes  actual shares that are earned by continued employment with a company)  is allowable, because the expense is fixed at the time the restricted stock  is awarded. On the other hand, compensation calculated or valued based  on changes in the prices of corporate securities or corporate security  ownership, such as stock options, is unallowable.
In addition to certain types of compensation costs being unallowable, the  cap set by the Office of Federal Procurement Policy can also limit the  amount of compensation paid to certain contractor employees that can be  charged to federal contracts. For purposes of the cap, the FAR defines  compensation to include 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. Because of the cap, there are compensation  costs that might be otherwise allowable, but are unallowable because  they exceed the cap. Figure 1 illustrates the impact of varying the cap on  the allowable costs of compensation paid to two different executives for a  company for which the only source of revenue was federal government  contracts.
In this hypothetical example, executive A was compensated a total of  $900,000 in fiscal year 2011. However, since the cap limited allowable  compensation costs to $763,029 in 2011, executive A’s compensation  included $136,971 that was not allowable because it exceeded the cap.  Executive B’s compensation was $600,000. Because $600,000 was  below the level of the cap, executive B’s compensation was not subject to  the cap. However, if the cap had been reduced to the salary of the  President ($400,000), then both executive A and executive B would have  received compensation that would be unallowable because of the  reduced cap. While the cap limits the compensation costs that contractors  can charge to government contracts, it does not limit what a company can  compensate an employee.
To be allowable, the FAR requires that compensation costs be  reasonable. In determining reasonableness, contracting officers can  consider the extent to which an employee’s compensation is consistent  with other companies that are similar in size, industry, geographic area,  and/or other factors. It is possible that compensation costs may be lower  than the cap, but not reasonable. For example, in the hypothetical  example provided in figure 1, some of Executive A’s compensation costs  beneath the $763,029 cap may not be considered reasonable, if, for  example, employees performing similar work and in companies with  similar characteristics are compensated at a much lower level.
As a part of its auditing responsibilities, DCAA may audit compensation  costs for allowability, allocability, and reasonableness. DCAA policy is  that compensation in total is considered reasonable if the contractor’s  compensation is within a 10 percent range of the market level of  compensation based on survey data.contractor are significant, auditors can request assistance from a  specialized compensation team within DCAA, which follows a defined  process for evaluating the reasonableness of executive compensation.  This specialized team within DCAA also supports the Office of Federal  Procurement Policy in developing the cap.
subsections: section_title: History of the Cap on Contractor Employee Compensation Costs
paragraphs: Since 1998, the Administrator for Federal Procurement Policy has  determined the cap on allowable compensation costs. The cap is set at  the median amount of the compensation provided for the five most highly  compensated employees of all publicly owned U.S. corporations with  annual sales in excess of $50 million for the most recent fiscal year for  which data are available at the time of the determination. To help  calculate the cap, DCAA contracts with an outside vendor, which collects  and analyzes data submitted by corporations as part of the corporations’  annual filing to the Securities and Exchange Commission. DCAA officials  stated the analysis includes data from more than 3,000 companies.  DCAA reviews the data provided by the vendor, then recommends the  cap level to the Office of Federal Procurement Policy, which publishes the  cap in the Federal Register.
Until recently, the cap on compensation costs has only applied to the five  most highly compensated employees in management positions at each  home office and each segment of a contractor. However, the National  Defense Authorization Act for Fiscal Year 2012 expanded the applicability  of the limitation to all contractor employees performing under contracts  awarded by DOD, the Coast Guard, and NASA. The act also provided  that the Secretary of Defense may establish narrowly targeted exceptions  for scientists and engineers, if it is determined that such an exception is  needed to ensure DOD has continued access to needed skills and  capabilities.
