Excessive Pass-Through Costs - Audit Oversight

Pass-through costs are indirect costs and profit/fee applied to subcontract costs. Excessive pass-through costs are those that add no or negligible value to a contract. No or negligible value means that the contractor could not demonstrate to the contracting officer's satisfaction that its effort adds value to the contract in accomplishing the work to be performed under the contract.

Six years ago, FAR (Federal Acquisition Regulation) was amended to prohibit contractors from claiming claiming excessive pass-through costs (see Excessive Pass-Through Costs). There are two parts to that prohibition - solicitation phase and contract phase. In the solicitation phase, if a contractor intends to subcontract more than 70 percent of the total cost of work to be performed, it must specify the amount of indirect costs and profit/fee applicable to the subcontracted work and provide a description of the added value it provides as related to the work performed by subcontractors. Of course we all know that circumstances change between the proposal submission and actual performance so the regulations also require contractors to notify the contracting officer when the level of subcontracted effort exceeds 70 percent (whether proposed that way or not) and some kind of verification that it has provided added value. If the contracting officer determines that excessive pass-through charges exist, the excessive costs are unallowable. The contract provision also gives the Government the right to examine and audit all contractor records necessary to determine whether the contractor proposed, billed, or claimed excessive pass-through charges.

Later in 2011, we published a three part series on how the Government intended to review and audit implementation of the excessive pass-through cost prohibition (see Excessive Pass-Through Costs, Part 1, Part II, and Part III) wherein we highlighted guidance that DCAA (Defense Contract Audit Agency) had published. Essentially, the guidance focused on compliance with the notification requirements if the level of subcontracting exceeded 70 percent. Noncompliances were to be reported to the contracting officer for a determination of whether pass-through costs were excessive on a case-by-case basis.

Audit Oversight during Incurred Cost Audits

During audits of incurred costs, auditors are directed to use the information contained in contractors' incurred cost proposals to ascertain whether any contracts approach the 70 percent threshold. Then, depending on the contract clause, will perform one of two analyses.

If FAR 52.215-23, Alternate I is included, the contracting officer already made a determination at the time of award that the prospective contractor has demonstrated that its functions provide added value to the contracted effort and there are no excessive pass-through charges. When Alternate I is present, auditors will compare the contractor demonstrated value-added functions with those disclosed to the contracting officer at the time of award to ensure the functions billed or claimed are consistent with the contracting officer determination. Additionally, the auditor will ensure that the disclosed value-added functions were performed and are reasonable.

If the contract does not contain the FAR Alternate I clause, the auditor is directed to perform procedures to determine if the contractor incurred excessive pass-through charges. This will include a request that the contractor identify the value-added functions it provided and a verification that the disclosed functions were performed, are reasonable and represent value-added effort, If the auditor concludes that the functions were not performed or add no negligible value to the contract, he/she is directed to question excessive pass-through costs (i.e. all of the indirect and profit/fee attributable to subcontract costs).

Obviously, there is a subjective element to the analysis that the auditor is required to perform and in some cases, may not be qualified to make. Our advice to contractors should auditors begin inquiring into this area is to engage your contracting officer as early in the process as possible. Ultimately the determination as to whether pass-through costs represent value-added is the contracting officer's responsibility and if you can obtain contracting officer concurrence before an audit report is issued, a lot of time and effort will be saved.