Defense Contracting: Contract Risk a Key Factor in Assessing	 
Excessive Pass-Through Charges (25-JAN-08, GAO-08-269). 	 
                                                                 
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. 				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-269 					        
    ACCNO:   A80149						        
  TITLE:     Defense Contracting: Contract Risk a Key Factor in       
Assessing Excessive Pass-Through Charges			 
     DATE:   01/25/2008 
  SUBJECT:   Competition					 
	     Contract administration				 
	     Contract costs					 
	     Contract oversight 				 
	     Cost analysis					 
	     Defense cost control				 
	     Defense procurement				 
	     Department of Defense contractors			 
	     Interagency relations				 
	     Policy evaluation					 
	     Private sector					 
	     Procurement policy 				 
	     Procurement practices				 
	     Reporting requirements				 
	     Risk assessment					 
	     Risk management					 
	     Subcontractors					 

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GAO-08-269

   

     * [1]Results in Brief
     * [2]Background
     * [3]Risks of Excessive Pass-Through Charges Are Assessed through

          * [4]DOD Generally Relies on Tools in Acquisition Regulations to
          * [5]Presence of Competition and Type of Contract Generally Guide
          * [6]Unique Circumstances Can Drive Contracting Arrangements Tha

     * [7]Selected Private Sector Companies Rely on Several Shared App

          * [8]Private Sector Companies Focus on Acquisition Planning and K
          * [9]Private Sector Companies Closely Manage Contractual Relation

     * [10]Contracting Officials Lack The Guidance and Insight Needed t
     * [11]Conclusions
     * [12]Recommendations for Executive Action
     * [13]Agency Comments
     * [14]GAO's Mission
     * [15]Obtaining Copies of GAO Reports and Testimony

          * [16]Order by Mail or Phone

     * [17]To Report Fraud, Waste, and Abuse in Federal Programs
     * [18]Congressional Relations
     * [19]Public Affairs

Report to Congressional Committees

United States Government Accountability Office

GAO

January 2008

DEFENSE CONTRACTING

Contract Risk a Key Factor in Assessing Excessive

Pass-Through Charges

GAO-08-269

Contents

Letter 1

Results in Brief 3
Background 5
Risks of Excessive Pass-Through Charges Are Assessed through Routine
Evaluations of Contractor Value 7
Selected Private Sector Companies Rely on Several Shared Approaches to
Minimize The Risk of Excessive Pass-Through Charges 17
Contracting Officials Lack the Guidance and Insight Needed to Effectively
Implement DOD's Interim Rule 20
Conclusions 22
Recommendations for Executive Action 22
Agency Comments 23
Appendix I Scope and Methodology 25
Appendix II Key Elements for Contracting Officers in Assessing Contractor
Value Added 29
Appendix III Comments from the Department of Defense 32

Tables

Table 1: Number of Selected Contracts by Competition and Risk 9
Table 2: Selected Companies and Operations 27

Figures

Figure 1: Total Subcontract Awards from DOD Contracts, Fiscal Years 2002
through 2006 6
Figure 2: Example of Costs with Subcontract Layers 7

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Abbreviations

ANC Alaska Native Corporation
DCAA Defense Contract Audit Agency
DCMA Defense Contract Management Agency
DFARS Defense Federal Acquisition Regulation Supplement
DOD Department of Defense
FAR Federal Acquisition Regulation
SARA Services Acquisition Reform Act
USACE U.S. Army Corps of Engineers

United States Government Accountability Office
Washington, DC 20548

January 25, 2008

Congressional Committees:

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.^1 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.^2 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.^3 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.^4
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.

^1 Pass-through charges are contractor charges for the costs associated
with subcontracting work.

^2 Section 852 of the John Warner National Defense Authorization Act
Fiscal Year 2007, Public Law No. 109-364.

^3 Contract actions consisted of base contracts, task orders placed
against existing contracts, and contract modifications.

