IG Report Has Implications for Contractors

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On Feb. 25, the Defense Department’s Office of Inspector General issued an audit report analyzing the prices of spare aviation parts purchased by the government from TransDigm Group Inc. The report has important implications for contractors doing business with the Pentagon.

The audit was conducted in response to letters from members of Congress, who had inquired whether the items were sold at fair and reasonable prices and in compliance with the Truthful Cost or Pricing Data Act.

The auditors reviewed the price reasonableness of 47 spare aircraft parts the Pentagon procured from TransDigm between January 2015 and January 2017. The probe confirmed that the company fully complied with the act. However, using uncertified cost or pricing data that was collected during the audit, the inspector general concluded that the contractor realized “unreasonable” profits — defined in this report as profits of greater than 15 percent — on all but one of the parts. The OIG then calculated that the company earned $16.1 million in “excess profit” for the parts at issue.

One of the reasons cited for these supposedly “excessive” profits was that TransDigm was the only manufacturer for most of the spare parts at issue, which arguably allowed the contractor to set the market price for these parts. According to the OIG, this dominant market position prevented contracting officers from relying on historical price analysis or competition to ensure price reasonableness because the price of some parts “appeared to be” excessive at the time the part was first sold to the government, and because other competitors had to buy their parts from TransDigm before re-selling to the government.

In response to its findings, the OIG took the highly unusual step of requesting that contracting officials pursue a “voluntary refund” from TransDigm for the supposedly excess profits — an amount totaling approximately $16 million — despite the absence of wrongdoing by the company.

The inspector general’s office also announced several recommendations directed towards defense pricing and contracting officials, including reviewing the U.S. Code, the Federal Acquisition Regulation and the Defense Federal Acquisition Regulation Supplement to determine changes needed in the acquisition process for sole-sourced parts to ensure that contracting officers obtain uncertified cost data when requested.

It also recommended expanding existing requirements to mandate reporting of all contracts for parts produced or provided from a sole source where the contractor opts not to provide cost or pricing data; and creating a team of experts to analyze reported data, including the assessment of high risk parts and the identification of lower cost alternatives.

The report and recommendations offer several lessons for the contractor community, particularly those that sell specialized spare parts or other items on a sole source basis.
Expect increased scrutiny, even of lawful practices. The OIG report represents a departure from a standard “fraud, waste and abuse” initiative in at least one significant respect: it borders on a form of public shaming in an effort to claw-back funds that a contractor fairly earned by acting within its rights. This practice underscores the importance of fully understanding rules governing the provision of cost or pricing data.

While the report suggests that cost data analysis is the most effective way to ensure price reasonableness, that certainly does not mean that contractors are required to furnish such data. The inspector general concluded that “performing a cost analysis using certified or uncertified cost data is the most reliable way to determine whether a price is fair and reasonable.” However, the Federal Acquisition Regulation does not require contractors to submit cost or pricing data in some circumstances, and the OIG recognized that TransDigm rightfully could decline to provide it in many cases. 

Don’t be afraid or ashamed of profit. The report appears to presume that contractors must inevitably accept narrow profit margins — 15 percent or lower — on government contracts. Not so. Although there are limits on profits for certain types of contracts, those limits are not applicable to the fixed-price contracts at issue here.

Both the government and contractors should be concerned with profit as a motivator of efficient and effective contract performance. Negotiations aimed merely at reducing prices by reducing profit, without proper recognition of the function of profit, are not in the government’s interest. Negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages to total estimated costs do not provide proper motivation for optimum contract performance.

Stay tuned. If implemented, the OIG recommendations could significantly alter the price negotiation process for defense contractors — particularly those that produce or sell items on a sole source basis.

Additionally, the Government Accountability Office has been conducting “a study of Department of Defense and Defense Logistics Agency processes for purchasing noncompetitive spare parts and make recommendations for how to improve transparency and reporting in this area.” This report undoubtedly will generate additional scrutiny upon its release, and contractors would be well-advised to closely monitor policy and regulatory developments that follow. 

Susan Cassidy and Mike Wagner are partners, and Ryan Burnette is an associate at Covington & Burling LLP.

Topics: Contracting, Government Contracting Insights, Government Collaboration, Government Policy