The Not So Subtle Shift in Contract Costs

Alan Chvotkin, Executive Vice President and Counsel, Professional Services Council

On October 14 the FAR Councils issued two interim rules that will significantly shift the burden to contractors for demonstrating that costs incurred in cost-reimbursement contracts are billable to government contracts and that incentive award fees are properly earned. By congressional mandate, both rules apply government-wide and became effective immediately upon publication.

And both will have a significant impact on contractors and their business relationships.

Congressional concerns about “excessive pass-through” costs on contracts have risen since Katrina and since the Government Accountability Office provided several reports to Congress. Congress imposed similar restrictions on the Department of Homeland Security (DHS) in 2007 and on DoD in 2008 before imposing this restriction government-wide and those agencies already have rules on the books.Both agency-specific rules will be repealed when this interim rule is finalized.I covered the DHS rules in my June 2007column.

Excessive pass-through limitations.The first rule, “Limitations on Pass-Through Charges,” is designed to minimize the “excessive pass-through” of subcontractor charges and prime contract expenses when a substantial amount of actual work will be (or was) performed by subcontractors. For civilian agencies, the rule applies to cost-reimbursement contracts greater than the simplified acquisition threshold ($100,000). For DoD, the rule applies to certain fixed price contracts, and to cost-reimbursement contracts, greater than the threshold to obtain cost or pricing data ($650,000).

The rule requires that proposals disclose the total value of work to be performed by the prime and each subcontractor, respectively. If subs are to perform over 70 percent of the total value of work, additional detail is required on the prime’s indirect costs and profit/fee applicable to the subs’ work and a description of the prime’s“added value” to the  subcontractor’s work.It’s then up to the contracting officer to “determine” – by an analysis not described in the rule – if that added-value work is a benefit to the government.If not, those costs are “excessive” and will not be allowed.

Second, the rule provides that, if a subcontractor’s effort exceeds 70 percent of the value of the work actually performed, the prime must demonstrate to the contracting officer that the prime added value to the subcontracted work; if not, the “excessive” costs will be disallowed. Finally, where “excessive” pass-through costs are not allowable, even in certain fixed-price DoD contracts, the government is entitled to a price reduction equal to the amount of those costs in the contract price.

To monitor compliance, the rule gives the contracting officer access to subcontractor records to determine whether the subcontractor proposed, billed or claimed excessive pass-through charges.

Award fee restrictions. This interim rule imposes restrictions on the use and implementation of new  cost-reimbursement, award fee, contracts. No award fee contract may be awarded unless (i) all of the FAR limitations on
cost-reimbursement contracts are met; (ii) the government completes an award fee plan as required by the FAR; and (iii) the head of the contracting activity issues a “determination and finding” that addresses the three FAR suitability factors relating to incentive contracts.

Any proposed award fee must be linked to the contractor’s cost, schedule and technical performance as measured against the contractor’s objectives. A contractor’s performance will be ranked according to a five-level adjectival award-fee evaluation scale detailed in the interim rule. Each performance level assigns a fixed range of available fee percentages. Furthermore, no award fee can be earned if the contractor’s cost, schedule and performance is rated “below satisfactory.”No unearned award fee may be rolled over into subsequent rating periods.

Five agencies – Defense, NASA, Energy, Homeland Security, and Health and Human Services – award over 95 percent of all federal government award fee contracts, and many of the provisions in this rule are already used by these agencies. In addition, in December 2007, the Office of Federal Procurement Policy published a memo entitled “Appropriate Use of Incentive Contracts” providing additional guidance to agencies when considering using award fee contracts.

This past August, I testified on award-fee contracts before a subcommittee of the Senate Committee on Homeland  Security & Governmental Affairs. I’m pleased that several of my recommendations were adopted in this rule.

While their substance has been around in various forms for several years, these interim rules introduce new elements
and significant compliance challenges for both government and contractors. In both cases, the rules put a premium on up-front contractor planning and proposal disclosures, along with careful monitoring during contract performance. For example, a prime could demonstrate added value where it is integrating the work of several subcontractors and  synthesizing their input to meet government requirements, or, where it is providing the supervision, security controls and billing for several task-oriented small businesses.

Expect both of these new requirements to be included in all new contracts but you should strongly resist having them applied to existing contracts.

What’s a contractor to do?

First, examine your internal “make-buy” and small-business subcontracting processes and be sure they are up-to-date. Both of these processes are pivotal in the determination of “excessive” pass-through and contribute to your decision of what work will be done with your workforce and what will be subcontracted.

New proposals will have to address both the excessive pass-through requirements as well as the significant criteria that benchmark an award fee plan, if applicable.As a prime contractor, you will want to contribute to both elements. If you’re a subcontractor, be prepared to address how your efforts will add significant capabilities to the prime and be ready to
work with the prime on addressing both the “added value” they bring and the award fee criteria you contribute to during your teaming negotiations and the prime’s proposal submission.

Second, if either rule applies, all primes and subs should be particularly alert to the performance and compliance challenges that kick in immediately after contract award.By creating the necessary reporting and monitoring provisions from the outset, you significantly minimize the risk of losing substantial costs and fees during performance.

Finally, prime contractors should involve your key subcontractors and vendors early in the proposal strategy to ensure that they are familiar with your processes and decisions, as well as the critical importance of satisfying the compliance and performance obligations under both new rules.

With these rules, the government is further intruding into a contractor’s business relationships and further dictating how it will manage its prime contractor relationships. Those firms that promptly address the requirements of the new rules, that demonstrate the significant value they bring, and that pay attention to the cost, schedule and technical performance elements of the contract stand to minimize their financial risk exposure and maximize successful contract execution.