We are seeing many critical observations related to a recent Defense Department interim rule passed to implement the 2007 DOD Authorization Act intended to encourage prime contractors and subcontractors to “add value” in connection with subcontract work or be prohibited from adding indirect cost and fee to certain subcontract work.  DFARS Clause 252.215-7003 and 7004 now require an offeror to disclose the total costs of its proposal along with the total subcontract costs and when more than 70 percent of total costs are subcontracts the offeror must disclose the total amount of indirect costs and profit applicable to subcontract costs and describe how it adds value to the subcontract work. Industry representatives have expressed considerable concern with the new rule stating the stakes are increasing since it appears the new rule will be incorporated into the FAR and hence apply to all government contracts and will likely generate considerable scrutiny by government auditors. When the issue is taken up with DOD representatives the responses are always the same – our hands are tied by the statute’s clear language that prohibits payment of indirect costs and fee unless the contractor seeking payment can establish added value.

A recent article in the September issue of the CP&A Report is a good example of the comments we have encountered where the authors, Brent Calhoon and Pete McDonald of Navigant Consulting, assert there are four areas that contractors should be aware of and take necessary action:

1. Define and document expected added value. The DOD defines added value as “subcontract management functions” which is distinguished from normal subcontract administration activities such as soliciting, awarding and administering subcontracts.  Subcontract management instead is more closely aligned with program and operations management which includes such efforts related to cost, scheduling, quality and technical aspects of contract performance such as defining requirements or deliverables and integrating product and services into higher level contract execution or deliverables.  If subcontracts represent a significant portion of contract costs offerors should identify and articulate elements of added value so they can document their intention to add value to their subcontracting efforts.

2.  Insist on Alternative 1. When a CO determines a contractor will add value, Alternative 1 of DFARS 252.215-7003 must be used to affirm no excessive pass-through charges exist. The authors point out that there is no language that prohibits post award audit assessments of added value on contracts or subcontracts below the 70 percent reporting threshold. In other words, on post award audits, excessive pass through costs may be unallowable under any circumstance which turns on demonstrating added value not the 70 percent threshold. It is advised this Alt 1 be incorporated into all contracts where subcontract work could be used – not just where the 70 percent threshold applies. The authors state that if Alt 1 is not present then offerors proposing subcontracting of significant amount, say 50 percent, government auditors will be able to second guess added value with the full benefit of hindsight. If the CO does not make an added value determination and use Alt 1 the prime contractor should show in its files evidence of intent of added value for its subcontract efforts.

3.  Monitor compliance with the 70 percent rule.  Even if a contract or subcontract was below the 70 percent threshold but ultimately exceeds it during performance the 7004 clause requires contractors and subcontractors to verify added value (essentially it’s a reopener clause). So contractors need to monitor the 70 percent threshold by modifying their project cost procedures and contractors need to ensure their subcontractors comply with the 70 percent threshold.

4. Accounting for excess pass through costs.  To its credit the DOD has established an all or nothing approach to allowability - any amount of added value that is more than a negligible amount renders all pass-through charges allowable. DOD also states that excessive pass-through charges are not expressly unallowable which makes penalties not applicable.

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