What are "Purchase Existence and Consumption" Audits?

This is an update to a posting we wrote more than six years ago. We are doing so because we just learned that DCAA (Defense Contract Audit Agency), the Pentagon's contract auditors have initiated "Purchase Existence and Consumption" audits some small business Government contractors. We don't know why. Perhaps the auditors have identified some "risk factors" in a contractor's material purchases. In one case, that wouldn't make sense because the contractor does research and buys very few materials. Perhaps the auditors just need something to do - its a pretty boring life out there for most contract auditors. You can read our earlier posting on the subject here.

PEC reviews (Purchasing Existence and Consumption) are not CPSRs (Contractor Purchasing System Reviews). CPSRs, performed by DCMA (Defense Contract Management Agency), not DCAA, are focused on internal controls over purchasing, especially subcontracting. A PEC review is focused on the specific materials purchased for a specific contract.

The purpose of a PEC review is to verify that purchased direct materials and services were, in fact received and (i) needed for the contract, (ii) purchased in reasonable quantities, (iii) purchased at prudent prices, (iv) used on the contract, and (v) properly accounted for as to initial charge, transfer in or out, and residual value.

Purchased materials are raw materials, purchased parts, sub assemblies, etc., which are physically incorporated into an end product. Equipment purchased for the Government's use on a flow-through basis, such as computer hardware, or commercially available items for the contractor's use in performing the contract such as trucks and other equipment, are not deemed to be incorporated in the end product.

Purchased services may include the performance of certain contract tasks by non-company personnel under the direction of the contractor or replacing entire functions within the contractor's organization. Services provided include purchased direct labor personnel to meet temporary requirements, who are supervised by the contractor, or purchasing specific types of services , such as engineers, technical writers and craftsmen, on a regular basis to perform contract requirements.

One unique aspect of PEC reviews is the request to physically locate all sampled material items. You can imagine that this might sometimes pose a problem. For example, how would you show the auditor an electronic component that has been assembled and sealed into a some kind of case? Or how do you prove to an auditor that a particular service was actually performed? There is no requirement for a work product in this case.

If you care to read DCAA's audit program for PEC audits, click here.

Understanding Agencies Roles in Purchasing System Reviews

FAR Part 44 lays out the purpose for evaluating contractor purchasing systems. The objective of a contractor purchasing system review (CPSR) is to evaluate the efficiency and effectiveness with which the contractor spends Government funds and complies with Government policy when subcontracting. The review provides the administrative contracting officer (ACO ) a basis for granting, withholding, or withdrawing approval of the contractor's purchasing system.

The administrative contracting officer (typically Defense Contract Management Agency or DCMA) has primary responsibility for reviewing contractor purchasing systems. DCMA has a CPSR review team that specializes in performing these contractor purchasing system audits. DCAA (Defense Contract Audit Agency) plays a subordinate (and often unwelcome) role in the review. DCAA's audit objective is the adequacy of the internal controls over the system and the contractor's monitoring of compliance with its controls.

The DCMA CPSR normally covers many DCAA concerns regarding internal control objectives, but not always all of them. Therefore before commencing any audit of a contractor's purchasing system, the auditor is required to coordinate with the contracting officer. There should be mutual agreement in the planning stage on what additional audit steps will be necessary to address any DCAA concerns.

Where DCMA has planned a CPSR, but he scheduled CPSR does not coincide with DCAA's cycle for evaluating purchasing system internal controls, DCAA will, to the extent possible, adjust its schedule to perform the internal control evaluation as part of a joint DCMA/DCAA CPSR. If a CPSR has not recently been performed and if there is no CPSR scheduled within the normal DCAA cycle for accounting and management system audits but the Agency believes a purchasing system internal control audit is required based on risk, the DCAA auditor is to discuss those concerns with the cognizant ACO. Where the ACO agrees with those concerns, the auditor should perform a purchasing system internal control audit (not a CPSR). The key here is the term "based on risk". The auditor must have some basis for believing an immediate audit is critical for protecting the Government's interests.

