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.

Eliminating Excessive Pass-Through Costs

According to Section 802 of the 2013 NDAA (National Defense Authorization Act), the Department of Defense as well as the State Department and the Agency for International Development (AID) were required to issue guidance and regulations to ensure that contracting officers complete additional analyses prior to awarding contracts over $700 thousand ($150 thousand for State and AID) where the prime contractor proposes to subcontract 70 percent or more of the total cost of work to be performed (these are called pass-through contracts). The concern, of course, is that with significant subcontracting activity, the Government might not be getting much value out of the prime contractor’s involvement in the contract.

The NDAA requires a “Notification, Review, and Determination” procedure for pass-through contracts. Under these procedures, if an offeror intends to award subcontracts for more than 70 percent of the total cost of work to be performed, it must inform the Government and identify the amount of the indirect costs and profit/fee applicable to the subcontracted work as well as a description of the value-added the offeror will provide to the Government.

The contracting officer then, must (i) consider the availability of alternative contract vehicles and the feasibility of contracting directly with a subcontractor or subcontractors that will perform the bulk of the work, (ii) make a written determination that the contracting approach selected is in the best interest of the Government and (iii) document the basis for such determination.

In June of this year, the GAO (General Accountability Office) initiated a review to determine how well the Agencies had implemented this new rule. The GAO found that nothing had really changed in the interim. In fact, DoD had done nothing because the Department was waiting for revisions to its FAR Supplement. As a result, the GAO concluded that the Government continues to be at risk for paying excessive contract prices.

As a result of its review, the GAO recommended that DOD, State, and AID issue guidance to assist contracting officers by identifying approaches for or examples of how to assess alternative contracting approaches to include the feasibility of contracting directly with proposed subcontractors, and documenting a determination that the approach selected is in the best interests of the Government. Additionally, the GAO recommended that the Agencies revise the processes and guidance governing management reviews of procurements to ensure that such reviews assess whether contracting officers are complying with the provisions of the 2013 NDAA.

You can read the entire GAO report here.

Excessive Pass-Through Costs - Part III

Today we conclude this three part series on the new excessive pass-through rules. Whenever a contractor expects to subcontract out more than 70 percent of the value of a contract, it must satisfy the contracting officer that it is adding value to the process. If the prime contractor is not adding value, the pass-through costs (primarily indirect costs and profit/fee applied to subcontract costs) are unallowable. Yesterday we discussed pre-contract aspects of this new rule. Today we will discuss some of the Government’s post-award emphasis.


Incurred Cost

Contractors who submit annual incurred cost submissions provide a wealth of information to the Government. For example, Schedule H (Schedule of Direct Costs by Contract/Subcontract and Indirect Expenses Applied at Claimed Rates) of the standard incurred cost submission for example gives the Government everything it needs to determine the percentage of subcontracted effort to total contract value and will readily show whether those subcontract costs were fully burdened with pass-through costs. Then, it’s a simple matter of referring to the contract to determine whether the contracting officer determined that the contractor added value to the effort. If so, auditors are being tasked to determine whether the contractor is performing the added-value functions as asserted during the initial proposal phase.

If it looks like the value of subcontract costs will exceed 70 percent of the contract value, the auditor will notify the contracting officer and request the contractor to provide a description and demonstration of the added-value by the contractor related to the subcontracted work. The auditor will then evaluate the functions to determine if the “added value” functions are consistent with the definition in the contract clause and perform testing to determine if the contractor is performing the “added value” functions and ascertain if the costs are reasonable. If not, the pass through charges applicable to the subcontracted effort will be questioned based on FAR 31.203(i).

Evaluations of Final Vouchers

During an evaluation of the final voucher, auditors will calculate the percentage of subcontract costs to the total costs of work performed. If the percentage exceeds 70 percent, the auditor will perform the steps described above. The auditor will also evaluate the functions actually performed to determine if the added-value functions are consistent with the definition in the contract clause. If the contractor cannot demonstrate its “added value” efforts, then the indirect costs (and profit) added by the contractor to the subcontracted work will be questioned as excessive pass through charges based on FAR 52.215-23 and FAR 31.203(i).

Allowability vs. Allocability

These FAR provisions create an allowability issue on excessive pass through costs, not an allocability issue. The excessive pass through costs are still allocable to a contract, but will not be paid by the Government (i.e., unallowable) if the contracting officer determines the contractor does not provide “added value” to the subcontracted portion of the work. This means that contractors cannot simply allocate their indirect cost pools over a base that excludes a particular contract. Auditors are being reminded that functions and related costs not determined excessive in accordance with FAR 31.203(i) are still subject to FAR 31.2, Allowability, Allocability, and Reasonableness and should be audited accordingly.