^4 This panel was authorized by Section 1423 of the Services Acquisition
Reform Act of 2003 (commonly known as the SARA panel). Pub.L.No. 108-136.
The panel's statutory charter was to review and recommend any necessary
changes to acquisition laws and regulations as well as governmentwide
acquisition policies with a view toward ensuring effective and appropriate
use of commercial practices and performance-based contracting. Some topics
examined included the use of commercial practices in federal contracting,
performance-based contracting, performance of acquisition functions across
agency lines of responsibility, and governmentwide contracts.

Results in Brief

DOD assesses the risk of excessive pass-through charges when work is
subcontracted as part of its routine contracting practices. While no
specific criteria exist for evaluating contractor value added, DOD
contracting officials rely on tools in federal and DOD acquisition
regulations. For the 32 selected contract actions we reviewed, DOD
contracting officials generally applied these tools to their assessments.
However, the extent to which these tools were applied depended on the
contract risk--that is, whether the contract was competed and whether the
type of contract required the government to pay a fixed price or costs
incurred by the contractor. According to the contracting officers we spoke
with, competitive fixed-price contracts may reduce the risk of excessive
costs to the government. As a result, they did not perform the same level
of assessment as they did on contracts with greater risk--such as those
awarded noncompetitively or without fixed prices. 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 costs for value added since market forces generally control
proposed contract cost, potentially minimizing the risk of excessive
pass-through charges. However, when using other than full and open
competition,^5 contracting officials were required to evaluate more
detailed cost information in assessing value added to minimize risk of
excessive pass-through charges, as market forces did not determine the
contract cost. For example, in a $3 billion noncompetitive contract for an
Air Force satellite program, contracting officials required detailed cost
and pricing data that included subcontractor costs to assess the
contractor's value added, and received DCAA and DCMA support to negotiate
lower overall contract costs. In another case--an $863 million
cost-reimbursement competitive contract for Navy support services--while
detailed cost information was considered in source selection, the
technical capability of the contractor to manage multiple tiers of
subcontractors was a significant factor in assessing its value added.
However, conducting assessments of the value added by contractors is
especially challenging under unique situations where requirements are
urgent in nature and routine contracting practices may be overlooked. For
example, 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.

^5 For purposes of this report, we refer to other than full and open
competitive procedures as noncompetitive.

To minimize the risk of excessive pass-through charges when procuring
goods and services, private sector companies we interviewed indicated that
they rely heavily on acquisition planning, knowledge of supply chain, and
managing contractual relationships. As part of their acquisition planning,
company officials told us that they seek to optimize competition to
control overall contract costs. Several companies indicated that they
enter into fixed-price competitive arrangements and form collaborative
business relationships with contractors and subcontractors that provide
greater insight into their supply chain and costs--a challenge DOD
continues to face. According to several companies, using other than
fixed-price contracts is sometimes necessary based on the requirements.
When doing so, however, they recognize the financial risks and devote
resources to ensure proper oversight and accountability. As we have
reported in the past, DOD's use of riskier contracts, such as
time-and-materials contracts, has not always ensured good acquisition
outcomes or a prudent expenditure of taxpayer funds.

In April 2007, DOD issued an interim rule that allows it to recoup
contractor payments that contracting officers determine to be excessive on
all eligible contracts. The rule specifically requires contracting
officers to insert a clause in these contracts that allows recovery of
excessive payments and contractors to report detailed information on their
value added when subcontracting reaches 70 percent or more of the total
contract cost. While the rule aims to provide contracting officers with
more information on contractor value added, it alone will not provide
greater insight into DOD's supply chain and costs--information that
companies told us they use to mitigate excessive costs. In addition, while
the rule is not yet final, contracting officials we spoke to indicated the
need for guidance on how to effectively implement the rule since they were
not clear what more they should be doing beyond applying tools in the FAR
and DFARS. This would ensure that contracting officers, particularly newer
and less experienced staff, consistently apply federal acquisition tools
in conducting their assessments of contractor value added and take into
account contract risk when determining the degree of assessment needed,
documenting assessments, and involving DCAA and DCMA as appropriate.

