Following on the heels of the coronavirus pandemic, high inflation now presents itself as the latest major challenge for government contractors. Inflation is on the rise, reaching levels that have not been seen in more than 40 years. While the causes of this dramatic increase in costs are myriad, they have had an impact on both individuals as well as businesses. And, whatever the causes, it is expected that inflationary pressures will continue for the foreseeable future. These pressures have caught the attention of the U.S. government, and most recently the Department of Defense (DoD), which issued Guidance on Inflation and Economic Price Adjustments (the Guidance) on May 25, 2022.
The Guidance notes that “[t]he 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.” At 1. Recognizing that inflation may have an impact on DoD contracts, the Guidance addresses two main issues: (1) the instances where “it is appropriate to recognize cost increases due to inflation under existing contracts” and (2) the “considerations” that contracting officers (COs) must address in new contracts. Id.
Regarding existing contracts, the Guidance explains that “the treatment of cost increases as a result of economic conditions is dependent on contract type.” Id. For cost reimbursement, fixed-price incentive (FPIF), and fixed-price with economic price adjustment (FPEPA) contracts, increases in contractor costs are already addressed in the contract. For cost-reimbursement contracts, “the Government may increase the contract funding to allow for continued contract performance,” and the contractor is not required to continue performance beyond what it can accomplish under the funded amount. Id. FPIF contracts recognize allowable and allocable costs up to the contract ceiling—if the actual cost is different from the target cost, “the target profit will be adjusted by application of the contract share ratio to the costs over or under the target cost.” Id. FPEPA contracts already include an economic price adjustment (EPA) clause, which will “mitigate specifically covered cost risks to both parties.” Id. In short, these types of contracts have built-in mechanisms that can address the impacts of inflation on a contractor’s costs. Contractors with existing contracts of these types who are experiencing inflation-related cost increases should review those contracts to ensure that they are realizing any potential offsetting cost mitigation the contract may provide.
Contractors with existing firm-fixed-price (FFP) contracts may have a more difficult time offsetting increased costs. The Guidance notes that “[i]n the absence of an applicable contract clause, such as an EPA clause authorizing a contract price adjustment as a result of inflation, there is no authority for providing contractual relief for unanticipated inflation under an FFP contract.” Id. at 2. The Guidance specifically mentions recent inquiries about the use of requests for equitable adjustment (REAs) “under FFP contracts to address unanticipated inflation.” Id. However, it makes clear that COs should not accommodate REAs, because they are instead for “a contracting officer-directed change.” Id. Despite the Guidance’s statements regarding FFP contracts, contractors with existing FFP contracts experiencing significant inflation-related costs increases should still communicate their concerns to their CO. There could be individual situations that present a stronger case than others, and it is conceivable that some contractors may be able to obtain relief on a case-by-case basis.
For prospective contracts, the Guidance states that “an EPA clause may be an appropriate tool to equitably balance the risk of inflation between the Government and contractor.” Id. The Guidance goes on to explain a number of considerations for COs to consider, both whether to include an EPA in a contract and how to craft an effective EPA.
The applicability or appropriateness of an EPA clause depends primarily on contract duration and whether certain costs are “likely to be impacted by economic fluctuations and should exclude costs that are not likely to be impacted by inflation” over that time period. Id. In other words, according to the Guidance, an EPA is appropriate only for particular costs that are particularly sensitive to larger “economic fluctuations” that occur “beyond one year after performance begins.” Id.
This means that contractors are best advised to carefully examine their costs and determine what costs are being affected—or at most risk of being affected—by inflation and other economic fluctuations over the relevant time period. The Guidance encourages COs to fashion an EPA against certain indexes and that those “clauses allow for contract price adjustments based on pre-established formulas rather than simply reopening price negotiations.” At 3. The recommended indexes are from DFARS Procedures, Guidance, and Information (PGI) 216.203-4 and include the Bureau of Labor Statistics 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.
Contractors who educate themselves on their industry and plan for inflation according to those indexes will be better situated to negotiate an effective EPA clause, because “EPA clauses will not be one-sided, but will be fair to both parties.” Id. The Guidance states that an equitable clause will allow for “both upward and downward revision of the stated contract price,” “use the same index to establish the negotiated price and to adjust the negotiated price under the terms of the clause,” and, if necessary, “incorporate a ceiling and a floor on adjustments.” Id. Knowledge of the indices is crucial not only to pricing a contractor’s base price, but also to negotiating the triggers and limits of any price adjustment to the EPA. This is especially true when bidding on FFP contracts because “[i]ncluding an EPA clause may enable a contractor to accept a fixed-price contract without having to develop pricing based on worst case projections to cover the cost risk attributable to unstable market conditions.” At 2. Contractors can price according to the market now and gain additional security for future price fluctuations through an EPA.
Contractors that identify cost risks associated with inflation and believe that an EPA would benefit them should take a number of steps when seeking a new contract with DoD. The first step, as noted above, is to understand their industry and the relevant indexes to accurately price their offers. Contractors should also carefully review all solicitations (and their existing contracts) for any appropriate terms and language allowing for reimbursements and/or price adjustments due to inflation. If no such language is included, it may be wise to ask for the inclusion of such terms. Finally, EPAs will need to be negotiated up front. Unless otherwise instructed in the solicitation, contractors should include their proposed EPA triggers, allowances, and ceiling/floor in their price proposal. As noted above, these figures should be based on the indexes that informed the contractor’s price proposal.
EPAs allow contractors to mitigate some of the risks associated with the economic headwinds that businesses will encounter for the foreseeable future. By understanding the how and why of an EPA clause, contractors can better position themselves to endure, and even prosper, in the face of those headwinds.