Defense Contracting: Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges
Published: 2008-01-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: One-third of the Department of Defense's (DOD) fiscal year 2006 spending on goods and services was for subcontracts. Concerns have been raised among DOD auditors and Congress about the potential for excessive pass- through charges by contractors that add little or no value when work is subcontracted. To better understand this risk, Congress mandated that GAO assess the extent to which DOD may be vulnerable to these charges. This report examines (1) DOD's approach to assessing the risk of excessive pass-through charges when work is subcontracted, (2) the strategies selected private sector companies use to minimize risks of excessive pass-through charges when purchasing goods and services, and (3) DOD's interim rule to prevent excessive pass-through charges. GAO's work is based on analysis of 32 fiscal year 2005 DOD contract actions at 10 DOD top contracting locations and discussions with DOD acquisition policy, audit, and contracting officials, including Defense Contract Audit Agency (DCAA) and Defense Contract Management Agency (DCMA) staff. GAO also interviewed nine selected private sector companies with diverse contracting experience.
section_title: What GAO Found
paragraphs: Although no specific criteria exist for evaluating contractor value added, DOD contracting officials generally rely on tools in the Federal Acquisition Regulation (FAR) to assess the risk of excessive pass-through charges when work is subcontracted. For the 32 selected contract actions GAO reviewed, DOD contracting officials generally applied these tools to their assessments. The degree of assessment depended on whether the contract was competed and whether the contract type required the government to pay a fixed price or costs incurred by the contractor. When using full and open competition, contracting officials assessed contractor value added based on the technical ability to perform the contract, but did not separately evaluate cost since market forces generally control contract costs, potentially minimizing the risk of excessive pass-through charges. However, when using noncompetitive contracts, contracting officials were required to evaluate more detailed cost information in assessing value added, as market forces did not determine the contract cost. For example, for a $3 billion noncompetitive contract for an Air Force satellite program, contracting officials assessed detailed cost or pricing data that included subcontractor costs, and received DCAA and DCMA support to negotiate lower overall contract costs. However, assessing contractor value added is especially challenging in unique situations where requirements are urgent in nature and routine contracting practices may be overlooked. Related GAO work and DOD audits on contracts awarded for Hurricane Katrina recovery efforts found multiple layers of subcontractors, questionable contractor value added, increased costs, and lax oversight. The selected private sector companies GAO interviewed rely heavily on acquisition planning, knowledge of supply chain, and managing contractual relationships to minimize risk of excessive pass-through charges when purchasing goods and services. They seek to optimize competition to minimize overall contract costs, and several companies indicated that they prefer fixed-price competitive arrangements. In addition, some form collaborative business relationships with contractors and subcontractors that provide greater insight into their supply chains and costs--a challenge DOD continues to face. When using other than fixed-price contracts, they recognize the financial risks and ensure proper oversight and accountability. As GAO has reported in the past, DOD's use of riskier contracts, such as time-and-materials contracts, has not always ensured good acquisition outcomes. DOD recently issued an interim rule requiring a contract clause in all eligible contracts, which allows it to recoup contractor payments that contracting officers determine to be excessive. The rule also requires detailed information from contractors on their value added when subcontracting costs reach 70 percent or more of total contract cost. However, the rule alone will not provide greater insight into DOD's supply chain and costs--information companies told us they use to mitigate excessive costs. Further, contracting officials indicated the need for guidance to ensure effective implementation and consistent application of tools in the FAR as appropriate.

section_title: Letter
paragraphs: In fiscal year 2006, the Department of Defense (DOD) spent over $294  billion to procure goods and services from prime contractors, with more  than one-third of this spending for awards to subcontractors. However,  concerns have been raised among federal auditors and Congress about the  potential for DOD to overpay contractors that subcontract work and add  little or no value. To help minimize this risk, Congress mandated that  DOD issue regulations on preventing these pass-through charges. It also  required GAO to assess the extent to which DOD may be vulnerable to  excessive pass-through charges. Specifically, we (1) determined DOD’s  current approach to assessing the risk of excessive pass-through charges  when work is subcontracted, (2) identified the strategies selected private  sector companies use to minimize risks of excessive pass-through charges  when purchasing goods and services, and (3) assessed DOD’s interim rule  to prevent excessive pass-through charges.
To determine DOD’s current approach to assessing the risk of excessive  pass-through charges when work is subcontracted, we reviewed and  analyzed the Federal Acquisition Regulation (FAR) and the Defense  Federal Acquisition Regulation Supplement (DFARS).  We also discussed  these regulations with DOD acquisition policy, audit, and contracting  officials. This included Defense Contract Audit Agency (DCAA) and  Defense Contract Management Agency (DCMA) staff to discuss their roles  in reviewing and managing contracts.  To obtain a broad perspective on  the processes in place to determine costs and extent of subcontracting, we  met with contracting staff from 10 of the top contracting locations across  DOD. At those locations, we reviewed and analyzed available  documentation for a nongeneralizable sample of 32 DOD contract actions  awarded in fiscal year 2005. Using DOD’s procurement information  system—DD350 database—we selected actions that had subcontracting  plans and small business contracts over $10 million.  While our sample  cannot be generalized to all DOD contract actions, it represented a range  of products and services, levels of competition, types of contracts, and  dollar value across DOD military services. We discussed these contracts  with the responsible contracting officials and examined the degree to  which available tools in acquisition regulations were used in assessing the  value added of contractors. Because no specific criteria exist for assessing  value added, we did not measure the adequacy of the contracting officials’  assessments. To understand how DOD approached the assessment for  contracts where much of the work was subcontracted, we reviewed recent  GAO and DOD audits and reports on questionable value added and costs  as well as discussed the reports with responsible DOD audit officials. We  also looked at practices outside of DOD to identify the strategies nine  selected companies use to minimize the risk of excessive pass-through  charges when purchasing a range of goods and services. We also reviewed  findings and recommendations of the Acquisition Advisory Panel’s 2007  report on commercial practices. We reviewed previous GAO reports and  issues raised in various GAO acquisitions forums and interviewed officials  from industry groups such as the Professional Services Council and the  Coalition for Government Procurement. To assess DOD’s recent efforts to  prevent excessive pass-through charges, we reviewed its interim rule  responding to the congressional mandate and discussed it with DOD  officials. We conducted this performance audit from March 2007 to  December 2007 in accordance with generally accepted government  auditing standards.  Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives.  We  believe the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.  A more detailed  discussion of our scope and methodology is provided in appendix I.
subsections: section_title: Background
paragraphs: DOD is increasingly relying on contractors to provide a range of mission- critical support from operating information technology systems to  providing logistics support on the battlefield. These contractors are  responsible for managing contract performance, including planning,  placing, and administering subcontracts as necessary to ensure the lowest  overall cost and technical risk to the government. Although total  subcontract awards from DOD contracts decreased 15 percent from fiscal  year 2005 to 2006, total subcontract awards have increased by 27 percent,  from $86.5 billion in fiscal year 2002 to $109.5 billion in fiscal year 2006.  (see fig. 1).
