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Whitepaper: The Audit World's Biggest Myths
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Whitepaper: The Audit World's Biggest Myths
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By: Craig Stetson, CPA

Contributing Authors: Navleen Sohi, Blake Duffy, Robert Kovacs, Benjamin Smith, Jillian Colebert, Aidan Moss, and Andrew Berry

The Federal Government of the United States is the single largest consumer of goods and services in the world. The Government engages with thousands of contractors through the award of procurement contracts to purchase everything from commercially available off-the-shelf items, to raw materials and aircraft engines, to landscaping services and advanced weapons systems, and virtually anything in between.

The availability of Government funds and the Government’s authority to purchase its needed goods and services is determined through various acts of the U.S. Congress. Based on those Legislative Branch decisions and funding appropriations, the Executive Branch agencies and contractors then engage in a solicitation or contracting process whereby contractors receive government funding to perform applicable contracts and ultimately deliver their respective goods or services to the Government.

Recently, a pressing issue for contractors and the Government has been excessive economic inflation, the resulting and continuing financial challenges borne by both parties (more so contractors) and development of an equitable process to resolve or mitigate the contract performance and delivery difficulties arising from the unforeseen inflation. In light of these challenges, 'Fixed price economic price adjustments' have emerged as a critical mechanism for managing the effects of inflation on fixed-price contracts, ensuring that contractors can sustain their operations despite financial pressures.

This article addresses a financial overview of federal contracts, economic price adjustments (EPA), the authorization and appropriation of Government funds, and implications and insights regarding the overall process.

Financial Overview of Federal Contracts

Contractors performing under government contracts are subject to various contract type-specific funding and financial requirements. Cost reimbursement contracts, for example, should contain FAR clauses 52.232-20 - Limitation of Cost and/or 52.232-22 - Limitation of Funds that govern the availability of funds specific to contract performance.

Contractors are paid, under cost reimbursement contracts, their actual and allowable costs incurred and, generally, contract performance costs adversely affected by economic inflation are reimbursable under active contracts for which available funding exists, as authorized in accordance with the above-referenced FAR clauses. These FAR clauses also provide the contractor and the Government a mechanism to potentially adjust the available contract funding amount to address additional contractor funding requirements needed to continue performance and due to, among other things, economic inflation.

Fixed-price contracts, however, are structured differently and generally commit the contractor to perform the contract scope of work for a fixed amount over the entirety of the contract’s period of performance.

Fixed-price contracts place all the financial risk or reward on the contractor, thereby requiring contractors to effectively manage their fixed contract funding amount to cover incurred costs – typically including direct labor and materials, indirect expenses, and a margin or profit as initially anticipated. Under the terms of fixed-price contracts, contractors are generally at risk for rising costs due to inflation unforeseen at the time of price negotiation.

In recent years, many contractors have experienced the adverse effects of inflation and rising costs as a real-life situation and have realized contract losses, especially in the construction and manufacturing industries; in such cases, attempts to successfully obtain from the Government contract modifications for price adjustments have been rare, under the premise that all financial risk or reward under fixed-price contracts rests with the contractor.

As significant levels of inflation occurred (and have since continued), the Department of Defense (DoD) and Congress reacted over the prior two-year period and took actions (DoD guidance memorandums and drafted legislation) to address the resulting financial impacts and stress on the sustainability of the contractor environment.

These actions included, but were not limited to, the potential incorporation of contractual provisions in current and prospective DoD contracts aimed at providing relief or an attempt to manage inflation risks. [RF1] [CS2] One such contractual provision is an Economic Price Adjustment (EPA).

What is an EPA?

EPAs in fixed-price contracts provide upward or downward revisions of stated contract prices upon the occurrence of specified contingencies. These adjustments may be based on one of the following factors: established prices, actual costs of labor or material, or cost indices for historical labor or material costs.

Fixed-price contracts with EPAs may be used when the stability of market or labor conditions is in doubt and/or when contingencies can be identified and covered separately in the contract. Incorporation of EPA provisions may require contractors to provide the Government with adequate data to establish the base level from which adjustments may be made (even if the contract did not initially require the submission of cost or pricing data).

