Subcontractor Cost Allowability And Systems Adequacy

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Subcontractor Cost Allowability and Systems Adequacy: New Focus and Increased Risk

Thomas A. LemmerSteven M. Masiello

August 9, 2011

• Standards for government subcontracting

• Recent DCMA/DCAA policies and guidance

• Business systems

• Subcontract formation

• Subcontract administration

• Questions

Subcontractor Cost Allowability

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• Contractors required to compete subcontracts “to the maximum practical extent”

• Despite Government insistence to the contrary, FAR procurement requirements do not apply directly to subcontracts (i.e., FAR Parts 12, 15, 16, etc.)

– But do provide guidance for supporting reasonableness

• Subcontractors must be responsible; not suspended or debarred– Contractor discretion in selecting/establishing subcontract relationships but

must use its proper business judgment

• Lack of compliance with purchasing procedures or effective subcontract administration creates risk of unallowable subcontract costs

Standards for Government Contracting – Subcontracts

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• Most challenged element in subcontractor cost allowability is reasonableness– “A cost is reasonable if, in its nature and amount, it does not

exceed that which would be incurred by a prudent person in the conduct of competitive business” (FAR § 31.201-3(a))

– Examples, government challenges of subcontract cost allowability:

• Used a contract type not identified in FAR Part 16

• Contract was incorrectly identified as a commercial item contract

• Relevant memorandum not in file

• Ineffective subcontract administration/surveillance/documentation

• Inadequate cost or price analysis

Standards for Government Contracting – Subcontract Cost Reasonableness

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• DCAA/DCMA emphasis on subcontractor cost allowability– Second guessing teaming arrangements/procurement decisions– Reevaluation of subcontract price reasonableness

determinations– Deviations from established purchasing system practice results

in unreasonable costs– Allegations of ineffective subcontract administration– Focus on lack of adequate documentation

Recent DCMA/DCAA Policies and Guidance

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• Field pricing audits– Thresholds for DCAA field pricing audits:

• $100 million for cost-type proposals

• $10 million for fixed price-type proposals

– Creates significant complications at subcontract level• Prime contractor review?

• Third-party audit?

• No review by prime?

DCMA/DCAA Policies and Guidance (cont.)

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• Risks– Disallowance of subcontract costs (either as direct costs or as

part of indirect rates)– Determination that purchasing systems are inadequate– Increased scrutiny of subcontractor costs included in proposals

• Mitigation– Maintain a comprehensive and well-documented purchasing

system– Keep written records justifying significant procurement decisions

and price reasonableness of subcontracts

DCMA/DCAA Policies and Guidance (cont.)

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• Increased emphasis on effective business systems (accounting, estimating, purchasing, earned value management, property)

• Interim rule permits withholding for any “significant deficiency” in business systems (76 Fed. Reg. 28,856 (May 18, 2011))– Final determination– 5% per system withholding, capped at 10%– Reduction of withhold– Reevaluation/approval of system

Business Systems

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• Rule applies to certain DoD contracts• Rule, along with FAR Subpart 44.3, provides best practices for

non-DoD contractors• DCMA/DCAA will audit DoD contractors based on these factors,

so the rule may become the expectation for non-DoD contractors• Informal DCMA/industry discussions predict that under the DoD

rule, contractors’ purchasing systems will have a high failure rate• Wartime commission report will likely factor into DCMA/DCAA

audits– DCAA and DCMA to speak with one voice for the government – DCAA to expand audit reports to go beyond pass/fail opinions– DCMA to develop aggressive compliance enforcement

Business Systems (cont.)

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• FAR § 44.202-2 requires COs to review contractors’ purchasing systems based on 13 “factors,” including:– Is subcontract consistent with contractor’s make-or-buy program?– Was adequate price competition obtained or is its absence justified?– Is proposed subcontract type appropriate?