The current cap was set at $763,029 and was published by the Office of  Federal Procurement Policy on April 23, 2012. The $763,029 cap applies  to costs incurred during the contractors’ fiscal year 2011 and to  subsequent contractor fiscal years, unless and until revised by the Office  of Federal Procurement Policy. The cap has more than doubled since  1998 in then-year dollars; when adjusted for inflation and measured in  2011 dollars, the cap has increased by about 63 percent in real terms.  Figure 2 shows how the cap has changed since the benchmarking  formula was first established.
section_title: Number of Contractor Employees with Compensation Costs in Excess of Reduced Caps
paragraphs: Reducing the cap to the salaries of the U.S. President or Vice President  would have substantially increased the number of employees with  compensation above the cap in 2010-2012, and in turn, increased the  amount of compensation costs that would have no longer been allowable   Across the 27 contractors reviewed, fewer than  under federal contracts.200 employees in any one year had compensation costs over the existing  cap, but this number would have increased to more than 500 if the cap  had been set at the President’s salary, and to more than 3,000 if the cap  had been set at the Vice President’s salary. At each cap level, most of  these employees were reported at the large-tier contractors; very few  were at small-tier contractors. All of the employees with compensation  costs in excess of the existing cap were identified as executives.  However, reducing the cap would have increasingly affected individuals  who were identified as being managers below the executive level, and in  some cases, would have included individuals serving in non-management  positions. With regard to compensation costs that would not have been  allowable at the various cap levels in 2010-2012, the 27 contractors  reported over $80 million per year in estimated compensation costs in  excess of the existing cap level. Were the cap set at the President’s  salary, this number would have risen to over $180 million, and at the Vice  President’s salary, to at least $440 million per year. The majority of costs  in excess of each cap was reported at the large-tier contractors.
subsections: section_title: Estimated Number of Contractor Employees with Compensation Costs Subject to a Reduced Cap
paragraphs: Based on our analysis of data from the 27 contractors that provided  detailed information, reducing the cap would have significantly increased  the number of employees whose compensation exceeded the cap (see  figure 3).
For example, our analysis indicates that over the last three years, the  contractors reported that in total less than 200 employees each year had  compensation costs that exceeded the existing cap level; however, they  reported more than 500 employees each year with compensation costs  that exceeded the President’s salary, and over 3,000 employees each  year had compensation costs that exceeded the Vice President’s salary.
Figure 4 shows that most employees with compensation exceeding the  various cap levels were employed at large-tier contractors.
As illustrated in figure 4, the seven large-tier contractors reported  approximately three times as many employees with compensation costs  that exceeded the President’s and Vice President’s salaries as did the 10  mid-tier contractors, and more than five times as many employees with  compensation costs that exceeded the existing cap. Small-tier contractors  reported very few employees above any of the cap levels—with only 3 of  the 10 small-tier contractors reporting an employee above any of the cap  levels. In total, the 10 small-tier contractors we reviewed reported no  employees in any year with compensation costs that exceeded the  existing cap level, no more than two employees in any year with  compensation costs above the President’s salary, and no more than five  employees in any year above the Vice President’s salary.
Collectively, the 27 contractors reported that employees whose  compensation exceeded the various caps represented 2 percent or less  of their total number of employees who had costs allocable to government  contracts (see figure 5).
The proportion of employees with compensation costs affected by the  different cap levels would generally have been greater at the 7 large-tier  contractors than the 10 mid-tier contractors reviewed. For example, in  2011, at the 7 large-tier contractors, an estimated 2.4 percent of  employees had compensation costs that would have exceeded the salary  of the U.S. Vice President, whereas at the 10 mid-tier contractors, 1.4  percent would have exceeded the salary of the Vice President.
section_title: Almost Half the Employees Affected by Reducing the Cap to the Vice President’s Salary Would Not Have Been Considered Executives
paragraphs: Figure 6 illustrates the number of contractor employees at different  management levels with compensation costs in excess of each cap for  2011. Contractors included in this review categorized employees as either  executives, non-executive managers, or other, non-management  employees.
