Bonuses and the Federal Acquisition Regulation

Entities that contract with governmental agencies and include bonuses in their claimed compensation must be certain to follow the Federal Acquisition Regulation (FAR) to ensure that the bonuses will be includable in their overhead rates as an allowable and reasonable cost. Governmental agencies, particularly state departments of transportation, use the overhead rate to determine total costs to be paid under a contract. Bonus plan payments often represent a large portion of allowable costs claimed as total compensation in an entity’s overhead. Making sure your bonuses are allowable is important because your overhead rate can change significantly if you fail to follow FAR guidelines.

Bonus plan basics

Bonuses are governed by FAR Part 31.205-6(f) — Compensation for Personal Services – Bonuses and incentive compensation. It states that bonuses are allowable costs under the following conditions:

1. 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; and
2. Basis for the award is supported.

Auditors are interpreting this to mean that 1) the plan has to be written and 2) for the basis of the award to be supportable, the recipient must understand what performance measures are required to earn a bonus and how those factors will be evaluated.

Best practices for bonus payouts

If a company is going to claim bonus payouts under the FAR, it should maintain a written bonus plan that documents the eligibility criteria, the period of the plan, the performance criteria (which should be measurable and verifiable), the form of payment, and the distribution timeline.

The eligibility terms should also include which members of the company qualify for the bonus. Some bonus plans cover all employees, but others are limited to professional and management staff. Measurable results should include a determination for whether success is based on results of an individual, a team, or a department, the company as a whole, or some combination of these factors. The calculation of the award should describe whether bonuses are based on a percentage of an employee’s base salary, a lump sum distribution, an available pool of money to be distributed, or some other factor.

The primary driver for the bonus must also be performance. It is understood that, in most instances, the payout of a bonus requires a profit; however, that must not be the primary factor in the company’s award process. A superior performer often receives incentive compensation even when the overall company performance is not positive. In the written bonus plan, the description of the company’s performance should be expansive and address metrics or state that the employee’s manager(s) will define each eligible participant’s metrics at the beginning of the plan period.

Communicate with employees

A company’s bonus plan and performance requirements should be communicated to employees prior to the performance of the service necessary to earn an award, generally at the beginning of the year or shortly thereafter. It is the company’s responsibility to establish that its bonus plan is compensation for performance in the award period. If the company’s overhead rate is audited by a department of transportation or another government agency, it is very likely the auditor will request individual performance requirements and metrics, and interview employees to assess their understanding of the plan and what was required of them to meet their goals and receive a bonus.

It is important that a company follows its bonus plan. If the bonus awards do not match the criteria in the plan, the bonuses may be considered unallowable and the overhead rate reduced.

Review your plan

A company claiming bonuses as an allowable cost under the FAR should review its bonus plan to ensure that it contains objective, performance-based criteria, and that the company has communicated to eligible staff prior to the measurement and performance period. Failure to follow the plan when determining bonus amounts generally results in the total disallowance of the cost.