CM Magazine - Contractor Employee Morale: The Government Benefits, but will They Pay for It?

It is axiomatic to say that good morale benefits a government contractor, and ultimately the government itself.  

It is also true that the many actions that contribute to morale, such as treating employees with respect, don’t cost anything. If your workforce is suffering from poor morale, it is unlikely that coffee mugs or company branded polo shirts are the solution. That said, virtually every company, including commercial firms, supplement their approach to maintaining/boosting morale by offering employees perks, events, activities, food, etc. that do cost money. The question for government contractors is, are employee morale costs “allowable”?

The Cost Principles

There are three separate Federal Acquisition Regulation (FAR) Part 31 cost principles that address the allowability of employee morale costs:

• The Employee Morale cost principle — FAR 31.205-13, “Employee Morale, Health, Welfare, Food Service and Dormitory Costs and Credits”; 
• The Entertainment cost principle — FAR 31.205-14, “Entertainment Costs”; and
• The Compensation for Personal Services cost principle — FAR 31.205-6, “Compensation for Personal Services.”

Employee morale costs are primarily, if sparingly, addressed in FAR 31.205-13, where employee morale is lumped together with such things as employee relations, health, welfare, food services, and dormitories. Most of the cost principle is devoted to the allowability of food and dormitory losses, which applies to very few present-day CONUS contractors.  

Through 1995, auditors, contracting officers, and even courts were inconsistent in interpreting this cost principal as it applied to employee morale costs. For instance, various courts ruled that the cost of such activities as company picnics, birthday luncheons, Friday afternoon pizza parties, and other employee “get-togethers” were allowable employee morale costs. These and similar rulings were made even though such costs are unallowable per the Entertainment cost principle. Per this cost principle, the costs of amusement, diversions, social activities, and any directly associated costs are unallowable. 

One plausible interpretation of the FAR was that even though the costs of picnics, parties, etc. are unallowable per the Entertainment cost principle, if the purpose of the event was to improve employee morale, the costs would be allowable per the Employee Morale cost principle. Government contracting veterans may recall when there was a serious debate about what employee morale costs could be claimed. 

For the most part, the confusion about whether employee morale costs were allowable was resolved on October 1, 1995, when the FAR was amended to more clearly limit the employee morale costs that can be claimed. The Employee Morale cost principle was changed to explicitly disallow the costs of recreation other than “company sponsored sports teams or other employee organizations designed to improve company loyalty, team work, or physical fitness.”In addition, the costs of gifts were made explicitly unallowable,unless they are part of the contractor’s formal compensation plan (and thus allowable as a “bonus” under the Compensation for Personal Services cost principle). Equally important, the Entertainment cost principle was amended to state that “[c]osts made specifically unallowable under this cost principle are not allowable under any other cost principle.” 

The current version of the Employee Morale cost principal is confusing because the opening sentence (“Aggregate costs incurred on activities designed to improve…employee morale…are allowable, subject to the limitations contained in this subsection”) seems to be a general grant of allowability. However, the two limitations contained further within the cost principlemean that most common costs associated with employee morale — specifically, costs associated with “gifts” and “recreation” — are unallowable. 

Gifts and Recreation

Neither gift nor recreation are defined in the FAR. However, gift can generally be defined as “something voluntarily transferred by one person to another without compensation”(i.e., a “present”). 

Wages, salaries, and fringe benefits are not “gifts” because the employee “pays” for these items by working the required hours. Any items of value given to employees that are not part of their salary/wages or the company’s fringe benefit package (or otherwise provided as compensation for something) are likely to be construed as “gifts.” 

Likewise, recreation may generally be defined as “refreshment of strength and spirits after work,” or “a means of refreshment or diversion”(i.e., a “hobby”). 

As one of our colleaguesis fond of saying, “If the expenditure results in anyone having fun, it is most likely unallowable.” 

Allowability of Employee Morale Costs

The Employee Morale cost principle lists several examples of allowable costs, including: 

• House publications (e.g., “employee newsletters”); 
• Health clinics; 
• Wellness/fitness centers; 
• Employee counseling services; and 
• Food and dormitory services at or near the contractor’s facilities. 

However, if you have ever experienced sleeping in a dormitory or eating cafeteria food, you may be challenged to state that these activities affirmatively improved your morale. Further, employee welfare programs and health clinics are designed to assist individual employees, not to improve overall morale. 

In addition to fitness centers,the Employee Morale cost principle only provides one other example of an “allowable” employee morale cost. This allowable cost includes the cost of employee participation in a company sponsored sports team. 

So, one can realistically glean two specific things from the Employee Morale cost principle regarding employee morale costs: 

• Fitness centers and company sponsored sports teams are allowable, and 
• Gifts and recreation are not allowable.  
• Even if the contractor can show that the cost is not for a gift or recreation, it may still be unallowable per the Entertainment cost principle. 

