Subcontract Pricing Considerations - Prime Contractors Must Demonstrate Reasonableness of Proposed Subcontract Costs

Earlier this month, we highlighted a revised audit policy from the Defense Contract Audit Agency (DCAA) concerning the evaluation of subcontract costs included in forward pricing proposals. FAR 15.404-3(3)(b) requires prime contractors to perform whatever cost/price analysis is necessary to determine the reasonableness of proposed prices. Sometimes they don't do that so historically, DCAA has considered them unsupported and perhaps identified the omission as an estimating deficiency. That policy did nothing to advance contract negotiations nor help procurement offices to negotiate fair and reasonable prices. Under the new guidance, DCAA is to provide whatever information it has available or conduct additional analytical work (i.e. develop decrement factors) to assist in any way it can. See "Revised Audit Policy for Reviewing Subcontractor Costs" for more information on the new policy.

Contractors need to be cautioned however that DCAA's performance of alternative procedures (or requesting an assist audit) does not relieve prime contractors or upper-tier contractors from their responsibility to perform cost or price analyses of subcontract proposals.

Whatever analytical work the auditors might perform, the procurement regulations stand. FAR 15.404-3(3)(b), Subcontract pricing considerations, unequivocally requires prime contractors and higher-tier subcontractors to conduct appropriate cost or price analyses to establish the reasonableness of proposed subcontract prices. It also requires the prime or higher-tie contract to include the results of these analyses in its price proposal.

When auditors encounter situations where contractors or higher-tier subcontractors have not met the regulatory requirement to prove the reasonableness of proposed subcontract prices, they will include that omission as a material noncompliance with FAR 15.404-3(b) in the audit report. What are the consequences of an inadequate estimating system? Well, it could be significant. It could result in additional auditing, additional oversight, the necessity of getting contracting officer consent to subcontract (with all the additional documentation that requires), and loss of future contracting opportunities.

Revised Audit Policy for Reviewing Subcontractor Costs

DCAA (Defense Contract Audit Agency) recently announced a significant policy change in the way it reports on deficient (i.e. incomplete or inadequate) prime contractor cost or price analyses of subcontractor proposals.

Until now, whenever a prime or higher-tier contractor had not competed the required subcontractor cost or price analysis at the time it submitted its own proposal, auditors would simply classify the costs as unsupported. This policy, while technically accurate, added no value to the procurement process and in some cases, delayed contract negotiations.

Under the new policy, auditors are now required to perform alternative procedures to establish a reasonable basis for the audit opinion. Depending on the overall risk and materiality, the auditors can consider a variety of procedures including, but not limited to, the following:

• Create a decrement based on purchase order history
• Create a decrement based on other relevant information (e.g. comparisons of prior subcontract proposals to historical cost or price analyses or negotiated amounts); and/or
• Coordinate with the subcontract audit team and request a DCAA assist audit based on the prime/higher-tier audit team's risk assessment.

This doesn't relieve the prime/higher-tier subcontractor from the requirements of FAR 15.404-3(b), Subcontract pricing considerations which requires the prime contractor or higher-tier contractor to conduct appropriate cost or price analyses to establish the reasonableness of proposed subcontract prices and to include the results of these analyses as part of its proposal o the Government. Contractor failure to do that will result in a material estimating deficiency report and could result in some form of adverse action such as increased audit coverage.

Decrement factors have been used in pricing forever. Many contractors develop decrement factors because they know that ultimate purchase prices will be lower than initial quotations. Contractors who do not prepare their own decrement factors often find that auditors (and sometimes cost/price analysts) will do it for them. Its better to be pro-active otherwise, contractors find themselves in a defensive posture trying to explain the inaccuracies in the auditors' analyses.

The new DCAA policy can be found here.