The Defense Department in May released guidance on handling rising inflation.

The Defense Department in May released guidance on handling rising inflation. jayk7 / Getty Images

How Can Defense Contractors Battle Rising Costs? Here Are Some Tips

Takeaways from the Pentagon's May memo on inflation.

Unless you’ve been living under a rock or on a self-sustaining deserted island, the chances are high that you have become quite familiar with the term “inflation” (i.e., the rising costs of goods and services) over the past few years. Indeed, everything (from gasoline to gumballs and milk to movie tickets) appears to be more expensive as of late. Unfortunately, government contractors are not immune from this current economic reality. As most of us know all too well, many contracts that were negotiated and priced over the past 18 to 24 months are simply more expensive to perform now than was reasonably anticipated when bids were prepared.

In recognition of these soaring prices, the Defense Department issued a May 25 memorandum titled “Guidance on Inflation and Economic Price Adjustments,” the purpose of which is to assist contracting officers in (i) navigating the impacts of inflation on existing contracts and (ii) managing downstream inflation risks on prospective contracts. Here are the key takeaways and our suggested courses of action for Defense contractors to best protect your company’s bottom line:

Existing Contracts

  • Cost-type contracts provide the most protection. Defense recognizes that cost-type contracts place the risks of increased costs—including those related to inflation—on the government. Contractors, in turn, are required to notify the government when incurred costs are approaching applicable contract limitations in accordance with the procedures specified in the operative contract. See, e.g., FAR 52.232-20, Limitation of Cost; FAR 52.232-22, Limitation of Funds. Upon receipt of notice, the government may increase the funding to allow for continued performance, but the contractor is not obligated to continue performance beyond what can be accomplished within the currently funded contract value.
  • Compliance tip: Carefully track incurred and expected contract costs and provide requisite notice in advance of hitting the contract ceiling. Remember to stop work when permitted by the contract so that you do not perform “at risk” work.
  • Some relief may be available under flexibly priced fixed-price contracts. For example, fixed-price incentive fee contracts provide that the contractor’s actual costs are recognized up to the agreed-upon contract ceiling. If actual costs differ from the target costs, the target profit is adjusted by application of the contract share ratio to costs that are over or under the target. In addition, fixed-price contracts with economic price adjustment provisions typically contain mechanisms to mitigate cost risks associated with contingencies beyond the control of any individual contractor. If an economic price adjustment clause is included in a contract, the clause should dictate the extent to which the government bears the risk of cost increases.
  • Compliance tip: If there is an economic price adjustment clause in your contract, review it carefully to ensure that you understand its coverage. Monitor the costs of the underlying covered areas (g., labor and/or material) and provide timely notice to the contracting officer if the clause is triggered.
  • Firm-fixed-price contracts present far more challenging hurdles. In this type of contract, the Defense Department’s view is that the contractor “generally must bear the risk of cost increases, including those due to inflation.” In addition, Defense states that it is “fielding questions” about the potential use of requests for equitable adjustments to address unanticipated inflation. Not surprisingly, the memorandum makes clear that contractors should not receive any cost relief in response to such adjustment requests because inflation is not a result of a government-initiated change.
  • Compliance tip: If costs are spiraling out of control and there are cheaper alternatives that meet contract requirements, consider—in consultation with the customer—modifying existing contract sources. In addition, carefully review your contract to determine whether there are any remedy-granting provisions outside of the traditional request for equitable adjustments process.

Prospective Contracts

  • Economic price adjustment clauses are likely appropriate. In light of “unusually high inflation,” the memorandum concedes that such clauses may be a useful tool that can “equitably balance” cost risks between contractors and the government. As is often the case, timing is everything. Citing to DFARS 216.203-4(1)(ii), the memorandum reminds contracting officers that economic price adjustment clauses based on established prices or the actual cost of labor and material should be used only when delivery or performance will not be completed within six months of contract award. In addition, Defense notes that FAR 16.203-4(d)(1)(i) limits the use of economic price adjustment clauses based on cost indices of labor and material to contracts with an extended period of performance, with significant costs to be incurred more than a year after contract performance begins.
  • Compliance tip: When reviewing prospective proposals that do not contain an economic price adjustment clause, consider asking the government to change its approach during the applicable Q&A process. Remember, some clauses are required to be included as a matter of regulation. If the government refuses to comply in the face of controlling regulatory authority, consider filing a pre-award protest.
  • Economic price adjustment clauses must be fair to both parties. The memorandum lays out Defense’s view as to what constitutes an “equitable” economic price adjustment clause. In particular, the clause should (i) allow for both upward and downward revision of the stated contract price upon the occurrence of specified contingencies; (ii) use the same index to establish the negotiated price and to adjust that price under the terms of the clause; and (iii) incorporate a ceiling and a floor on adjustments that are of the same magnitude (if a ceiling and a floor are included at all). Defense also instructs its contracting officers to ensure that economic price adjustment clauses allow for contract price adjustments based on pre-established formulas.
  • Compliance tip: Carefully negotiate economic price adjustment clauses to account equitably for downstream price fluctuations. Ensure that your company understands how the clause functions, and pay particular attention to events that trigger the clause.

Key Considerations Moving Forward 

Contractors with existing Defense agreements should carefully examine the operative clauses in those contracts to determine whether there are mechanisms to request upward pricing adjustments in light of inflation. Ensure that any such request is carefully supported by available data and is drafted in strict compliance with the terms of the applicable clause(s). Companies that are in the process of negotiating new contracts with the Defense Department should pay attention to the contemplated pricing structure and should attempt to incorporate an appropriately balanced economic price adjustment clause to the extent possible.

Franklin Turner is co-chair of the Government Contracts & Global Trade Practice Group at McCarter & English. A partner in the firm’s Washington, D.C. office, he has extensive experience representing a broad array of companies – ranging from multinational Fortune 100 corporations to mid-market clients and small businesses operating in the aerospace, defense, information technology, health care, and industrial supply sectors. He can be reached at fturner@mccarter.com.

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