We are recommending that as DOD finalizes its rule on avoiding excessive
pass-through charges and develops guidance for assessing contractor value
added, DOD (1) require contracting officials to take contract risk into
account when determining the level of assessment needed, (2) require
assessments of contractor value added be documented, and (3) involve DCAA
and DCMA in facilitating assessments as appropriate. In written comments
on a draft of this report, DOD concurred with the recommendations and
noted planned and current actions underway that are directly responsive.
DOD's comments are included in appendix III.

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.^6 (see fig. 1).

^6 The annual subcontracting data were obtained from the Office of the
Under Secretary of Defense, Office of Small and Disadvantaged Business
Utilization, for fiscal years 2002 through 2006. We did not independently
test the reliability of the data obtained from this office, which relies
on DOD contractors to report this subcontract information semiannually on
Standard Form 295 (SF295).

Figure 1: Total Subcontract Awards from DOD Contracts, Fiscal Years 2002
through 2006

Notes: All dollar figures have been converted to fiscal year 2007 dollars.
DOD officials were not able to explain the decrease from fiscal year 2005
to fiscal year 2006.

While subcontracting plans submitted by contractors are required for most
contracts over $550,000,^7 this information is reported only for first
tier subcontracts.^8 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.

^7 Subcontracting plans are required for most contracts over $550,000 or
$1 million for construction contracts. FAR 19.702(a)(1)&(2); 13 CFR S
125.3(a). Subcontracting plans are not required (1) from small businesses;
(2) for personal service contracts; (3) for contracts or contract
modifications performed outside any state, territory, or possession of the
United States, the District of Columbia, and the Commonwealth of Puerto
Rico; or (4) for modifications of contracts within the general scope of
the contract that do not contain the clause FAR 52.219-8, Utilization of
Small Business Concerns. FAR 19.702(b)

^8 For purposes of this report, we refer to each level of subcontracting
as a layer or tier.

Figure 2: Example of Costs with Subcontract Layers

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:^9

           o 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. ^10

           o Solicitation procedures allow contracting officers to select the
           prospective contractor that represents the best value to the
           government.^11 
           o Contract pricing is used to determine price reasonableness for
           the contract, including subcontracting costs.^12

           o Contract administration is intended to obtain a variety of audit
           and administration services to hold contractors accountable for
           operating according to their proposals.^13

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) .

^9 Appendix II provides more detail on these key elements.

^10 FAR 16.103 (b). A firm-fixed-price contract is ordinarily used when
the risk involved is minimal or can be predicted with an acceptable degree
of certainty. When a reasonable basis for firm pricing does not exist,
other contract types should be considered. FAR 16.104(j). If the
contractor proposes extensive subcontracting, a contract type reflecting
the actual risks to the prime contractor should be selected.

^11 FAR 15.101. In different types of acquisitions, the relative
importance of cost or price may vary. 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.

^12 When prices are based on adequate price competition, no other
information is generally needed. In other cases, more information may be
needed from the prime contractor as well as any subcontractors. See FAR
15.403-3, Subcontract Pricing Considerations.

^13 Contracting officers can request further assistance in contract
administration from DCMA reviews and DCAA cost audits, which include
evaluation and surveillance of contractor management systems that relate
to subcontractors.

Table 1: Number of Selected Contracts by Competition and Risk

            Full and open competition                              Noncompetitive
Fixed-price Cost-reimbursement Time-and-materials Fixed-price Cost-reimbursement Time-and-materials 
                                                                                                    
    (2)            (11)               (3)             (7)            (7)                (2)         
                   Lower risk                                        Higher risk

Source: GAO analysis of DOD contract data and the FAR.

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,^14 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.

^14 Contracting officials estimated that over 90 percent of the contracts
at two Air Force commands we visited are competitive.

Contracting officials told us that contracts awarded noncompetitively
decrease their assurance of price reasonableness since there is no basis
of comparison through competition.^15 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.^16 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.

           o 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.

           o 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.

           o 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.

^15 In fiscal year 2006, DOD reported that 37 percent of its contracts
were awarded as other than full and open competition.

^16 FAR Subpart 15.4.

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.^17
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.

