Excessive Pass-Through Costs

Last month, the FAR councils published an interim rule that limits excessive pass-through costs charged to Government contracts. The limit on excessive pass-through costs has applied to DoD contracts since 2007. The new interim rule covers all Government contracts.

 We will discuss how the new rule works, but first, some definitions.

• Pass-through costs are defined as indirect costs and profit or fee.
• Excessive pass-through costs arise when a contractor (or a higher-tier subcontractor) subcontracts out all or a substantial portion of the work and adds no or negligible value to contract performance. Excessive pass-through indirect costs are unallowable.
• No or negligible value means that the contractor cannot demonstrate to the contracting officer that its effort added value to the contract in accomplishing the work performed under the contract.
• Added value means that the contractor performs subcontract management functions that the contracting officer determines are a benefit to the Government (e.g. processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, and performing quality assurance functions.

For DoD contracts, this regulation applies to negotiated cost-type and fixed price contracts greater than $650 thousand (cost or pricing data threshold). For civilian agencies, it apples to cost-type contracts over $100 thousand (simplified acquisition threshold).

The interim rule includes requirements for both offerors/contractors and Government contracting officers.

Proposal preparation phase:

1. Offerors must identify the total cost of the work to be performed by the offer and the total cost of the work to be performed by each subcontractor.
2. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed under the contract, the offeror shall identify
• the amount of indirect costs and profit/fee applicable to the work to be performed by subcontractors
• a description of the added value provided by the offeror as related to the work to be performed by the subcontractors

Negotiation and award phase:

• If the offeror intends to subcontract more than 70 percent of the cost of work to be performed, the contracting officer must make an affirmative determination that pass-through costs are not excessive.

After contract award phase:

1. Contractor must notify the contracting officer (in writing) if it changes the amount of subcontract effort after award such that it exceeds 70 percent of the total cost of work to be performed.
• must identify the revised cost of the subcontract effort.
• must include verification that the contractor will provide added value
2. If the contracting officer determines that excessive pass-through charges, the Government can recover.
• for cost-type contracts - unallowable for reimbursement
• for fixed price contracts - contract price reduction
3. Contracting officer or authorized representative (e.g. DCAA) has right to examine and audit contractor records necessary to determine whether the contractor proposed, billed, or claimed excessive pass-through charges.

PNWC observations.

1. A contractor's G&A base will influence whether indirect pass-through costs are excessive. The three most common G&A allocation bases are total cost input (TCI), modified TCI (excludes subcontract costs) and single-element (usually direct labor costs). Modified TCI and single-element allocation bases already exclude subcontract costs which means that subcontract costs are not burdened with G&A and therefore could not have excessive pass-through indirect costs.
2. Profit/Fee percentages might already reflect the anticipated level of subcontracting. When the Government uses the weighted guidelines method to establish negotiation targets for profit or fee (most of the time), it assigns weights to various risk factors. One of those factors is the degree of management effort necessary to ensure that contract requirements are met. Many contracting officers weight this element lower when the offeror has proposed significant subcontract costs.
3. Subjectivity of the contracting officer determination: The determination of whether contractor activities benefit the Government include an assessment of such things as processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, performing quality assurance functions. This is a very subjective assessment and contractors should not underestimate the benefit of "good writing" when describing the value it intends to add to the subcontracted effort. 
4. GAO Review: The GAO reviewed DoD implementation of the earlier interim regulation (see GAO-08-269, Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges). The GAO stated that contracting officers needed guidance in how to assess whether proposed pass-through costs are reasonable for the work performed. Additionally, they should obtain DCMA and DCAA input. DoD responded that it willl issue guidance once the regulation becomes final.