DoD Offers Guidance to Contractors on Inflation and Economic Price Adjustment Clauses | Vide Rome LLP
On May 25, 2022, the Department of Defense (“DoD”) issued a memorandum acknowledging that contractors are not immune to the “period of abnormally high inflation”. The memorandum, titled “Guidance on Inflation and Economic Price Adjustments,” provides guidelines on when relief from cost increases due to inflation is appropriate and provides considerations for the appropriate use of economic price adjustment (“EPA”) clauses when entering into new contracts.
For existing DoD contracts, whether contractors are eligible for inflation relief depends on the type of contract.
- Cost reimbursement contracts: Because the government bears the risk of increased costs under cost reimbursement contracts, the government must bear the risk of cost inflation and, upon notice, the government may increase contract funding to allow for a continued performance. Also, the contractor has no obligation to continue execution once it runs out of funding.
- Fixed price incentive contracts: The DoD indicates that the contractor’s actual costs are accrued up to the contract ceiling and to the extent that the actual cost differs from the target cost, the target profit will be adjusted by applying the contract’s share ratio to the above costs or below target cost.
- Fixed price contracts with economic price adjustment: The EPA clause provides a mechanism to mitigate the costs covered for both parties beyond the control of the contractor. For this type of contract, the State will bear the cost risk up to the limit specified in the APE clause.
After explaining the three situations in which DoD contractors may be able to recoup costs from inflation, DoD states that “Contractors performing Firm Fixed Price (FFP) contracts must generally bear the risk of increased costs, including those due to inflation”. This is not a surprising take from the DoD. However, contractors with existing FFP contracts may be able to claim increased costs due to any changes or delays imposed by the government under, among other clauses, the variations clause, the delay clause of the government or the stop work clause.
For new contracts being developed or negotiated, the DoD states that the inclusion of an EPA clause may be an appropriate way to fairly balance the risks between the government and the contractor. Rather than limiting the inclusion of EPA clauses to cost-type contracts, the DoD says including an EPA clause in a fixed-price contract can help balance inflation risks, encouraging contractors to accept fixed-price agreements without taking into account worst-case projections of unstable market conditions into proposals. The DoD noted four additional guidelines for using EPA clauses in contracts.
- Firstthe indices of all EPA clauses should follow “the cost elements considered to be the most unstable”, since industries do not feel the effects of inflation in the same way.
- SecondEPAs should not affect the benefit of the contract.
- Thirdthe DoD should not use EPA clauses in short-term contracts of one year or less.
- Fourth, the EPA clauses “will not be unilateral, but will be fair to both parties. . . [and will] allow for upward and downward revision of the contract price with a specified ceiling and floor of the same magnitude.
The DoD says these guidelines are important to ensure that contract price adjustments are based on “pre-determined formulas rather than simply reopening price negotiations.”
So while contractors with existing firm fixed price contracts probably cannot be relieved of cost increases due to inflation alone, contractors in the process of negotiating their contracts should push for the inclusion of a clause APE to balance inflation risks during execution.