To ensure a structured approach to these adjustments, the Federal Acquisition Regulation (FAR) outlines the criteria and processes for implementing 'Economic price adjustments FAR,' particularly within fixed-price contracts.

This regulatory framework offers a standardized method for both contractors and government agencies to navigate the complexities of economic fluctuations, ensuring that contract terms remain fair and viable over time. It’s crucial for contractors to familiarize themselves with FAR 16.203-1 and 16.203-2, which detail the conditions under which economic price adjustments may be applied, providing a solid foundation for these critical adjustments.

Risks of Fixed-Price Contracts and Need for Inflation-Based EPAs

The second half of 2020 was the start of a pattern of substantial increases in economic inflation levels that signaled to contractors that existing fixed-price contracts may or will experience losses or, at a minimum, diminished margins.

Industry sectors with significant volumes of government contracts, e.g., construction, have been hit particularly hard by increases in the cost of labor and materials. According to the Associated General Contractors, the Producer Price Index (PPI) for nonresidential construction stood at a 11.2% year-over-year increase in December of 2022.[1] Many specific construction-related commodities (e.g., steel, other metals, electronics, etc.) experienced significant price increases during this period as well.

With no end in sight, contractors in many sectors were forced to seek price relief through an EPA or EPA-like provision. FAR 16.203-2 states: “Price adjustments based on labor and material costs should be limited to contingencies beyond the contractor’s control.” This reliance on 'Economic price adjustments FAR' guidance underlines the necessity for contractors to navigate inflation impacts within the structured framework of federal acquisition regulations, ensuring that adjustments are justifiable and within the bounds of contractual agreements.

While this may seem like a solution to remedy contracts that did not account for record inflation, most fixed-price contracts do not include an EPA clause. Furthermore, there was little guidance on what data contractors should use to demonstrate that actual inflation was a significant risk to their ability to sustain performance for a prolonged and unknown period.

This ongoing and ‘new normal’ situation led Congress to specifically address these economic and contractor performance challenges via legislation and the law-making process, leading to statutory provisions and, ultimate enactment in the 2023 National Defense Authorization Act (NDAA).

The NDAA's acknowledgment of inflation's impact on defense contracts paves the way for applying 'Economic price adjustments FAR' principles more broadly. This legislative backing ensures that contractors can seek adjustments based on established FAR guidelines, reinforcing the practical application of EPAs in federal contracts. By aligning the NDAA’s provisions with FAR's established mechanisms for economic price adjustments, contractors are afforded a more robust framework to navigate the financial uncertainties posed by inflation, ensuring the sustainability of critical defense projects and the health of the defense industrial base.

NDAA for Fiscal Years 2023 and 2024

In 2023, amidst unprecedented economic volatility, Congress took action by establishing goals of maintaining resilience in defense acquisitions, supporting a vibrant Defense Industrial Base and safeguarding national security interests. This action resulted in the drafting of specific legislation that was ultimately enacted as a provision of the 2023 NDAA. Section 822 of the 2023 NDAA introduced the first action plan regarding inflation's impact on the defense industry and existing defense contracts.

By introducing measures for the modification of contracts, this legislation provided contractors an opportunity to receive extraordinary relief—if specific conditions were met. As inflationary pressures have affected virtually all industrial sectors, including to a large degree DoD procurement, this legislation enabled the DoD to adjust existing contracts to alleviate the financial strain contractors were experiencing under their fixed-price contracts.

Sec. 822. Modification of contracts to provide extraordinary relief due to inflation impacts

Section 822 states: “a prime contractor may submit to the Secretary of Defense a request for an amendment or modification to an eligible contract pursuant to subsection (a) when, due solely to economic inflation, the cost to a covered subcontractor of performing an eligible subcontract is greater than the price of such eligible subcontract.”[2]

This provision, in summary, permitted contractors and subcontractors to file claims for relief, if impacted by the new economic environment and inflation, under Public Law 85-804. By granting the Government discretionary authority to renegotiate terms and conditions, such as pricing structures, delivery schedules, and cost escalation clauses, Section 822 provided contractors and the Government a mechanism to navigate unforeseen economic challenges while ensuring the continuity of vital defense projects.

