Inter-Company Transfers - Limitations

Material costs, including such items as raw materials, parts, sub-assemblies, components, whether manufactured by the contractor or purchased are, of course, allowable costs on Government contracts (see FAR 31.205-26, Material Costs). There are limitations however, when those materials are being purchased from an affiliated company.

Paragraph (e) of the aforementioned FAR (Federal Acquisition Regulations) Cost Principle provides the following:

Allowance for all materials, supplies, and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred. That means, no profit can be added. However, allowance may be at price when (i) it is the established practice of the transferring organization to price inter-organizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate under a common control and (ii) the item being transferred qualifies for an exception under FAR 15.403-1(b) and the contracting officer has not determined the price to be unreasonable.

Note the two conditions; there must be an established practice that is followed for both commercial and Government customers and the item(s) must qualify for some kind of exemption. What are those exemptions? FAR 15.403-1(b) lists the exceptions to certified cost or pricing data requirements. Among them are

1. When the contracting officer determines that prices agreed upon are based on adequate price competition
2. When the contracting officer determines that prices agreed upon are based on prices set by law or regulation
3. When a commercial item is being acquired
4. When a waiver has been granted, or
5. When modifying a contract or subcontract for commercial items.

The idea behind these limitations is to avoid doubling up on profit, to pay a contractor profit on top of a material item for which it has already received profit. Contract auditors are very aware of this potential and will closely scrutinize any estimates or costs incurred under cost-type contracts for inter-company transactions to ensure that costs are consistent with the FAR limitations.

Inter-divisional Transfers at Price

Materials, supplies, and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates under common control must be made on the basis of cost incurred with one exception; transfers may be made at price when it is the established practice when it is the established practice of the transferring organization to price inter-organizational transfers at other than cost for commercial work and the price of the item being transferred is based on adequate price competition, is set by law or regulation, is a commercial item, or a waiver has been granted. Additionally, the contracting officer cannot have already determined the price to be unreasonable (see FAR 31.205-26(e)).

 ATS is a Government contractor that provides counter-terrorism training services and solutions, including training related to how to identify, defuse, and evaluate IEDs (Improvised Explosive Devices). The company has two divisions involved in delivering training; one involved in training and the other involved in manufacturing training aids and devices used in the training. The training materials and equipment produced by ATS and are sold commercially including commercial sales under the GSA Schedule.

In 2009, the Army awarded a $200 million five-year CPFF (Cost Plus Fixed Fee) contract to ATS to provide training for armed forces to proactively defeat IED threats. ATS proposed that training materials and equipment produced by its sister-division would be charged to the contract at "price" based on provisions in FAR 31.215-26. In its pre-negotiation objective memorandum (POM) the Government noted that those particular costs were "realistic, fair and reasonable". Work began and ATS began billing the Government for inter-divisional materials at catalog prices.

In 2011, DCAA (Defense Contract Audit Agency) issued an audit report declaring that ATS' accounting system was inadequate, containing a "significant deficiency that is considered to be a material weakness..." DCAA found that ATS was billing materials acquired from its sister-division at "price" instead of at "cost". Turns out, DCAA was relying on an accounting technicality because ATS was not first transferring the material from one division to another before billing the Government. DCAA noted that ATS had established commerciality of its products and demonstrated a physical transfer of material goods between its two divisions, there was never an accounting entry made to reflect that transfer. Thus, DCAA (and later DCMA - Defense Contract Management Agency) did not believe that ATS satisfied the requirements of FAR 31.205-26(e)(1)(2).

Eventually, the contracting officer issued a final decision disallowing the transfer at "price". ATS appealed to the Armed Services Board of Contract Appeals (ASBCA). The ASBCA ruled in favor of ATS, calling out the Government for its failure to carry its burden of proof to justify the allowance under FAR 31.205-26(e) and secondarily ruling that ATS is entitled to recover its commercial catalog prices for training materials. Essentially, the ASBCA called nonsense, the Government claim that there must first be an accounting entry showing the transfer from one division to another before the item(s) can be billed to the Government at price.

You can read the entire ASBCA decision here.