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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
Footnotes
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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