CHAPTER 9

Contract Modifications

Contract modifications (i.e., changes to existing contracts) also require attention from estimators and reviewers. There are several modification scenarios: (1) those arising from unilateral changes by the buyer, (2) those arising from changes identified by either party and bilaterally negotiated, and (3) those that the buyer does not acknowledge as an entitlement and where the seller believes the contract has been constructively changed by events caused by the seller. The last situation gives rise to a request for an equitable price adjustment, perhaps continuing into claim status if the buyer does not relent.

Pricing additional work under a modification is not much different from pricing the original work, except that, most commonly, the modified work has already been performed. This means that actual costs will be needed to support the proposed price adjustment. Deleted work creates many pricing issues. Deleted work is that work which is no longer necessary under the contract.

Often, a modification based on a constructive change involves a delay of work, which creates cost issues related to idled resources, unabsorbed overhead, and price escalation.

DIRECT-LABOR HOURS

When a modification is being priced before the work has occurred, the estimation process is similar to any price proposal. However, when the impacted work has already occurred, then the issue is identifying, after the fact, how many additional hours were required because of the modification. For federal contracts, the government is entitled to know what the actual hours were. In other situations, the actual hours are good evidence to make one’s case. But much of determining actual hours involves estimated actuals, because the direct-labor hours are often not segregated as the events occur. There are many reasons for this. One is that often a contractor is well into a modification situation before it is aware of this fact. Other reasons include a reluctance to request an equitable price adjustment or submit a modification to the customer and a lack of knowledge as to what constitutes a changed condition.

Causes of Increased and Decreased Direct-Labor Hours

Increases in direct-labor hours occur because a modification may involve additional work. To accomplish the additional work, the contractor may need to use larger crews, pay overtime, or acquire employees with different skills than formerly needed. Additional time might be required just to identify the modification circumstances, discuss issues with the customer, or address the issues with subcontractors. In addition, work may be deleted as part of a contract change so that direct-labor hours must be reduced. Significantly, hours tend to increase because of inefficiencies in the use of labor.

Cost Accounting for Direct Labor

Direct labor must be accounted for in a manner consistent with a company’s established practices and its Cost Accounting Standards (CAS) Board disclosure statement, if applicable. CAS 401 requires that the same labor categories used to price a modification be used in recording the costs of the modification. If labor categories used in pricing the modification are not consistent with the categories used to record the actual costs, a noncompliance with CAS will result. The disclosure statement is useful in establishing the baseline, because it represents the contractor’s established practice. CAS 402 requires that a labor category be either direct or indirect. In other words, if a labor category is normally indirect, a contractor may not be able to charge that category to direct on a specific modification. Under some circumstances, if the labor category is used under differing circumstances, treatment as both direct and indirect may be acceptable.

Supporting Documentation

Supporting documentation is critical. In a perfect world, time recording would provide a record of the extra hours caused by modification conditions. When possible, a contractor should set up separate accounts or subaccounts to collect hours related to the modification conditions. The contractor must make sure that its employees actually use these accounts. It is a problem if some employees follow the instructions and others do not. One should not assume that all employees will comply; a contractor should follow up with labor reviews to ensure these directives are being followed.

Timesheets alone are seldom sufficient to document the time related to a modification. This means that some estimating is required. Estimates should be based on employees’ knowledge of what they were working on when the modification events occurred. Employees may need to be interviewed or be provided a questionnaire to determine what portion of their time pertained to the modification. This is sometimes problematic, because memories are not perfect. Some employees may even exaggerate hours, believing this is best for the company. Others may not agree with a modification situation and underestimate hours caused by the alleged modification.

One safeguard in this circumstance is to compare employees’ recollections of time recordings to the payroll records. Some employees have recalled working on a modification for an entire month during the past year, only to find out that they were on vacation for two weeks during that month. It is sometimes a good idea to have a signed statement from the employee, for two reasons: (1) if the employee was inaccurate or dishonest, the company has a signed statement to rely on, not just the notes of the company officer conducting the interview; (2) if employees are subsequently dismissed, they might change their entire story in retaliation against the employer when later interviewed by a reviewer.

Employee memories of what was worked on can be supplemented by employee calendars, employee notes, engineer log books, emails, and similar documents. Also helpful are documents that are independent of the employee, such as travel records, visitor logs, meeting documentation, correspondence, program status reports, activity reports, and photographs in estimating time spent on a modification event. Program status reports may be counterproductive if program managers inaccurately report satisfactory progress with no complications when in fact an event giving rise to a modification has already occurred. The same is true of other contemporaneously prepared reports.

When pricing before the events, determining or evaluating an estimate for the total hours required to produce an item or provide services is a job for technical personnel such as industrial engineers, cost analysts, and estimators. These people should be able to examine the plans and specifications, the contract statement of work, the contract statement of objectives, the proposal, and any accompanying literature describing the item to be produced or services to be provided and estimate how many hours of engineering, manufacturing, and/or other direct labor should be needed to deliver the goods or services. A sound understanding of the direct labor involved in the modification is indispensable, and a reasonable price cannot be negotiated without such knowledge.

When an item (either a good or a service) is to be produced for the first time, technical personnel must rely on the drawings and the proposal. However, if the item has been produced previously, there is likely to be considerable information available on the labor hours required to produce the item in the past. Although government reviewers as a group tend to prefer historical data, care should be taken to ensure that that history is representative of what will happen in the future. Frequently, changes in production methods over time render historical data of limited value.

In some instances, it may be possible to compare the labor hours estimated on previous contracts with the hours actually experienced when the contracts were performed. If the actual hours have been consistently close to the estimates and the same estimating technique is still being employed, the new estimates may be viewed as reasonably accurate. On the other hand, there may be considerable discrepancies between the actual labor hours and the estimated hours. If this is so, then the estimates may not be considered as reliable. The reasons for the differences should be determined and analyzed. If the reasons for the differences are determined to be valid, the estimates can be viewed with greater confidence.

