Inflation. A word no one likes, but it is something that is currently impacting nearly every facet of our lives. Gas prices continue to rise, grocery costs are through the roof, and everyday living expenses are taking more hard-earned money from our country’s workers than ever before. However, consumers are not the only ones feeling the effects. Costs and expenses of running a business have increased dramatically as well, and those in the federal contracting world are no exception. Questions from both contractors and contracting officers (CO) prompted the Department of Defense (DOD) release new guidance on May 25, 2022, conveying how it plans to handle inflation through economic price adjustments (EPA) as well as when the use of EPAs is appropriate. However, the guidance also discourages flexibility for increased costs based on inflation.
CONTRACT TYPES
To understand the new guidance, it is important to first understand what type of contract the contractor is performing under. There are four main ways that contractors can be paid under a DOD contract: cost reimbursement, fixed-price incentive, fixed-price with economic price adjustment (EPA), and firm fixed price.
Cost Reimbursement Type Contracts. The Government bears the risk of increased costs, including those due to inflation, in cost reimbursement contracts. Contractors have the responsibility to promptly notify the CO “that the costs incurred are approaching the limits specified in the applicable clause.” Federal Acquisition Regulation (FAR) clause 52.232-20, Limitation of Cost, and FAR clause 52.232-22, Limitation of Funds address the contractor’s obligations in further depth. When the Government receives such notice, it may choose to increase the contract funding for continued performance, or not. If it chooses not to, the contractor is under no obligation to work past the contract’s funded amount.
Fixed-Price Incentive Contracts. The contractor’s actual, allowable, and allocable costs are recognized up to the contract ceiling in fixed-price incentive contracts. If actual cost differs from the target cost, “the target profit will be adjusted by application of the contract share ratio to the costs over or under the target cost.”
Fixed-Price Contracts with Economic Price Adjustments. Under fixed-price contracts with economic price adjustment, “the EPA clause normally establishes a mechanism to mitigate specifically covered cost risks to both parties as a result of industry-wide contingencies beyond any individual contractor’s control; the Government will bear the cost risk up to the limit specified in the clause (if any).”
Firm-Fixed-Price Contracts. Unlike the three previously mentioned contract types, those contracted as firm-fixed-price contracts (FFP), leave the contractors to bear the burden of any increased costs. This includes increases due to inflation and occurs because FFP contracts do not contain “authority for providing contractual relief for unanticipated inflation under an FFP contract.” Many have inquired about the possibility of using a request for equitable adjustment (REA) for this purpose, but the DOD points out that REAs are only to be utilized in the event of CO directed changes. This is a common contract type for many contractors. Unfortunately, the DOD is not encouraging flexibility for inflation: “Since cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change, COs should not agree to contractor REAs submitted in response to changed economic conditions.”
DEPARTMENT OF DEFENSE’S SOLUTION
To fill the void created by rapidly increasing inflation, DOD has recommended that FFP contracts that are for periods of time longer than six months insert an EPA clause. EPA clauses based on established prices or on the actual cost of labor and material should only be used when delivery or performance will not be completed within six months after contract award. DFARS 216.203-4(1)(ii). EPA clauses based on cost indices of labor and material are limited to contracts with significant costs that will be incurred beyond one year after performance begins. FAR 16.203-4(d)(1)(i).
DOD recommends the following factors be taken into account by COs when drafting an EPA clause:
- When a CO is choosing indices to be used to measure inflation for purposes of an EPA clause, the index used should be “closely related to the cost components judged to be most unstable”;
- The scope of the EPA clause should be limited to costs most likely to be impacted by economic fluctuations, excluding costs not likely to be affected by inflation from adjustment;
- Economic price adjustments often do not apply to the profit portion of the contract;
- CO should use independent, recognized sources as the basis for measurement of inflation in EPA clause; and
- The index used to measure inflation should not be too large or too small, so only relevant fluctuations are taken into account.
Further, EPA clauses should:
- Be fair to both parties;
- Allow for contract price adjustments based on pre-established formulas rather than simply reopening price negotiations;
- Exclude contingency allowances from the base contract price;
- Explain the method that will be used to calculate price adjustments; and
- Identify when a price adjustment will be warranted.
DOD points out that any clause in a contract that includes adjustments due to changed economic conditions is considered an EPA, whether the term is used or not. Unfortunately, this guidance did not include any information on how DOD plans to address inflation for currently active contracts.
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