Monday, March 28, 2011

Excessive Pass-Through Costs - Audit Guidance

Last October, the FAR councils added an interim rule to FAR that limited the allowability of excessive pass-through costs on Government contracts. The interim rule was replaced by a final (essentially unchanged) rule in December and the final rule became effective last January. Refer to our post of December 17, 2010 for an overview of the pass-through requirements. Now that the requirement has been in place for a few months, we can offer a few insights into how the Government will ensure contractor compliance with the provisions. Today and for the next two days, we will discuss compliance aspects that contractors should be cognizant of during the pricing, performance, billing, and closeout phases of a contract in order to comply with these new prohibitions on excessive pass-through costs.

First some background. For DoD contracts, the new pass-through provisions apply to fixed price and cost-reimbursement type solicitations where the estimated contract value exceeds the threshold for obtaining cost or pricing data (currently $700 thousand). For civilian agencies, the provisions apply to solicitations for cost-reimbursement contracts greater than $100 thousand.

When these thresholds are reached, prospective contractors must identify in their proposals, the total cost of work they will perform and the total cost of work to be performed by subcontractors. If the proposed subcontracted effort is expected to exceed 70 percent of the total cost of work to be performed, the prospective contractor must also identify the amount of indirect costs and profit/fee applicable to the work to be performed by the subcontractor along with a detailed description of the "added value" to be provided by the offeror as related to the work to be performed by the subcontractor.

"Added Value" in this context is defined in FAR 52.215-23 but has a subjective aspect to it as well. Added value according to FAR means that the contractor will perform subcontract management functions that the contracting officer determines are a benefit to the Government. Note the contracting officer's role in determining whether a contractor adds value. Examples of subcontract management functions listed in FAR include (i) processing orders of parts or services, (ii) maintaining inventory, (iii) reducing delivery lead times, (iv) managing multiple sources for contract requirements, (v) coordinating deliveries, and (vi) performing quality assurance functions.

If a prospective contractor cannot establish to the contracting officer’s satisfaction that it will add value to proposed subcontract costs, any indirect costs and profit/fee applicable to those proposed subcontract costs, those allocations are determined to be “excessive pass-through” costs and are unallowable and will not be paid or reimbursed by the Government. Those costs are also unallowable, meaning they cannot be allocated to other Government contracts.

Pass-through charges are indirect costs and profit/fee applied to subcontract costs. Excessive pass-through charges 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.

Tomorrow: What the Auditors Might be Looking For.

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