All employees with compensation costs that exceeded the existing cap  were identified as executives. Many of those above the existing cap were  identified by their job title as corporate officers or executive vice  presidents. As the cap is reduced, however, employees in non-executive  management positions, or in some cases, those who would not be  considered managers, were increasingly affected. For example,  contractors reported that reducing the cap to the President’s salary would  mean that 147 employees that they considered management, but not  executives, would have been affected, as well as 32 non-management  employees. At this cap level, many employees were identified as senior  vice presidents and vice presidents. At the Vice President’s salary, over  one-third of the affected employees would have been considered non- executive management personnel, and approximately 10 percent would  have been employees who contractors would not consider to be serving  in a management position. Employees whose compensation exceeded  the Vice President’s salary included program managers and directors, as  well as others, such as systems engineers or intelligence analysts.
section_title: Amount of Compensation Cost Potentially Affected by a Reduced Cap
paragraphs: As the number of employees that would have been affected by reducing  the existing cap increases, so too does the amount of compensation that  would have no longer been allowable under government contracts. As  illustrated in figure 7, the 27 contractors reported, in total, over $80 million  in each year in estimated compensation costs that exceeded the existing  cap level.
Contractors identified over $180 million per year in compensation costs  that would have exceeded a cap set at the President’s salary, and at least  $440 million per year if set at the Vice President’s salary.
Large-tier contractors reported greater amounts of compensation costs  that exceeded each of the cap levels than did mid-tier contractors, as  shown in figure 8.
As figure 8 illustrates, in 2011, the 7 large-tier contractors reported  approximately twice as much compensation cost that exceeded the  existing cap level than did the 10 mid-tier contractors. The large-tier  contractors also reported more than three times as much compensation  cost that exceeded the Vice President’s salary than did the mid-tier  contractors, and more than twice as much compensation cost that  exceeded the President’s salary. Small-tier contractors reported very  small amounts of compensation cost above any of the cap levels.
Overall, across all 27 contractors, reported compensation costs in excess  of any of the cap levels represented approximately 1 percent or less of  the contractors’ total revenues from the U.S. government, as shown in  figure 9.
We found that compensation costs in excess of the existing cap were  slightly higher as a percentage of revenues from the government for the  10 mid-tier contractors than the 7 large-tier contractors, and slightly lower  at the other two cap levels.
section_title: DOD Has Not Created an Exception for Scientists and Engineers but the Impact Is Minimal at the Current Cap Level
paragraphs: DOD has not established an exception for scientists and engineers as  permitted under recent legislation and has no ongoing efforts to do so.  DOD officials noted that few, if any, individuals whose compensation  exceeds the current cap level are serving as a scientist or an engineer.  DOD officials noted that if the cap were to be reduced, then it would  consider the need for an exception for scientists and engineers at that  point. While the ability to create exceptions had support from industry,  contractor and industry association representatives identified a number of  challenges that DOD could face in creating an exception for scientists and  engineers. Both DOD and contractors expressed the need for an ability to  create additional exceptions should the need arise.
subsections: section_title: DOD Has Not Created an Exception for Scientists and Engineers
paragraphs: The 2012 legislation expanding the cap on contractor compensation costs  to all contractor employees also allowed the Secretary of Defense to  establish narrowly defined exceptions for scientists and engineers to  ensure that the DOD has access to critical skills and capabilities. As of  April 2013, DOD had not established such an exception, and according to  DPAP officials, there are no ongoing efforts to do so. DPAP officials  explained that at the current cap of $763,029, few, if any, individuals  whose total compensation exceeds that cap are serving as a scientist or  engineer. DPAP officials also noted they believed this would continue to  be the case even after DOD issues regulations to implement the 2012  legislation to expand the cap to cover all contractor employees working  under contracts awarded by DOD, the Coast Guard, and NASA.
Were the cap to be reduced, however, DPAP officials noted that they  would need to consider whether to establish an exception because the  compensation of more individuals would be covered by the cap. DPAP  officials told us that while no formal planning process is underway, among  the options they could consider would be to approve an exception on a  case-by-case basis based on a request from a contractor or from within  DOD, or potentially on a broader class basis for scientists or engineers  that possess critical skill sets that are not widely available in the private  sector. DPAP officials noted that these could include nuclear engineers  with experience in designing propulsion systems or engineers with  experience in space launch technologies. A senior official from DOD’s  Office of the Assistant Secretary of Defense for Research and  Engineering identified others, such as industrial engineers with cost  estimating experience, who might merit consideration, especially if the  economy improves. DOD officials also told us that in order for contractor  employees to qualify for an exception, they would need to function as a  scientist or engineer rather than be identified as such solely based on  background or education.