Excessive Pass-Through Costs - Part II

Today we continue our discussion on excessive pass-through costs. The impetus behind this new rule was Section 866 of the Duncan Hunter National Defense Authorization Act for Fiscal Year 2009. The Act required that the FAR be amended to minimize excessive pass-through charges by contractors (or lower-tier subcontractors) that add no or negligible value to the subcontracted work.


Generally, the determination as to whether the functions a contractor performs relative to the subcontract provides “added value” to the contracting effort and that there are no excessive pass-through charges is made at the time of contract award. The contracting officer (and the auditors, if the proposal is being audited) reviews the ratio of subcontract value to total proposed price. If greater than 70 percent, they will then review to see if the contractor adequately demonstrated that it would provide “added value”. If the contracting office is satisfied that the prime is adding value to the subcontract, he/she will make a determination to that effect and also insert the following into the actual contract:

The Government will not pay excessive pass-through charges. The Contracting Officer has determined that there will be no excessive pass-through charges, provided the Contractor performs the disclosed value-added functions.

Sometimes however, contractors change the amount of subcontract effort after contract award such that it exceeds 70 percent of the total cost of work under the contract. This can happen for a variety of reasons – overcapacity in the contractor’s facility, more cost effective to buy than to produce in-house, or shortage of skilled workers, to name a few. When this happens, contractors must notify the contracting officer in writing of the revised cost of the subcontract effort. The notification must include verification that the contractor will provide “added value” (FAR 52.215-23(c)). If after review of the contractor submitted data the contracting officer concludes that excessive pass-through charges exist, the Government has a contractual mechanism to recoup those costs. On cost-type contracts, billings will be reduced. On fixed-price contracts, the Government will be entitled to a priced reduction. The FAR clause does not specify how these reductions are to be computed and negotiated but we would expect guidance will be forthcoming.

 

Price Proposals

 

When evaluating price proposals where subcontract costs exceed the 70 percent threshold, DoD auditors are being instructed to perform sufficient testing to determine FAR compliance. Specifically, auditors are being told to:

1. Ensure the contractor’s proposal includes a description of the contractor’s “added value” as required by FAR 52.215-22.
2. Evaluate the reasonableness of the contractor’s description and supporting documentation of the “added value” to assess whether the contractor is in compliance with the requirements set forth in FAR 52.215-23.

If the “added value” description is not included, contractors face potential estimating deficiencies. Auditors are being instructed to consider such a proposal to be inadequate. That will certainly slow down the acquisition process as the proposal is returned for revision.

 

The more significant concern however is that auditors are also being instructed to consider such an omission to be an estimating system deficiency and to consider issuing an estimating system deficiency report. This could jeopardize contractors’ success in future solicitations and it could possibly result in temporary billing withholds on existing contracts when the new business system rules become final.

 

Tomorrow we will conclude this series with some comments on incurred costs and final vouchers.

 

 

 

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.

Excessive Pass-Through Costs

Back in October of 2009, the FAR Councils adopted an interim rule intended to ensure that contractors (or higher-tier subcontractors) do not receive indirect costs or profit/fee (i.e. pass-through costs) on work performed by subcontractors to which the contractor (or higher-tier subcontractor) adds no or negligible value. “No or negligible value” means the Contractor or subcontractor cannot demonstrate to the Contracting Officer that its effort added value to the contract or subcontract in accomplishing the work performed under the contract.


On December 13th, this interim rule became final (with some minor changes) with an effective date of January 12, 2011. This provision applies to most DoD contracts (exceptions include competitive and commercial procurements) above the TINA threshold (currently $700 thousand) and Civilian Agency cost-reimbursable contracts greater than the Simplified Acquisition threshold (currently $150 thousand). However, it can apply to contracts below these threshold's at the discretion of the contracting officer.

There are two provisions in this new rule. FAR 52.215-22 applies to solicitations and FAR 52.215-23 applies to contracts.

Solicitation Phase (FAR 52.215-22)

The prospective contractor must identify in its proposal the total cost of the work to be performed by the offeror, and the total cost of the work to be performed by each subcontractor. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed, the offeror must identify

• The amount of the offeror’s indirect costs and profit/fee applicable to the work to be performed by the subcontractor(s); and
• A description of the added value provided by the offeror as related to the work to be performed by the subcontractor(s).

Contracting Phase (FAR 52.215-23)

The Government will not pay excessive pass-through charges and it is the contracting officer's responsibility to determine whether excessive pass-through charges exist.

Contractors must notify the contracting officer in writing after contract award when the level of subcontracted effort exceeds 70 percent of the total cost of work to be performed. The notification must include the cost of the subcontracted effort and verification that the contractor will provide added value.
If the Contracting Officer determines that excessive pass-through charges exist, the excessive costs are unallowable - either by a reduction in billings or a price reduction, depending upon the type of contract.

The Government has the right to examine and audit all the Contractor’s records (as defined at FAR 52.215-2(a)) necessary to determine whether the Contractor proposed, billed, or claimed excessive pass-through charges.