A common problem arising in government audits is that the reviewer compares the actual hours to the original budget hours. If the actual hours or dollars are less than the budgeted hours or dollars, the reviewer alleges no damages. However, if the actual hours or dollars are more than the budgeted hours or dollars, the reviewer properly does not accept that amount as the damage. But the difference between the budget and the actual cost for a function is not a measure of damages, because the difference includes efficiencies and inefficiencies and does not isolate the damages caused by the government’s actions. The extra hours for a modification must be supported by facts and estimates, not merely the difference between the original estimate and the actual labor.

For example, assume a contractor claimed an additional 50 hours of labor due to modification conditions. The reviewer requested the budgeted and actual hours for this activity. The budget was 600 hours and the actual hours were 550. The reviewer questioned all 50 hours of the modification on the basis that if the actual costs were less than the budget, how could the contractor have been damaged?

The answer was that the contractor had found efficiencies and would have been able to perform the activity for 500 hours rather than 600 hours before the modification. Thus, when the modification circumstances arose, the additional 50 hours brought the total actual hours to 550. Using the reviewer’s approach is a variation of the properly discredited total cost approach. The reviewer erred in not looking at the contractor’s development of the 50-hour amount.

The modification should not deny a contractor the benefit of efficiencies and should not allow a contractor to recover inefficiencies. The difference between the initial estimate or budget and the actual hours must be analyzed as in the examples in Exhibit 9-1.

EXHIBIT 9-1: Examples of Potential Claim Scenarios

In each of these scenarios, the difference between the budget and actual hours is different, but the modification amount should always be the same. These differences should be due to efficiencies and inefficiencies with a constant (i.e., supported by a cost estimate) amount for the modification conditions. No valid conclusion can be reached by merely comparing the budgeted hours to the actual hours.

Loss of Efficiency

It is a well-established principle of contract law that contractors are entitled to recover additional costs incurred as a result of a government-caused loss of efficiency or disruption in work. During a period of delay, a contractor generally incurs direct costs which do not result in productive work. This is particularly true in construction contracts, where there is frequently no other contract work to which resources can easily be transferred. A contractor is entitled to recover, in its modification for equitable adjustment, direct costs which could not be avoided through good management, even though it is generally not possible to calculate exactly the costs allocable to periods of delay.

Often a delay will not completely stop a contractor but will impede its performance and reduce the efficiency of its laborers. Efficiency of labor can be affected by such factors as interruption to the work sequence; lack of a steady flow of work, causing slow-down; increases in the quantity of corrective work caused by the assignment of persons with limited skill to multiple operations; or crew time lost in traveling from one site to another because access to nearer sites was not available.

Loss of efficiency caused by particular working conditions is also compensable. A loss of efficiency was allowed in one case¹ because backfilling operations were slowed down by order of the government. Also, costs related to changed conditions that slowed production and forced a move to another quarry have been deemed allowable.² A suspension-of-work order necessitated pouring of concrete during freezing weather and resulted in allowable costs.³ Costs related to a suspension of work that carried performance into the winter also are allowable.⁴

To recover such costs, a contractor must prove that government-caused delays directly impacted other work in the contract. The General Services Board of Contract Appeals (GSBCA) denied recovery for impact costs where the delayed work was not on the critical path.⁵ The contract called for the construction of a seven-story building for occupancy by several federal agencies. The government requested certain changes on the fourth, sixth, and seventh floors, yet ultimately cancelled these modifications. While the negotiations were taking place, however, the contractor was forced to suspend work on demountable partitions on those floors, since such work was inextricably intertwined with the changes contemplated by the government. The government unreasonably delayed issuing directives to proceed with this interrupted work once the modifications were cancelled.

Once the directives were issued, labor inefficiencies and accelerated costs resulted (e.g., the subcontractor installing partitions was required to work on more than one floor at a time). The GSBCA held that although the contractor was entitled to an adjustment, such recovery would not include impact costs, since the demountable partition delay was not on the critical path and all other work could have proceeded unimpeded. Thus, the contractor’s request for costs due to delay in installation of carpets, lighting fixtures, air-conditioning vents, and sprinklers was denied.

Direct labor may include engineering labor, manufacturing labor, quality control, or transportation—in short, any function that contributes directly to the production of the item. In some accounting systems (though not many), even personnel and purchasing department labor costs are treated as direct labor.

Improvement Curve

Labor productivity often can be expected to increase as production of the same item or activity continues. A number of factors contribute toward this progressive increase in productivity. Among these factors may be the adoption of improved methods and tools, increased efficiency of the individual worker, changes in product design, improvement in shop organization, and improvement in the handling and flow of materials. The rate of improvement through learning, referred to as a learning curve, is generally computed in terms of person-hours, but it may also be computed in terms of dollars.

The Defense Contract Audit Agency (DCAA) Contract Audit Manual (DCAM) was revised in 2005 to eliminate Appendix F, Improvement Curve Analysis Techniques. This document contained valuable information on the application of an improvement curve, much of it originally from guidance developed before the formation of DCAA in 1965. During the late 1960s, the DCAA developed computer software for improvement curves and expanded on the audit guidance in this appendix. The software was eventually converted from BASIC computer language to Windows-compatible software, leading the agency to subsequently remove the appendix as unnecessary. However, the software documentation does not address the intricacies of the improvement curve as well as they were formerly addressed in the DCAM Appendix F. Chapter 10 addresses improvement curves in detail, using many tables and illustrations from the old Appendix F.

A properly priced contract will provide for recovery of learning curve–related costs. The item or activity unit price generally will be lower than the actual production cost at the beginning of the contract but higher than the production costs incurred at the peak of the learning curve. When a contract is terminated early, this built-in adjustment is never realized, since the item prices paid for completed units have not fully compensated the contractor for his incurred costs. This learning curve cost is a proper, allowable element of a termination modification.