Hypotheticals

Hypotheticals can show the nuanced way the three applicable cost principles must be viewed collectively to determine allowability. Suppose a contractor’s established incentive compensation plan includes awarding the employee of the quarter a $500 bonus, payable in cash. The $500 award is “allowable” as it qualifies as an exception to the gift limitation in the Employee Morale cost principle because it is to recognize achievement and is considered “allowable incentive compensation” under the Compensation for Personal Services cost principle. However, if instead of $500, the employee was awarded box seat tickets to a professional sports game worth $500, the cost would be unallowable — even if the contractor could argue that attending the game was not “recreation” and that the award was allowable as a “bonus” under the Compensation for Personal Services cost principle. This is because the tickets would be unallowable pursuant to the Entertainment cost principle — which states, “[c]osts made specifically unallowable under this cost principle are not allowable under any other cost principle.”

Another example of an unallowable employee morale expense is treating the staff to lunch at a nice restaurant as a reward for working especially hard during the month. Conversely, catering the same food into a conference room meeting with the staff to discuss a business subject, such as “how to improve employee morale,” might be an allowable cost as a business meal.

Lastly, suppose a contractor offers employees a free hour of yoga instruction on Tuesdays and Thursdays after work. The cost for the instructor might be allowable under the “physical fitness” exception to recreation under the Employee Morale cost principle,but is it unallowable as an amusement or diversion pursuant to the Entertainment cost principle? As you can see, the allowability of employee morale costs can depend on subtle differences. 

Specific Unallowable Costs

Based on the 1995 amendments to the FAR, there is consensus that the following costs are unallowable:

• Mugs;
• Apparel, such as company shirts;
• Holiday parties;
• Company picnics;
• Employee outings, such as a night at the ball park;
• Meals not qualifying as business meals;
• Birthday or other celebratory cakes;
• Flowers; and
• Tickets to sporting events, concerts, plays, etc. — plus directly associated costs.

However, not all contractors are aware of the consensus, and many contractors — especially those new to government contracting — do claim those costs and other even more exotic expenditures. While these costs are typically relatively modest, they represent “low hanging fruit” to the auditor and may be subject to penalties and interest based on the fact that such costs are explicitly unallowable. 

Practical Tips

Just because some employee morale costs are unallowable does not mean they all have to be. For instance, contractors need to be careful with their bonuses or employee achievement awards. Though the Employee Morale cost principle excludes bonuses and achievement awards from the definition of gift, there is a caveat: To be allowable, the bonus or award must be paid —

• Under an agreement between the company and the employees, or
• Pursuant to a plan or policy followed so consistently as to imply an agreement.

If there is no agreement or consistently followed bonus/incentive compensation policy, a bonus or award payment takes on the characteristics of an unallowable gift in lieu of allowable compensation. 

Account nomenclature is also important. Costs included in a trial balance account entitled “Employee Morale” or something similar will almost certainly be reviewed. (It is recommended that an account be established in the unallowable cost section of the trial balance entitled “Employee Morale.” Only costs that the company is willing to treat as unallowable should be booked there.)

Bonuses and other employee achievement awards should be charged to an indirect account, such as fringe benefits. If your building contains a fitness center, the costs should be charged to a facilities account. The costs of offering employees discounts to join a local fitness center should be charged to fringe benefits. Companies that sponsor employee sports teams usually charge these costs to an office supply account.   

Conclusion

One has to understand three costs principles in order to correctly account for employee morale costs. Mingling allowable and unallowable employee morale costs in the same account is asking for trouble in the audit. Utilizing an unallowable Employee Morale account and charging allowable employee morale costs to other accounts will greatly simplify the audit.  

Finally, with a little foresight and some documentation, many employee morale costs can be structured to be allowable. By following these tips, you will not let disallowed employee morale costs lower your morale. CM

 

Tom Marcinko

Principal Consultant, Aronson LLC’s Government Contract Service Group

Member, Florida BAR 

 

Deirdre Bond 

Managing Consultant, Aronson LLC’s Government Contract Service Group

This article describes the cost principles that govern the allowability of employee morale costs, provides examples of allowable and unallowable costs, and concludes with practical tips to help contractors correctly account for such costs.

 

Endnotes

1.) FAR 31.205-13(c).

2.) Ibid., at (b).

3.) FAR 31.205-14.

4.) I.e., FAR 31.205-13(b) and (c).

5.) Definition of “gift,” Merriam-Webster.com, available at https://www.merriam-webster.com/dictionary/gift.

6.) Definition of “recreation,” Merriam-Webster.com, available at https://www.merriam-webster.com/dictionary/recreation.

7.) At Aronson LLC.

8.) FAR 31.205-13(a). (Note that 31.205-13(a)(5)(i) and (ii) list several examples of allowable “food and dormitory services.”)

9.) FAR 32.205-13(a)(3).

10.) FAR 32.205-13(c).

11.) I.e., FAR 31.205-13(a)(2).

12.) FAR 31.205-6(f)(1)(i).