Government Contractors: Help! Inflation's Killing Us--Government: We're Here to Help (or not)

My esteemed colleague has been sounding the alarms about inflation in this blog since December and to me personally for many months before that. Well, he’s been right for quite some time - inflation is definitely here—likely for a while. The Department of Labor announced last Friday that the inflation rate for the 12 months ending in May 2022 was 8.6 percent. And the Fed has just announced its steepest interest rate increase in 28 years in an effort to tame the inflationary beast.

It doesn’t take a PhD in economics to recognize that the largest increases are occurring in the energy sector seeing a 50% inflation rate for all energy commodities combined (i.e., gasoline, fuel oil, piped gas, and electricity). Between labor shortages and increasing wages and the overall increase in the cost of doing business, many contractors no doubt are looking at some lean times for the immediate future.

John Tenaglia, the Principal Director for Defense Pricing and Contracting of the Department of Defense (“DoD”) issued a memorandum just before Memorial Day regarding “Guidance on Inflation and Economic Price Adjustments.” In the opening paragraph the memo states it is intended to “provide[] guidance to assist [contracting officers (“COs”)] to understand whether it is appropriate to recognize cost increases due to inflation under existing contracts as well as offer considerations for the proper use of [economic price adjustment (“EPA”) clauses] when entering into new contracts.”

At first, I thought this might be good news for federal contractors that are struggling to remain profitable to the extent that they have extended fixed price contracts. Many federal contracts have a five year period of performance if all of the one-year options are exercised during the life span of the contract. Contracts that were awarded in 2019 and perhaps even 2020 likely were priced on the assumption that inflation wouldn’t run away like it has so far this year. Hence, cost escalations proposed for the option periods likely were held low to ensure the competitiveness of the proposal. Under current circumstances, that’s a great deal for the Government.

So, I continued reading. The memo described how contractors that hold cost reimbursement contracts will be insulated from inflation (of course at the expense of the Government). Yep, I know that. It then went on to discuss other types of contracts (e.g., fixed price incentive contracts and fixed price contracts with economic price adjustments) and how inflationary pressures might be addressed under them. These types of contracts spread the risk of inflation between the contractor and the Government to a greater or lesser extent depending on the particulars of the contract and the clauses. I know that too.

Then, smack, at the top of the second page, we are reminded that “contractors performing under firm-fixed-price (FFP) contracts generally must bear the risk of cost increases, including inflation.” OK, that’s right but might there be any options for giving some relief? The memo takes a very hard line approach as to whether a contract’s changes clause could support an equitable adjustment to account for inflation. In a word, nope. Expressed more fully, the Director states that “[s]ince cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change [to the work or contract], COs should not agree to contractor REAs submitted in response to changed economic conditions.” Oh well.

The Director, however, does hold out a glimmer of hope for the future when he states that COs can consider adopting EPA clauses for fixed price contracts going forward in appropriate cases (which I won’t go into here). That’s cold comfort for contractors - especially the 45,000 or so small businesses that perform nearly 25% of DoD’s prime contracts in terms of contract dollars. They will have to live with the here-and-now of their current contract portfolio with only minimal cash reserves or lines of credit to sustain them before they receive more profitable awards.

Some agencies have provided relief to account for increased costs. For example, the Department of Veterans’ Affairs provided ceiling price relief to vendors that provide healthcare staffing services on the Federal Supply Schedule. We also have heard about COs who have granted upward adjustments to account for increased costs attributable to COVID compliance. We have assisted clients in crafting proposals for such increases.

But this memo hits hard because it instructs COs to take a hard line. Nevertheless, we urge contractors to examine whether there have been (or could be) changes in the nature of performance that could be leveraged to support an equitable adjustment to account for increased costs.

I offer one last piece of doom and gloom. Many service contractors seek price adjustments to account for the increased costs of complying with DOL Wage Determinations under the Service Contract Act. Such adjustments are based on FAR clause 52.222-43. Under this clause, a fixed-price contractor can request an upward adjustment for the “actual” increased cost of paying SCA-compliant prevailing wages. That’s all well and good if your business can hold the line on wages to the minimums set forth in a WD. Your price adjustment would be tied to the increased hourly rate between the old WD and the new WD. But we are seeing more and more contractors who are having to pay higher wages than what’s required by a WD in order to attract and retain workers. That can render the price adjustment clause to nearly be a dead letter if there is no actual increase due to a change in prevailing wages under the WD.

I look forward to a return of low inflation. In the meantime, I hope the Government will consider options for providing some relief from inflation. After all, a five-year contract with little or no price escalations could bestow quite the windfall on the Government.