Where agreement is not reached with the ACO, and the Agency believes that the Government is at risk, these concerns should be elevated to the regional office prior to any audit effort. It seems unlikely to us that this would ever occur.

If the auditor initiates a purchasing system audit without DCMA, you need to inquire as to why and request to know the risk factors they considered in scheduling the audit.

Purchasing Files - What's Required.

Contractors should organize and administer the purchasing department to ensure the effective and efficient procurement of required quality materials and parts at the most economical cost from responsible and reliable sources.

To this end, contractors prepare and maintain what is typically referred to as "purchasing files". The purchasing files should contain appropriate information to support the vendor selected and the price paid. Over the years, Defense Contract Management Agency (DCMA) and Defense Contract Audit Agency (DCAA) who jointly participate in reviewing purchasing systems, have developed a checklist of data that should be contained in a purchasing file, when applicable. These include:

1. The purchase order
2. The purchase requisition
3. The request for quotation
4. Copies of the vendors' quotes
5. A bid tabulation sheet that summarizes and compares vendor quotations
6. Certificates for the rent-free use of Government facilities
7. Vendor surveys or facilities capability reports
8. Source selection explanation
9. Price or cost analysis data
10. Negotiation summary
11. Basis for selection of contract type
12. Copies of technical data
13. Price re determination or termination data
14. Correspondence between the purchasing department and the bidders
15. Evidence of Small and Disadvantaged Business enterprise consideration
16. Information concerning the use of special terms and conditions and approve thereof
17. Departmental and management approvals, if required
18. Administrative Contracting Officer notification and consent
19. Certificate of Current Cost or Pricing Data if procurement meets the requirements.

Where these items are applicable but not found in the purchasing files, the Government will certainly make inquiries. Significant omissions could lead to disapproved systems and possible withholds. It would be useful to compare your files against this list to see how well you match up.

Withholding or Withdrawing Purchasing System Approval

Last week, we discussed one of many important reasons for maintaining adequate purchasing systems – an approved system will facilitate the awarding of subcontracts. And a few weeks ago, we discussed the proposed DoD regulations that will require contracting officers to withhold billings whenever inadequacies are disclosed in certain internal control systems, including the purchasing system. Contractor purchasing systems are a big deal for the Government. An adequate purchasing system is one of the first lines of defense in ensuring the reasonableness of materials, purchased parts, and subcontracted items charged to Government contracts.


Today we want to address the process used by DoD to monitor and resolve purchasing system deficiencies. The process described is not dissimilar to that used by other agencies, however the DoD has taken the effort to formalize it in Part 244 of the DFARS (DoD FAR Supplement).

The ACO shall maintain a sufficient level of surveillance to ensure that the contractor is effectively managing its purchasing program. First of all, the administrative contracting officer (ACO) is solely responsible for initiating reviews of the contractor's purchasing systems, but other organizations may request that the ACO initiate such reviews. Those “other organizations” are often times DCAA (Defense Contract Audit Agency) or the PCO (Procuring Contracting Officer) or a PCO representative.

Whenever purchasing system weaknesses are identified, the ACO (or the purchasing system analyst (PSA) with the concurrence of the ACO) may initiate a special review of specific weaknesses. Weaknesses, according to PGI 244.304, may arise because of major changes in the contractor’s purchasing policies, procedures, or key personnel or changes in plant workload or type of work. Weaknesses may be discovered during reviews of subcontracts submitted under advance notification and consent or from information provided by Government personnel.

15, 10, and 10: At the conclusion of these reviews, regulatory timeframes kick in. The ACO is required to hold an exit conference with the contractor to present the review team’s recommendations and request the contractor submit a formal plan for correcting deficiencies or making improvements within 15 days. At this time, the ACO will not comment on the pending decision to grant or withhold approval of the purchasing system.

Once the corrective action plan is received from the contractor, the PSA (or whoever performed the review) has ten days to complete a report to the ACO. The ACO reviews the report and the contractor response before making any decision on granting, withholding, or withdrawing purchasing system approval. The ACO must notify the contractor within ten days of receiving the report.

