In latest edition of The Wright Toolbox:
- The DOD Issues Guidance on Addressing Rising Costs and Inflation
The DOD Issues Guidance on Addressing Rising Costs and Inflation
As we all know, inflation and other supply chain issues have been effecting the cost of goods, materials and equipment needed to perform virtually every government contract. With rising costs of performance, many government contractors are turning to Requests for Equitable Adjustments (“REA’s) or Equitable Price Adjustments (“EPA”) as a means of attempting to address the cost impacts. The Department of Defense (“DoD”) is aware of this challenging economic environment and on May 25, 2022, issued a Memorandum (the “Memorandum”) addressing inflation and economic price adjustments. The Memorandum provides guidance to assist contracting officers in understanding when it is appropriate to recognize cost increases due to inflation under existing contracts, as well as provide considerations for the proper use of equitable adjustments when entering into new contracts.
The Memorandum begins by noting that for purposes of existing DoD contracts, the treatment of cost increases as a result of economic conditions is dependent on contract type and contract provisions. Under cost reimbursement type contracts, the government bears the risk of increased costs, including those due to inflation. Contractors are responsible for promptly notifying the contracting officer that the costs incurred are approaching the limits specified in the applicable clause, as applicable under Federal Acquisition Regulation (“FAR”) clause 52.232-20, Limitation of Cost, or FAR clause 52.232-22, Limitation of Funds. Under fixed-price incentive (firm target) (FPIF) contracts, the contractor’s actual (allowable and allocable) costs are recognized up to the contract ceiling. To the extent the 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. Under fixed-price contracts with economic price adjustment (FPEPA), 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). Unlike contractors performing under cost-reimbursement, FPIF, or FPEPA contracts, contractors performing under firm-fixed-price (FFP) contracts generally must bear the risk of cost increases, including those due to inflation. In the absence of an applicable contract clause, such as an EPA clause authorizing a contract price adjustment as a result of inflation, the DoD believes that there is no authority for providing contractual relief for unanticipated inflation under an FFP contract.
The Memorandum specifically addresses the use of REA’s under FFP contracts to address unanticipated inflation. It states that “REAs entail a contractor’s proposal to the contracting officer seeking an equitable adjustment to the contract terms based on a contracting officer directed change within the scope of the contract, in the areas defined by the applicable Changes clause, or by another contract clause that authorizes an equitable adjustment based on specific actions taken.” The DoD’s guidance to its contracting officers is that “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.”
The Memorandum also provides guidance for contracting officers considering the use of an EPA clause in new contracts to be awarded. It states that “[f]or contracts being developed or negotiated during this period of unusually high inflation, an EPA clause may be an appropriate tool to equitably balance the risk of inflation between the Government and contractor.” An EPA clause may enable a contractor to accept a fixed-price contract without having to develop pricing based on “worst case” projections to cover the cost risk attributable to unstable market conditions because of the EPA clause’s built-in mechanism to mitigate such risk. The Memorandum notes that appropriate “EPA clauses will not be one-sided, but will be fair to both parties.” An example is provided noting that an equitable EPA clause will: 1) allow for both upward and downward revision of the stated contract price upon the occurrence of specified contingencies; 2) use the same index to establish the negotiated price and to adjust the negotiated price under the terms of the clause; and 3) incorporate a ceiling and a floor on adjustments that are of the same magnitude (if a ceiling and floor are included).
The Memorandum concludes by stating “[t]he challenges presented in this period of economic uncertainty require us to employ appropriate solutions to both protect Government interests and ensure the continued health of the defense industrial base to support our mission. . . . , COs must work with contractors to ensure EPA clauses provide appropriate risk mitigation while being fair to all parties to the contract.”
If you have any questions regarding the subject matter of this article please contact any member of the WCS Government Contracts practice group.