section_title: Contractor Perspectives on Challenges in Creating Exceptions
paragraphs: While the ability to create exceptions had support from industry,  contractors and industry groups noted that a key challenge in developing  any exception would be how to identify and verify those who would  qualify. For example, industry representatives told us that there might be  added administrative requirements on the government and the industry to  verify how particular employees spend their time in order to qualify for an  exception. One contractor explained that using job titles to identify  scientists and engineers would not be meaningful since it may or may not  reflect an employee’s functional status as a scientist or engineer. In that  regard, in our analysis of the data provided by contractors, we found that  the number of scientists and engineers identified by the contractors was  not always consistent with the number of contractor employees with  “engineer” or “scientist” in their job title. For example, one contractor  classified a total of 10 employees as scientists or engineers that would be  affected by the various cap levels, but listed 33 employees over the cap  with the word “engineer” or “scientist” in their job title. Another contractor  listed 126 employees with compensation costs over the salary of the Vice  President that had the word “scientist” or “engineer” in their job title, but  chose not to classify any of these individuals as scientists or engineers,  as they considered these scientists and engineers to be executives.
Similarly, industry representatives noted that if the exception were to be  based on whether or not the individual performed a scientific or  engineering function, then scientists and engineers that are promoted into  supervisory or managerial positions may not qualify. Industry  representatives noted these individuals often play critical functions in  executing DOD programs, but may not necessarily be performing  engineering or scientific tasks. For example, based on the data provided  by the contractors for fiscal year 2011, if the cap were reduced to the  salary of the Vice President, the majority of the scientists and engineers  that would have been affected were classified as serving in non-executive  management positions. Industry representatives also noted that there is a  growing trend to train employees to be able to perform multiple tasks and  wondered how an exception would account for employees that spend  their time performing engineering and/or financial tasks, supervising  projects, and programming.
Both DOD and contractor representatives noted that the exception is  limited to scientists and engineers, but there may be others providing  valuable skills for the government and that these skills may change over  time. DPAP officials noted that the legislation currently limits the ability to  establish an exception to scientists and engineers and indicated that  other specialties, such as surgeons in the medical profession, may also  warrant an exception. These officials indicated that DOD would need to  seek additional legislation if it determines a need to attract or retain such  skills and capabilities. Similarly, contractor representatives noted they  have employees who provide other types of critical skills to DOD, such as  in the medical or cyber-security areas, and that these skills can shift over  time. For example, they noted that previously there was a shortage of  structural engineers which resulted in higher compensation levels for  those employees, whereas currently software engineers are in high  demand. Consequently, they suggested an ability to develop or modify  exceptions to cover changing conditions would be beneficial.
section_title: Government and Contractor Views on the Potential Effects of a Reduced Cap Differed
paragraphs: Government and contractor representatives emphasized differing  perspectives on the potential effects should the current cap be reduced to  the salary of either the U.S. President or Vice President. Government  representatives generally supported reducing the cap as a means to help  reduce the costs of DOD contracts, whereas industry representatives and  most contractors we reviewed emphasized potential negative impacts to  reducing the cap.
subsections: section_title: Government Representatives Generally Supported Reducing the Cap
paragraphs: OMB and DOD representatives generally supported a reduced  compensation cap. OMB noted that the growth in the cap has outpaced  the rate of inflation, the rate of growth of private sector salaries generally,  and the rate of growth of federal salaries. OMB believed a reduced cap  could bring pay parity between the amount taxpayers pay for senior  executives of the federal government and the amount it pays contractors  to reimburse the costs of compensation for senior executives who  perform work for the federal government on certain types of contracts.  OMB noted that the cap does not and would not limit the amount a  contractor compensates its employees; rather it limits how much  taxpayers reimburse the contractors. OMB staff also noted that they  support the idea of an exception for scientists and engineers to alleviate  situations where the government should pay more than the capped  amount to obtain the necessary talent.