^17 FAR 16.301-2 and FAR 16.301-3 describe limitations on the use of
cost-reimbursement contracts. FAR Part 16.601(c) describes the application
of time-and-materials contracts.

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.^18
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.^19 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.^20

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.

^18 A multiple award indefinite delivery, indefinite quantity contract
occurs when an agency enters into a contract with two or more sources
under the same solicitation. These contracts provide for an indefinite
quantity, within stated limits, of products or services during a fixed
period. Agencies place orders for individual requirements under these
contracts.

^19 GAO, Defense Contracting: Improved Insight and Controls Needed over
DOD's Time-and-Materials Contracts, [20]GAO-07-273 (Washington, D.C.: June
29, 2007).

^20 DFARS 216.601(e).

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.^21 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.

^21FAR 15.1--Source Selection Processes and Techniques--provides
considerable flexibility to the buying activity in evaluating competitive
proposals. An agency can obtain best value in negotiated acquisitions by
using any one or a combination of source selection approaches. The process
permits trade-offs among cost or price and noncost factors, such as
technical capabilities, when it is in the best interest of the government
to consider awarding to other than the lowest-priced offeror.

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,^22 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).^23 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.^24

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.

^22 The Small Business Administration's 8(a) program is one of the federal
government's primary means for developing small businesses owned by
socially and economically disadvantaged individuals. This program allows
the government to award contracts to participating small businesses
without competition below certain thresholds.

^23 FAR 52.219-14, Limitations on Subcontracting. In the case of a
contract for supplies (other than procurement from a nonmanufacturer in
such supplies), the concern will perform at least 50 percent of the cost
of manufacturing the supplies, not including the cost of materials.

^24 While representing a small amount of total federal procurement
spending, obligations for 8(a) contracts to ANC firms increased from $265
million in fiscal year 2000 to $1.1 billion in 2004. GAO, Contract
Management: Increased Use of Alaska Native Corporations' Special 8(a)
Provisions Calls for Tailored Oversight, [21]GAO-06-399 (Washington, D.C.:
Apr. 27, 2006); GAO, Alaska Native Corporations: Increased Use of Special
8(a) Provisions Calls for Tailored Oversight, [22]GAO-07-1251T
(Washington, D.C.: Sept. 19, 2007).

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.^25 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.

^25 GAO, Agency Management of Contractors Responding to Hurricanes Katrina
and Rita, [23]GAO-06-461R (Washington, D.C.: March 2006).

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.^26 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.

^26 U.S. Army Audit Agency, Debris Removal Contracts: U.S. Army Corps of
Engineers, Audit Report: A-2007-0016-FFD (Washington, D.C.: Nov. 9, 2006).

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.^27 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.^28 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.^29

^27 GAO's high-risk designation is given to major programs and operations
that need urgent attention and transformation in order to ensure that our
national government functions in the most economical, efficient, and
effective manner possible. It also emphasizes programs that are at high
risk because of their great vulnerability to fraud, waste, abuse, and
mismanagement.

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.

^28 GAO, Highlights of a GAO Forum: Managing the Supplier Base in the 21st
Century, [24]GAO-06-533SP (Washington, D.C.: Mar. 31, 2006).

^29 GAO, Defense Contracting: Improved Insight and Controls Needed over
DOD's Time-and-Materials Contracts, [25]GAO-07-273 (Washington, D.C.: June
29, 2007).

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.^30 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.^31 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.

^30 72 Fed. Reg. 20758 (April 26, 2007). Excessive Pass-through Charges.
As of December 2007, DOD was in the process of responding to public
comments and revising its interim rule.

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.

^31 The rule excludes (1) firm-fixed-price contracts awarded on the basis
of competition, (2) fixed-price contracts with economic price adjustment
awarded on the basis of adequate price competition, (3) firm-fixed-price
contracts for the acquisition of a commercial item, or (4) fixed-price
contracts with economic price adjustment for the acquisition of a
commercial item.

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:

           o 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.

           o Require contracting officials to document their assessments of
           contractor value added in the contract files.

           o 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
[26]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
[email protected]. 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.

