Subcontracting: Avoid Allegations of Excessive Pass-Through Charges

Do you subcontract a large portion of your U.S. government contract work to outside organizations or individuals? If so, you may be found to have incurred excessive pass-through charges, which could affect your recovery of a portion of your costs and related profit.

In accordance with Section 866 Duncan Hunter National Defense Authorization Act for Fiscal Year 2009, the Federal Acquisition Regulation (FAR) was amended to disallow excessive pass-through charges by contractors (or lower-tier subcontractors) that add no — or negligible value — to the subcontracted work. (The FAR implemented the law through the promulgation of the solicitation provision at FAR 52.215-22 and the contract clause at FAR 52.215-23.)

These FAR provisions/clauses are included in civilian contracts when the estimated contract value or order value exceeds the simplified acquisition threshold and the contemplated contract type is expected to be a cost-reimbursement type.

For DoD contracts, they are included in contracts when the total estimated contract or order value exceeds the threshold for obtaining certified cost or pricing data unless:

  • The contract is fixed price (firm fixed price, fixed-price with economic price adjustment or fixed-price incentive) awarded on the basis of adequate price competition, or
  • The contract is fixed price for the acquisition of commercial items.

These FAR provisions define excessive pass-through charges as follows:

“Excessive pass-through charge,” with respect to a contractor or subcontractor that adds no or negligible value to a contract or subcontract, means a charge to the government by the contractor or subcontractor that is for indirect costs or profit/fee on work performed by a subcontractor (other than charges for the costs of managing subcontracts and any applicable indirect costs and associated profit/fee based on such costs).

As part of your proposal submission process, if you intend to subcontract more than 70 percent of the total cost of work to be performed under the contract, you must describe the added value you will provide as related to the work to be performed by the subcontractor(s). Thus, when you anticipate subcontracting out more than 70 percent of the work, it is imperative that you include an adequate description of the value you will add.

Failure to provide an adequate description will significantly increase the likelihood you will not receive the contract award. Guidance issued by the Defense Contract Audit Agency instructs auditors to classify your proposal as inadequate if the “added value” description is not included. Also note that contracting officers will not necessarily come back to you and ask for a more detailed description if the auditor states the proposal is inadequate and/or the contracting officer believes the initial description is lacking.

Submission of an adequate description of the value added at the time of proposal submission also protects you from post-award allegations of excessive pass-through costs. This protection is provided by Alternate I to FAR 52.215-23, which is included in the contract when the contracting officer determines that you have demonstrated during the pre-award stage that your functions provide added value to the contracting effort and there are no excessive pass-through charges.

Here is the language: “Alternate I: (b) General. 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.”

Thus, in cases where Alternate I is included, you need to only show that you have performed the functions disclosed in its proposal/description. Inclusion of this language mitigates the potential for a newly assigned contracting officer or auditor to challenge the adequacy of the description in the proposal after contract award. Therefore, prior to entering into a contract where the proposal exceeds the 70 percent threshold, you should request that the Contracting Officer include Alternate I in your contract.

From a post-award perspective, if your proposal submission did not anticipate subcontracting out more than 70 percent of the total cost of the work, but the amount of subcontract effort changes after the award such that it exceeds (or is anticipated to exceed) the 70 percent threshold, you must notify the government of the change. In such cases, the government will then verify that you will provide added value.

The contract clauses require that you perform similar efforts when awarding subcontracts, and flow-down similar notification requirements to your subcontractors. The government will hold you liable for excessive pass through costs incurred by your subcontractors.

Tips

Here are some tips for contracts that are anticipated to have significant subcontract costs — and/or they actually incur them:

  • Include an adequate description of the value to be added in your proposal submission.
  • Ensure that Alternate I of the clause at FAR 52.215-23 is included in your contract.

For contracts that are not anticipated to have significant subcontract costs — and/or actually incur them:

  • Establish procedures to monitor subcontracting efforts and costs incurred during contract performance to identify any changes from anticipated execution that may result in exceeding the 70 percent threshold.
  • Notify the government immediately that the threshold is anticipated to exceed — or has been exceeded — and include an adequate description of the value you will be adding.
  • Ensure proper flow-down of the clause to your subcontractors, and consider including an additional indemnification clause to require subcontractor reimbursement of any cost impact on your contract that may result from the subcontractor’s noncompliance with these requirements.

To assure compliance with this clause, you should monitor the amount of subcontract work performed on contracts. A best practice would be a system that flags any contracts that were not anticipated to exceed 70 percent at the time of proposal submission, but then exceed (or are anticipated to exceed) the 70 percent threshold during contract performance.

This should trigger an automatic notice to the government that the threshold has been exceeded. When the contractor submits the notification during post-award, it is best if the contractor includes an adequate description of the value being added as part of its notice to the government. This facilitates the process and potentially avoids unnecessary disputes and/or cost disallowances.

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