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Department of Defense Offers Guidance to Contractors Battling Inflation

On Behalf of | Sep 13, 2022 | Capital Connections

Few government contractors who negotiated contracts prior to 2021 could have foreseen the rampant inflation that the economy has seen in recent months.[1] In fact, the Federal Reserve continued to refer to pandemic-related inflation as “transitory” up until the end of 2021,[2] giving many businesses a false sense of security. That prediction of course proved to be overly optimistic, as it has become apparent that inflation is here to stay for the foreseeable future. Recognizing the current economic landscape and the unforeseen impact that inflation has had on government contractors, the Department of Defense (“DoD”) issued a memorandum on May 25, 2022 titled “Guidance on Inflation and Economic Price Adjustments” (“DoD Memo”).[3] After receiving feedback and concerns from industry, the DoD recently issued a second memorandum on September 9, 2022  to more fully address concerns related to contractors’ ability to perform under firm-fixed-price contracts (“Updated DoD Memo”).[4]

The DoD Memo begins by acknowledging that the “current economic environment requires we understand the impacts of inflation to existing contracts and consider various approaches to manage risk of inflation to prospective Department of Defense (DoD) contracts.” In particular, the memo focuses on the use of economic price adjustments (“EPA”) as the primary vehicle for contactors to seek recovery for increased costs caused by inflation. The memorandum then divides its guidance into two categories: existing contracts and contracts being currently developed or negotiated.[5]

Existing Contracts

Cost-reimbursement contracts: Cost-reimbursement contracts naturally provide contractors the highest level of protection against inflation, as the Government generally bears the risk of any increased costs—including those due to inflation.[6] Nonetheless, if a contractor’s costs are nearing the applicable contract limits, the DoD Memo advises that the contractor should immediately notify the contracting officer (“CO”).[7] The Government may then increase funding for the contract to allow for continued performance.[8] Significantly, whether or not funding is increased, the contractor will not be required to perform work beyond the funded amount under the contract.[9]

 Firm-fixed-price (“FFP”) contracts: On the opposite side of the spectrum, contractors holding a FFP contract are generally expected to bear the risk of increased costs, including cost increases due to inflation.[10] While the DoD Memo states that DoD is continuing to field questions about the use of requests for equitable adjustment (“REA”) to address inflation under FFP contracts, it makes clear that a CO should not approve an REA for cost increases due to inflation.[11] In particular, the memo states that because “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.” As such, contractors holding FFP contracts face by far the greatest obstacles in recovering increased costs caused by inflation.

Acknowledging the challenges that FFP contracts currently pose for affected contractors, the Updated DoD Memo attempts to address concerns that it was not doing enough to blunt inflation’s impact on FFP contractors. The DoD states that “there may be circumstances where an accommodation can be reached by mutual agreement of the contracting parties, perhaps to address acute impacts on small business and other suppliers.”[12] The DoD suggests that these accommodations “may take the form of schedule relief or otherwise amending contractual requirements.”[13] Additionally, the DoD points out that each of the Secretaries of Defense have authority to afford Extraordinary Contractual Relief and grant upward adjustment of existing FFP contract price. At the same time, however, the Updated DoD Memo warns that this power is limited by “stringent criteria”.[14]

Fixed-price incentive contracts with a firm target (“FPIF”): While not providing the broad protection of a cost-based contract, FPIF contracts do offer some recourse to contractors experiencing increased costs due to inflation. In an FPIF contract, the contractor’s actual costs are recognized up to the stated contract ceiling.[15] When actual costs differ from this target, the contractor’s target profit will be adjusted by the contract share ratio.[16] For example, under a 50/50 share ratio, the Government will share in half of the increased costs.[17]

Fixed-price with economic price adjustment (“FPEPA”) contracts: A FPEPA contract does provide protection against increased costs for those covered by the economic price adjustment (“EPA”) clause.[18] However, the right to an EPA extends only to those costs that are specifically delineated in the contract. Thus, because inflation is a relatively new concern, in many cases the relevant EPA clause may not be construed to extend to inflation.

 Contracts Being Developed or Negotiated

Thankfully, for contracts yet to be executed, the DoD Memo recognizes EPA clauses as a useful tool for COs to include in contracts to balance the risk of rising inflation.[19] EPA clauses are beneficial to both the Government and contractors because they allow contractors to accept fixed-price contracts without making price projections based on the worst-case-scenario.[20] However, the DoD reminds COs developing new contracts that an EPA clause based on “established prices or on actual cost of labor and material” should only be used when delivery or performance will not occur within six months of the contract award.[21] Furthermore, EPA clauses for contracts based on “cost indices of labor and material” are limited to “contracts with an extended period of performance” where significant costs will be incurred more than one year after performance begins.[22] An appropriate EPA clause will be fair to both the Government and the contractor, measuring inflation by a proper basis that does not fluctuate significantly based on irrelevant factors, while being broad enough that the inflation rate is not “significantly affected by a single company.”[23]

In summary, a contractor’s ability to combat inflation under an existing contract will largely depend on the type of contract, ranging from the Government bearing the cost (up to the applicable limits) under a cost-reimbursement contract, to the contractor typically bearing the cost under an FFP contract. On the other hand, for new contracts, the DoD acknowledges the hardship the current economic situation places on contractors. The DoD Memo thus suggests the use of properly crafted EPA clauses to provide contractors an avenue to seek recourse for the effects of continuing inflation. As the memo states, this approach not only provides needed protection to contractors, it also helps ensure that the Government will continue to obtain the essential goods and services it needs. As DoD states: “The 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.”[24]

If you have questions about your options to address inflation under an existing contract, or to protect against inflation in a contract that is currently being negotiated, please contact the Government Contract attorneys at Eckland & Blando LLP.

[1]      Research and drafting assistance provided by Adrian Kipp, law clerk at Eckland & Blando LLP.

[2]      Rich Miller, Jerome Powell Ditches ‘Transitory’ Tag, Paves Way for Rate Hike, Bloomberg, https://www.bloomberg.com/news/articles/2021-11-30/powell-ditches-transitory-inflation-tag-paves-way-for-rate-hike (last visited June 16, 2022).

[3]      Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. (May 25, 2022).

[4]      Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. at 1 (Sept. 9, 2022).

[5]      Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. at 1-3 (May 25, 2022).

[6]      Id. at 1.

[7]      Id.

[8]      Id.

[9]      See id.

[10]    Id. at 2.

[11]    Id.

[12]     Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. at 1 (Sept. 9, 2022).

[13]    Id.

[14]    Id; see 48 C.F.R. subp. 50.1.

[15]    Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. at 1 (May 25, 2022).

[16]    Id.

[17]    See Robert Antonio, The Fixed-Price Incentive Firm Target Contract: Not as Firm as the Name Suggests, WIFCON, http://www.wifcon.com/anal/analfpif.htm (last visited June 21, 2022).

[18]    Memorandum from John M. Tenaglia, Principal Director, Defense Pricing and Contracting to Commander, United States Cyber Command, et al. at 1 (May 25, 2022).

[19]    Id.

[20]    See id.

[21]    Id.

[22]    Id.

[23]    Id. at 2-3

[24]    Id.

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