Pass-through is at cost. Until the buyer audits it.

What pass-through is supposed to be.

Pass-through pricing is the part of the TSA where the seller charges the buyer at cost, with no mark-up, for services or licences provided by third parties. Cloud capacity, software licences, telecommunications, professional services retainers. The seller holds the master agreement with the third party. The buyer's use of the underlying service gets billed through the TSA at the actual cost the seller incurs.

The pass-through arrangement makes sense at signing. The carved-out entity cannot stand up its own contracts with every third-party vendor on Day One. The buyer needs continuity of service. The seller passes the cost through. Both sides agree that there is no margin built into the pass-through. The seller's commercial return on the TSA comes from the cost-plus services, not from the pass-through layer.

In practice the pass-through layer accumulates hidden charges over time. Sometimes through error. Sometimes through ambiguous allocation methodology. Sometimes through deliberate inclusion of items that should not be there. The audit is what finds them. The contractual basis for pass-through pricing is covered in TSA pass-through pricing.

A typical TSA has 20 to 50 percent of its total cost in pass-through. On a $20M annual TSA, that is $4M to $10M flowing through the pass-through layer. A 5 percent error rate inside that layer is $200K to $500K per year. The audit pays for itself many times over.

The three patterns the audit catches.

The first pattern is hidden mark-up. The seller charges the buyer a higher rate than the underlying invoice. Sometimes this is built into the catalog as an administrative fee, which is sometimes contractually permitted. More often it is a quiet inflation of the rate without explanation. The audit catches this by reconciling the pass-through invoice line against the underlying third-party invoice.

The second pattern is inflated allocation. The seller's third-party contract covers usage by multiple business units, of which Newco is one. The allocation methodology decides how much of the total cost lands on Newco's invoice. Sellers sometimes apply allocation factors that overstate Newco's share. A unit that uses 30 percent of the capacity gets billed for 45 percent of the cost. The audit catches this by requesting the seller's allocation methodology and reconciling against actual consumption.

The third pattern is the undocumented charge. The pass-through invoice line has no underlying third-party invoice that the seller can produce. The charge has been included on the basis of an internal allocation table that the seller maintains, with no corresponding external cost. These are the lines that should not exist. The audit catches them by requesting documentation and noting which lines have none.

Each pattern produces a different remedy. Hidden mark-up gets repaid as a credit and the rate gets corrected going forward. Inflated allocation gets a retroactive credit and an updated allocation methodology. Undocumented charges get removed entirely with a full retroactive credit.

How to invoke audit rights.

The audit clause exists in most TSAs and most buyers do not invoke it. Invoking it correctly matters. The first move is a formal written notice from the buyer's finance leadership to the seller's TSA lead. The notice references the contractual audit clause, identifies the pass-through period under audit, requests the underlying third-party invoices for that period, and specifies a 30 day SLA for the seller to produce the documentation.

The seller's first response is sometimes procedural pushback. The underlying invoices are confidential. The seller's vendor agreements prevent disclosure. The audit is unusual. The buyer's response is to point to the contract. The audit clause is in the TSA. The pass-through cost basis cannot be confidential to the buyer who is paying it. The audit must proceed.

For vendor confidentiality concerns, the seller can redact pricing terms unrelated to Newco. The buyer needs the line items that map to the pass-through invoice. Vendor names, vendor pricing for unrelated services, and other commercial information not relevant to Newco can be redacted. The principle is that the buyer is entitled to see the cost basis of what the buyer is paying.

If the seller resists past 30 days, the buyer escalates through the dispute resolution clause. Most disputes settle at the escalation notice rather than the formal escalation. The seller's commercial calculation favours providing the documentation rather than triggering a contractual dispute. The full process is detailed in TSA audit rights.

The reconciliation in detail.

The reconciliation is mechanical once the documentation arrives. For each pass-through line on the TSA invoice, the audit team pulls the corresponding underlying third-party invoice. The cost on the underlying invoice is compared against the cost on the TSA invoice. The difference, if any, is documented with the reason.

For lines where the underlying cost exceeds the TSA charge, no action is required. The seller has under billed the pass-through. The buyer does not flag this. For lines where the TSA charge exceeds the underlying cost, the difference is the audit finding. Each finding is categorized into one of the three patterns above and the remedy is identified.

The reconciliation also tests the allocation methodology. For pass-through lines where Newco is a partial consumer of a larger third-party contract, the allocation factor is documented. The factor is reconciled against actual consumption data, such as user counts, transaction volumes, or capacity utilization. Variances above 5 percent generate a request to renegotiate the allocation.

The reconciliation produces a written report. Each finding has a dollar amount, a category, a recommended remedy, and a citation to the supporting documentation. The report goes to the seller's TSA lead, the buyer's program director, and the governance committee.

Settling the findings in writing.

The settlement process follows a predictable rhythm. The seller's TSA lead reviews the report and responds within 30 days. Some findings are conceded immediately. The seller acknowledges the error and applies the credit. Some findings are disputed. The seller's position is documented in writing and the parties enter into a structured discussion.

Most disputed findings resolve at the second meeting between the buyer's finance team and the seller's. The reconciliation evidence is hard to argue with when it lines up against the underlying third-party invoice. The seller typically concedes 70 to 90 percent of the findings on review. The remaining findings either get partial settlements or move to formal escalation.

The settlement is documented in a written amendment to the TSA or in a credit memo signed by both parties. The credits are applied to the next invoice. The corrected rates, allocations, or methodologies are applied going forward. The amendment specifies the period covered, the dollar amount of the credits, and the changes to the pass-through methodology.

The audit is not a one time exercise. Sellers that have been caught once tend to clean up their pass-through billing going forward. Sellers that have not been audited tend to repeat the same patterns. A disciplined buyer runs the audit every twelve months on TSAs that run longer than that and on a final basis at termination. The same disciplines that drive TSA overcharge identification apply here.

When to run the audit.

The audit is most useful at three points. The first is at month four to six of the TSA. By then the seller's pass-through billing rhythm is established and any patterns will be visible. The audit catches issues early and corrects them for the rest of the term.

The second is at the annual anniversary. If the TSA runs longer than twelve months, the annual audit catches drift that accumulates over the year. Pass-through arrangements have a tendency to creep up in cost as third-party vendor pricing changes and as the seller's allocation methodology evolves. The annual audit resets the baseline.

The third is at termination. The final invoice reconciliation is the buyer's last opportunity to recover cost that has been overcharged through the term. The termination audit also covers the wind down period where pass-through services may continue beyond the formal end date. These windows are particularly prone to errors as the seller's billing operation shifts focus to new engagements.

The audit is not adversarial. It is the discipline that makes the contract operate as written. Most sellers respect a buyer that audits properly. The audit signal also affects negotiation of future contracts. A buyer that audits is taken seriously across the broader value creation discipline covered in TSA cost reduction tactics.

More on TSA cost reduction.