Government Contractor Inflation Risk: What Have You Considered and Are You Prepared?

The recent memo from the Defense Pricing Center (DPC) has created quite the stir around the current economic uncertainties in the government contractor community tied to inflation. The unfortunate reality is that for many years, economically speaking, the risk of inflation has been a steady 2-3% and so both contractors and the acquisition professionals on the other side have not had to realistically consider this factor in pricing/negotiating contracts. History has shown us that the threat is all too real and can cause significant hurdles for contractors to weather an inflationary period like we saw in the 80s, early nineties and as recently as 2009. The question of is it transitory or are we headed toward a recession is best left to our friend the magic 8-ball, but I do think there are a few things that all contractors should be aware of during this time.

• Price-to-win at all costs is always dangerous, but in these times relying on absorption strategies (i.e., bidding work at near or below break-even because of the overall base increase the award will provide, which will lead to increased profitability on other contracts) for growth/profitability is especially risky. If/when inflation continues, any gains from an absorption pricing strategy can easily be outpaced by inflationary pressures related to labor and other costs. We do feel that we are starting to see a supply chain catch up, so relying on increasing direct material costs to further the absorption strategy may be risky as well.
• The DPC memo made it clear that REAs should not be used to address issues caused by inflation, however, contractors should be especially vigilant for any constructive/deductive changes to contracts, as well as delays during this time. Even relatively minor change order worthy events offer opportunities to “catch-up.” Contractors should be educating their PMs and even field employees to be vigilant for requested changes to ensure all change order opportunities are addressed timely. Many program offices have become accustomed to the contractor handling minor changes with no request for consideration. This is no longer the case and contractors impacted by inflation should be seeking a request for equitable adjustment (REA) in every situation afforded by the contract.
• The DPC memo further indicated that the use of Economic Price Adjustment clauses were the preferred means of addressing inflationary pressures and that their use should be tied to appropriate indices. The problem is, outside of manufacturing/materials and SCA-based contracts, the use of EPA clauses is a rarity. If you are lucky enough to have one of the four clauses in your contract, then you should absolutely be exercising your contractual rights to an economic price adjustment. The clauses you should be looking for are:
  52. FAR 52.216-2 Economic Price Adjustment – Standard Supplies
  53. FAR 52.216-3 Economic Price Adjustment – Semistandard Supplies
  54. FAR 52.216-4 Economic Price Adjustment – Labor & Material
  55. Potentially FAR 52.216-5 Price Redetermination – Prospective and FAR 52.216-6 Price Redetermination – Retroactive, though these would be situation dependent.
• Even the EPA clauses are not a silver bullet. Despite the DPC memo stating,

“Appropriate EPA clauses will not be one-sided, but will be fair to both parties. For example, an equitable EPA clause will: 1) allow for both upward and downward revision of the stated contract price upon the occurrence of specified contingencies; 2) use the same index to establish the negotiated price and to adjust the negotiated price under the terms of the clause; and 3) incorporate a ceiling and a floor on adjustments that are of the same magnitude (if a ceiling and floor are included).[emphasis added]”

All of the EPA clauses referenced above have common language limiting the increase, but potentially providing an unlimited decrease in contract price. For example, FAR 52.216-4(c)(4) states, “The aggregate of the increases in any contract unit price made under this clause shall not exceed 10% of the original unit price. There is no percentage limitation on the amount of decreases that may be made under this clause.” The fact that this language directly contradicts the direction provided by DPC is concerning and would require modification of the clause in order to align with DPC guidance. Further, given inflation is hovering near 9%, a single EPA adjustment could exhaust the aggregate 10%. If you do have EPA clauses, now is the time to open a dialogue with your contracting officer on any ceilings and the impact to your business.

We also see downward adjustments for service contractors being a potential significant future problem. For services contractors their current employee’s salaries do not simply go down when inflation drops. Maintaining the technically skilled workforce to support a government program is not built into most potential labor indices, so take caution and understand what any downward adjustments could cause downstream when we encounter potential for over employment as the Fed continues to tighten interest rates.

• If you have a GSA contract there is some good news. GSA issued a Memorandum addressing the impact of inflation on Federal Supply Schedule (FSS) contracts with certain EPA clauses. GSA pointed out that contractors are requesting contract modifications to increase pricing or they are removing items from FSS contracts to avoid selling at a loss. The GSA stated they were providing greater flexibility to support contractors by:
  1. Lowering the approval for price increases from the contracting director to one level above the contracting officer,
  2. Relaxing time limitations on EPA increases,
  3. Relaxing the number of EPA increases that can be requested, and
  4. Not enforcing a limitation when a contractor removes a Schedule contract item and adds it back at a higher price.

It is critical that as a contractor community we continually push back on unreasonable government expectations concerning pricing. The unfortunate reality is in a competitive environment if the contractors continue to focus on a race to the bottom with pricing, we will continue to see ongoing decreases in profitability and ultimately harm to the Defense Industrial Base. The days of assured contract profitability because of a stable economic climate may be over and contractors who want to weather this storm need to prepare and focus on developing realistic prices to perform, not just win.

As recently as this March in single-source negotiations, we saw that the government was continuing with the belief that inflation simply did not exist. Even realistic proposed inflationary projections that assumed a 2–3-year increased inflation followed by a reduction, which is consistent with historical inflationary periods, were met with complete disdain by the negotiators on the government side. The DPC memo is positive, however there is far more to the story to tell, and this single advisory memo does little to help contractors hurting right now. The small business contractor community was already impacted by COVID-19 and saw next to no relief due to the treatment of PPP loan forgiveness. If the small business community is expected to endure the highest levels of inflation seen in 50-years with little to no consideration from their government customers it will mean real impacts to our industry. GSA has quickly established some flexibility with regards to lifting limitations in EPA clauses on Federal Supply Contracts. It is my hope that there is more to this story to be told by DPC and that will include positive solutions for our DIB, and in particular the small businesses who are often the least equipped to deal with these types of economic uncertainties.