Labor productivity often can be expected to increase as production of the same item or activity increases, being enhanced through worker education, training, improvement in methods of production, and acts of management. Numerous methods of plotting productivity have been devised to compute the slope of the curve resulting from learning and improved labor productivity and to derive average individual unit cost and cumulative unit costs from it.

The labor effort at the inception of production will generally be substantially greater than during later stages. This higher cost is generally treated as benefiting the production of later units and is the rationale for averaging the cost of all the units produced. This concept of improved labor productivity through learning is relevant to the initial pricing of production contracts, as well as the pricing of modifications involving the addition or deletion of items. Thus, a partial termination or deductive change order will result in the contractor’s average cost of production being higher than under the contract. The contractor, in such cases, will have to recover its that higher initial production costs to be “made whole.”⁶

Often modifications arise from delays in production (e.g., stop-work orders). When this happens and the work restarts, the learning curve is impacted. The break in production causes the improvement pattern to revert to an earlier production point. (See Chapter 10 for a detailed discussion of this topic.)

Idle Direct Labor

The costs of idle direct labor during a delay period also may be recoverable. The circumstances of a remote site location and difficulties of mobilization may make it impracticable to discharge idle labor. As a result, the contractor is generally allowed to recover its standby costs. The basic rule is that the contractor can recover those direct-labor costs which it could not avoid through the use of good management.

Contractors that retain employees during work stoppages should be careful on how these employees are utilized. Often a contractor might retain the employees but put those employees to work on “make-work” assignments. A reviewer will not accept this as idle labor if that labor is doing anything at all that relates to company business. A contractor should be prepared to establish that dismissal and rehiring of employees is more costly than retaining employees during a work stoppage.

DIRECT-LABOR RATES

Labor rates may increase because different skills are required for the modification work than for the work that was planned. A large increase in the number of hires may cause the labor rates to increase due to local shortages of that particular skill. When labor is performed later than planned, it may be more costly due to wage increases.

Supporting Documentation

If the work has already been performed, the actual labor rates should be used. If the labor is yet to be performed, estimated rates are required. Direct labor generally is charged at the actual rates paid to employees. Contractors are permitted, however, to price direct labor on other bases, such as departmental average rates, labor categories, or standard labor rates. Any basis is acceptable if it is in accordance with generally accepted accounting principles applicable in the circumstances and if the results are equitable. The method must also be applied consistently.

Composite wage rates eliminate the differential normally found between wages of employees performing different types of work. Thus, they provide contractors with an easy and accepted means of estimating an average hourly wage when pricing modifications for additional labor expenses. To calculate a composite straight time wage for a project, a contractor would divide the total amount of straight time wages paid employees by the total number of employees. The same method of calculation may be used to determine a composite overtime premium. However, a significant caveat is in order: the use of composite rates may in some cases distort a contractor’s true costs. Therefore, the appropriateness of such rates must be closely examined by the contractor on a case-by-case basis.

The employer’s cost of a labor hour includes not only the basic wage rate but also taxes, insurance, and benefits. These costs can be charged as direct costs to a contract as long as there is no double charging and standards conforming to generally accepted accounting principles are consistently applied. Federal Insurance Contribution Act (FICA) and Federal and State Unemployment Act (FUTA and SUTA) tax costs are allowable and may be charged directly. Fringe benefit costs have been allowed as direct charges. Holiday pay, hospital, and travel insurance premiums have been charged as direct. Again, these costs must be charged in a manner consistent with the contractor’s accounting system. Benefits may not be charged directly for a modification and included in the overhead cost pool. The normal practice is not to charge these costs directly, but rather to charge such costs indirectly.

A contractor may need to compute payroll burdens separately for straight time and overtime. Straight time payroll burden computations include both straight time wages paid and payroll burden items such as union benefits, subsistence, taxes, and insurance. Overtime payroll burdens generally do not include union benefits. More commonly, these costs are included in a separate fringe benefit cost pool or included in overhead and are not charged directly.

Various miscellaneous labor costs may legitimately be charged directly to a contract. These include such items as job site expenses, supervision and nonproductive labor expense, and idle labor. However, claimed job expenses (labor and other) including an arbitrary fixed percentage of the salaries of a company’s president and clerical staff, telephone and postage charges, and travel charges associated with the presentation and appeal of a modification are not generally acceptable, because of the arbitrary fixed percentage.

In claiming such expenses directly, it is important that generally recognized accounting procedures be used and that no double charge for an expense is made. Thus, it must be shown that such direct labor charges have been pulled out of overhead and/or general and administrative (G&A) costs. Legitimate direct charges might not be allowed if it cannot be shown that they were not covered in overhead.

Wage rates, especially for manufacturing labor, vary considerably in different parts of the country. It is important, therefore, to make certain that the wage rates stated in the proposal will, in fact, be the wage rates in effect at the location where the goods are to be manufactured or services are to be provided. Information on average wage rates in effect in different parts of the country is available from the Bureau of Labor Statistics and should be used to price a contract. Because of geographic differences in wage rates, analysts should be careful about comparing wage rates proposed by different offerors in different locations, because comparisons must consider geographic differences in compensation. Provisions of the Service Contract Act, the Fair Labor Standards Act, and the Walsh-Healey Act regarding minimum wages and benefits must also be observed.

Many manufacturing workers are covered by collective bargaining agreements that govern wages paid to all workers in a shop covered by an agreement. If wage escalation is included in the proposal, the analyst must determine when the collective bargaining agreement will expire and whether the new wages are consistent with other labor contracts in the industry and in the area. Generally, the allowability of costs arising from union agreements is not challenged by government reviewers.

Wages paid for labor, both engineering and manufacturing, are almost invariably tied to the skills of the workers. The proposed wage rate should be consistent with the level of skill required to perform the task. Engineering labor should not be accepted if the only engineering work required is the drafting of shop drawings, a task normally done by draftsmen. The same is true for manufacturing labor, where contractors typically submit average wage rates. The use of average wage rates may result in excessive labor charges if most of the manufacturing effort will be performed by less skilled workers. Note that the use of average wage rates is often unavoidable in large-scale manufacturing operations and should not be rejected unless the use of average rates will be inequitable in a given situation.