While subcontracting plans submitted by contractors are required for most  contracts over $550,000, this information is reported only for first tier  subcontracts. Historically, DOD has limited insight into costs associated  with using multiple layers of contractors to perform work. Figure 2 depicts  how lower tier’s costs become part of the higher tier’s and prime  contractor’s overall costs.
section_title: Risks of Excessive Pass-Through Charges Are Assessed through Routine Evaluations of Contractor Value
paragraphs: DOD contracting officials generally rely on tools in the FAR and DFARS in  assessing the risk of excessive pass-through charges when work is  subcontracted. For the 32 selected contracts we reviewed, when there was  full and open competition, contracting officials assessed contractor value  added based on the technical ability to perform the contract, but did not  need to separately evaluate costs for value added as market forces  generally control the proposed contract cost. However, contracts with  greater risk—such as those awarded noncompetitively or without fixed  prices—require contracting officers to consider more than the technical  ability to perform the work in assessing value added. We found that  conducting assessments of contractor value added is especially  challenging in unique circumstances, such as when requirements are  urgent in nature and routine contracting practices may be overlooked.
subsections: section_title: DOD Generally Relies on Tools in Acquisition Regulations to Assess Contractor Value Added
paragraphs: The FAR and DFARS contain requirements for contracting officials when  entering into contractual relationships that are intended to help ensure the  best value for products and services. Contracting officers have wide  latitude to exercise business judgment when applying these regulations.   While no specific criteria exist for contracting officers to use in evaluating  contractor value added, several key elements in acquisition regulations,  however, provide them with a mix of tools to gain insight into how prime  contractors intend to do the work and the associated costs, including the  role and costs of subcontracting:  Acquisition planning is key to determining contract requirements,  level of competition available based on market research, and the  appropriate contract vehicle to be used based on level of risk.
Solicitation procedures allow contracting officers to select the  prospective contractor that represents the best value to the  government.
Contract pricing is used to determine price reasonableness for the  contract, including subcontracting costs.
Contract administration is intended to obtain a variety of audit and  administration services to hold contractors accountable for operating  according to their proposals.
section_title: Presence of Competition and Type of Contract Generally Guide the Use of Assessment Tools
paragraphs: According to DOD contracting officials and based on our review of selected  contracts, assessments of contractor value added are typically driven by  contract risk—the presence of competition and whether the type of contract  requires the government to pay a fixed price or costs incurred by the  contractor. When using full and open competition, the value added by the  prime contractor was determined by its technical ability to perform the  contract, but generally contracting officers did not do a separate detailed  evaluation of cost to determine value added. DOD contracting officials told us  that competitive fixed-price contracts allow the market to control overall  contract value, which provided them with reasonable assurance of the  contractor’s value added and potentially minimizing the risk of excessive  pass-through charges. When using noncompetitive contracts, however, the  market forces did not control contract cost and required contracting officers  to consider—in addition to cost—the technical ability to perform the work.  Specifically, DOD contracting officials noted that noncompetitive as well as  other than fixed-price contracts require additional oversight and  administration, including more detailed information to conduct the  assessment of contractor value added and minimize the risk of excessive  pass-through charges. For the 32 selected contracts we reviewed, 16 were  awarded noncompetitively, with 7 of those on a cost-reimbursement basis and  2 on a time-and-materials basis. (see table 1) .
DOD contracting officials noted that fixed-price contracts incentivize  prime contractors to keep overall contract costs low—to include any  subcontract costs—as they will have to absorb cost overruns under such  contracts. In reviewing two fixed-price competitive contracts for Air Force  space systems, acquisition planning and market research up-front  provided insights into reasonable prices as well as identified the best- qualified suppliers to do the work. Air Force officials stated that because  competitive contracts are often proposed by a team of contractors—the  prime plus the subcontractors—market pricing extends to subcontractor  costs as well. In discussing the two contracts, these officials added that  fixed prices lowered the government’s risk of increased costs. As a result,  the contracting officials said that in assessing the prime contractor’s value  added, they focused more on the technical capabilities—rather than  cost—to ensure contractors were responsive in meeting the mission.
Contracting officials told us that contracts awarded noncompetitively  decrease their assurance of price reasonableness since there is no basis of  comparison through competition. Therefore, they rely on other pricing  tools contained in the FAR and DFARS.  These tools assist the contracting  officers in obtaining more detailed information to provide reasonable  assurance of contractor value added and potentially minimize the risk of  excessive pass-through charges. Our review of contract files also  revealed the role that DCAA and DCMA played in reviewing cost  information in several of the 16 noncompetitive contracts we reviewed  and helping to negotiate subcontract costs.
For the Air Force’s estimated $3 billion satellite program contract,  DCAA reviewed the certified cost and pricing data that the contractor  was required to provide. The required data included not only the  contractor’s costs but a detailed description of the efforts and costs of  each subcontractor, including subsidiary companies. The contracting  officer judged the proposed costs based on results of audit reports and  a technical evaluation. Because of the high dollar value and complexity  of this contract, the program office required the prime contractor to  submit cost data reports at the conclusion of each effort and cost  performance reports to provide insight into the prime contractor’s and  subcontractor’s cost and schedule data. Additionally, DCAA and DCMA  helped to negotiate individual subcontracts and, in some cases, achieve  lower overall costs.