DOD noted that it fully supported the principle of paying only reasonable  compensation costs and some DOD officials supported reducing the cap,  though DOD cautioned that there are limited data on the potential impacts  of doing so and that the impact on the defense industry would need to be  carefully monitored and assessed. DPAP officials stated that industry  would still be able to access necessary talent and noted that many  positions within defense companies involve skills and capabilities readily  available in the commercial marketplace. However, they also stated that  there are certain specialties that are critical to achieving DOD’s missions  and that individuals in those specialties should be compensated  appropriately. At the same time, DPAP officials stated that it is not DOD’s  role to determine how much contractor employees are compensated. In  terms of the administrative impact of a reduced cap on contract audit and  oversight processes, DCAA and DCMA officials stated that they would  expect additional workload associated with a reduced cap. For example, if  the cap were set at the salary of the Vice President, DCAA officials noted  they would need to evaluate whether individuals working on a single  contract might have compensation costs that exceeded the cap.
section_title: Industry Association and Contractor Views on Reducing the Cap
paragraphs: Industry associations and many contractors questioned the premise of  capping allowable contractor compensation costs at a set amount which  is not based on market competition, emphasizing that standard industry  practice is to benchmark employee compensation levels based on  compensation levels for similar positions at their competitors and other  private sector companies. In addition, an industry association noted that  the FAR states that a cost is considered reasonable if it does not exceed  “that which would be incurred by a prudent person in the conduct of  competitive business,” and linked this statement to the defense industry  practice of analyzing market trends in compensation.
According to industry representatives and contractor representatives,  defense companies generally obtain market survey information to aid in  determining the appropriate compensation levels for a range of positions,  not just senior executives. For example, the defense industry competes  for highly specialized engineers, software engineers, and manufacturing  specialists that help design, test, and manufacture DOD weapon systems.  Other company representatives noted that the defense industry also  competes with global industries of all types for highly qualified  management personnel, including finance specialists, program managers,  and other functional experts. Market survey information forms the basis  for offers companies make to prospective new hires as well as changes in  compensation designed to retain existing employees at all levels within  the company. To be competitive for talent and manage total personnel  costs to the company, industry associations and contractor  representatives reported that defense companies typically target  compensation levels at the median amount offered in the market for a  given position, and have established ranges above and below that level  that can be used to address specific circumstances. In that regard, an  industry association provided summary benchmarking information that  indicated the competitive compensation ranges for a variety of disciplines  and positions, including those in engineering, finance, general  management, information technology, general counsel, and  manufacturing and quality assurance, exceeded the salary of the Vice  President, and in some cases, exceeded both the salary of the President  and the current cap. Industry representatives noted that the definition of  compensation used in the summary benchmarking information differs  from the definition of compensation used for the cap. As a result, it is not  possible to directly compare the summary benchmarking information  provided to the potential new cap levels.
Additionally, industry associations and contractor representatives cited a  number of long-term negative impacts or potential unintended  consequences of reducing the cap. For example, several contractor and  industry representatives stated that even though a cap does not limit what  the company can pay the employee, companies may consider limiting the  compensation paid to their employees over the long term. These  representatives noted that industry relies on capital markets to provide  the capital necessary to operate and invest in future capabilities. To  attract capital, the markets demand that industry match its cost structure  to what its customers, such as the government, are willing to pay. If large  numbers of employees were paid in excess of what is allowable under  government contracts, then the companies’ cash flow would be disrupted  and the potential to generate earnings would be reduced. In turn, this  condition would impair a company’s access to capital markets, and  damage shareholder value. To mitigate the risk posed by this scenario,  these representatives noted that a company may reduce the  compensation levels for employees to reduce or eliminate the gap  between what is paid to the employee and what is reimbursed by the  government.
Similarly, several contractors stated their view that companies’ ability to  attract and retain the most highly talented individuals may be reduced if  the company limits their compensation, particularly once they become  most valuable in terms of their skills and expertise. Some contractors  further noted that if government contractors are unable to attract and  retain top talent, this may result in a lower quality of products and  services provided to the government. For example, one industry  association representative stated that knowledgeable, practiced, and  compensated talent can more efficiently and effectively address complex  issues as opposed to less experienced talent.