Obviously, considerations of the type described above require considerable knowledge about the operations of the contractors whose proposals a reviewer is required to evaluate. Often, DCAA reviewers will have information on contractors’ wages and wage policy. An industrial engineer may be able to advise the analyst on the skill levels required.

Labor Rate Escalation

When work is delayed, forcing the contractor to work in a later period of time, costs may increase due to increases in the cost of higher wage rates. In times of rising inflation, such costs can be very important because an increase in labor, material, and associated costs due to inflation is frequently experienced. If the contractor can establish that such increases occurred, it can recover these costs.⁷

The amount includable in a modification for escalation of wages is based on any increased wage rates for work performed during the delay period. Merely proving that total wage costs have increased is insufficient because it would not differentiate between inefficiency costs and costs of wage increases.

However, the fact that the amount of the wage increase is not proved with a high degree of mathematical certainty is not a proper basis for complete denial of such a modification.⁸ In Keco Industries, in pricing its claimed wage rate increase of $.28/hour (difference between $2.20 and $2.48), the contractor did not use labor rates incurred on that particular contract, because he said they would not be representative of the actual labor mix during the delay period. Instead, the contractor used labor costs on a similar job to arrive at the $2.20 figure and used plantwide labor costs for a one-week period to arrive at the $2.48 figure. The plaintiff’s $2.20 figure was disallowed, and a starting point of $2.26 was taken from the bid estimates. The Armed Services Board of Contract Appeals (ASBCA) then allowed the plaintiff an increase of $.22 but stated that the allowance was not as accurate as would be desirable. Expressing a preference for actual labor cost data, the Board stated:

The record indicates that there is, or at least should be, sufficient labor cost data available … to show what … wage rates, in fact, were…. The board believes that such a Comparison would be a more satisfactory and accurate way to arrive at increased wage rates.⁹

When dealing with smaller contractors, government reviewers often request copies of Internal Revenue Service form W-2 to establish the amount of compensation and compensation rate actually paid to employees.

DIRECT MATERIALS AND SUBCONTRACTS

The term direct materials includes raw materials, purchased parts, and subcontracted items required to manufacture and assemble completed products. A direct material cost is the cost of materials used in making a product and, in the context of a modification, is directly associated with a change in the product. In addition, for accounting purposes, to justify treating the cost as a direct cost, it should be significant enough to warrant the cost of accounting for it as a direct cost.¹⁰

As with other cost elements, the two pricing concepts are determined by whether or not the cost has already been incurred. If the cost has been incurred, then an examination of the books and records is needed to determine that the cost is required. If the costs are yet to be incurred, then the estimates need to be reviewed.

Causes of Increased and Decreased Material Costs

Material costs may change due to elimination of materials from an item or addition of work that require either more or different materials. New material requirements may involve minimum buys to obtain necessary materials. When more materials are required, the market prices for those materials may have changed. The quantity of materials being purchased will also impact unit prices. Schedules may require accelerated delivery premiums to be paid for materials. Cancellation charges may be incurred for materials removed from the scope of work. The purchase of materials later than initially planned can cause increased costs due to increases in material prices. The cost of storage of materials intended to be used at an earlier date could also be a modification cost.

Supporting Documentation

The allowable cost of material usually will be the price paid by the contractor unless that price is shown to be unreasonable:

Typically, a contractor or subcontractor supports its materials estimates with a priced bill of materials based on quotations from suppliers or charges from inventory. The task of estimating and evaluating costs involves a verification that adequate price competition was generated among material suppliers and/or that the inventory valuation method used is consistent with the contractor’s general accounting practice (e.g., last-in-first-out [LIFO], first-in-first-out [FIFO], standard costs). Other factors must be considered as well.

Attrition in the form of scrap, spoilage, rework, pilferage, process yields, and materials made obsolete by contract changes must be considered. These costs are unavoidable in the production process. Material loss in processing (i.e., scrap) typically varies from 1 percent to 10 percent (with an average of about 5 percent) and even higher for production of high-tech items such as computer chips. The percentage allowance for scrap should be based on history.

Material overhead refers to the transportation, handling, inspection, and storage cost of materials as well as insurance. Some contractors have an established overhead cost pool for these costs. Others include these costs in manufacturing overhead or G&A costs.

Where the material is obtained from the contractor’s inventory, the cost chargeable to the contract will depend on the method used by the contractor to price his inventory. Where the material is obtained from another division or subsidiary of the contractor, the procurement regulations impose restrictions on the cost chargeable to the contract. This is addressed in the section on intercompany transfers.

The cost charged to a contract for materials should include not only the direct cost of the material but also indirect cost markups associated with material costs. A charge for material overhead reflecting the cost of purchasing, handling, storing, and distributing the material should be added to the direct cost of the materials if the contractor has such an overhead cost pool. Further markup of material costs through allocation of G&A also is permitted. In addition, in appropriate circumstances, a material variance account should be used to compensate for the costs of spoilage and scrap. If the contract is subject to the CAS, CAS 411, Accounting for Acquisition Costs of Materials, also should be considered.

For subcontracts, the upper-tier (sub)contractor must assure that modifications are adequately supported. This may require obtaining and analyzing cost or pricing data. If a subcontractor objects to upper-tier review of proprietary data, the upper-tier (sub)contractor may request an assist audit from the cognizant government reviewer. An assist audit is an evaluation of a subcontractor price proposal that cannot be made by the upper-tier (sub)contractor because the lower-tier subcontractor does not want to release proprietary business data to the upper tier.

