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Allowability of Prime's markup on CFE added by Prime


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One of our clients is providing material to their sub at cost.  There is no business relationship between the two entities other than as Prime and Sub (this cannot be viewed as an intercompany transfer in any way).  Here's a simplified version of what's going on:

  • Prime purchases material from distributor for $1,000
  • Prime sells to Sub for $1,000 cost 
  • Sub adds value of $500 (including labor and/or other materials, OH, G&A, and profit)
  • Sub sells to Prime for $1,500
  • Prime sells to end customer for $2,000 (including added labor, material, OH, G&A, and profit)

I'm being told by two "former DCAA auditors" that this is not in alignment with far and is also "unethical."  Their view is that the Prime-Sub relationship counts as a "Related Entity" and therefore the sub must sell back to the Prime at cost.  Their view is that the arrangement as outlined above is "double dipping."

I don't see any allowability issues here, but I wanted to get the opinion of those in this forum.  Any input is appreciated.

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6 hours ago, Patrick Mathern said:

One of our clients is providing material to their sub at cost.  There is no business relationship between the two entities other than as Prime and Sub (this cannot be viewed as an intercompany transfer in any way).  Here's a simplified version of what's going on:

  • Prime purchases material from distributor for $1,000
  • Prime sells to Sub for $1,000 cost 
  • Sub adds value of $500 (including labor and/or other materials, OH, G&A, and profit)
  • Sub sells to Prime for $1,500
  • Prime sells to end customer for $2,000 (including added labor, material, OH, G&A, and profit)

I'm being told by two "former DCAA auditors" that this is not in alignment with far and is also "unethical."  Their view is that the Prime-Sub relationship counts as a "Related Entity" and therefore the sub must sell back to the Prime at cost.  Their view is that the arrangement as outlined above is "double dipping."

Your two former DCAA auditors are wrong. A prime/sub relationship does not an "affiliated entity under common control" make.

Determining whether there is common control is fact-dependent and requires the exercise of judgment. That said, "Entities that are consolidated by the same parent—or that would be consolidated, if consolidated financial statements were required to be prepared by the parent or controlling party—are considered to be under common control." [Source: PricewaterhouseCoopers website.]

The way you describe the transaction, there is no double-dipping. If the subK purchased the material from the distributor on its own, it would pay $1,000 and add $500 in value, and then it would sell the finished good to the prime for $1,500. There is nothing unethical going on here that I can see.

However, you have skipped over any discussion of rate impacts, and revenue recognition. In the scenario you describe, the prime has counted the same material cost twice in its indirect rate allocation base--once when it purchases the material and then again when it accepts the subcontractor's finished goods. In my view, that's a problem if the amounts are significant. Also, the prime seems to have recorded revenue twice as well--once when it sells $1,000 of material to the subK and then again when it sells $2,000 worth of product to the end customer. I would be concerned about those impacts.

Hope this helps.

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19 hours ago, Patrick Mathern said:

I don't see any allowability issues here, but I wanted to get the opinion of those in this forum.  Any input is appreciated.

You said "any input," Patrick, so here is mine.

My experience about how to handle it contractually...I don't know if it resolves the auditor concern or not, or creates new ones.  The issued subcontract could indicate that the article is customer (prime) furnished. Alternatively, if the cost of the item was already included in the subcontract, prime should furnish it and reduce the price of the subcontract by the appropriate amount included in the subcontract for the item.

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16 hours ago, here_2_help said:

However, you have skipped over any discussion of rate impacts, and revenue recognition. In the scenario you describe, the prime has counted the same material cost twice in its indirect rate allocation base--once when it purchases the material and then again when it accepts the subcontractor's finished goods. In my view, that's a problem if the amounts are significant. Also, the prime seems to have recorded revenue twice as well--once when it sells $1,000 of material to the subK and then again when it sells $2,000 worth of product to the end customer. I would be concerned about those impacts.

Thank you - I agree with this.  Keeping pool and bases straight is important here and worth mentioning to the client.