• The DoD rule contains 24 requirements for contractors’ purchasing systems, including:– Adequate system description– Apply a consistent make-or-buy policy– Use competitive sourcing to maximum extent possible– Require management level justification for sole source awards– Integrated systems for tracking subcontract price/costs and

administration

Purchasing Systems

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• Overlapping requirements with purchasing system

• The DoD business systems rule contains 17 requirements for contractors’ estimating systems that may be applied to subcontractor proposals, including:– Establish clear responsibility for preparation, review, and approval of

cost estimates and budgets

– Provide for adequate supervision throughout the estimating process

– Provide for consistent application of estimating and budgeting techniques

– Provide for detection and timely correction of errors

– Protect against cost duplication

Estimating Systems

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• What the rule means for contractors:– Requires formal and written purchasing procedures and forms– Increased subcontract administration, accounting, estimating,

and compliance resources– Must maintain a data library and accessible reports of

subcontract estimates and incurred cost data– Investments in integrated systems with purchasing, estimating,

and accounting– Additional training and systems compliance monitoring

Impact of New Systems’ Requirements

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Subcontract Formation

• Prime contractors possess discretion in the administration of subcontracts, including choice of contract type

• Contract types:– Fixed price– Time and materials (“T&M”)– Cost reimbursement

Types of Subcontracts

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• Fixed price contracts:– Provide for a firm price or sometimes an adjustable price– May include a ceiling price, a target price, or both– Issues:

• Negotiation• Documentation• Price reasonableness assessments

Types of Subcontracts (cont.)

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• T&M contracts:– Priced on the basis of direct labor hours at specified fixed hourly

rates – Hourly rates include wages, overhead, general and

administrative expenses, profit and the actual cost of materials– Issues:

• Negotiation• Price reasonableness assessments and documentation• Appropriateness of contract type• Confirmations of expertise for labor categories billed• Cost reimbursement of material costs• Use of higher tier rates

• Cost reimbursement contracts– FAR Subpart 31.2– A cost is allowable when it is:

• Reasonable

• Allocable

• Consistent with GAAP/CAS

• Consistent with the terms of the relevant prime contract

• Not made unallowable by one of the cost principles contained in FAR Subpart 31.2

– Issues:• Negotiation

• Reasonableness assessments and documentation


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• FAR § 52.244-6, Subcontracts for Commercial Items; encourages commercial item subcontracting “to the maximum extent practicable”– If services are “of a type offered and sold competitively” and

items are “of a type customarily used by the general public” then they may qualify as commercial items

– Commercial item subcontracts exempt from certain requirements• No TINA or cost analysis required to determine price

reasonableness

• Commercial item subcontracting is beneficial to both prime contractors and subcontractors

Commercial Item Subcontracting

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• Commercial item determination must be documented– Objective evidence and justification of commerciality– Procurement checklists– Training

• Possible subcontract indemnity/certification to manage risks

Commercial Item Subcontracting (cont.)

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• TINA requires certified cost or pricing data for contracts and subcontracts exceeding $700,000 unless an exception applies:– Adequate price competition– Prices are set by law or regulation– Commercial item– Waiver– Modifying a contract or subcontract for commercial items

• Price analysis is acceptable when certified cost or pricing data is not required

• Cost analysis is required when certified cost or pricing data is required

• Lack of field audit support– Subcontractors often deny prime contractors’ requests for audit– Difficult to conduct cost analysis when subcontractors deny audit rights

Cost and Price Information

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Subcontract Administration

• Mandatory flowdowns:– Commercial procurements (FAR § 52.244-6)– Non-commercial procurements: review prime contract terms

• Best practices flowdowns:– In addition to mandatory subcontract terms, it may be appropriate to

flow down certain additional clauses– Examples:

• Changes• Termination• Disputes (requirement to continue work)

• All negotiable from a subcontractor’s perspective• Government focus on “usurping government rights” even if it

creates a risk to prime contractor regarding flowdown implementation

Subcontract Terms

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• Contractors are responsible for:– Accounting for subcontract costs appropriately and for

maintaining records, • No specific documentation is necessary to support a reimbursable

cost (BearingPoint Inc., ASBCA No. 55354, 09-2 BCA ¶ 34,289)

– Making changes– Ensuring subcontract compliance– Closing out subcontracts

Performance Information

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• Prime contractors must pay subcontractors in accordance with the terms of the prime contract and subcontract

• Lack of available data increases risk of disallowance of subcontractor invoiced costs – Labor rate records– Compensation system information

Invoices

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• Thomas A. Lemmer

[email protected]

303-634-4350

• Steven M. Masiello

[email protected]

303-634-4355

Questions

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Documents

Subcontractor Cost Allowability And Systems Adequacy