Pentagon Releases Inflation Guidance to Industry

By Scott Freling, Paul Rowley and Evan R. Sherwood

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In response to industry-wide questions about price adjustments for inflation, the Defense Department released guidance May 25 about when and how contracting officers may provide financial relief to defense contractors working on fixed-price contracts.

The department’s guidance recognizes that “inflation is impacting several segments of our economy” and has caused increased performance costs for many contractors. Those increases have eroded the profit margin of contractors working under fixed-price contracts, which are generally not subject to any price adjustment based on increased performance costs.

As an exception to that general rule, contracting officers may make an equitable adjustment to a fixed-price contract in cases covered by the standard “Changes” clause under Federal Acquisition Regulation 52.243-1, or similar adjustment clauses. The Defense Department explains that it has been “fielding questions about the possibility of using requests for equitable adjustment” under the standard Changes clause to help contractors “address unanticipated inflation.”

Unfortunately for fixed-price contractors, the department has adopted a narrow view of when to grant an inflation-related adjustment. The guidance states that “since cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change, [contracting officers] should not agree to contractor [requests for equitable adjustment] submitted in response to changed economic conditions.” In other words, this guidance discourages contracting officers from granting equitable adjustments based purely on inflation.

That said, the guidance leaves open the possibility of inflation-related claims when a contracting officer has directed changes. That could include situations where a contracting officer directs a different method of performance because of changed economic conditions — for example, directions to use a component other than the one specified or to meet a different schedule of performance. Indeed, contractors experiencing increased costs should think broadly about potential changes caused by the contracting officer, which could open the door to adjustments.

The department’s guidance offers a modest solution for contractors performing under certain fixed-price agreements. It encourages contracting officers to provide relief under “economic price adjustment” clauses, often referred to as EPAs.

The FAR provides a list of standard clauses, allowing for economic price adjustments — an increase or decrease in contract price — upon the occurrence of a specified trigger event. Generally, price adjustments are based on changes in agreed-upon or otherwise established catalog or market prices of specific items; actual costs of labor or material that the contractor experiences during performance; or contractually specified cost indexes of labor or material relevant to the contractor’s performance.

Economic price adjustment clauses can thus account for unexpected cost increases due to inflation and can allow contractors to seek an adjustment. However, most existing fixed-price contracts do not include price adjustment clauses, rendering this potential remedy unavailable to contractors in many cases. In addition, adjustment clauses are not a silver bullet for contractors, because they normally cap price adjustments at a pre-set amount.

The department’s guidance recommends that contracting officers consider including tailored price adjustment clauses in new solicitations based on an economic index, such as the Bureau of Labor Statistics Producer Price Index series.

The guidance provides four key suggestions for contracting officers to consider when drafting economic price adjustment clauses in new solicitations and contracts: allow both upward and downward price adjustments; incorporate ceilings and floors on adjustments of a similar magnitude; use carefully selected indices that are broadly exposed to the market, but narrow enough as to be relevant to contract performance; and clearly describe the events that trigger a price adjustment, and the mechanism through which such price adjustment will be calculated.

The Pentagon’s willingness to use price adjustment clauses in future contracts to address the current inflationary period should be a welcome development for the defense contracting community. At the same time, industry should understand that adjustment clauses come with special regulatory burdens, and defense contractors should be prepared to account for those burdens before accepting a clause. There are three key issues to consider.

First, clauses allow for a price adjustment only when specified conditions are met — for example, the market price of a specified widget increases. Therefore, clauses must be drafted to provide clear and unambiguous conditions for when the government must grant an adjustment. If a solicitation contains a confusing or vague clause, defense contractors should consider raising the issue with the contracting officer and may even want to consider whether a pre-award protest is appropriate.

Second, clauses often require contractors to disclose financial or sales information to the government. This sharing of otherwise nonpublic information can present unique challenges, particularly for contractors that have not previously dealt with cost or pricing disclosure rules.

Third, economic price adjustment clauses cut both ways. A contractor may be able to claim an upward adjustment if costs increase, but the government normally has a right to claim a downward adjustment if costs decrease during contract performance.

Scott A. Freling is a partner and Paul Rowley and Evan R. Sherwood are associates in the government contracts practice group at Covington and Burling LLP.

Topics: Defense Department

Comments (1)

Re: Pentagon Releases Inflation Guidance to Industry

Backlog repricing

Paul Fraipont at 12:47 PM
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