More generally, companies also noted that reducing the cap might  encourage companies to shift away from defense or other government  contract work to commercial work. For companies with both commercial  and government work, some company representatives stated that  assigning the company’s best talent to the commercial side of the  business may become a more prudent business decision because of the  ability to recover the total costs of an employee’s compensation;  contractor employees who have a choice may also opt not to work on  government contracts to avoid potential constraints on compensation.  They also stated their view that, if this were the case, then the  government may not have access to the skills and capabilities needed to  successfully produce or deliver high-quality, technologically advanced  goods and services to DOD.
While industry associations and many of the large-tier and mid-tier  contractors expressed concerns should the cap be reduced, most small- tier companies we reviewed generally stated they would either be only  minimally affected or not affected should the cap be reduced because  they generally did not offer compensation above the Vice President’s  salary.
section_title: Agency Comments and Our Evaluation
paragraphs: OMB’s e-mailed response stated that the compensation amounts  identified in the report underscore the need for action to reform the cap.  OMB stated that it has sent a legislative proposal to Congress that would  abolish the current formula for calculating the cap, tie the level of the cap  instead to the President’s salary, and apply it to all employees for both  defense and civilian cost reimbursement contracts. OMB also stated that  savings from lowering the cap would be substantially higher than the  $180 million cited in the report as compensation costs exceeding the  President’s salary, since the contractors included in the sample account  for 7 percent of DOD’s fiscal year 2012 contract obligations. OMB also  provided technical comments, which were incorporated into the report as  appropriate.
DOD provided written comments on a draft of this report. DOD stated that  the report provides a significant amount of information, but expressed  concern that it is based on a relatively small sample of DOD contractors  and cited a need for additional research to determine what constitutes  reasonable employee compensation costs. DOD also stated that, while it  fully supports the principle of paying only reasonable compensation costs,  it must avoid a policy that would drive away the talent needed to maintain  strategic advantage and the national industrial base. DOD’s comments  are reprinted in appendix III.
We noted in the report that our sample was not generalizable and that  some findings, particularly those associated with the impact that the  potential reductions of the cap may have on the large-tier contractors, are  limited since the three largest contractors selected did not provide  requested data. Nevertheless, we believe the report provides valuable  insights into the potential implications of changes in the cap. These  insights include (1) how the cap levels would have affected selected  large-tier, mid-tier, and small-tier contractors differently, both in terms of  numbers of employees affected and the amount of compensation costs  considered unallowable, and (2) how, as the cap is lowered, more  employees in non-executive positions would have been affected at these  contractors.
We are sending copies of this report to interested congressional  committees, the Secretary of Defense; the Director of the Office of  Management and Budget; and other interested parties. This report will  also be available at no charge on GAO’s website at http://www.gao.gov.
If you or your staff have any questions concerning this report, please  contact me at (202) 512-4841 or by e-mail at dinapolit@gao.gov. Contact  points for our Offices of Congressional Relations and Public Affairs may  be found on the last page of this report. Key contributors to this report are  listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Section 864 of the National Defense Authorization Act for Fiscal Year  2013 directed GAO to report to Congress on the effect of reducing the  allowable costs of compensation to the salary of the U.S. President or  that of the U.S. Vice President, which are currently $400,000 and  $230,700, respectively. This report provides (1) estimates of the number  of employees of a sample of Department of Defense (DOD) contractors  whose compensation would have exceeded a cap set at the salaries of  either the U.S. President or Vice President, and the amount of  compensation that would not have been allowable; (2) the status of  DOD’s efforts to establish an exception for scientists and engineers and  the extent to which scientists and engineers would be affected by  reducing the cap; and (3) the views of government and contractor  representatives on potential effects of a reduction in the cap. In addition,  in response to a matter identified in Section 864 of the National Defense  Authorization Act of 2013, appendix II includes information on the extent  to which employees of DOD contractors included in this review received  compensation in the form of vested or unvested stock options.
