Limitations on Subcontracting for Manufacturers: Compliance in Four Steps

October 28, 2019

As a government contracts attorney, I’ve counseled hundreds of clients on the FAR and SBA small business regulations. Few of these rules have proven as confusing to my clients as the so-called limitations on subcontracting. So, in this post, I’m offering a step-by-step guide for manufacturers to comply with the SBA’s limitations on subcontracting in 13 C.F.R. 125.6. If you’re not a manufacturer, I’ve got you covered, too. Check out similar posts for construction contractors, service providers, and nonmanufacturers.

manufacturers

Before we get going, let’s take care of a couple of preliminaries – what speakers at conferences like to call “housekeeping.”

First, this post covers compliance with the SBA’s regulations. The subcontracting limits have been a bit convoluted for several years, ever since Congress made significant changes to the underlying statute, the Small Business Act. The SBA has amended its regulations to conform with the statute, but, as of this writing, the FAR Council has yet to finalize a corresponding change to the FAR. This means that your contract might be subject to a different limitation on subcontracting than the one I’m covering here. If you’re unsure, ask your Contracting Officer.

Second, while I’m an attorney by trade, this post is for your educational use only. As the disclaimer below reiterates, this post is not legal advice. If you have questions about how these rules apply to your specific circumstances, you should consult with a government contracts attorney.

With those caveats in mind, let’s dive into the four steps to compliance.

Step #1 – Ensure You’re the “Manufacturer”

When the government is buying manufactured products, the SBA allows two options for a small business to satisfy the limitations on subcontracting. First, if the small business is the manufacturer of the product, the small business can meet a 50% monetary threshold. Second, if another company is the manufacturer, the small business can qualify as a “nonmanufacturer” under a special four-part test. 

This article is about the first option – the 50% threshold. I’ll discuss the nonmanufacturer rule in the next article in this series. But first things first – are you the manufacturer?

The word “manufacturer” is a term of art. The SBA’s regulations, in 13 C.F.R. 121.406(b)(2), specify that “for size purposes, there can be only one manufacturer of the end item being acquired.”  

In many cases, it’s obvious that only one company could possibly qualify as the manufacturer. But what happens when two or more companies play a major role in creating the end product?

The SBA says that the “manufacturer” is “the concern, which, with its own facilities, performs the primary activities in transforming inorganic or organic substances, including the assembly of parts and components, into the end item being acquired.” The SBA also advises that performing “minimal operations” doesn’t do the trick, and cautions that “[f]irms that add substances, parts or components to an existing end item to modify its performance will not be considered the end item manufacturer where those identical modifications can be performed by and are available from the manufacturer of the existing end item.”

That’s a mouthful, but it does provide some useful guidance. After applying this definition, the SBA will use three factors to determine which company is the manufacturer of an end item:

  1. The proportion of total value in the end item added by the efforts of the concern, excluding costs of overhead, testing, quality control, and profit;
  2. The importance of the elements added by the concern to the function of the end item, regardless of their relative value; and
  3. The concern’s technical capabilities; plant, facilities and equipment; production or assembly line processes; packaging and boxing operations; labeling of products; and product warranties.

If you’re thinking, “hmm… that seems a little subjective,” you’re absolutely right. In some cases, reasonable minds could differ about which company is the manufacturer of a product. If you find yourself in that situation, you’d be well-advised to seek input from the SBA or your government contracts legal counsel.

Step #2 – Understand the Baseline Formula

Okay, you’ve decided that you are the manufacturer of the end product the government is buying.  Now what?

The SBA’s regulation says that when a manufacturer sells products to the government, the manufacturer must agree that “it will not pay more than 50% of the amount paid by the government to it to firms that are not similarly situated.”

That provides a solid baseline metric. We will make adjustments, so please keep reading. But we now know that after those adjustments, you need to meet or exceed a 50% target.

One final note: in my experience, a large majority of manufacturers think that they are required to self-perform 51%, not 50%. This is not, and never has been, the requirement. That said, there is absolutely nothing wrong with treating 51% as your self-performance floor. Doing so builds in a little margin of error to help ensure compliance.

Step #3 – Exclude Cost of Materials

The 50% metric starts with the amount paid by the government, but the regulation specifies that the “cost of materials are excluded and not considered subcontracted.” So, we next need to exclude the cost of materials.

But what the heck is the “cost of materials?” 13 C.F.R. 125.6 doesn’t say, but a separate SBA regulation, 13 C.F.R. 125.1, provides a definition:

Cost of materials means costs of the items purchased, handling and associated shipping costs for the purchased items (which includes raw materials), commercial off-the-shelf items (and similar common supply items or commercial items that require additional manufacturing, modification or integration to become end items), special tooling, special testing equipment, and construction equipment purchased for and required to perform on the contract. In the case of a supply contract, cost of materials includes the acquisition of services or products from outside sources following normal commercial practices within the industry.

It’s a lengthy definition, but the bottom line is that, in most cases, the money you spend buying the items you’d ordinarily view as “materials” are excluded.

An example may help.

Let’s say you’ve been awarded a $100 million DoD contract to provide boots to the Marine Corps. The Contracting Officer assigned NAICS code 316210 (Footwear Manufacturing). You’ve read through the SBA regulations, and you’re convinced that you are the manufacturer of the boots.

Assume that it will cost you $40 million to purchase the various materials you need to manufacture the boots. First, you should subtract $40 million from the total value of the contract, leaving you with $60 million. Then, you should apply the 50% number to the $60 million, not the total amount paid. Under this contract, assuming you have no SSEs, your self-performance number is $30 million. You can subcontract up to $30 million to non-SSEs.

