Inflation continues to have a significant impact on organizations across all industries. For government contractors with fixed price and time and material contracts, it can be especially challenging to manage cost and deliverables while maintaining positive margins. Contractors performing on fixed-price type contracts are the most impacted, as costs are increasing at rates that are significantly higher than anticipated when the work was priced. This has forced contractors to become leaner, increase efficiencies, and update labor and material cost escalation estimation methods more frequently when proposing on new contracts.
At MorganFranklin, our Government Contracts Advisory Services (GCAS) team supports clients in analyzing and updating pricing strategies to respond to the current high inflation and supply chain delays environment. Contracts that span several years have an increased likelihood of inflation impacting profitability of the overall contract. Below are some of our recommended strategies and tools for combating the effects of inflation on current contracts and accounting for inflation when proposing on new work.
Potential impacts include:
Potential impacts include:
- Contract Costs: Rising prices of labor (including recruiting cost), materials, and other cost inputs can make it more expensive to fulfill contract obligations. Contractors may need to pay higher wages to attract and retain skilled workers, and the cost of raw materials or subcontracted services may also increase. This can put pressure on profit margins and potentially impact the contractor’s ability to meet contract requirements within the original budget.
- Profitability: Contractors usually factor in inflation expectations when developing their pricing strategies, but if the actual inflation rate surpasses those expectations, it can negatively affect profit margins. This can be especially challenging for long-term contracts where the impact of inflation can accumulate over time.
- Cash Flow: As costs increase due to inflation, contractors may need to allocate more funds to cover expenses. The timing of payments from the customer may not align with increased costs, leading to cash flow challenges. If payments are delayed or if contractors are not adequately reimbursed for increased costs (e.g., in fixed price contracts where payments remain the same across the contract period of performance), organizations may face liquidity issues affecting their ability to meet financial obligations and invest in ongoing operations.
- Competition: Higher inflation rates may deter some contractors from bidding on projects or discourage new entrants, particularly if they anticipate difficulties in managing costs and maintaining profitability. This could lead to reduced competition and potentially limit the options for securing the most competitive and innovative solutions.
Key Consideration #1: Utilize the Inflation Index
Performing an analysis of the cost of raw materials, labor, and supplies over the span of a few years (typically three to five) is essential to understand the increase in cost of goods sold due to inflation. Contracts should additionally review published inflationary indices that most closely align with the type of goods being acquired. Contractors should ensure the index selected is not only relevant to the type of good purchase but also current.
If an escalation index is included in a government contract, it typically specifies a formula or methodology for adjusting the contract price based on changes in specific cost factors. The most common escalation indexes used in government contracts include the Consumer Price Index (CPI), Producer Price Index (PPI), or other relevant industry-specific indexes.
When performing these analyses, it is important to take the following into consideration:
- Historical Inflation Rates and trends to understand the potential magnitude of future inflation.
- Market Conditions including supply and demand dynamics to anticipate potential cost increases.
- Labor Costs including wages, benefits, and union agreements to anticipate the potential impact of labor cost inflation.
- Material Costs including commodities, raw materials, and energy prices to anticipate and understand the volatility of material costs.
- Regulatory Changes including environmental regulation to anticipate how these may impact sourcing decisions and cost of labor and goods.
How can this risk be mitigated?
Once a full analysis of market conditions, inflationary rates and other factors is performed, and contractors are ready to negotiate a contract, the following should be considered to adequately incorporate protection against inflation impacts when submitting your bid:
- Escalation Clauses: Propose to include clauses that allow for adjustments in contract prices based on changes in inﬂation or speciﬁc cost indices.
- Market-Based Pricing: Factor in projected inﬂation rates and market conditions when determining single and multi-year pricing structures.
- Contingency Reserves: Allocate contingency reserves (a hedge amount that might be set aside to protect the contractor) within the bid to account for potential cost increases due to inﬂation.
- Clear Assumptions: Clearly communicate the inﬂation assumptions made in the proposal to ensure transparency with the customer.
- Price Adjustment Clauses: Incorporate price adjustment clauses that allow for contract modiﬁcations in response to inﬂationary changes.
- Contract Negotiations: During contract negotiations, discuss the potential impact of inﬂation and seek appropriate contractual protections.
- Engage Economists or Financial Experts: Use subject matter experts to assess inﬂation risks and provide guidance on appropriate inﬂation
adjustments. Leverage their expertise to analyze economic indicators, forecast inﬂation, and recommend suitable mitigation strategies.
Key Consideration #2: Manage Impact of Inflation on Current Work
Many ﬁxed price type contracts include an Economic Price Adjustment (EPA) clause. The purpose of economic price adjustment is to provide a fair and equitable mechanism for both the contractor and the government to share the risks associated with changes in economic conditions. By including an EPA clause in the contract, the parties can address the potential impact of inﬂation, ﬂuctuations in commodity prices, or other economic variables that could aﬀect the cost of contract performance. In instances of high inﬂation, the contractor can rely on this clause to renegotiate ﬁxed fees on the contract because of unexpectedly high inﬂation.