The Army similarly relied on DCAA and DCMA assistance on a $1  billion fixed-price contract for a family of heavy tactical vehicles. The  Army did not pursue full and open competition, citing the lack of  industry response, thus requiring contracting officers to gain more  insight into prime contractor and subcontract costs to assess  contractor value added and minimize the risk of excessive pass- through charges. The Army used a teaming arrangement that allowed  the contracting command, DCAA, DCMA, and the contractor to  evaluate, discuss, and negotiate the costs. Each cost element was  mutually agreed upon, resulting in a negotiated price list. Contracting  officials told us that these negotiated prices applied to subcontracts for  vehicle parts as well, preventing overcharges by lower-tier  subcontractors.
For an $11 million Navy contract for fighter aircraft support, DCMA  provided an evaluation of prime contractor and subcontractor costs for  certain services. In prenegotiation discussions with the Navy, DCMA  described the technical evaluation of the contractor’s cost proposal,  providing a cost summary of what was proposed by the contractor and  what was recommended during the technical evaluation.  For one  portion of the contract, the evaluators questioned the direct labor  hours proposed by the prime contractor for managing the project  because most (if not all) the actual work would be done by  subcontractors. The DCMA technical evaluator found the hours  proposed to be excessive, raising questions about the prime  contractor’s value added relative to the costs. Documentation in the  contract file stated that although the prime contractor believed the  hours proposed were fair, it agreed to a 25 percent reduction in the  hours.
In addition to the presence of competition, the risk associated with  contracts in which the government pays based on costs incurred also  affects the degree to which contracting officers assess contractor value  added and potentially minimize the risk of excessive pass-through charges.  These contracts, which include cost-reimbursement and time-and- materials contracts, increase DOD’s need to ensure appropriate  surveillance during performance to provide reasonable assurance that  efficient methods and effective cost controls are used. Because of the risks  involved, the FAR directs that these contracts should be used only when it  is not possible at the time of award to estimate accurately the extent or  duration of the work or to anticipate costs with any reasonable degree of  confidence. Of the selected contracts we reviewed, 18, or 56 percent,  were cost-type contracts with 11 noncompetitively awarded. Contracting  officials told us that under these arrangements, although competition  increases the assurance of reasonable prices and controls contract cost,  the absence of a fixed price requires them to take additional steps to  obtain other information to assess the roles and costs of prime contractors  and subcontractors, which assists in evaluating contractor value added.
For example, a task order awarded under a $3 billion Army multiple award  contract, which reimbursed the contractor based on the cost of its time  and materials, demonstrated the risk associated with these contracts.  Under this multiple award contract, eight prime contractors competed for  task orders, with one of the contractors identifying over 75 subcontractors  in its proposal. On the task order we reviewed, for engineering services,  most of the work was subcontracted. Contracting officers stated that  because the contract was awarded on a time-and-materials basis, the  government was particularly vulnerable to the prime contractor charging  more than it paid for its subcontractor since at this time prime contractors  could charge for subcontract labor at the prime’s rate and keep any  difference between its rate and the subcontractor’s. While the prime  contractor was not required to submit certified cost or pricing data, it was  required to provide a task execution plan that described the specific duties  of both the prime contractor and the subcontractor, including the fees  they were charging the government to manage the subcontractor. The  Army evaluated the plan and determined that the number of hours and  rates proposed by the prime contractor were reasonable based on the data  provided.  We have previously reported that for some time-and-materials  contracts, DOD paid more than actual costs for subcontracted labor. To  minimize this risk with time-and-materials contracts, a new DOD  regulation set forth different rules about how prime contractors are to be  reimbursed for subcontracted labor to ensure that prime contractors do  not charge the government higher rates than those charged by  subcontractors.
In our review of other cost-type contracts, DOD gained insight into value  provided by the prime contractor in determining price reasonableness.  The cost or pricing data in some cases provided the contracting officer  with added insight by breaking out costs of the prime contractor and  major subcontractors by the work they were to perform.  Further, in some  cases, DCAA questioned the proposed subcontractor costs and provided  an estimate for the contracting officer to use in negotiating a more  reasonable price to ensure best value. For example, in a $92 million Army  contract for the redesign of a chemical demilitarization facility, DCAA  questioned the surcharges applied to certain subcontractor costs and  recommended lower rates. The contractor accepted the lower rates,  reducing the overall cost to the Army.
According to several contracting officials, as prime contractors assign  subcontractors more critical roles to achieve a mission, the increased need  for detailed cost information is coupled with the need for more insight into  the technical capabilities of the subcontractors. Because cost is not always  the primary criterion used to determine best value, technical capabilities  can also be evaluated to determine the role of the prime contractor when  work is subcontracted. We found that cost was not always ranked as the  highest factor in reviewing source selection criteria for five cost-type  contracts. For one example—an $863 million Navy contract for support  services related to a destroyer—the technical evaluation determined the  ability of the prime contractor and multiple tiers of subcontractors to  perform the work. While detailed cost information was obtained from the  prime contractor and considered in the source selection, its ability to  consolidate and manage efforts that had previously been conducted under  five separate contracts was a particularly significant factor in evaluating  the contractor’s value added. In another example—a $2.9 billion Navy  contract for a major weapons system—given the size of the contract and  magnitude and complexity of work involved, the contracting officer  required greater insight into how the prime contractor intended to  subcontract. As a result, the contracting officer modified the contract to  increase requirements for the prime contractor to obtain consent to  subcontract. The contracting officer told us that although prime  contractors are ultimately responsible for managing their subcontractors,  DOD still needed to maintain a certain level of insight into subcontracting,  given the increased role.
section_title: Unique Circumstances Can Drive Contracting Arrangements That Carry Greater Risk of Excessive Pass-Through Charges
paragraphs: Some unique contracting arrangements that are noncompetitive or where  requirements are urgent in nature carry greater risk of excessive pass- through charges and pose challenges in conducting assessments of  contractor value added. This was the case with a contract we reviewed  that had been awarded to an Alaska Native Corporation (ANC) firm  through a small business development program. In addition, related GAO  work and DOD audits on contracts awarded for Hurricane Katrina  recovery efforts found multiple layers of subcontractors, questionable  value added by contractors, increased costs, and lax oversight.