Cost Accounting for Direct Material

A contractor’s CAS Board disclosure statement and established practices must be followed in the pricing of materials and subcontracts. CAS 411.40(b) should be considered if specific identification is to be used. In Air Flite Components, Inc., material costs were disallowed because, according to the Board: “The record provides no basis upon which we may conclude that the cost billed to the Government was allowed, as required by the contract, from a fair allocation in accordance with generally accepted accounting principles.”¹²

Pricing

When materials are purchased specifically for and identifiable solely with performance under a specific contract, the actual purchase cost of that material should be used. For materials unique to a contract and purchased for that contract, specific identification is practical and preferred.

Where the materials used on a contract are acquired from the contractor’s stores or inventory, the material costs chargeable to the contract may be greatly affected by the method used to price inventory. When materials are issued from stores, any generally recognized method of pricing the material is acceptable if the method is consistently applied and the result is equitable. Acceptable inventory costing methods are FIFO, LIFO, arithmetic average, weighted average, moving average, standard costs, and specific identification.

Material Adjustments

Certain adjustments in the cost of materials are provided for in the FAR Part 31 cost principles. The cost principles specifically recognize that a contractor is not capable of perfect performance and that even the most efficient contractor will either buy more material than is necessary or spoil or damage some material in the course of production. Thus, FAR 31.205.26(a) provides: “In computing material costs, consideration shall be given to reasonable overruns, spoilage, or defective work.”

However, the actual quantity of the materials consumed in the production process will normally exceed the minimum quantity indicated in the specifications. The difference is primarily due to scrap generated through normal production processes. Scrap is unavoidable and arises during the production process in cutting, trimming, punching, boring, and machining materials. Spoilage and defective items also cause the quantity of material used to exceed the amount specified. Spoilage is distinguished from scrap as the direct result of mechanical or human error in the production process. Defective items are similar to spoiled items, except they may be reworked into an acceptable product. Changes may also be made in specifications after parts and materials have been purchased, rendering the parts and materials obsolete. Obsolescence usually is an important consideration only when products are subject to developmental technology.

A contractor may allow for scrap and spoilage through an upward adjustment in the quantities of materials required or by price only if the accounting records contain separate cost accounts for scrap. For example, if a contractor estimated a bill of materials quantity of 1,000 and a scrap and spoilage rate of 10 percent on an item that cost $1.00 per unit, the price bill of materials may show 1100 pieces of material at $1.00.

The Boards of Contract Appeals also recognize that it is impractical for a small business concern to record the many small losses that occur in the operation of its plant on a day-to-day basis. Thus, the legitimacy of a material variance account has been recognized. As stated:

Adjustments also must be made for trade and cash discounts, refunds or rebates on materials returned or of lower quality, and scrap or salvage materials returned or sold.¹⁴

Intercompany Transfers

FAR 31.205-26 places certain limitations on the pricing of work performed by other divisions of the contractor or by an organization under common control of the contractor:

When a commercial item is transferred at a price based on a catalog or market price, the price should be adjusted to reflect the quantities being acquired and may be adjusted to reflect the actual cost of any modifications necessary because of contract requirements.

It is sometimes an industry practice (particularly for commercial entities) to price intercompany transfers at a transfer price which is neither a cost nor a commercial selling price. These transfer prices usually are established by corporation-wide pricing policies designed to assure the producing unit of recovering its costs incurred plus a profit. The transfer price usually exceeds the manufacturing cost but is less than the selling price, because certain costs (e.g., credit investigation, customer financing, bad debt losses, advertising, and sales expenses) incurred in a commercial sale are not usually incurred in an interplant transfer.

The ASBCA has interpreted this regulation as allowing payment for costs actually incurred by the subsidiary or division in furnishing the material, supplies, or equipment, rather than the cost the contractor had obligated itself to pay the subsidiary or division by way of a fixed-price subcontract. In one case,¹⁶ a prime contractor entered into a fixed-price subcontract with its subsidiary in the amount of $81,800. In performance, the subsidiary incurred costs in the amount of $115,141. The prime sought reimbursement of the full costs incurred under its cost-reimbursement contract with the federal government. The government declined to pay the costs in excess of the subcontract price. The contractor took an appeal to the Board that was sustained. In the opinion of the Board¹⁷:

OTHER DIRECT COSTS

Other direct costs consist of either purchased items or in-house labor costs. In this regard, the costs are estimated just as for any other purchase or labor charge discussed in previous sections.

Travel Costs

Travel costs under federal contracts must be within certain allowability limits discussed in a previous section of this manual. The costs of meals and lodging must be estimated in accordance with the per diem allowances contained in the either the Federal Travel Regulation or the Joint Travel Regulation, maintained by the General Services Administration and the Department of Defense, respectively. To estimate costs, the location of the travel and the current rates (including escalation for out-years) must be established.

For airfares, it may be necessary to negotiate the estimated costs based on the anticipated fare conditions. If a trip is planned well in advance and a weekend stay, 15-day advance purchase, and nonrefundable ticket are used, the cost could be 20 percent of the full-fare coach ticket. Not all travel can be accomplished on such discount tickets. Larger contractors maintain records of actual versus full coach fares and decrement full coach fares by this ratio when estimating costs.

Equipment Costs—Construction Contracts

Generally, construction contracts are subject to the cost principles and procedures in Subpart 31.2 of the FAR. However, some special rules on allowable equipment costs are contained at FAR 31.105. In addition, this section suggests, in light of widely varying factors such as the nature, size, duration, and location of construction projects, that advance agreements may be entered into regarding equipment usage costs.

Allowable equipment costs

Construction equipment is defined by FAR 31.105 as equipment “in sound workable condition, either owned or controlled by the contractor or the subcontractor at any tier, or obtained from a commercial rental source, and furnished for use under government contracts.”

The preferred method of establishing allowable ownership and operating costs for equipment is through the use of actual cost data. Such data are to be obtained from the contractor’s accounting records. The data can be for particular items of equipment or for groups of similar serial or series equipment.

When actual cost data are not available, the contracting agency may specify the use of a schedule of predetermined rates to determine ownership and operating costs of construction equipment.¹⁸ These predetermined rates provide average ownership and operating rates for construction equipment. The allowance for ownership costs should include the cost of depreciation, taxes, and insurance and may include a charge for facilities capital cost of money. The allowance for operating costs may include costs for such items as: (1) fuel, filters, oil, grease; (2) servicing, repairs, and maintenance; and (3) tire wear and repair.

