Homeland Security Proposes to Limit Subcontracting

Whenever Homeland Security kicks into action as a result of a natural disaster, man-made disaster, or terrorism, it hires private companies to do whatever work has to be done. In the wake of Hurricane Katrina, Congress heard a lot of testimony on how excessive tiering of subcontractors under disaster recovery cost-reimbursement type contracts led to inflated costs (overhead and fees), and poor prime contractor oversight on subcontractor work. As a result, the Post-Katrina Emergency Management Reform Act was passed to limit the amount of subcontracts under these situations.

Homeland Security has now published a proposed FAR Supplemental regulation to implement this Act. The regulation applies to cost-type contracts (greater than $100 thousand) awarded under emergency situations and restricts the value of subcontracts to 65 percent of direct costs. When bidding on a contract, prospective contractors will be required to submit sufficient evidence to the contracting officer to permit him/her to make a determination that the offeror will or will not award subcontras that exceed 65 percent of the cost (excluding indirect costs and fee) of the contract, or any individual task or delivery order under the contract. The proposed regulation includes a process where the contracting officer can request a waiver from someone higher up in their organization. For contractors, its rarely a good strategy to request and hope for a waiver. If there are competing proposals, the contracting officer will go down the path of least resistence and award to an offeror that is not requesting a waiver.

The comment period for this proposed regulation expires on August 9th.

Excessive Pass-Through Costs - The Indirect Allocation Base Matters

In October 2009, the FAR concils published an interim rule that limits excessive pass-through costs charged to Government contracts. This rule brings the rest of Government contracting in to conformity with DoD which has had the rule since 2007.

In November of last year, we posted a comprehensive discussion of the interim rule along with some observations and implementation advice. One of the points we made was that the allocation base for allocating G&A (or Indirect Costs) matters. To read that post, click here. We continue to field a fair number of questions on this subject so we will explain what we mean when we say that the allocation base matters.

Before continuing, it may be helpful to read our prior post on the subject.

Pass-through costs are defined in FAR as indirect costs and profit (or fee). The extent to which indirect costs are allocated to subcontracts, depends wholly on the allocation base. If the base includes subcontract costs, then indirect costs will be allocated to (added to) the amount of the subcontract. Conversely, if the allocation base does not include subcontract costs, then no indirect costs will be allocated to the subcontract.

FAR requires that indirect costs be aggregated into logical cost groupings and allocated to contracts on a basis of the benefits accruing to those contracts. In some ways, the determination of the allocation base is subjective and every Government contractor must decide on the allocation base that best allocates costs to its contracts. The Cost Accounting Standards (CAS) list three acceptable bases for allocating G&A; a total cost input base that includes all direct and indirect costs (excluding G&A), a value-added base that includes all direct costs except materials and subcontracts, and a single-element base such as direct labor costs (If you've got that big Government contractor swagger, you can probably get away with a completely different allocation base but for most contractors, using one of these three bases is advised).

Of the three allocation base methodologies, only the first include subcontract costs. So, if you allocate your G&A over a total cost input (TCI) base, you will need to be concerned with excessive pass-through costs when submitting your proposal and during contract performance. If you allocate your G&A over a value-added or single element base, you will not need to be concerned with excessive pass-through costs because no indirect costs will be allocated to subcontracts. Its that simple.

Excessive Pass-Through Costs

Last month, the FAR councils published an interim rule that limits excessive pass-through costs charged to Government contracts. The limit on excessive pass-through costs has applied to DoD contracts since 2007. The new interim rule covers all Government contracts.

 We will discuss how the new rule works, but first, some definitions.

• Pass-through costs are defined as indirect costs and profit or fee.
• Excessive pass-through costs arise when a contractor (or a higher-tier subcontractor) subcontracts out all or a substantial portion of the work and adds no or negligible value to contract performance. Excessive pass-through indirect costs are unallowable.
• No or negligible value means that the contractor cannot demonstrate to the contracting officer that its effort added value to the contract in accomplishing the work performed under the contract.
• Added value means that the contractor performs subcontract management functions that the contracting officer determines are a benefit to the Government (e.g. processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, and performing quality assurance functions.

For DoD contracts, this regulation applies to negotiated cost-type and fixed price contracts greater than $650 thousand (cost or pricing data threshold). For civilian agencies, it apples to cost-type contracts over $100 thousand (simplified acquisition threshold).

The interim rule includes requirements for both offerors/contractors and Government contracting officers.

Proposal preparation phase:

1. Offerors must identify the total cost of the work to be performed by the offer and the total cost of the work to be performed by each subcontractor.
2. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed under the contract, the offeror shall identify
• the amount of indirect costs and profit/fee applicable to the work to be performed by subcontractors
• a description of the added value provided by the offeror as related to the work to be performed by the subcontractors

Negotiation and award phase:

• If the offeror intends to subcontract more than 70 percent of the cost of work to be performed, the contracting officer must make an affirmative determination that pass-through costs are not excessive.

After contract award phase:

1. Contractor must notify the contracting officer (in writing) if it changes the amount of subcontract effort after award such that it exceeds 70 percent of the total cost of work to be performed.
• must identify the revised cost of the subcontract effort.
• must include verification that the contractor will provide added value
2. If the contracting officer determines that excessive pass-through charges, the Government can recover.
• for cost-type contracts - unallowable for reimbursement
• for fixed price contracts - contract price reduction
3. Contracting officer or authorized representative (e.g. DCAA) has right to examine and audit contractor records necessary to determine whether the contractor proposed, billed, or claimed excessive pass-through charges.

PNWC observations.

1. A contractor's G&A base will influence whether indirect pass-through costs are excessive. The three most common G&A allocation bases are total cost input (TCI), modified TCI (excludes subcontract costs) and single-element (usually direct labor costs). Modified TCI and single-element allocation bases already exclude subcontract costs which means that subcontract costs are not burdened with G&A and therefore could not have excessive pass-through indirect costs.
2. Profit/Fee percentages might already reflect the anticipated level of subcontracting. When the Government uses the weighted guidelines method to establish negotiation targets for profit or fee (most of the time), it assigns weights to various risk factors. One of those factors is the degree of management effort necessary to ensure that contract requirements are met. Many contracting officers weight this element lower when the offeror has proposed significant subcontract costs.
3. Subjectivity of the contracting officer determination: The determination of whether contractor activities benefit the Government include an assessment of such things as processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, performing quality assurance functions. This is a very subjective assessment and contractors should not underestimate the benefit of "good writing" when describing the value it intends to add to the subcontracted effort. 
4. GAO Review: The GAO reviewed DoD implementation of the earlier interim regulation (see GAO-08-269, Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges). The GAO stated that contracting officers needed guidance in how to assess whether proposed pass-through costs are reasonable for the work performed. Additionally, they should obtain DCMA and DCAA input. DoD responded that it willl issue guidance once the regulation becomes final.