Through the Small Business Administration’s 8(a) program, DOD and  other federal agencies can award sole-source contracts to ANC firms for  any dollar value. The Small Business Administration requires agencies to  monitor the percentage of work performed by the 8(a) firms versus the  percentage performed by their subcontractors to ensure that small  businesses do not pass along the benefits of their contracts to  subcontractors. The “limitations on subcontracting” clause in the FAR  requires that for 8(a) service contracts with subcontracting, the firm must  incur at least 50 percent of the personnel costs with its own employees  (for general construction contracts, the firm must incur at least 15 percent  of the personnel costs). However, for one contract we reviewed that was  awarded to an ANC firm, contracting officials had failed to include the  required FAR clause in the contract and other contracting officials we  spoke to were unsure who should be monitoring compliance—findings  consistent with our past work on ANC 8(a) contracts.
For an Army logistics support services cost-reimbursement contract for  $54 million awarded to an ANC noncompetitively, substantial variations in  workload created too much cost risk to make it a fixed-price contract.  According to the contracting officer, usually with a scope of work this  large and varied, the contract lends itself to subcontracting. When asked  about the level of insight into how the ANC would use subcontracted  support, the contracting officer responded that this was challenging since  small businesses are not required to submit subcontracting plans. In  reviewing the base contract, we found that it did not contain the required  clause that limits subcontracting. We brought this to the attention of the  contracting officer, who told us that although he was not aware of any  subcontracting, the clause should have been included and it was an  oversight. Several other contracting officials we spoke to said they were  unsure of whose responsibility it is to monitor compliance with the  subcontracting limitations under these 8(a) contracts. They recognized  that they should be doing more to monitor compliance. By not ensuring  compliance with the limits on subcontracting requirement, there is an  increased risk that an inappropriate degree of the work is being done by  large businesses, raising questions about the value added by the ANC firm.
According to contracting officials we spoke with, assessing the value  added by a prime contractor is especially challenging in emergency  situations, where requirements are critical and urgent in nature, such as  those for recovery from Hurricane Katrina. We have similarly reported that  the circumstances created by these situations can make it difficult to  balance the need to deliver goods and services quickly with the need for  appropriate controls. Our past work has cautioned, however, that limited  predictability must not be an excuse for poor contracting practices. In  some cases, the response to Hurricane Katrina suffered from inadequate  planning and preparation to anticipate requirements for needed goods and  services. The scale of operations and the government’s stated inability to  provide program management after Katrina drove the decision to award  contracts with large scopes of work that, in certain cases, led to multiple  layers of subcontractors and increased costs.
GAO’s past work in reviewing orders and contracts for the Katrina  recovery effort found that the U.S. Army Corps of Engineers (USACE)  disclosed increased costs associated with multiple supplier layers. In  reviewing orders and contracts for portable public buildings in Mississippi,  which were awarded in 2005, we found that USACE ordered 88 buildings  that were purchased and sold through two to three layers of suppliers,  resulting in prices 63 percent to 133 percent higher than manufacturers’  sales prices. In one example, 45 of the 88 portable public buildings were  purchased from a contractor who in turn purchased the buildings from a  distributor, who in turn purchased them from another distributor, who had  purchased the 45 buildings from the manufacturer. Each layer added an  additional fee, resulting in USACE agreeing to a price that was 63 percent  higher than the manufacturer’s price.
DOD auditors have noted additional concerns in some Katrina contracts  they reviewed. For example, a November 2006 Army Audit report stated  that unclear requirements for four post-Katrina debris removal contracts  awarded by USACE—for $500 million each with an option for an  additional $500 million—resulted in prices renegotiated in unfavorable  circumstances. According to the report, the urgency to award contracts  quickly did not give USACE contracting personnel sufficient time to  develop a well-defined acquisition strategy—one that defined desired  outcomes and risks related to the acquisition to ensure contracts were  structured in the government’s best interest. Contracting officials were  less diligent about complying with acquisition regulations regarding best  value contracts and reasonable pricing. Fixed-price contracts were  renegotiated at higher prices without the benefit of a DCAA review.  USACE’s decision to use four large contracts also resulted in multiple tiers  of subcontractors to accomplish the work, with each tier adding costs.  Post-award audits performed by DCAA found substantial overcharges by  the debris contractors.
USACE officials we spoke with noted that they have revised the  acquisition strategy to structure the size and scope of contracts to  maximize competition and minimize subcontractor tiers. New contracts  will have reduced performance periods to ensure that prices reflect the  existing conditions. While USACE previously set production rates in its  contracts, it did not measure them during the performance of the contract.  USACE officials further stated that under the revised strategy, they will  negotiate the production rate and measure the contractor’s ability to  maintain it. To ensure price reasonableness of proposed prices, USACE  plans to request DCAA to assist the contracting officer in reviews of  competitive proposals and in negotiations. According to the officials, these  revisions to USACE’s acquisition strategy were designed to address  concerns related to prime contractors passing work on to subcontractors  and increasing costs to the government without adding value.
section_title: Selected Private Sector Companies Rely on Several Shared Approaches to Minimize The Risk of Excessive Pass- Through Charges
paragraphs: Selected private sector companies we interviewed had several strategies in  common for minimizing the risk to them of excessive pass-through  charges when purchasing goods and services. These companies focus  resources on acquisition planning and knowledge of their supply chains  and costs—challenges DOD continues to face. They also seek to optimize  competition, preferring fixed-price competitive arrangements. According  to several companies, they recognize the financial risks of other types of  contracts, such as time-and-materials, and enter into them with proper  oversight and accountability. As we have previously reported, DOD’s use  of these riskier contracts has not always ensured good acquisition  outcomes and prudent expenditure of taxpayer dollars. In addition,  company officials we interviewed told us that continuous and close  management of the contractual relationship is critical to minimizing risks  of excessive costs.