Step #4 – Address Similarly Situated Entities

The SBA regulation allows you to take credit for work performed by “similarly situated entities,” or SSEs. As with the word “manufacturer,” the phrase “similarly situated entity” is a term of art. Take a look at 13 C.F.R. 125.1, which says:

Similarly situated entity is a subcontractor that has the same small business program status as the prime contractor. This means that: For a HUBZone requirement, a subcontractor that is a qualified HUBZone small business concern; for a small business set-aside, partial set-aside, or reserve a subcontractor that is a small business concern; for a SDVO small business requirement, a subcontractor that is a self-certified SDVO SBC; for an 8(a) requirement, a subcontractor that is an 8(a) certified Program Participant; for a WOSB or EDWOSB contract, a subcontractor that has complied with the requirements of part 127. In addition to sharing the same small business program status as the prime contractor, a similarly situated entity must also be small for the NAICS code that the prime contractor assigned to the subcontract the subcontractor will perform.

That’s a bit of a mouthful, but we can break it down into two key components.

First comes socioeconomic status. To be an SSE, a subcontractor must possess whatever socioeconomic status is required by the prime contract.  So, for example, if the prime contract is a HUBZone set-aside, an SSE must be HUBZone-certified.  

Where can you find a potential subcontractor’s socioeconomic status? Usually, you can check SAM. For VA SDVOSB and VOSB contracts, you should go to the VetBiz database. If you want to be extra careful, you may wish to require your prospective subcontractor to certify in writing (as part of a teaming agreement, subcontract, or both) that it qualifies.  

Second is size. As the regulation says, an SSE must be “small for the NAICS code that the prime contractor assigned to the subcontract the subcontractor will perform.” In my experience, the words “prime contractor assigned to the subcontract” often cause confusion. Most prime contractors don’t realize that they’re supposed to assign NAICS codes to their subcontracts; instead, they believe that the prime contract’s NAICS code automatically flows down to subcontracts.

As I wrote in a blog post a few years back, the prime decides the appropriate NAICS code based on the principal purpose of the subcontract. If you’re not sure what NAICS code to assign, you can review the definitions in the NAICS Manual to pick the best fit. Once you assign a NAICS code, you’ll judge your subcontractor’s size by using the SBA size standard associated with that code. The SBA’s size standards are found in 13 C.F.R. 121.201.

Manufacturers must be careful, because the size standard for a subcontractor may be larger or smaller than the size standard assigned to the prime contract.

Let’s go back to our boot manufacturer – the one awarded a $100 million contract under NAICS code 316210. That NAICS code carries a 1,000-employee size standard. But if the manufacturer wants to subcontract the manufacture of an information card to accompany the boot, the appropriate NAICS code may be 322230 (Stationery Product Manufacturing). That NAICS code carries a 750-employee size standard. This means that if the subcontractor has 900 employees, it’s not an SSE – even though it has fewer employees than the 1,000-employee threshold under the prime contract’s NAICS code.  

SAM is a good starting point for size self-certification, but I’d also ask my subcontractor to certify in writing (again, as part of a teaming agreement or subcontract) that it is small. Keep in mind that many contractors don’t update their SAM profiles more than once a year, so a SAM self-certification may be outdated.  

The SBA’s regulations state that work performed by SSEs is “not considered subcontracted” for purposes of determining compliance with the limitations on subcontract. While the regulation itself is a little fuzzy about whether SSE work is simply excluded altogether (like the cost of materials), or counts as though it were performed by the prime, the FAR Council’s proposed rule clarifies that “Work performed by similarly situated entities is counted as if it were performed by the prime contractor in determining compliance with the limitations on subcontracting.”

So, let’s go back to our boot manufacturer with the $100 million prime contract. After subtracting $40 million in materials costs, the total self-performance number is $30 million (50% of the remaining $60 million). But let’s say that the prime contractor subcontracts $10 million to an SSE. That work counts as though the prime performed it, leaving the prime with a self-performance requirement of only $20 million. 

One final note. An SSE’s subcontract only counts toward the prime’s workshare if the SSE performs the work with its own employees. If the SSE sub-subcontracts work to anyone – regardless of whether that sub-subcontract would count as an SSE – the work doesn’t count toward the prime’s workshare.

Some Final Thoughts

The limitations on subcontracting for manufacturing contracts can be confusing, and the penalties for non-compliance can be harsh. By following these four steps (and seeking outside help, including legal advice, if appropriate), small government contractors can help ensure that they stay on the right side of these important rules.

If you’re a nonmanufacturer, don’t worry: the next article in our series will provide a walkthrough for ensuring compliance.

Nothing contained in this article is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and information purposes only. Although the author strives to present accurate information, the information provided in this article is not guaranteed to be accurate, complete, or up-to-date. Reading this article does not establish an attorney-client relationship with the author.  

Steven Koprince

Steven J. Koprince is the founder and former Managing Partner of Koprince Law LLC. Steven retired from the active practice of law in May 2019, but he continues to be involved in government contracting as a teacher and writer. Before his retirement, Steven’s legal practice focused exclusively on providing comprehensive legal services to federal government contractors. He is the author of The Small-Business Guide to Government Contracts (AMACOM Books, 2012) and founded the blog SmallGovCon (smallgovcon.com), where he has written more than 1,100 posts on government contracting legal issues. Steven has been quoted in several national news outlets, has appeared on numerous radio programs and podcasts, and has spoken to dozens of audiences across the country on government contracting matters.

Steven Koprince

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