The costs of labor, mobilization, demobilization, overhead, and profit usually are not reflected in predetermined rate schedules and should be claimed separately.¹⁹ When a schedule of predetermined rates is used to determine direct equipment cost, all costs included in the rates need to be identified and eliminated from the contractor’s other direct and indirect costs charged to the contract. The purpose of this analysis is to avoid duplicate cost recovery.

The FAR does not specify which predetermined rate schedule is to be used. This choice is left to the discretion of the contracting agency. The FAR also allows recovery of the reasonable costs of renting construction equipment. In addition, the costs of maintenance and minor or running repairs incident to operating the rented equipment are allowable. However, the costs incident to major repair and overhaul or rental equipment are unallowable. Where the equipment is rented from a division, subsidiary, or organization under common control, the allowability of the rental charges is controlled by FAR 31.205-26(e).

The use of predetermined rates has been accepted as a valid means of compensating a contractor in damage cases where actual cost records are unavailable. In one such case, the Court of Claims stated:

However, do not place too much reliance on this decision; government reviewers and most courts will very much prefer actual costs to predetermined, unauditable rates.

Idle equipment and idle capacity

The cost of idle equipment during a period of government-caused delay also should be included when pricing a modification. The FAR provides that: “In periods of suspension of work pursuant to a contract clause, the allowance for equipment ownership shall not exceed an amount for standby cost as determined by the schedule or contract provision.”²¹

These techniques are common methods of approximating the effect of equipment sitting idle rather than being used and compensate for the fact that no wear and tear is suffered during the idle period.

The costs of idle equipment during a period of government-caused delay also should be included when pricing a modification. The technique prescribed by the regulations, and utilized by the Court of Claims in computing damages, is to include 50 percent of the equipment ownership expense rate.²² The 50-percent technique is also a common method of approximating the effect of equipment sitting idle rather than being used, which compensates for the fact that no wear and tear was suffered during that period. The Army Corps of Engineers’ schedule sets the depreciation for idle equipment modifications.²³

A contractor is entitled to recover its equipment costs for the periods of time in which it either sat idle as the result of government delays or the equipment was not available for use on other projects. Entitlement to an equitable adjustment results in indirect costs for idle equipment and labor during the period of government-imposed delay.²⁴ The Court found that to be compensated for idle equipment the contractor must show: (1) that the equipment for which compensation is claimed was reasonably and necessarily set aside and awaiting use in performing the contract and (2) that it was deprived of productive use of the equipment by being compelled to keep the equipment idle by circumstances for which the government is responsible and not that the equipment was idle because the contractor had no other use for it at the time.

The Court has found that the fair and reasonable measure of damages for plaintiffs’ equipment expenses for contractor-owned equipment, absent actual cost records for the delay period, is the acquisition cost (of each piece of equipment involved) applied to the formula set forth in the ownership expense manual of the Associated General Contractors (an industry association) and reduced by 50 percent for idle time, during which time the equipment suffers no wear and tear.²⁵ In addition to the above, however, the Court of Claims in a later decision²⁶ added that a contractor is also entitled to recover the actual cost of renting equipment for another job on which it could not use its idle equipment that otherwise would have been available for use on the other project. This is directly applicable where a contractor is forced to subcontract out a major portion of a concurrent contract because its equipment was unavailable for use elsewhere.

Equipment loss of efficiency

Contractors also may be entitled to modification compensation for equipment loss of efficiency caused by a delay or acceleration if the equipment is rented on an hourly basis and if the operator-engineer has experienced a loss of efficiency.

Equipment Costs—Supply Contracts

Equipment costs may result from either purchased and depreciated assets or from rental costs.

Depreciation

The primary equipment-related cost on a supply contract is depreciation. The cost is allowable to the extent that the contractor can demonstrate that it is reasonable and allocable to the contract. This cost is defined as “a charge to current operations which distributes the cost of a tangible capital asset, less estimated residual value, over the estimated useful life of the asset in a systematic and logical manner.”²⁷

Contractors with contracts subject to CAS 409, Depreciation of Tangible Capital Assets, must adhere to the requirement of that standard for all fully CAS-covered contracts and may elect to adopt the standard for all other contracts. Depreciation or rental costs on property fully depreciated by the contractor or by any division, subsidiary, or affiliate of the contractor under common control is not allowable. However, a reasonable charge for using fully depreciated property may be agreed upon and allowed.

Idle facilities and idle capacity

Generally, the cost of idle facilities (i.e., facilities that are excess to the contractor’s current needs) are unallowable. The circumstances in which such costs are allowable are when the facilities are: (1) necessary to meet fluctuations in workload or (2) no longer necessary and are now idle because of changes in requirements, production economics, reorganization, termination, or other causes which could not have been reasonably foreseen.²⁸

According to this regulation, however, costs of idle facilities are allowable only for a reasonable period, ordinarily not to exceed one year.²⁹ However, in periods of major downsizing, a “reasonable period” could very well be much longer than the one year “ordinary” period.

Idle capacity refers to the unused capacity of partially used facilities. Idle capacity costs are a normal cost of doing business and are allowable provided that “the capacity is necessary or was originally reasonable and is not subject to reduction or elimination by subletting, renting, or sale, in accordance with sound business economics, or security practices.”³⁰

Special tooling and special test equipment costs

The costs of special tooling, as well as of special test equipment, are allowable. Each cost must be allocated to the specific government contract or contracts for which it was acquired. Where an item fails to qualify as special tooling or special test equipment because, with relatively minor expense, it can be made suitable for general-purpose use, the costs of adapting the item for use on the contract and returning it to its prior configuration are allowable. Additionally, there are several statutory limitations that preclude agencies from reimbursing contractors for the full cost of assets under the initial contract.

