Audits of Direct Costs - Subcontracts

For the past few days, we have been discussing audits of direct costs that are performed as part of the review of contractor annual incurred cost submissions. As previously discussed, some contractors are surprised when the contract auditor makes inquiries concerning claimed direct costs, thinking that their incurred cost submissions are primarily about indirect costs. But, at the end of the day, an audit of an incurred cost proposal is opining on the allowability, allocability, and reasonableness of all costs charged to flexibly priced contracts. Previously, we discussed material costs, direct labor costs, and ODCs (other direct costs). Today we conclude this series with a discussion of subcontract costs.

For the purpose of this discussion, the term "subcontract" means an auditable subcontract, purchase order, or other form of agreement under which materials or services are to be furnished on a flexibly priced basis to a prime contractor under a flexibly priced contract subject to audit. As discussed earlier in this series, flexibly priced contracts include all cost-type, fixed-price-incentive, and fixed-price-redeterminable contracts, orders issued under indefinite delivery contracts where final payment is based on actual costs incurred, and portions of time-and-material and labor-hour contracts.

The responsibility of the prime contractor for managing its subcontracts is stated in FAR 42.202(e)(2). Essentially, the prime contractor is primarily responsible for subcontract award, technical and financial performance monitoring, ensuring that indirect rate proposals and annual rate adjustments are submitted on a timely basis, and payment to the subcontractor for the work accomplished under subcontract terms. To accomplish this responsibility, the prime contractor should have adequate internal controls to identify and notify the Government of auditable type subcontracts and intracompany orders under auditable type Government contracts, and to assure that subcontract/intracompany costs are allowable, allocable, and reasonable.

Prime contractors must notify the Government of awards of subcontracts (as well as intracompnay orders) as soon as practicable after award, and as part of the prime contractor's annual incurred cost proposal submission. The schedule of subcontracts (known as "Schedule J" in the DCAA's standardized incurred cost model) submitted with the proposal should include the prime contract number, subcontract number, amount, and type of order (e.g. CPFF, T&M, etc).

Auditors will review the prime contractors internal control system over subcontracts to ensure that appropriate flow down clauses are included in the subcontract. Key clauses that auditors tend to focus on include:

• Provide either the Government or the prime contractor access to the subcontractor's books and records for the purposes of performing the annual incurred cost audit.
• Require that billings include only allowable costs pursuant to FAR 52.216-7, and
• Require the subcontractor to submit annual incurred cost proposals pursuant to FAR 42.7

Failure to maintain adequate controls could impact a contractor's ability to stay on the direct billing program.

It is the prime contractors responsibility to audit its subcontracts. The Government auditor will review the adequacy of the work performed by the prime contractor. The contract auditor has a pretty good idea of what is required in an audit so when it looks at the work performed by the prime contractor, it is expecting to find something that looks similar to the kind of audit it would perform, if it were to perform one on the particular subcontractor.

Under certain circumstances, it is desirable that the Government auditor audit the subcontractor. Examples of these conditions include

1. the subcontract dollar value is significant in amount and in relation to the prime contract dollar value
2. the subcontractor objects, usually for competitive reasons, to an upper-tier contractor auditing its records,
3. a Government auditor is already performing audit work at the subcontractor's plant and can perform the audit more economically or efficiently,
4. the contract or subcontractor has a substantial financial interest in the other.