When a contractor advises that it has corrected deficiencies that led the ACO to withhold or withdraw the purchasing system approval, the ACO will request the PSA to verify that the contractor has indeed corrected the deficiencies and implemented any other recommendations the ACO made. This is important for contractors to know. Contractors must initiate this phase whenever it has completed the corrective actions.

Consent to Subcontract - Part II

Contractors without Government approved purchasing systems must go through a long and tortuous process before they can subcontract any effort over $100 thousand or 5 percent of the (estimated) contract price. Yesterday we took a look at the data package that contractors must prepare and submit to the contracting officer for review and approval. If you missed that posting, you can read it here. Today we will explain the requirements placed upon the Contracting Officer in reviewing these Consent to Subcontract" requests.

The contracting officer responsibility for reviewing consent to subcontract requests is delineated in FAR Part 44. The overall objective of the contracting officer review is to ensure that the proposed subcontract is appropriate for the risks involved and consistent with current policy and sound business judgement. The contracting officer responsible for consent must, at a minimum, review the request and supporting data and consider the following:

• Is the decision to subcontract consistent with the contractor’s approved make-or-buy program, if any (see 15.407-2)?
• Is the subcontract for special test equipment, equipment or real property that are available from Government sources?
• Is the selection of the particular supplies, equipment, or services technically justified?
• Has the contractor complied with the prime contract requirements regarding—
• Small business subcontracting, including, if applicable, its plan for subcontracting with small, veteran-owned, service-disabled veteran-owned, HUBZone, small disadvantaged and women-owned small business concerns (see Part 19); and
• Purchase from nonprofit agencies designated by the Committee for Purchase From People Who Are Blind or Severely Disabled
• Was adequate price competition obtained or its absence properly justified?
• Did the contractor adequately assess and dispose of subcontractors’ alternate proposals, if offered?
• Does the contractor have a sound basis for selecting and determining the responsibility of the particular subcontractor?
• Has the contractor performed adequate cost or price analysis or price comparisons and obtained certified cost or pricing data and data other than certified cost or pricing data?
• Is the proposed subcontract type appropriate for the risks involved and consistent with current policy?
• Has adequate consideration been obtained for any proposed subcontract that will involve the use of Government-provided equipment and real property?
• Has the contractor adequately and reasonably translated prime contract technical requirements into subcontract requirements?
• Does the prime contractor comply with applicable cost accounting standards for awarding the subcontract?
• Is the proposed subcontractor in the Excluded Parties List System?

The guidance goes on to caution that particularly careful and thorough consideration under certain circumstances, especially these "high risk" considerations.

• The prime contractor’s purchasing system or performance is inadequate;
• Close working relationships or ownership affiliations between the prime and subcontractor may preclude free competition or result in higher prices;
• Subcontracts are proposed for award on a non-competitive basis, at prices that appear unreasonable, or at prices higher than those offered to the Government in comparable circumstances; or
• Subcontracts are proposed on a cost-reimbursement, time-and-materials, or labor-hour basis.

If a contracting officer cannot make these determinations based on the data provided in the consent package, the package will often be returned as "inadequate". Sometimes, if the deficiencies are not too significant, the contracting officer will simply request the contractor to submit the data that is missing. In any event, the process is extended.

Contracting officers do not have a statutory time frame for turning around these requests. We have seen everything from a few days to 60 days. In any event, if you are contemplating subcontracting out some of your work, you need to factor in the time it takes to prepare and obtain contracting officer approval of your consent to subcontract packages into overall contract performance.

Government's Consent to Subcontract

There is a procedure found in FAR Part 44 that applies to Government contractors who wish to subcontract some of its contracted effort. The procedure kicks in when a contractor does not have an approved Purchasing System although contractors with approved purchasing systems are not entirely off the hook if a contracting officer decides to specifically invoke the requirements because of he/she feels it is necessary to protect the Government's interest because of contract type, complexity, value, or because the subcontract needs special surveillance. DCMA (Defense Contract Management Agency) is the organization responsible for reviewing and approving a contractor's purchasing system. Without an approved purchasing system, contractors are required to submit substantial amounts of paperwork for contracting officer review, consideration, and approval.