Other Costs

For construction contracts in particular, additional direct costs might relate to work at a construction site. For example, during a delay in construction a contractor might incur additional expenses for an on-site office trailer, utilities, taxes, and similar costs. These costs might be overhead for a manufacturing or service contract, but are more appropriately direct under these conditions.

ESTIMATING TECHNIQUES

If the impacted labor has already been incurred, the actual cost should be determined. If the impacted labor is yet to be incurred, estimates are necessary. Direct costs must have been estimated on a time-phased basis to apply indirect-cost rates by cost accounting period. Estimates should be based on budgets or forecasts by the fiscal year covered in the proposal. Historical indirect-cost rate data can be useful in supporting forecasts; however, the primary basis for indirect-cost rates should be forecasts. Year-to-date rates are never appropriate for use in pricing—the entire year must be considered.

A misconception often arises regarding audited indirect-cost rates, in that the term applies to rates already incurred. Forecasts cannot be audited because they have not yet occurred; they may be evaluated but not audited. Use of an outdated historical—albeit audited—indirect-cost rate is not as appropriate as an estimated rate.

Escalation factors for costs are often limited by procurement offices to about 3 percent; this is a practice, not a regulation. Unallowable costs must be eliminated from pricings. The impact of business volume on indirect-cost rates must be considered. Regression analysis may be used in lieu of detailed cost buildups. Corporate allocations should be carefully reviewed for allocability and allowability.

Impact of Inefficiencies

A shift of work between years will likely cause an increase in indirect rates and costs. Idle time and other standby costs may also impact indirect costs. Storage costs, which may not be direct, could also increase due to contract changes. Personnel issues may cause recruitment costs to increase. Overtime premium costs due to changes and accelerations must be considered in pricing modifications. Additional taxes might also be incurred due to a delay.

Unabsorbed Overhead

Unabsorbed overhead is a term used to identify fixed indirect costs that would have been allocated to delayed contract base costs which would have been incurred and allocated to the delayed contract but for a delay. Fixed manufacturing overhead and G&A costs that continue to run during a period of shutdown or idling of factory facilities are referred to as unabsorbed overhead. The term also has been applied to construction contracts involving suspensions of work. Direct costs and indirect costs that are variable can be avoided during a delay period; however, fixed costs cannot be avoidable, thus, recovery of such costs is the objective. In some instances, even the direct costs may be fixed.

These costs are typically claimed when a delay has occurred. The term unabsorbed overhead is actually a misnomer, because all indirect costs are allocated to and absorbed by contracts in process. Nevertheless, the term has received general acceptance by contractors, government personnel, and Boards of Contract Appeals.

Illustration 9-1 depicts the impact of a delay and how the costs would have been allocated but for the delay. The rectangle contains all the costs for an accounting period. The horizontal displays work that continues and work that is delayed. On the vertical, there are: (1) direct costs, (2) variable indirect costs, and (3) fixed indirect costs. When work is delayed, a contractor may be able to avoid direct costs and variable indirect costs, but not the fixed indirect costs. The lightly shaded area represents the fixed or unavoidable costs that need to be recovered.

This shaded area, unabsorbed overhead, represents the dollars for the delay impact. Illustration 9-2 depicts where these fixed costs are allocated due to the delayed work. The costs are allocated to the other, continued work during that accounting period—technically, nothing is “unabsorbed.” The next issue is whether that allocation resulted in increased revenue on those jobs. First, any fixed-price work could not have increased revenue due to this allocation change; these are real damages. Second, for flexibly priced contracts, whether increased revenues will occur must be determined on a case-by-case basis. If a cost-reimbursement contract has indirect-cost rate ceilings, this allocation may not result in increased revenue on such contracts. Also, this means that even those contracts without ceilings will result in less work for the client for the same amount of money.

ILLUSTRATION 9-1: Impact of Delayed Work—Costs for Accounting Period

A request for unabsorbed indirect costs is a request to recoup increased indirect costs allocated to other work because of the work stoppage which occurred on the delayed contract. In other words, unabsorbed indirect costs are that amount of indirect expense actually incurred which would have been allocated to the contract had the delay not occurred, and is not recoverable in the revenue from any other work. The delay, of course, must have been caused by the government in order for such costs to be allowable.

The burden of proof is on the contractor to demonstrate that a government-caused delay resulted in the contractor’s other work being burdened with increased indirect costs. However, even where the contractor does not demonstrate conclusive proof, a Board of Contract Appeals might presume that such indirect costs were increased due to a government-caused delay.

Issues of entitlement to unabsorbed indirect costs arise when the government alleges that the contractor actually obtained replacement work during a delay period or inappropriately turned down replacement work. Another issue is whether or not a 100-percent work stoppage is required for entitlement. Board decisions have varied on this, and the exact circumstances of each incident must be addressed.

ILLUSTRATION 9-2: Impact of Delayed Work—Unabsorbed Overhead Cost Allocation

At one time, the issue of whether unabsorbed indirect costs should include all indirect costs or just fixed indirect costs was unsettled. This question likely arose because initial cases involved construction and allocation of home-office expenses, which in that environment are mostly fixed expenses. However, as this concept began to be applied to manufacturing and services, the necessity to consider only fixed indirect cost became apparent. In fairness, only fixed expenses should be included in unabsorbed indirect costs.

Board and court decisions have used several methods to determine the amount of unabsorbed indirect costs. The most common is the Eichleay method. Other methods are accepted by the courts but have fallen out of use due to the Boards’ preference for the Eichleay method.

Eichleay method

The most frequently used method to determine the amount of unabsorbed indirect costs is the Eichleay method.³¹ Under the Eichleay method, the normal fixed overhead allocable to a contract is identified and expressed in terms of a daily rate. Boards and courts have normally considered all home-office overhead as fixed. The daily rate is then multiplied by the days of delay to arrive at the total amount of unabsorbed overhead. The Eichleay method originally was used to measure home-office unabsorbed overhead for construction contractors. However, its use has subsequently been extended to cover other indirect costs at manufacturing as well as construction firms. When using this method, it is important that the contractor remove variable costs from the calculation.

