Pentagon offers a shred of hope for inflation relief on fixed-price contracts

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The Federal Acquisition Regulation is clear, fixed-price contracts are just that: Fixed price. There’s no provision for adjustments because of inflation. Or is there? A memo last week from the Defense Pricing and Contracting office offers some hope. The Federal Drive with Tom Temin spoke with someone who has studied the memo closely: Zach Prince, a partner at Smith, Pachter, McWhorter.

Interview transcript:

Tom Temin: Zack, good to have you back. All of the defense contractors, and I guess maybe civilian contractors also are complaining that inflation is eating into their ability to deliver on their fixed-price. Exactly what does the FAR say about that? And is this also true of the DFAR?

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Zach Prince: The FAR is clear in defining a fixed-price contract as a type of contract that provides for a price that’s not subject to any adjustment based on the contractor’s actual cost experience. So the idea is that it places a risk on the contractor; it also potentially affords the contractor opportunity to make much higher profits than you would under a cost-type contract. This is under the DFARs and the FAR as well.

Tom Temin: Right, I guess the supposition is that if the contractor can creatively cut costs, then so much the better for them, they can make the profit increase. And therefore if costs go up, tough. I mean, that’s the general theory here?

Zach Prince: That’s right.

Tom Temin: Alright, so then with inflation kind of galloping away in the last few months, some of the people in contracting and some of the people in the Pentagon probably don’t remember when inflation was a generalized scourge of the land 40-50 years ago. What’s going on now?

Zach Prince: Now that we’re seeing inflation that’s in the upper single digits, really unprecedented in modern memory, contractors are facing the reality that when they priced these contracts, often many years ago, they were assuming certain contingencies. Those contingencies were based on expected reasonable historic numbers. They weren’t based on anything like what we’re seeing today. So companies are facing significant losses when being forced to perform at prices that they proposed five-plus years ago at times.

Tom Temin: Do you know any examples of fixed-price contracts or types of contracts that could be affected by this? Because there’s services contracts, which tend to be wage inflation driven, but can’t fixed-price contracts also be for delivery of goods that are manufactured, where you’re facing raw material supply costs?

Zach Prince: Absolutely. And this issue is hitting across industry, even in the services sector, especially when you’re on a time and materials contract where you’re stuck in certain hourly prices. But where I’m hearing the biggest complaints are from the manufacturing side of things. My manufacturing clients are being forced to abide by prices that they proposed in a very, very different world.

Tom Temin: Just give us an example, if you can, without identifying clients, what it is they make are the types of goods and or services they’re delivering?

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Zach Prince: Sure. So for example, if you’re producing an electronic part, a circuit board or assembly of some sort, not only are you facing much higher prices, because of inflation, you’re also facing serious supply chain challenges. And this has been increasing over the past few years. But you’re getting to a point where some parts are either unavailable entirely or if they’re available, are at a much higher price than could have been anticipated.

Tom Temin: I guess if you’re also supplying ordinance, for example, or ammunition for small guns, you’re buying brass, you’re buying lead, you’re buying different metals and different powders and chemicals. And I imagine those are all up too; commodity prices are up.

Zach Prince: Absolutely. And when you think about a final assembly, whether it’s a plane, or a ship or something smaller like small arms, you’re talking about thousands, if not millions, of individual parts in the supply chain.

Tom Temin: We’re speaking with Zach Prince. He’s a partner at Smith, Pachter, McWhorter. Alright, so now the certain unit in the Defense Department has come out with a memo, where did it come from? And what does it say?

Zach Prince: The memo comes from the director of defense pricing and contracting. And this is a follow up to a memo they issued in late May. The memo in May was extremely disappointing. It essentially said there’s no basis for contracting officers to even consider requests for equitable adjustment to firm fixed-price contracts. It did instruct contracting officers to consider economic price adjustment clauses (EPAs). Those afford contractors the ability to have prices trued up. They’re prospectively or retrospectively, depending on the clause, usually based on pre-agreed indices. The Bureau of Industrial Statistics will put out their numbers about inflation. And if you hit a certain threshold, you’ll be entitled to a price increase. That helps contractors going forward. It doesn’t help contractors looking back. So this new memo, which came out last Friday, September 9 gives two conceptual bases for recovery. So it goes a little bit further. The first really isn’t much. There are some circumstances where an accommodation can be reached. It doesn’t say what that accommodation is. And it seems to suggest that that wouldn’t include price increases. Maybe that includes schedule relief, which contractors may be entitled to anyway for an excusable delay. But in any case, it says it has to be with consideration for the government. I’m not sure what that consideration is. But if the government is getting consideration, presumably you’re not getting a price increase.

Tom Temin: Then there’s also a second possibility for relief under this memo, then, too.

Zach Prince: That’s right, so that the second possibility may be more meaningful, although it’s going to be challenging for contractors to take advantage of it. There is a statute, Public Law 85-804, within the FAR and DFAR as a Part 50 that provides for discretionary relief in extraordinary circumstances. You don’t see this happen very frequently. But what happened is, if you can demonstrate to the government that there is no other basis for you to get recovery, you’re facing a substantial loss that will impair your ability to continue existing as a contractor and appropriated amounts are available, you might be able to get released from the government under this 85-804 basis. The memo says that this could be a basis for contractors to recover in fixed-price contracts. We’ll see how this plays out in practice. I fear that in reality, because of how challenging administratively this thing is to submit requests under, the contractors that are hit the hardest, which are the small businesses, are going to find it very challenging even to go through the administrative rigmarole of getting the request in front of the agency.

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Tom Temin: Yeah, because as you point out, there are some provisions; for example, if there’s no basis for recovery, or the contractor is going into a loss, or may not be viable as a result, but there’s that other clause you mentioned, number two, ‘if appropriated amounts are available.’ Now we’re heading into a continuing resolution. And the government could say, Well, look, I’d have to reprogram the money to be able to pay you more for the circuit board or that bullet. And I’m not going to go and ask for a reprogramming of dollars, therefore the appropriated money is not available. That seems like the government’s out here, I’m guessing.

Zach Prince: It is. And I’m sympathetic to the government’s concerns. And the inflationary pressures are not just hitting contractors; the government’s budgets are certainly being squeezed as well. But considering the government’s ongoing concerns about a shrinking defense industrial base, it seems prudent for agencies to go to Congress and request more money and figure it out somehow.

Tom Temin: All right, so ‘tighten your belt, contractors’ is your basic advice here.

Zach Prince: That’s right. And because of this environment, contractors might be tempted to press forward with claims, for example, that they otherwise would have just let slide by, because they can’t let any opportunity to get relief that they’re contractually entitled to slip through their fingers, given the inflationary pressures.

Tom Temin: I wonder if there is some specification in a contract, such that the contractor can wiggle their way out of a cost by meeting a spec in a cheaper way. I mean, value analysis or something, or the wall of this can be reduced by five mills, and therefore we’ll save 3% on the cost of xyz material. Kind of like the way Hershey bar makers keep making it smaller and smaller for the same price.

Zach Prince: It’s possible. I think contractors are going to have to be very careful to read their contracts closely. And they’re gonna have to be creative in coming up with ways to recover their costs without harming the taxpayer or the agencies.

Tom Temin: Zach Prince is a partner at Smith, Pachter, McWhorter, thanks so much.

Zach Prince: Glad to be here.

 

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