subsections: section_title: Private Sector Companies Focus on Acquisition Planning and Knowledge of Supply Chain
paragraphs: The contracting officials we spoke with at selected private sector  companies told us that to avoid unnecessary pass-through charges when  purchasing goods and services, they devote attention to planning  acquisitions. Some companies told us that they invest in teams of experts  and consultants to define contract requirements and then structure  contracts based on the complexity of the acquisition. For example, one  company described the use of cross-functional teams to obtain input on  information technology, purchasing, quality, and other internal expertise.  Having such information assists in developing comprehensive project  acquisition plans and clear and stable requirements. One company seeks  input from its engineers to develop a set of criteria based on the product  or service acquisition. Officials from another company told us they will  determine the optimum number of subcontracts required to procure a  particular product or service and group them based on the requirements  and need to subcontract. One company contracting official told us that it is  an “expensive fishing expedition” when the requirements are not clearly  defined, as it limits the company’s ability to enter into fixed-price  competitive contracts and can increase its vulnerability to excessive costs.  Private sector firms that spoke before the Acquisition Advisory Panel— established to review federal acquisition laws and regulations on a number  of issues—also described a vigorous acquisition planning phase when  buying services. These firms invest time and resources necessary to  clearly define requirements first, allowing them to achieve the benefits of  competition.
According to some company contracting officials, they use rigorous  market research and requests for information to develop a range of  potential suppliers and cost and pricing data. Having this information on  their supply chain allows these companies to minimize the risk of  excessive pass-through charges. To gain additional information into costs,  some companies work in a collaborative environment with contractors  and subcontractors. However, they indicated that in these types of  arrangements, companies have to be willing to share information openly  and communicate their concerns and needs to achieve best value from the  contractual relationship.
Company officials told us that clearly defined requirements contribute to  their ability when purchasing goods and services to enter into fixed-price  contracts that lower costs and mitigate the risks of unnecessary charges  relative to value added by the prime contractor. While the vast majority of  their contracts are competitive fixed-price type contracts, some  companies noted that the use of other contracts is sometimes necessary.  Companies we met with recognize the financial risks involved and enter  into them only with proper oversight and accountability. Buyers from  companies who spoke before the Acquisition Advisory Panel also noted  that when they enter into time-and-materials contracts, for example, they  “endeavor to maintain tight controls over the contracting process, costs,  and levels of effort.”
Prior GAO work has found that DOD has been challenged in adequately  planning many of its major acquisitions. In 1992, GAO identified DOD  contract management as high-risk due to long-standing concerns in  planning, execution, and overseeing acquisition processes. We have  reported that to produce desired outcomes, DOD and its contractors need  to clearly understand acquisition objectives and how they translate into a  contract’s terms and conditions. Likewise, we have reported that obtaining  reasonable prices depends on the benefits of a competitive environment,  yet we have found cases where DOD failed to adequately define contract  requirements, making it difficult to hold DOD and contractors accountable  for poor acquisition outcomes. Moreover, participants at a October 2005  GAO forum related to Managing the Supplier Base noted that DOD faces  challenges in maintaining insight into its supply chain and recognized the  importance of promoting competition in managing multiple tiers of  suppliers. In addition, our recent work on DOD’s use of time-and- materials contracts noted that contracting and program officials frequently  failed to ensure that these contracts were used only when no other  contract type was suitable. DOD officials cited speed and flexibility as the  main reasons these contracts were used, and we reported inconsistencies  in the rigor with which DOD monitored contractor performance, as called  for in time-and-materials contracts.
section_title: Private Sector Companies Closely Manage Contractual Relationships to Control Costs
paragraphs: Company officials we interviewed told us that continuous management  of the contractual relationship is critical to minimizing risks of  excessive costs. The specific management practices used by companies  generally include establishing clear contract terms and periodic  evaluations to monitor performance. Subcontractor management  practices include the use of clear contract terms to guide the  relationship and ensure both parties understand each other’s needs.  Some companies told us that the type of contract arrangement depends  on the product or service and some contract terms may include more  detail than others. According to one company, the level of detail of  information requested also depends on the product or service procured,  size of the procurement, and complexity of the work to be performed.  This company told us that in such cases it has requested information on  all parties who would be performing the work, down to the fifth level.  In other cases it may retain the right to renegotiate the contract to  ensure it is receiving the best price throughout the contractual  agreement. Typically, both parties agree to renew the contract as long  as the performance and benefit goals are being met.
Company officials stressed the importance of having performance  monitoring systems to ensure that the prime contractor’s value added  relative to subcontractor costs is being met.  For example, one company  we interviewed told us that it periodically checks prices in the  marketplace against cost information provided by the supplier. Similarly,  another company emphasized the need to continuously check prices  against the market, since similar to DOD, it does not have insight below  the first-tier subcontractors.  Some companies we interviewed also  emphasized the importance of periodically evaluating and assessing the  contractor’s value added relative to the costs and the need for continuing,  changing, or ending the contract relationship.
section_title: Contracting Officials Lack The Guidance and Insight Needed to Effectively Implement DOD’s Interim Rule
paragraphs: DOD recently issued an interim rule that allows it to recoup contractor  payments that contracting officers determine to be excessive on all eligible  contracts. The rule requires detailed information from the prime  contractor on value added when subcontracting reaches 70 percent or  more of the total contract. While the rule aims to provide contracting  officers with more information, it will not provide greater insight into  DOD’s supply chain and costs. Further, while the rule is not yet final,  contracting officials indicated to us that guidance is needed to ensure  effective and consistent implementation in assessing contractor value  added, particularly for newer and less experienced contracting staff.
Congress required DOD in the Fiscal Year 2007 National Defense  Authorization Act to prescribe regulations on excessive pass-through  charges, which are defined in the act as charges (overhead and profit) for  work performed by a contractor or subcontractor that adds no, or  negligible, value. In April 2007, DOD issued an interim rule to require a  contract clause that provides audit rights and cost recovery should these  excessive pass-through charges occur. The rule also requires specific  disclosure by a contractor that intends, or subsequently decides, to  subcontract most of the work.  Specifically, the contractor is to identify in  its proposal the percentage of effort it intends to perform, and the  percentage expected to be performed by each subcontractor under the  contract, task order, or delivery order, or if a decision to subcontract  comes after award, the contractor must notify the contracting officer in  writing. Under the interim rule, prime contractors are required to inform a  contracting officer of the value added that they are providing when  subcontract costs exceed 70 percent of the total contract value. While the  rule may enhance insight into contractor value added under these  circumstances, it will not address DOD’s challenges in obtaining insight  into its supply chain and costs—key information needed to mitigate risk of  excessive pass-through charges according to companies we interviewed.
