Limitations on pass-through charges: Should you consider a subcontractor handling rate?

Complying with the requirements of Federal Acquisition Regulation (FAR) Clauses 52.215-22, Limitations on Pass-Through Charges – Identification of Subcontract Effort, and 52.215-23, Limitations on Pass-Through Charges can be daunting. This is especially true when you incur or propose a large amount of subcontract costs under a Government contract. The failure to appropriately track subcontract costs, including the indirect costs and profit passed on to the Government for work performed by subcontractors that exceeds 70% of the prime contractor’s award value, can result in a determination of unallowable subcontract costs. This has resulted in an increasing number of Government contractors re-engineering their indirect rate structures to include a subcontractor handling rate. This is to preclude excessive subcontractor costs from being passed on to the Government, and to remain competitive in a rapidly-changing Government contracting environment.

In addition to ensuring that the prime contractor is adding suitable value to the contract effort, the objective of FAR Clauses 52.215-22 and FAR 52.215-23, is to limit the amount of indirect costs and profit passed on to the Government for significant contract work performed by subcontractors. The FAR clauses define excessive pass-through charges as costs for services that add little to no value to the contract. Excessive pass-through charges do not include prime contractor costs to manage subcontracts or any applicable indirect costs on those management costs. Contracting Officers are becoming increasingly aware of the requirements of these FAR clauses, stipulating that the clauses be included in contracts and confirming that Government contractors are adhering to these FAR clause requirements.

Incorporating a subcontractor handling rate can make you more competitive by reducing the indirect costs allocated to subcontract costs. A typical indirect subcontractor handling rate allocation base consists of direct subcontracts. Costs included in a subcontractor handling pool are typically the costs to acquire, process, and administer those subcontracts included in the indirect subcontractor handling base. These costs are accumulated in a separate pool and applied to the subcontract direct costs instead of the typical G&A rate.

Generally, the indirect subcontractor handling rate is smaller than a typical G&A rate due to the composition of the pool and base previously described as well as the smaller amount of pool costs associated with subcontractor handling relative to the larger value of direct subcontractor costs. This typically results in fewer indirect costs passed onto the Government when a contract has a substantial amount subcontract costs. This can be a key factor when determining proposal partners and/or when bidding on opportunities with significant subcontract costs. If your company has the capability to distinguish the costs associated with the subcontractor, it may be beneficial to consider a change to your indirect rate structure to include an indirect subcontractor handling rate.

This information can be used to explore indirect rate re-engineering changes including the addition of a subcontractor handling indirect rate and a G&A base change to a value-added allocation base. Prior to making such a change, the contractor must perform an analysis to determine if the change would fairly represent the total activity of the business and, accordingly, would not create an inequitable allocation of costs among contracts.

You may decide to update your subcontract monitoring policies and procedures. Some things to consider in reviewing these policies and procedures are regular subcontract cost reviews to monitor the 70% threshold, notification of the Government if the threshold is anticipated to be exceeded, and documentation to verify that the prime contractor is adding value to the contract.

The limitation on pass-through charges clause is a required flowdown clause to subcontractors. Therefore, take this information and review or update your subcontract agreements/contracts accordingly.

For more information, contact Jontue Sumler, Manager, at jontue.sumler@cohnreznick.com or (703) 744-8517 or Kristen Soles, Partner at kristen.soles@cohnreznick.com or (703) 744-6700.