Addressing Maximum Pass-Through Rates in an Incurred Cost Submission

By John N. Ford, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: jford@cbh.com

Recently, Congress has been concerned about what it has termed "excessive pass-through charges" on defense contracts. Those charges arise in situations where the majority of the work on the contract will be done by subcontractors, with little or no value added to the work by the prime contractor.

However, the prime contractor adds indirect costs and profits (or fees) onto the price charged to the prime contractor by the subcontractor. Congress is concerned about prime contractors recovering indirect costs and profits on these contracts in cases where the prime contractor adds little in terms of real value. Legislators seem intent on curtailing contractors’ ability to charge the government for these costs and profit.

Despite any potential Congressional intervention, pass-through rates remain the subject of increased scrutiny. Our CB&H Goverment Contractor Services Group recently had the occasion to advise a client with regard to a contracting office’s attempt to restrict pass-through charges through the use of a clause that limits “Maximum Pass-Through Rates.”

In this particular instance, the contract involved is a multiple award IDIQ contract, and the clause in question is stated to apply to all task orders under the contract. This clause provided that:

The Contractor agrees that the maximum pass-through rate that shall be charged against any and all line items under this contract shall not exceed __%. For purpose (sic) of this clause, the pass-through rate is defined as the cumulative amount of the two elements listed below divided by the price paid to the subcontractor or the vendor:

1. any and all indirect costs including, but not limited to, program management, subcontract management, invoice processing, Quality Assurance, overhead, material handling charges, G&A, burdens and mark-ups; and
2. any and all prime contractor profit or fee.

The Prime Contractor may not apply any additional fees or burdens on the elements of pass-through.

Other than the elements of pass-through, no additional costs, charges, indirect rates (such as overhead or G&A) or fees maybe proposed or applied to subcontract costs.

While the contractor was permitted to propose the rate to be applied, the contract limited the maximum rate to eight percent. Once the pass-through rate was established, the contract did not require that it be adjusted to reflect actual indirect costs. Further, the contract did not require a separate statement of what component of the pass-through rate represented indirect costs and what component was profit when proposing or billing for task orders. Accordingly, it could be all indirect costs, all profit or a combination of the two.

In short, the clause did not contemplate the rate being comprised strictly of costs. From a contractor’s perspective, if the prime contractor’s indirect costs, which are normally allocated to subcontract costs, are low, then the pass-through rate could result in almost all profit.
For example, if the contractor used a value-added G&A base where subcontracts are not included in the base, then the profit element of the pass-through rate could be significant. Conversely, if the prime contractor had significant indirect costs to be allocated to subcontract costs so that under its normal accounting practices more than an eight percent rate would be applied to subcontract costs, then the prime contractor would receive no profit through the pass-through rate.

In fact, the prime contractor could lose money on the transaction. This unique aspect of the pass-through rate presented interesting issues when billing for task orders issued on a cost-plus-fixed-fee (CPFF) basis.

As noted above, the clause prohibited the prime contractor's fee from being computed or associated with the subcontractor's effort. Therefore, when a CPFF task order was issued, all fees were computed and shown as relating to prime contractor costs only.

However, the pass-through rate in this instance did contain a fee component. This fee component was not separately stated on vouchers because billings were conducted in accordance with the way the task orders were priced, i.e., subcontractor costs plus an amount calculated by application of the pass-through rate. Moreover, this was in accordance with the billing instructions in the contract. Although completely proper and compliant with contract terms, this led to complications when the contractor was preparing its incurred cost submission.

Given the way the pass-through rate was required to be represented on vouchers, a reviewer would likely get the impression that the pass-through rate was a cost unless they were familiar with the Maximum Pass-Through Rates clause. Consequently, when reconciling total billings under this contract with costs incurred, one would initially get the impression that the contractor had overbilled the government because contract billings exceeded cost incurred.

On closer examination, this apparent overbilling was easily explained by the prime contractor’s profit element contained in the pass-through rate. This raised the issue of how to present this matter to the DCAA in an understandable way using the DCAA’s Incurred Cost Electronic (ICE) model for submission of incurred cost proposals.

Although the DCAA frequently states that the ICE model is not mandatory for use and is only a guide for submission for proposals to establish final indirect cost rates, in our experience, DCAA will rarely accept a submission that deviates from the ICE model. Attempts to do so usually result in the DCAA considering the proposal inadequate and insisting on strict compliance with the ICE model.

Rigid adherence to the ICE model would not permit proper explanation of the pass-through rate because there is no schedule in the model that is suitable for such an explanation. Therefore, we determined that the best way to approach this problem was to prepare a cover letter to the incurred cost submission.

In that cover letter, we explained the Maximum Pass-Through Rates clause, and attached a copy of the clause to the letter. Finally, we prepared a schedule to illustrate the impact of the profit element in the pass-through rate on billings and demonstrate that there was no overbilling of costs.

This case study is an example of the innovative and proactive ways that our CB&H Government Contractor Services Group can deliver practical solutions based upon our years of government contracting experience and knowledge of the procurement process. Please do not hesitate to contact us if our government contracting specialists may be of service to you or your business.

John is a Senior Government Contracting Consultant with CB&H and a member of the Firm's Government Contractor Services Group.