 

I've gotten a bit more color commentary on the individuals' concerns...maybe this will spark something for you Vern:

What we are actually talking about is “Arms-Length Transactions”.  The reason an IDWA can only have profit applied once is the division is not considered at “Arms Length”.   The same applies to the Buyer Furnished Equipment of a Prime and Subcontractor.  Because of their prior and continuing relationships they would not necessarily be considered to be at “Arms Length” for the type of transactions we are talking about. A Government Contracting Officer could draw a conclusion upon review that the Prime and Subcontractor were colluding to increase the price of the end item to the Government. [...]  To be safe, BFE equipment should be supplied to the subcontractor at no cost and have the profit applied to the part at the prime only and a $0 cost from the sub in the final assembly for the detail part or the value of the detail when sold at cost to the sub  has profit applied at the sub and the value of the detail has no profit applied at the prime.

 

In my view, they are now effectively saying that this could raise eyebrows and attract attention (a major walk-back from the "unethical" and "unallowable" concepts raised earlier.  I don't see any explicit FAR violations here.

Thanks all.

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My issue continues to be pressed under the idea that there’s an appearance that it’s not an “arm’s length transaction.” Based on this, my former DCAA auditors are recommending the prime does not add profit so as to avoid any appearance of conflict/collusion. 
 

I’m still of the opinion that the Prime should add full markups to the item when it’s purchased from the sub. I would bet nearly every major subcontractor out there has had this situation in the past and treated it the same way. 
 

I’ve searched FAR and DFARS, Cost Principles, and attempted to search for case law. I see nothing. Is anyone aware of a precedent for this?

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Patrick,

You haven't made the case for why this is in the government customer's best interest. Why is this transaction being done? Who saves money? Who saves schedule?

My recommendation is to start by building the business case for why this makes sense. Perhaps then you will be able to refute the "perception problem" your former DCAA auditors are concerned about.

I will share that I have dealt with this situation a couple of times before. In each case, there was a business justification/rationale for the prime selling stuff to the subKtr, who then refined it and sold it back. In each case, we were able to show that the government customer was not paying any more for the end item deliverable than would have been the case if the subKtr had purchased the material input on its own--even with profit added. In fact, we were able to show significant schedule advantages to doing what we wanted to do. Since it was in our government customer's best interest, there were no concerns expressed.

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1 hour ago, Patrick Mathern said:

Is anyone aware of a precedent for this?

I am not. I'm not seeing a problem. 

From what your auditors wrote, they seem to think that profit is allocated like indirect costs (e.g. "IDWA can only have profit applied..."). Although the Government's structured approaches to profit analysis assume so, profit is not necessarily a function of cost. Just because it can be expressed as a percentage does not mean that it gets "applied" to costs. The prime should propose the dollar amount of profit it wants for the contract and should not link it to its proposed costs. The prime shouldn't submit an Excel spreadsheet that contains a formula in the "Profit" cell that changes when other costs on the spreadsheet change. If the contracting officer tells the prime that they're not allowed to have profit on a particular cost, the prime should explain that there is no direct relationship between their proposed profit and their proposed cost.

As far as what a Government contracting officer would "conclude"--they shouldn't conclude anything regarding "collusion" without a lot more information. 

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On 1/11/2023 at 1:44 PM, Patrick Mathern said:

I'm being told by two "former DCAA auditors" that this is not in alignment with far and is also "unethical."  Their view is that the Prime-Sub relationship counts as a "Related Entity" and therefore the sub must sell back to the Prime at cost.  Their view is that the arrangement as outlined above is "double dipping."

@Patrick Mathern"Not in alignment with far"? What the heck does that mean?

Whenever buyer and seller engage in cost-based pricing, the buyer will look for items and amounts to challenge, and they will make arguments based on justification, fairness, reasonableness, ethicality, arms-length bargaining, particle physics, the existence of a multiverse, or whether Moby Dick was just a whale. Whatever works.

Unless the argument against a practice can be clearly and persuasively supported by reference to statute, regulation, or case law, it's probably just a a bargaining gambit (or a misunderstanding). Bottom line: They want a lower price. I would ignore a gambit and focus on the sale. In such cases there are only two pertinent questions:

  1. Will I lose this or future sales to this customer if I refuse to reduce my price?
  2. Am I willing to walk away from this customer?

If you do lower your price, don't concede the argument, even if you think it may have merit. If they ask why you lowered your price, tell them that you want them to be happy.

BTW, you know an auditor doesn't have a case when they start arguing based on appearances.

