Managing Inflation in Government Contracts
With inflation surging to the highest level in over 40 years, there is heightened focus on how to equitably balance risk between the government and the contractor. This is particularly a concern when it comes to fixed-price contracts, where contractors generally bear the risk of cost increases, including inflation.
Unless the contract states otherwise, there is no mechanism to compensate a contractor for unanticipated inflation under a firm fixed-price (FFP) contract. A contractor can seek a Request for Equitable Adjustment (REA) under certain circumstances, but, for changed economic conditions – such as inflation – the government is not obliged to approve the contractor’s REA. A contractor can also ask to have its contract terminated for convenience, as at least one contractor has done, but then the contractor will not earn the profit that was anticipated when the contract was executed.
When pricing its proposal in response to a FFP Request for Proposal, a contractor attempts to anticipate and account for inflation. If the contract in question has multi-year performance, this amounts to little more than macro-economic fortune-telling by the contractor. If the contractor significantly overestimates inflation, its offer will likely be significantly higher than its competitors’, and thus will likely fail. But if the contractor underestimates inflation, it may end up “under water” – performing the contract at a significant loss.
There is a better way. The FAR’s Economic Price Adjustment (EPA) clause provides for modification of the stated contract price in the event of certain price fluctuations. Adjustments are based on established prices, actual costs of labor or material, or cost indexes of labor or material. However, the clause itself, and similar clauses that appear in agencies’ FAR supplements, are vague and rarely used.
On May 25, 2022, DoD issued a memo that, along with the DFARS, and related guidance, outlines some considerations when deciding whether or not and how to incorporate the EPA clause in new contracts:
- The EPA clause should not be one-sided – the contract should allow for both upward and downward revisions of the stated contract price.
- Any adjustments or revisions should be based on pre-negotiated formulas that exclude the prime contractor’s fixed-price subcontract costs.
- The EPA clause should not be used to modify existing contracts.
- Contract length must be a primary consideration when deciding whether to use an EPA clause. For example, EPA clauses based on established prices or on the actual cost of labor and material should only be used when delivery or performance will not be completed within six months after contract award.
- Contracting Officers should limit the scope of the EPA clause to costs that are most likely to be impacted by economic fluctuations.
- For adjustments based on indexes of labor or material, Contracting Officers should select an independent, recognized index (or indexes) closely related to the cost components judged to be most unstable. Potential indexes include the Bureau of Labor Statistics (BLS) Producer Price Index series; the Employment Cost Index for wages and salaries, benefits, and compensation costs for aerospace industries; and the North American Industry Classification System (NAICS) Product Codes.
- Contracting Officers should seek help from other expert resources in DoD, including their legal counsel, when considering whether to use EPA clauses, and should account for the contingent liabilities presented by EPA clauses as prescribed by DoD financial regulations.
The DoD memo also notes that, even if the contract does not formally include an EPA clause, any language addressing potential contract cost or price changes due to inflation is still effectively an EPA clause. As such, contractors should not only give careful consideration to asking the Contracting Officer to include an EPA clause in an RFP, but should be on the lookout for similar language in existing contracts.
Ward & Berry will continue to monitor these developments. If you have any questions, please do not hesitate to contact us.