What Is a Pass-Through Cost & How Does It Work?

Pass-through costs are expenses initially paid by one party on behalf of another, with the understanding that these costs will be fully reimbursed without any markup. This concept is prevalent across diverse business and consumer settings, ensuring the party incurring the cost acts as an intermediary. The direct reimbursement mechanism allows for clear pricing structures for core services and goods, as these incidental expenses are handled separately.

Understanding Pass-Through Costs

Pass-through costs are expenses a business incurs on behalf of a client or customer, where the business intends to recover the exact amount of the expense without adding any profit. These costs are distinct from the primary goods or services a company offers and are not part of its operational expenses or profit margin. They are characterized by being client-specific, meaning they are incurred for a particular project or service agreement.

These expenses are fully reimbursable, with the expectation that the client will pay them back. The arrangement for what constitutes a pass-through cost and how it will be reimbursed is outlined in a contractual agreement. Businesses choose to pass certain costs through to maintain transparent pricing for their main offerings and to recover specific out-of-pocket expenses incurred solely for the client’s benefit.

Practical Examples of Pass-Through Costs

Pass-through costs are common across various industries, appearing in different forms. One example is shipping and handling fees, where an online retailer charges a customer the cost of postage and packaging for an item. Another instance involves credit card processing fees, which some businesses directly charge to the customer.

In professional services, reimbursable expenses like travel, printing, or specialized software licenses incurred by a consultant for a client are pass-through costs. In rental agreements, landlords might bill tenants for their utility usage, such as electricity or water. Government fees or taxes, like sales tax, also function as pass-throughs when a business collects these amounts from customers and remits them directly to the relevant authority.

Accounting for Pass-Through Costs

The accounting treatment for pass-through costs ensures they do not inflate a company’s reported revenue or expenses. These costs are recorded as an expense offset by a corresponding reimbursement, resulting in a net zero impact on the entity’s profitability. Under Generally Accepted Accounting Principles (GAAP), these expenses are not reported as part of the company’s revenue because the company acts merely as an intermediary.

When a business collects pass-through funds, such as sales taxes or vehicle licensing fees, these amounts are recorded as a liability on the balance sheet rather than revenue. This approach prevents artificially inflating reported revenue and cost of goods sold. Maintaining clear documentation, including receipts and invoices, is important for auditing and tax compliance, substantiating the legitimacy of these expenditures.

Pass-Through Costs in Contracts

Clearly defining and managing pass-through costs within contractual agreements helps prevent disputes. Contracts specify which types of costs are considered pass-throughs, ensuring mutual understanding between parties. These agreements also outline documentation requirements, such as requiring receipts or invoices, to evidence the expenses.

Contracts include provisions for approval processes, detailing if client consent is needed for expenses exceeding a certain threshold. The billing frequency and method for these costs are stipulated, clarifying how and when they will be invoiced. Transparency and a shared understanding at the outset are important for successful business relationships when pass-through costs are involved.