In addition, DOD has not developed guidance for contracting officers to use  in implementing the rule. Specifically, it lacks guidance that addresses  contract risk associated with presence of competition, contract type, and  unique circumstances where requirements are urgent in nature. As we found  during our contract review, these are key risk factors to take into account  when determining the degree of assessment needed, not necessarily the  percentage of subcontracting alone.  However, contracting officers have wide  latitude in exercising judgment on how to apply these tools.  While  contracting officers we met with were generally applying these tools in  conducting their assessments of contractor value added for the selected  contract actions we reviewed, they indicated that guidance—particularly for  newer and less experienced staff—would help ensure the tools are  consistently applied and that assessments are properly documented in the  contract files.  We brought this to the attention of DOD procurement policy  officials, who told us that as they develop implementing guidance, they will  emphasize that contracting officers need to include contract risk in  conducting their contractor value added assessments and document the  results.
While the regulation allows contracting officers to recoup charges that they  determine to be excessive, it does not specify the roles of DCAA and DCMA in  this process.  As we found in our contract review and in discussions with  contracting officials, these organizations played a key role in assessing cost  information.  However, contracting officials indicated the importance for  newer and less experienced staff to involve DCAA and DCMA as appropriate.   We spoke with officials from both of these agencies, who also indicated that  they would play a role in implementing this regulation and in assisting  contracting officers in determining whether costs are excessive, but they said  they had not fully considered the extent or the resources needed. We brought  this to the attention of DOD procurement policy officials, who agreed these  organizations need to be involved in assisting contracting officers in their  assessments of whether pass-through charges are excessive, and as they  develop implementing guidance, they will emphasize the involvement of  DCAA and DCMA in facilitating the assessments as appropriate.
section_title: Conclusions
paragraphs: Assessing contractor value added and minimizing the risk of excessive  pass-through charges have taken on heightened importance given the  increasing role of subcontractors in providing DOD with critical goods and  services—especially for emergency situations, where routine contracting  practices may be overlooked in an effort to meet urgent requirements.  Historically, DOD has lacked insight into subcontractor costs, raising  questions about the value added when multiple layers of contractors  perform the work. Optimizing competition—an acquisition strategy the  private sector companies we interviewed emphasized when purchasing  goods and services for their own operations—can minimize DOD’s risk of  paying excessive payments since market forces generally control contract  cost. However, without insight into the supply chain and associated costs,  it is difficult to assess the risk of excessive pass-through charges.  While  DOD’s new interim rule is a step in the right direction, it by itself will not  help contracting officials gain this insight. Further, although we found that  contracting officers were generally applying tools in the FAR in  conducting assessments of contractor value added for selected contracts  we reviewed, implementing guidance for the new rule would help ensure  these tools are consistently applied in determining the degree of  assessment needed, documenting the assessments, and appropriately  involving DCAA and DCMA.
section_title: Recommendations for Executive Action
paragraphs: As DOD finalizes its rule on preventing excessive pass-through charges  and develops implementing guidance to ensure consistency in how  contracting officials assess contractor value added, we recommend that  the Secretary of Defense direct the Director of Defense Procurement and  Acquisition Policy to take the following actions:    Require contracting officials to take risk into account when  determining the degree of assessment needed. Risk factors to consider  include whether (1) the contract is competed; (2) the contract type  requires the government to pay a fixed price or costs incurred by the  contractor; and (3) any unique circumstances exist, such as  requirements that are urgent in nature.
Require contracting officials to document their assessments of  contractor value added in the contract files.
Involve DCAA and DCMA in facilitating assessments as appropriate.
section_title: Agency Comments
paragraphs: We provided a draft of this report to DOD for comment.  In written  comments, DOD concurred with our recommendations and noted actions  planned and underway that are directly responsive.  Specifically, DOD  anticipates issuing a second interim rule in February 2008 and expects a  final rule in August 2008.  Once the rule is finalized, DOD intends to  provide extensive guidance to supplement the regulation that will cover a  range of issues, including those GAO recommended.  DOD’s comments are  reproduced in appendix III.
We are sending copies of this report to the Secretary of Defense and will  make other copies available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions about this report or need additional  information, please contact me at (202) 512-4841 or calvaresibarra@gao.gov.  Contact points for our Offices of Congressional Relations and Public Affairs  may be found on the last page of this report. Key contributors to this report  were John Neumann, Assistant Director; Barry DeWeese; Yvette Gutierrez- Thomas; Kevin Heinz; Maurice Kent; Julia Kennon; John Krump; and   Karen Sloan.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine the Department of Defense’s (DOD) approach to assessing  the risk of excessive pass-through charges when work is subcontracted,  we reviewed and analyzed tools in the Federal Acquisition Regulation  (FAR) and the Defense Federal Acquisition Regulation Supplement  (DFARS). We met with DOD officials from the Office of the Secretary of  Defense, Defense Procurement and Acquisition Policy, Defense Contract  Audit Agency (DCAA), Defense Contract Management Agency (DCMA),  and contracting officials from 11 DOD contracting locations to discuss  these regulations and their approach to assessing the risk of pass-through  charges, evaluating contractor value added, and factors that drive these  assessments. We selected 10 of these locations, which had some of the  highest spending in fiscal year 2005, to visit and discuss specific contracts,  policies, and processes related to evaluating contractor value added when  work is subcontracted. In addition, while we did not visit the Army Tank  and Automotive Command in Warren, Michigan, we obtained contract  documents from it for review. While our selection of locations cannot be  generalized to the population of all DOD contracting locations, those  selected represented each of the military services and represented a  variety of goods and services procured. The specific military locations we  visited were:   Air Force Space Command, Colorado Springs, Colorado    Air Force 21st Space Wing, Peterson Air Force Base, Colorado Springs,    Air Force 50th Space Wing, Schriever Air Force Base, Colorado    Air Force Space and Missile Command, El Segundo, California   U.S. Army Space and Missile Defense Command, Peterson Air Force  Base, Colorado Springs, Colorado    Army Contracting Agency, Fort Carson, Colorado Springs, Colorado    Army Communications and Electronics Command, Fort Monmouth,    Army Sustainment Command, Rock Island, Illinois   Naval Sea Systems Command, Washington Navy Yard, District of    Naval Air Systems Command, Patuxent River, Maryland.
