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

Letter

Background

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.

Risks of Excessive Pass-Through Charges Are Assessed through Routine Evaluations of Contractor Value

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.

DOD Generally Relies on Tools in Acquisition Regulations to Assess Contractor Value Added

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.

Presence of Competition and Type of Contract Generally Guide the Use of Assessment Tools

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.

Unique Circumstances Can Drive Contracting Arrangements That Carry Greater Risk of Excessive Pass-Through Charges

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.

Selected Private Sector Companies Rely on Several Shared Approaches to Minimize The Risk of Excessive Pass- Through Charges

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.

Private Sector Companies Focus on Acquisition Planning and Knowledge of Supply Chain

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.

Private Sector Companies Closely Manage Contractual Relationships to Control Costs

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.

Contracting Officials Lack The Guidance and Insight Needed to Effectively Implement DOD’s Interim Rule

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.

Conclusions

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.

Recommendations for Executive Action

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.

Agency Comments

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.

Appendix I: Scope and Methodology

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.

Appendix II: Key Elements for Contracting Officers in Assessing Contractor Value Added

Description

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).

Appendix III: Comments from the Department of Defense