To assess these objectives, we reviewed relevant laws (e.g., National  Defense Authorization Act for Fiscal Year 2012 (Pub. L. No. 112-81, §  803(a)(1) (2011)), National Defense Authorization Act for Fiscal Year  1998 (Pub. L. No. 105-85, § 808(a)(1) (1997)), regulations (e.g., Federal  Acquisition Regulation (FAR) Subpart 31.2—Contracts with Commercial  Organizations), and guidance (e.g., Defense Contract Audit Agency  (DCAA) Contract Audit Manual Chapter 6 (Incurred Costs Audit  Procedures)) and interviewed representatives from Defense Procurement  and Acquisition Policy, the Office of the Assistant Secretary of Defense  for Research and Engineering, DCAA, the Defense Contract  Management Agency, the Office of Federal Procurement Policy within the  Office of Management and Budget, selected contractors, and industry  associations with knowledge of contractor compensation issues, including  the Aerospace Industries Association, Financial Executives International,  Professional Services Council, and TechAmerica.
We also requested data from a stratified, random sample of 30  contractors on a number of items related to each objective. Detailed  information on how we selected the 30 contractors is included below. In  our data request, we asked for data on most questions for fiscal years  2010, 2011, and 2012. To simplify the data request, we collected for fiscal  year 2011 information on some questions where we determined one year  of information was sufficient to provide useful insights, such as questions  related to the number of employees at different management levels and a  question about employee job titles. In these instances, we chose fiscal  year 2011 rather than fiscal year 2012 to ensure that contractors would  have the information available at the time of our request. While we did not  independently verify the contractor reported data, we did take a number  of steps to assess the reliability of the data. Specifically, we reviewed  written responses provided by the contractors on the source of the data,  when that data source was last reviewed or audited, steps taken by the  contractor to ensure the accuracy and completeness of the data provided,  critical assumptions made, and any known limitations on the reported  data. We also looked for inconsistencies in the data, and followed up as  necessary to resolve these inconsistencies. From these efforts, we  believe the information is sufficiently reliable for the purposes of this  report.
In addition to the tasks performed that were relevant to all objectives, we  performed the following tasks specific to each objective:
To determine the extent to which DOD contractors would be affected  by reducing the cap to the salaries of the President and Vice  President, we collected and analyzed data from selected contractors  on the estimated number of employees with compensation costs that  would have been allowable (as determined by the contractors) but for  the cap and exceeded the contractor fiscal year 2010 cap of  $693,951; the fiscal year 2011 cap of $763,029; and, for fiscal year  2012, the amount of $763,029. We also collected data on the dollar  amounts of compensation costs for these employees that would have  been considered unallowable in 2010, 2011, and 2012 by virtue of  exceeding either the current cap, the salary of the President, or that of  the Vice President. To provide insight into the types of employees  affected, we also collected information on the titles of the individuals  who would have exceeded those three potential cap levels in  contractor fiscal year 2011, as well as on whether the contractor  would have classified affected employees as executives, non- executive management, or non-management.
To determine the status of DOD’s exception for scientists and  engineers and the extent to which scientists and engineers would be  affected by reducing the cap, we interviewed DOD officials on the  status of and/or plans for establishing an exception and to whom such  an exception might apply. We collected and analyzed data from  selected contractors on the number of employees the contractor  would have classified as scientists and engineers, based either on  function, education, or background, and information on the proportion  of these scientists and engineers considered executives, non- executive management, or non-management for contractor fiscal year  2011. We also interviewed other government representatives, industry  associations, and selected contractors to identify the potential impact  of reducing the cap on scientists and engineers and other highly  skilled professionals.
To determine government and contractor representatives’ views on  the potential impacts of reducing the cap, we interviewed government  representatives and industry associations. We also analyzed  qualitative responses obtained as a part of our data request from  contractors selected for review on the potential impacts of reducing  the cap.