At the locations we visited, and to provide a broad perspective on extent  to which contracting officials apply existing tools in acquisition  regulations in assessing risk of excessive pass-through charges and  contractor value added, we analyzed and discussed 32 selected contract  actions awarded in fiscal year 2005. These selected actions included base  contracts, task orders under contracts, and modifications to contracts.  Since DOD’s procurement information system—DD350 database—does  not contain a specific field for percentage of subcontracting, of all DOD  contract actions over $10 million and had reported submitting a   subcontracting plan, we selected a nongeneralizable sample of actions that  provided a mix of contract types, levels of competition, dollar values, and  goods and services procured.  Moreover, we also selected small business  contracts over $10 million. While small businesses are not required to  submit subcontracting plans, the dollar value of these actions would have  otherwise required them. We relied on data provided in the DD350  database and verified the reliability of the information where practical  with contracting officers, contract files at contract locations visited, and  through review of contract documents in DOD’s Electronic Data Access  Web-based system. On the basis of this assessment, we found the DD350  database to be sufficiently reliable for our purposes.
We reviewed and analyzed available documentation for the selected DOD  contract actions and discussed these actions with the responsible  contracting officials. While our selection of contract actions cannot be  generalized to all DOD contracts, those selected represent each of the  military services and a number of different contract actions, allowing us to  obtain a variety of perspectives from DOD contracting officials. In  reviewing and discussing contract files with contracting officials at these  locations, we examined factors that drove the need to assess prime  contractor and subcontractor costs, guidance and tools available to  conduct assessments, and level of insight into subcontracting activity.  Included in the contract files and also reviewed were documents from  DCAA and DCMA that were used to support the decisions of contracting  officials. We met with both of these agencies to discuss their roles in  assisting contracting officials. Because no criteria exist for assessing value  added relative to costs, our review does not include a determination of  whether the DOD contracting officer adequately assessed the value added  and costs, but rather the extent to which the contracting officer applied  existing tools in the FAR and DFARS. In addition, to obtain additional  information on contracts that had been identified as having questionable  costs, we also interviewed the Army Corps of Engineers, the Army Audit  Agency, and the DOD Office of Inspector General. We reviewed and  analyzed documents from these agencies as well as past GAO work to  determine how tools in acquisition regulations were applied in contracts  with questionable costs. We also discussed strategies being explored to  help mitigate risks of excessive costs on future contracts.
To identify the strategies selected private sector companies use to  minimize risk of excessive pass-through charges when purchasing goods  and services, we selected nine companies to interview. Our selection of  companies was based on diversity in commercial and public sector  contracting and a range of goods and services. In the company interviews,  we discussed the perspectives and practices for managing and assessing  value added relative to prime and subcontractor costs. In addition to the  interviews, we reviewed findings and recommendations of the Acquisition  Advisory Panel’s 2007 report on commercial practices. We also reviewed  previous GAO reports and issues raised in various GAO acquisition forums  and met with industry associations, such as the Professional Services  Council and Coalition for Government Procurement. Table 2 provides a  list and description of the companies we interviewed.
To assess DOD’s interim rule to prevent excessive pass-through charges,  we reviewed the specific mandate for DOD in Section 852 of the Fiscal  Year 2007 Defense Authorization Act.  We discussed this requirement with  DOD procurement policy officials and reviewed the interim DOD rule on  excessive pass-through charges in response to the mandate as well as any  changes made based on public comments received. We also spoke to  DCAA and DCMA regarding their role in implementing the rule and  obtained perspectives from contracting officials we interviewed at the  military locations we visited on potential challenges in implementing the  rule.
section_title: Appendix II: Key Elements for Contracting Officers in Assessing Contractor Value Added
subsections: section_title: Description
paragraphs: Acquisition planning determines the requirements of the contract, the level of competition available  based on market research, and the appropriate contract vehicle to be used.
Requirements and logistics personnel should avoid issuing requirements on an urgent basis or with  unrealistic delivery or performance schedules, since it generally restricts competition and increases  prices. Early in the planning process, the planner should consult with requirements and logistics  personnel who determine type, quality, quantity, and delivery requirements. (FAR 7.104(b))
Market research is conducted to determine if commercial items are available to meet the government’s  needs or could be modified to meet the government’s needs. The extent of market research will vary,  depending on such factors as urgency, estimated dollar value, complexity, and past experience.  Market research involves obtaining information specific to the item being acquired using a variety of  resources. The availability or unavailability of items in commercial markets drives the contracting  procedures used. (FAR 10.001 and 10.002)
Contracting officers shall provide for full and open competition through use of competitive procedures  that are best suited to the circumstances of the contract action and consistent with the need to fulfill  the government’s requirements efficiently. (FAR Part 6.101) When adequate price competition exists,  generally no additional information is necessary to determine the reasonableness of price. (FAR  15.403-3) Acquisition plans should address when subcontract competition is both feasible and  desirable and describe how it will be sought, promoted, and sustained throughout the course of the  acquisition. (FAR 7.105(b)(2)(iv))
A wide selection of contract types is available to the government and contractors in order to provide  needed flexibility in acquiring goods and services. The objective is to negotiate a contract type and  price that will result in reasonable contractor risk and provide the contractor with the greatest incentive  for efficient and economical performance. A firm-fixed-price contract, which best utilizes the basic profit  motive of business enterprise, shall be used when the risk involved is minimal or can be predicted with  an acceptable degree of certainty. However, when a reasonable basis for firm pricing does not exist,  other contract types should be considered, and negotiations should be directed toward selecting a  contract type that will appropriately tie profit to contractor performance. If the contractor proposes  extensive subcontracting, a contract type reflecting the actual risks to the prime contractor should be  selected. (FAR 16.1)
In different types of acquisitions, the relative importance of cost or price may vary. For example, in  acquisitions where the requirement is clearly definable and the risk of unsuccessful contract  performance is minimal, cost or price may play a dominant role in source selection. The less definitive  the requirement, the more development work required, or the greater the performance risk, the more  technical or past performance considerations may play a dominant role in source selection. (FAR Part  15.101)