Following the 2023 NDAA, many contractors and Government individuals still faced obstacles navigating when and how the Government’s discretionary authority would be able to provide financial relief on affected fixed-price contracts. The 2024 NDAA further addressed the issue with amendments to the 2023 NDAA as follows:

Sec. 824. Modification and extension of temporary authority to modify certain contracts and options based on the impacts of inflation

Section 824 amended section 822 of the prior year NDAA. The amendments added: “If any such amounts are so specifically provided, the Secretary may use them for such purposes.” This verbiage was added to subsection (b) and extended the authority of relief to December 31st, 2024, within subsection (e).[3]

Sec. 826. Modification of contracts and options to provide economic price adjustments

Through section 826, the DoD now has authority to use appropriated funds to modify the terms and conditions of a contract, or may provide an EPA, if it is consistent with FAR 16.203-1 and 16.203-2 during the relevant period of performance.

Guidance regarding the implementation of the authority now given in section 826 is to be released by the Under Secretary of Defense for Acquisition and Sustainment no later than 30 days after the enactment of the 2024 NDAA.[4] The 2024 NDAA was enacted on December 22, 2023; unfortunately, this section 826-mandated guidance has not been publicly released as of the date of release of this paper.[MOU3]

Requirement for Appropriated Funds

As mandated by the 2023 NDAA, the Government’s authority to grant inflation-related contractual relief through EPAs or similar provisions requires, among other things, use of appropriated funds. The appropriation of government funds is the result of a Congressional budgetary and statutory process whereby the Government is granted the legal authority to use funds for a designated purpose.

Generally, federal agencies create and submit budget requests to the White House Office of Management and Budget (OMB). The OMB uses the agencies’ budget requests to build an overall budget for submission to the President.

The President takes the various agency budget requests and consolidates it with other goals of the Administration, and then submits a full proposed budget to Congress. This process continues for several months and involves various Congressional hearings, markups, and conferences.

The outcome for DoD purposes is enactment of the annual NDAA whereby the funding of the overall DoD budget is authorized. Then, through further Acts of Congress, various appropriations bills are enacted based on the NDAA, separate appropriations bills or omnibus spending requests whereby funds are appropriated. [MOU4] 

Implications and Recommendations for Government Contractors

As inflation and contract performance costs began to soar in 2020, contractors had little guidance or support from the DoD regarding development of a realistic solution to address the resulting cost impacts and challenges faced during execution of their contracts. 

The recent NDAA legislation is an encouraging sign for contractors that are facing increased contract performance costs and/or performance and delivery challenges. Although any granted relief is subject to a contracting officer’s discretion, this legislation provides a rather significant departure and change in direction from the DoD’s initial guidance and position on this matter pursuant to its May 25, 2022 memorandum “Guidance on Inflation and Economic Price Adjustments”. 

The NDAAs seek to protect the DoD’s timely and reliable access to the Defense Industrial Base through creation of statutory authorities providing a means for contractors to seek reimbursement from the government while performing federal government contracts during extraordinary times. Hopefully, DoD issues practical guidance in the near term regarding its procedures to review and process contractor requests for increased costs “solely due to inflation”.

It is important that contractors understand these developments and the Government’s current appetite regarding authorizing price adjustments under fixed-price contracts.

In the meantime, and as the DoD’s reaction to the current inflationary environment is procedurally undefined and an evolving matter, contractors facing economic challenges and contract losses under their DoD contracts are encouraged to: i) timely and periodically communicate with their customer, ii) maintain thorough and adequate records and supporting documentation related to anticipated versus actual costs, and iii) proactively seek and document attempts to mitigate adverse inflationary impacts to the maximum extent practicable.  

[1] Associated General Contractors of America. (2022, December). AGC construction inflation alert. 2022 Construction Inflation Alert. https://www.agc.org/learn/construction-data/agc-construction-inflation-alert

[2] Senate and House of Representatives of the United States of America in Congress, James M. Inhofe National Defense Authorization Act for Fiscal Year 2023 1–1722 (2022). Washington, DC; 117th Congress.

[3] Senate and House of Representatives of the United States of America in Congress, James M. Inhofe National Defense Authorization Act for Fiscal Year 2024 1–973 (2023). Washington, DC; 118th Congress

[4] Ibid, 3.

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Whitepaper: The Audit World's Biggest Myths
Download Now
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