To determine the extent to which contractor employees received  compensation in the form of stock options, we reviewed regulations (e.g.,  FAR § 31.205-6(i)) and guidance (e.g., DCAA Contract Audit Manual 7- 2123) governing the allowability of stock options and other stock related  compensation. We collected and analyzed data from selected contractors  on the number of contractor employees performing under government  contracts who were granted stock options, and the number of contractor  employees performing under government contracts who were granted  restricted stock, for contractor fiscal years 2010, 2011, and 2012.
subsections: section_title: Contractor Selection Methodology
paragraphs: To obtain data for each of the objectives, we selected a stratified, random  sample of 30 contractors that had received fiscal year 2012 obligations in  excess of $1 million on DOD contracts for non-commercial items.  Because the cap is concerned with cost-based contracts, we excluded  commercial item contracts, as well as contractors that only had  obligations on firm fixed price contracts and/or fixed-price with economic  price adjustment contracts. We based our selection of contractors on data  from USAspending.gov.
We divided the contractors into four strata: contractors with fiscal year  2012 obligations (1) greater than $25 billion; (2) between $2 billion and  $25 billion; (3) between $15 million and $2 billion with primarily non-small  business dollar obligations; and (4) between $1 million and $15 million  with obligations that were primarily small business dollars. All contractors  in the first stratum were selected (2 total). The 19 contractors in the  second stratum were divided into those that primarily provided products  and those that primarily provided services, and 4 contractors were  randomly selected from each of those groups (8 total). Ten contractors  were randomly selected from the third stratum, and another 10  contractors were randomly selected from the fourth stratum. For the  purposes of this report, we refer to contractors from the first two selection  groups as large-tier contractors, the third group as mid-tier contractors,  and the fourth group as small-tier contractors. The 30 contractors  received about 25 percent of all fiscal year 2012 DOD contract  obligations. We randomized the full lists of contractors at each stratum  before making the selection, anticipating that certain contractor  characteristics not evident at the time of randomization may require  exclusion from the sample. This approach allowed us to move to the next  contractor on the list in cases where contractors did not meet criteria for  selection, while still maintaining a random selection process. Reasons for  exclusion included the contractor being a non-profit, imperfections in the  data (e.g., the Department of Energy being listed as a company), or the  contractor not being incorporated in the United States. This sample is not  generalizable, but is designed to illustrate the potential impact that  reducing the cap would have on contractors of varying sizes.
We conducted this performance audit from January 2013 to June 2013 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives, with one limitation. We  received complete responses to our data request from 27 of the 30  contractors in our sample—seven large-tier, 10 mid-tier, and 10 small-tier.  The three largest contractors from which we requested data—The Boeing  Company, Lockheed Martin Corporation, and Northrop Grumman  Corporation—provided responses to our questions regarding company  size, revenue, compensation practices and the potential impact of  reducing the cap to the salaries of the U.S. President or Vice President.  However, these contractors did not provide data on the number of  employees with compensation costs greater than the salaries of the U.S.  President or Vice President or on the estimated amount of total  compensation that would no longer be allowable at these cap levels.  These three contractors collectively accounted for about 18 percent of all  DOD obligations in fiscal year 2012. Without the data from these three  contractors, our findings with regard to the first objective do not fully  reflect the impact on the large-tier contractors. For the purposes of this  report, data presented on our entire sample reflect responses of the 27  contractors that provided us with complete data; these contractors  accounted for 7 percent of DOD’s contract obligations in fiscal year 2012.  Of the 27, data on large-tier contractors reflects responses from 7  contractors.
section_title: Appendix II: Grants of Stock Options or Restricted Stock to Contractor Employees
paragraphs: Across the large-tier and mid-tier contractors included in this review,  seven reported their company granted stock options (vested or unvested)  to employees with compensation costs allocated to U.S. government  contracts in any of the years covered. These contractors granted stock  options on average to between 0.6 percent and 0.9 percent of employees,  depending on the year. Nine of the contractors reported granting  restricted stock to employees. These contractors granted restricted stock  on average to between 0.8 percent and 1.2 percent of employees,  depending on the year. No small-tier contractor included in this review  reported granting stock options or restricted stock to any employees  during the years covered.
section_title: Appendix III: Comments from the Department of Defense
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above Karen Zuckerstein (Assistant  Director), Robert Bullock, Virginia Chanley, John Crawford, Danielle  Greene, Julia Kennon, John Krump, Janet McKelvey, and Roxanna Sun  made key contributions to this report.