If the contractor does not have an approved purchasing system, consent to subcontract is required for cost-reimbursement, time-and-materials, labor-hour, or letter contracts, and also for unpriced actions under fixed price contract greater than $100 thousand or five percent of the total estimated cost of the contract. That's a pretty low threshold. The data required to be submitted to support the "consent" request includes:

• A description of the supplies or services to be subcontracted
• Identification of the type of subcontract to be used
• Identification of the proposed subcontractor
• The proposed subcontract price
• The subcontractor’s current, complete, and accurate cost or pricing data and Certificate of Current Cost or Pricing Data if required by contract provisions.
• The subcontractor’s Disclosure Statement or Certificate relating to Cost Accounting Standards when such data are required by other provisions of this contract.
• A negotiation memorandum reflecting -
• The principal elements of the subcontract price negotiations;
• The most significant considerations controlling establishment of initial or revised prices;
• The reason certified cost or pricing data were or were not required;
• The extent, if any, to which the Contractor did not rely on the subcontractor’s certified cost or pricing data in determining the price objective and in negotiating the final price;
• The extent to which it was recognized in the negotiation that the subcontractor’s certified cost or pricing data were not accurate, complete, or current; the action taken by the Contractor and the subcontractor; and the effect of any such defective data on the total price negotiated;
• The reasons for any significant difference between the Contractor’s price objective and the price negotiated; and
• A complete explanation of the incentive fee or profit plan when incentives are used. The explanation shall identify each critical performance element, management decisions used to quantify each incentive element, reasons for the incentives, and a summary of all trade-off possibilities considered.

Tomorrow we will continue our discussion on "Consent to Subcontract" by explaining what the contracting officer does with this information, once received.

Long Term Agreements

A "Long Term Agreement" (LTA) is an agreement entered into between a prime contractor and a subcontractor to establish pricing for future purchases of specified items. FAR 15.404-3(c) allows prime contractors to reach price agreements with subcontractors prior to an agreement with the Government on the prime contract so LTAs are acceptable pricing methods.

LTAs can benefit both the contractor and the Government by providing better subcontract pricing due to a more stabilized business volume and reduced acquisition cycle times. There are two aspects of LTAs that the Government will be concerned about. The first is whether the the prime contractor adequately evaluated the cost or pricing data as of the date of agreement on the LTA price. Secondly, the Government will require contractors to demonstrate that the negotiated LTA prices continue to be fair and reasonable at the time the prime contract is negotiated.

Generally, there is no specific time period for which LTA pricing should be considered adequate. The market and other conditions must be reviewed on a case by case basis. In some cases, the LTA pricing may be adequate for several years while in other cases, a single month may find that the LTA pricing is no longer fair and reasonable. For example, if a subcontractor made significant changes to its manufacturing process that materially impacted costs, and those changes were not reflected in the negotiated LTA pricing, the negotiated LTA price would no longer be considered fair and reasonable.

LTAs can help facilitate and streamline the estimating and purchasing processes. Contractors need to perform some level of testing however, to assure the Government that the negotiated prices continue to be fair and reasonable.

Contractor Employee Goes to Jail - What Can We Learn?

A manager working for a contractor providing facilities management at a Government facility, set up three fictitious companies and then conspired with a Government employee working there to use his Government credit card to place orders with the bogus companies. Over a period of four years, the two conspirators made about $1 million in bogus purchases and then split the proceeds. Yesterday, September 16th, the judge sentenced the contractor employee to 15 months in jail and ordered him to repay the $1 million. The Government employee previously plead guilty. There was no indication in the Department of Justice's press release on this case that the contractor was implicated in any way. Neither was there any indication of how the fraud was exposed.

When we read of these cases, we are immediately drawn to consider how something like this could have been prevented in the first place. Conspiracies, according to the Association of Certified Fraud Examiners (ACFE) are usually the most difficult of fraudulent activity to discover. Two or more persons acting in concert can easily override the internal controls that companies have established to prevent fraud from happening.