Normally, competition establishes price reasonableness. Therefore, when contracting on a firm-fixed- price or fixed-price with economic price adjustment basis, comparison of the proposed prices will  usually satisfy the requirement to perform a price analysis, and a cost analysis need not be performed.  In limited situations, a cost analysis may be appropriate to establish reasonableness of the otherwise  successful offeror’s price. When contracting on a cost-reimbursement basis, evaluations shall include  a cost realism analysis to determine what the government should realistically expect to pay for the  proposed effort, the offeror’s understanding of the work, and the offeror’s ability to perform the  contract. The contracting officer shall document the cost or price evaluation. (FAR 15.305(a)(1))
The source selection records shall include an assessment of each offeror’s ability to accomplish the  technical requirements; and a summary, matrix, or quantitative ranking, along with appropriate  supporting narrative, of each technical proposal using the evaluation factors. Cost information may be  provided to members of the technical evaluation team in accordance with agency procedures.  Additionally, the evaluation should take into account past performance information regarding  predecessor companies, key personnel who have relevant experience, or subcontractors that will  perform major or critical aspects of the requirement when such information is relevant to the instant  acquisition. (FAR Part 15.305(a)(2))
In negotiated acquisitions, each solicitation that is expected to exceed $550,000 ($1,000,000 for  construction) and that has subcontracting possibilities, shall require a subcontracting plan. If the offeror  fails to negotiate a subcontracting plan acceptable to the contracting officer within the time limit  prescribed by the contracting officer, the offeror will be ineligible for award. (FAR 19.702(a)(1)&(2)).  Each subcontracting plan must include percentage goals for using different types of small businesses,  a statement of the total dollars planned to be subcontracted, a statement of the total dollars planned to  be subcontracted to small businesses, and a description of the principal types of supplies and services  to be subcontracted.(FAR 19.704(a))
Contracting officers must purchase supplies and services from responsible sources at fair and  reasonable prices. When prices are based on adequate price competition, no other information is  generally needed. In other cases, more information may be needed. (FAR 15.402(a))
When required, a disclosure statement must be submitted as a part of the offeror’s proposal unless  they have already submitted a statement disclosing the practices used in connection with the pricing of  the proposal. (FAR 52.230-1(b)). Prime contractors or higher tiered subcontractors can be required to  include subcontractor accounting practices in their disclosure statements (FAR 30.202-8(a)). DCAA  provides audit services in assuring compliance with Cost Accounting Standards.
The contracting officer shall require the prime contractor to submit cost and pricing data and a  certificate that states that the data are accurate, complete, and current. Any subcontractor or  prospective subcontractor should submit similar data and certification to the prime contractor or  appropriate subcontractor tier. (FAR 15.403-4)
The contracting officer is responsible for obtaining information that is adequate for evaluating the  reasonableness of the price or determining cost realism. The contracting officer may request other  information to use in this evaluation, including, the prices at which the same item or similar items have  previously been sold. (FAR 15.403-3)
The contracting officer is responsible for the determination of price reasonableness for the prime  contract, including subcontracting costs. The contracting officer should consider whether a contractor  or subcontractor has an approved purchasing system, has performed cost or price analysis of  proposed subcontractor prices, or has negotiated the subcontract prices before negotiation of the  prime contract, in determining the reasonableness of the prime contract price. This does not relieve the  contracting officer from the responsibility to analyze the contractor’s submission, including  subcontractor’s cost or pricing data. (FAR 15.404-3)
The contracting officer should request field pricing assistance when the information available at the  buying activity is inadequate to determine a fair and reasonable price. The contracting officer must  tailor requests to reflect the minimum essential supplementary information needed to conduct a  technical or cost or pricing analysis. (FAR 15.404-2). DCAA’s Financial Liaison Advisors provide  financial advisory service support at customer sites to assist contracting officers in determining fair and  reasonable contract prices. These services include market research and analysis of certified cost and  pricing data and other information.
DCMA can also provide requested assistance through technical analysis (i.e., engineering evaluation  of proposed labor hours or material requirements) and special analyses (i.e., evaluations of specific  cost elements, rates and factors, or, in some cases, estimating methodologies).
DCAA, as the responsible audit agency, submits information and advice to the requesting activity  based on the auditor’s analysis of the contractor’s financial and accounting records or other related  data as to the acceptability of the contractor’s incurred and estimated costs. DCAA may also perform  other analyses and reviews that require access to the contractor’s financial and accounting records  supporting proposed and incurred costs. (FAR 42.101)
The contracting officer delegates many functions to a contract administration office. This office can be  DCMA or another agency that offers a wide variety of administrative services. However, since the  prime contractor is responsible for managing its subcontracts, this office’s review of subcontracts is  normally limited to evaluating the prime contractor’s management of the subcontracts. Therefore,  supporting contract administration shall not be used for subcontracts unless the Government otherwise  would incur undue cost or successful completion of the prime contract is threatened. For major system  acquisitions, the contracting officer may designate certain high-risk or critical subsystems or  components for special surveillance in addition to requesting supporting contract administration. (FAR  42.201 and 42.202).
The contracting officer may require consent for subcontracts to protect the government because of the  subcontract type, complexity, or value, or because the subcontract needs special surveillance.  These  can be subcontracts for critical systems, components, or services. (FAR 44.201-1(a)).  Notification  submitted to the contracting officer should include a description of the supplies or services to be  subcontracted, the type of subcontract to be used, the proposed subcontractor and proposed price, the  subcontractor’s current cost or pricing data, certificate of cost and pricing data, and the subcontractor’s  Disclosure Statement or Certificate to Cost. (FAR 52.244-2 (f)(1)).
The objective of a contractor purchasing system review 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 a basis for granting,  withholding, or withdrawing approval of the contractor’s purchasing system. (FAR 44.301).  Evaluation  of the purchasing system pays special attention to items such as the degree of price competition  obtained, methods of obtaining accurate cost or pricing data, and methods of evaluating subcontractor  responsibility. (FAR 44.303).
section_title: Appendix III: Comments from the Department of Defense