Contractors can also consider the use of a price redetermination. A price redetermination is a mechanism that allows for adjustments to the contract price based on certain predetermined factors. The clause is typically included in long-term contracts where the costs of the goods or services being provided is expected to ﬂuctuate over time. The purpose of price redetermination is to provide a fair and equitable way to account for changes in labor rates, material costs, or other relevant factors that may aﬀect the overall cost of performance during the contract period. It ensures that the contractor is adequately compensated for any increased costs incurred and prevents them from bearing the entire burden of cost ﬂuctuations.
In the event an EPA or price redetermination clause is not included in a contract, a request for equitable adjustment (REA) may be made to the government. A REA is a formal process used in federal government contracts to seek compensation for additional costs or time extensions resulting from changes made by the government that impact the contractor’s performance or obligations under the contract. The REA allows the contractor to request an adjustment to the contract terms to maintain fairness and balance in the contractual relationship. A REA is typically submitted when the contractor encounters changes that were beyond their control and were directed by the government. These changes can include modiﬁcations in the scope of work, design revisions, delays, or other unforeseen events that impact the cost or schedule of the project. Please note that this typically does not include inflation adjustments and it is not really intended to cover inﬂation increases but might be considered and proposed if all other options have been exhausted.
It is critical to proactively design and implement sound controls to adequately monitor and manage direct and indirect cost, even more so during inﬂationary periods, recessions, or during supply chain shortages. As such, contractors should routinely:
- Review Incurred Cost for Allowability:
- Implement an adequate process for reviewing costs based on nature, when incurred, for allowability and reasonability.
- Implement controls for reviewing the general ledger and/or supporting schedules to ensure costs recorded to expense accounts are properly classiﬁed.
- Review Direct Costs and Indirect Rates for Optimization of Cost Recoverability:
- Implement reviews (at least annually) of cost classiﬁcation practices to ensure the following:
- Costs directly related to contracts and incurred solely for the purpose of a speciﬁc contract are classiﬁed as direct costs (this optimizes cost recovery).
- The indirect rate structure allocates indirect costs to intermediate and ﬁnal cost objectives proportionately to how they are beneﬁted by the indirect costs.
- Costs overruns (e.g., indirect costs in excess of provisional billing rates) are limited and suﬃcient action is taken to obtain approval to bill (i.e., recover) these costs.
- Monitor Indirect Rates:
- Implement a regular (at least quarterly review) of actual indirect cost rates compared to provisional billing rates and the annual budget.
- Deﬁne a threshold for what a “signiﬁcant” variance is which would require investigation.
- Ensure signiﬁcant variances are addressed for each period the review is performed.
- Determine action plans to remediate for signiﬁcant variances, as necessary.
Key Consideration #3: Negotiate for the Most Advantageous Contract Type
In the current environment of unpredictable inﬂation, contractors can adjust contract solicitation and contract negotiation practices to guard against negative impacts of future inﬂation. A few methods include:
- Use favorable escalation factors and indices in proposals. Escalation rates involve many factors including inﬂation itself, market shifts, changes in the supplies of unique materials, contractors’ and the government’s costs of doing business, government purchasing strategies, economies or diseconomies of scale, changes in the mix of the workforce and other inputs to production, rate eﬀects, technological change, and learning-by-doing; therefore, a detailed analysis of escalation factors and indices is essential to accurate pricing and the estimation of future cost ensuring old escalation factors are not used on multi-year contracts and are re-evaluated based on current market rates versus the standard of 3%.
- Negotiate with the Contracting Oﬃcer to use Fixed Price type contracts with EPAs.
- Establish sound estimating practices that will produce fair and reasonable cost or price on government contracts that is supportable and defensible but also achievable.
The key strategies addressed in this article can support contractors in mitigating risks associated with unexpected inﬂation while staying competitive and proﬁtable. Contractors should continue to perform detailed market analysis to stay abreast of new conditions and updates to inﬂation indices, as well as actively manage contracts and work with customers to employ mechanisms like REAs an EPAs, as necessary, to adjust for signiﬁcant changes in market conditions.
MorganFranklin Consulting Government Contracting Advisory Services
We work with our clients to provide guidance to successfully contract with the Federal Government. We provide comprehensive and customized solutions including identification of the government contract risk proﬁle, audit readiness assessments and ongoing audit support, DFARS business system compliance reviews, and implementation of system transformation compliance controls to help businesses eﬃciently and eﬀectively execute government contracts. To learn more about MorganFranklin’s Government Contracting Advisory Services, contact one of our experts.
Managing Director, Government Contract Advisory Services
JOSE J. SOTO
Director, Government Contract Advisory Services
Manager, Government Contract Advisory Services