Ann Calvaresi Barr
Director, Acquisition and Sourcing Management

List of Committees

The Honorable Carl Levin
Chairman
The Honorable John McCain
Ranking Member
Committee on Armed Services
United States Senate

The Honorable Daniel K. Inouye
Chairman
The Honorable Ted Stevens
Ranking Member
Subcommittee on Defense
Committee on Appropriations
United States Senate

The Honorable Ike Skelton
Chairman
The Honorable Duncan L. Hunter
Ranking Member
Committee on Armed Services
House of Representatives

The Honorable John P. Murtha, Jr.
Chairman
The Honorable C. W. (Bill) Young
Ranking Member
Subcommittee on Defense
Committee on Appropriations
House of Representatives

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:

U.S. Air Force

           o Air Force Space Command, Colorado Springs, Colorado
           o Air Force 21st Space Wing, Peterson Air Force Base, Colorado
           Springs, Colorado
           o Air Force 50th Space Wing, Schriever Air Force Base, Colorado
           Springs, Colorado
           o Air Force Space and Missile Command, El Segundo, California

U.S. Army

           o U.S. Army Space and Missile Defense Command, Peterson Air Force
           Base, Colorado Springs, Colorado
           o Army Contracting Agency, Fort Carson, Colorado Springs, Colorado
           o Army Communications and Electronics Command, Fort Monmouth, New
           Jersey
           o Army Sustainment Command, Rock Island, Illinois

U.S. Navy

           o Naval Sea Systems Command, Washington Navy Yard, District of
           Columbia
           o 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.

Table 2: Selected Companies and Operations

Company                   Description                                      
Accenture                 A consulting firm providing management           
                             consulting and technical assistance, and         
                             outsourcing services to government and           
                             commercial clients.                              
ALCOA                     The world's leading producer and manager of      
                             primary aluminum, fabricated aluminum, and       
                             aluminum facilities.                             
IBM                       A global leader in business services and         
                             computer hardware and software.                  
John Deere                A leading manufacturer of agricultural           
                             equipment, construction and forestry equipment,  
                             commercial and consumer equipment.               
Miratek                   An information technology solution and           
                             environmental engineering services small         
                             business company with mostly government clients. 
Northrop Grumman          A global defense and technology company          
                             providing innovative systems, products, and      
                             solutions in information and services,           
                             electronics, aerospace, and shipbuilding to      
                             government and commercial customers worldwide.^a 
Raytheon                  A technology leader specializing in defense,     
                             homeland security, and other government markets, 
                             that provides mission systems integration, and   
                             other capabilities in communications and         
                             intelligence systems, as well as a broad range   
                             of mission support services.                     
Science Applications      Specializes in scientific, technical, and        
International Corporation engineering work. Develops technical solutions   
                             and provides systems integration and             
                             mission-critical support services to federal,    
                             state, local, and foreign governments and        
                             private sector customers.                        
Vangent                   The company's markets as well as services        
                             include consulting, systems integration,         
                             business process outsourcing, and human capital  
                             management.                                      

Source: GAO analysis

^a GAO also met with the Northrop Grumman Information Technology division
that provides commercial information technology services and solutions.

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

Element of framework     Description                                       
Acquisition planning     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.          
Defining requirements    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          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)          
Competition              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))            
Type of contract         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)                              
Source selection         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)       
Cost or price evaluation 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))                    
Technical and past       The source selection records shall include an     
performance analysis     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))              
Subcontracting plans     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))                     
Contract pricing         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))        
Cost accounting          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.                             
Cost and pricing data    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)                              
Information other than   The contracting officer is responsible for        
cost and pricing data    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)                              
Subcontract pricing      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)                                         
DCAA                     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                     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).                                   
Contract management                                                        
Audit services           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)                      
Contract administration  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).          
Consent to subcontract   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)).       
Contractor purchasing    The objective of a contractor purchasing system   
system review            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).                     

Source: GAO analysis of the FAR.

Appendix III: Comments from the Department of Defense

(120668)

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