In this case, there seems to have been a significant purchasing system internal control weakness. The contractor employee was responsible for the repair and upkeep of the facilities. When he needed supplies and services to accomplish the mission, he would prevail upon the Government card-hold to order the items and pay for them with the card. That procedure was probably not sufficient to prevernt the fruad. An adequate purchasing system would have the following minimum requirements.

• Someone initiates a purchase order - the purchase order must include justification for the purchase.
• Someone else reviews and approves the purchase order.
• The order is placed by someone independent of the initiator and approver. The purchasing department is responsible for finding sources and establishing best prices.
• A fourth independent person verifies that materials were received or services rendered.
• Accounts payable makes payment after matching purchase order, invoice, and receiving document.

Note that there are five people involved in the process, not two. It is much more difficult to sustain a conspiracy with five player than it would be with two.

This would be a good time to consider the strength of your own purchasing policies and procedures.

Business System Requirements - Purchasing

Over the past few days, we've been discussing the proposed DFARS (DoD FAR Supplement) regulations that will allow the Government to withhold funds from contracts with contractors that have inadequate business systems. We discussed the six systems addressed by the regulations, the procedures from audit finding to initial determination to final determination, and the amount of the withholds (10 to 100 percent). It is readily apparent that if this reguation is implemented in any form resembling the proposal, contractors are going to be heavily incentivized to pay more attention to their business systems. Implementation will come at a cost. One commentator quipped that this is Sarbanes-Oxly for defense contractors, meaning that everyone spends lots of money to set up internal control systems and spends more money to test for compliance while unable to show any tangible benefits.

Regardless of how the final regulation fleshes out, the sections that list specific requirements for each of the six business systems will most likely remain intact. These specific requirements are not exactly new however. They've been brought in from other sources. For example, the requirements for a purchasing system are essentially those that DCMA (Defense Contract Management Agency) tests for when conducting  a CPSR (Contractor Purchasing System Reviews). Beginning today and continuing until we cover the six business systems, we will list the specific requirements that the Government will expect systems to include. We begin with the 17 requirements for an adequate purchasing system.

Purchasing systems must:

1. Have an adequate system description including policies, procedures, and operating instructions that comply with the FAR and DFARS.
2. Ensure that all applicable purchase orders and subcontracts contain all flow down clauses, including terms and conditions and any other clauses needed to carry out the requirements of the prime contract.
3. Maintain an organization plan that establishes clear lines of authority and responsibility.
4. Purchase orders are based on authorized requisitions and include complete history files.
5. Establish and maintain adequate documentation to provide a complete and accurate history of purchase transactions to support vendors selected and prices paid.
6. Apply a consistent make or buy policy that is in the best interest of the Government.
7. Use competitive sourcing to the maximum extent practicable and ensure debarred or suspended contractors are properly excluded from contract award.
8. Evaluate price, quality, delivery, technical capabilities, and financial capabilities of competing vendors.
9. Require management level justification and cost/price analysis as applicable for any sole or single source award.
10. Perform appropriate cost or price analysis and technical evaluation for each subcontractor and supplier proposal or quote.
11. Document negotiations in accordance with FAR 15.406-3.
12. Seek, take, and document appropriate purchase discounts, including cash discounts, trade discounts, quantity discounts, rebates, freight allowances, and company-wide volume discounts.
13. Ensure proper type of contract selection and prohibit issuance of cost-plus-a-percentage-of-cost subcontracts.
14. Maintain subcontract surveillance to ensure timely delivery of an acceptable product and procedures to notify the Government of potential subcontract problems that may impact delivery, quantity, or price.
15. Document and justify reasons for subcontract changes that affect cost or price.
16. Notify the Government of the award of an auditable subcontract and perform adequate audits of those subcontracts.
17. Enforce adequate policies on conflict of interest, gifts, and gratuities, including the requirements of the Anti-Kickback Act.