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On 1/11/2023 at 7:50 PM, here_2_help said:

In the scenario you describe, the prime has counted the same material cost twice in its indirect rate allocation base--once when it purchases the material and then again when it accepts the subcontractor's finished goods. In my view, that's a problem if the amounts are significant. Also, the prime seems to have recorded revenue twice as well--once when it sells $1,000 of material to the subK and then again when it sells $2,000 worth of product to the end customer. I would be concerned about those impacts.

@here_2_helpWhy would you be "concerned"? Do you think those things violate a law, a regulation, or an accounting principle? How does the amount affect the propriety of the transaction?

I'm not challenging, just asking.

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2 hours ago, Vern Edwards said:

@here_2_helpWhy would you be "concerned"? Do you think those things violate a law, a regulation, or an accounting principle? How does the amount affect the propriety of the transaction?

I'm not challenging, just asking.

Fair question.

First, I only care if amounts are "material" as defined by FAR 30.602 (which directs a contracting office to 48 CFR 9903.305 in CAS-land). If the amounts are not material, then I am not concerned. (Note I will try to use "materiel" for goods to distinguish between goods and the concept of materiality.)

To your question: The goal of any indirect rate is to allocate costs across many "cost objects" (let's call them contracts) in reasonable proportion to the benefits received. (Ref. FAR 31.203(c).) The costs in the indirect pools are, generally, related to functions and activities. For example, a materiel burden pool may contain the costs of purchasing, quality control, and other activities related to acquiring and using materiel. In my view, when the materiel was originally acquired it was properly burdened with the costs of those functions/activities. Then the materiel was sold to a supplier. Then the supplier returned the materiel in the form of a finished good. Unless the contractor is careful, that same original materiel cost will be burdened again. 

That's not a problem so much for the government, because all the contractor is doing is increasing the denominator of its indirect cost rate calculation, but it could result in excess indirect costs being allocated to the contract with this relatively infrequent transaction type while other contracts receive relatively less indirect cost allocations.

The issue with double-counting the revenue should be fairly obvious. A succinct summary with a good example is found here. There are other articles available.

Quote

The error of double counting occurs when the value added by a certain activity in the production chain is added twice. For instance, the value of bread sold is inclusive of the value of the flour, the manufacturing, the packaging, and transport. If we added the cost of transport once again to the final value of bread, the error of double-counting has been committed.

 

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9 minutes ago, here_2_help said:

Unless the contractor is careful, that same original materiel cost will be burdened again. 

But is it the same material cost? I buy something for $1000. Then I sell it to someone else for that amount. They use it to make something new, then sell it to me for $1,500. I then make some changes to the thing and sell it to someone else for $2,000. It seems to me that the buyer's only question should be whether $2,000 is fair and reasonable.

I suspect that I'm being simple-minded, but where am I going wrong?

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On 1/11/2023 at 4:44 PM, Patrick Mathern said:
  • Prime purchases material from distributor for $1,000
  • Prime sells to Sub for $1,000 cost 
  • Sub adds value of $500 (including labor and/or other materials, OH, G&A, and profit)
  • Sub sells to Prime for $1,500
  • Prime sells to end customer for $2,000 (including added labor, material, OH, G&A, and profit)

A few questions, (1)  when the prime purchases the material, does it charge the government for the material?

(2)  If the prime charges the government for the material when it is purchased, how does the prime treat the revenue from the sale to the sub, e.g., as a credit to previous charges?

(3)  When the sub sells the finished product to the prime, does the prime charge that cost to the government?

(4)  If the answer to (1) or (3) is yes, how is that charge treated in regard to what is billed in the $2K final charge to the government?

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5 hours ago, Vern Edwards said:

But is it the same material cost? I buy something for $1000. Then I sell it to someone else for that amount. They use it to make something new, then sell it to me for $1,500. I then make some changes to the thing and sell it to someone else for $2,000. It seems to me that the buyer's only question should be whether $2,000 is fair and reasonable.

I suspect that I'm being simple-minded, but where am I going wrong?

Vern, the issue is that the first company is not selling the materiel to just anybody; they are selling it to a supplier who then sells it back. This is not necessarily a problem but it could be. And if you'll refer to my first response under this thread, I think you'll find that we are in agreement from the buyer's perspective. I was focusing on the accountant's perspective, as I tend to do.

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