Illustration 9-3 contains relevant data for computation of unabsorbed overhead under several methods. Most methods were developed in the construction environment and address home-office expense allocations. Courts and Boards of Contract Appeals accept the methods for manufacturing and services as well; thus, these methods can be applied by substituting the term fixed indirect costs (including, potentially, multiple overhead cost pools and a G&A cost pool) for the term home-office expense. Illustration 9-4 contains a sample application of the Eichleay method. Illustration 9-5 contains an example of the most common variation on the Eichleay method.

Allegheny method

Using the Allegheny method, the impact of a delay can be visualized as a timeline.³² As the timeline proceeds from left to right, the delay occurs. For the duration of the delay, the reduced cost allocation bases require other contracts to absorb more fixed overhead, resulting in higher contract costs. As one proceeds to the right on the line, the delay ceases and the contract base is higher than normal as the remaining work is performed. The higher-than-normal case results in a lower fixed expense to other contracts. The Allegheny method involves a shifting of the delayed effort from right to left on this timeline to recreate what would have happened had the delay not occurred.

The difference between the recreated overhead rate and the rate actually experienced should, in theory, demonstrate the effect of overhead expense on contract performance due to government delay. One advantage in using the Allegheny method is that, by considering the entire period of contract performance, the method complies with the FAR changes clause by determining the effect of out-of-period performance on contract cost. Another advantage is that it does not require a determination of the delay period in terms of the number of days.

The Allegheny method is appropriate for use only in those situations where the remaining work on the contract can be performed simultaneously with other scheduled work of the contractor and the contractor did not turn down other work that would have been performed (and would have absorbed fixed overhead) during the period of extended contract performance.

The Boards at one time accepted the Allegheny method in many cases involving manufacturing concerns that had been completely closed down because of a delay and were not exclusively occupied with the performance of a single government contract.³³ This method may need to be coupled with a demonstration that the Eichleay method yields inequitable results. This is evidenced by a Board conclusion that “the government indicated a preference for the Allegheny method of computing unabsorbed overhead, but it did not establish that the Eichleay method had been improperly used by the contractor.”³⁴ Illustration 9-6 contains a sample application of the Allegheny method.

ILLUSTRATION 9-3: Facts for Unabsorbed Overhead Calculations

ILLUSTRATION 9-4: Eichleay Method
Eichleay Corp., ASBCA No. 5183, 60-2 BCA ¶2688, mot. for reconsideration. Denied, 61-1 BCA ¶2894 (1960).

ILLUSTRATION 9-5: Eichleay Variation Method
Schindler Haughton Elevator Corp., GSBCA No. 5390, 80-2 BCA ¶14671 (1971).

ILLUSTRATION 9-6: Allegheny Method Allegheny Sportswear Co., ASBCA No. 4163, 58-1 BCA ¶1684 (1958).

Carteret method

The Carteret method³⁵ is a two-step calculation that uses the indirect-cost rates incurred during the delay period and the normal indirect-cost rates. This equation is applicable when the delayed contract comprises the only work in progress when the delay occurred. First, the contractor calculates the excess overhead rate caused by the delay. This is the actual indirect-cost rate less the normal or expected indirect-cost rate, which calculates the excess indirect-cost rate. Second, the contractor multiplies the excess rate by the total original base in the proposal. Illustration 9-7 contains a sample application of the Carteret method.

(Most historical board and court decisions refer to unabsorbed overhead and an overhead rate. Accounting systems have become more complex and now often consist of numerous indirect-cost pools. Each must be included to calculate unabsorbed indirect costs, not merely unabsorbed overhead.)

Burden fluctuation method

Under certain circumstances, the Boards have recognized the burden fluctuation method.³⁶ Under this method, the difference between the actual burden rates and the burden rates used by the contractor in its bid proposal is determined and this difference is multiplied by the value of residual labor costs. The residual labor costs represent the difference between the incurred total direct labor dollars and the labor dollars incurred on the contract. The result is designated unabsorbed overhead.

ILLUSTRATION 9-7: Carteret Method
Carteret Work Uniforms, Inc., ASBCA No. 1647, 6 CCF §61651-1951 (1954).

This approach does not consider that the contract bid price may have been understated or that the increase in burden rates may be due to factors under the contractor’s control and not related to any government action. When using the burden fluctuation method, the realism of the bid rates must be established. Illustration 9-8 contains a sample application of the burden fluctuation method.

ILLUSTRATION 9-8:
Burden Fluctuation Essex Electro Engineers, Inc., ASBCA No. 21066, 79-2 BCA ¶14035 (1979).

Hudson method

The Hudson method³⁷ was established by the courts in the United Kingdom and subsequently used extensively in Canada. It derives a daily home-office overhead rate on the basis of the bid price and assumes that the bid rate should hold constant throughout the life of the project. Illustration 9-9 contains a sample application of the Hudson method.

ILLUSTRATION 9-9: Hudson or Canadian Method J.F. Finnegan, Ltd. v. Sheffield City Council, 43 Build. L.R. 124 (Q.B. 1989).

Simulation method

A somewhat similar method is referred to as the simulation method. This method divides contract billings by the actual days worked to determine average contract billings per day worked. The daily average is then multiplied by the number of days of delay to simulate the work that would have been performed had the delay not occurred. This amount is added to both contract billings and total billings, and the resulting ratio is used to allocate total overhead to the contract. The total amount so allocated, less the amount allocated to actual work performed, yields the amount of the delay modification. This method overcomes the objection that the Eichleay formula is flawed, because it includes delay days in computing the daily rate. Illustration 9-10 contains a sample application of the simulation method.

ILLUSTRATION 9-10: Simulation Method

Ernstrom method

The Ernstrom formula³⁸ is based on a theory of a direct relationship between overhead costs and labor costs that can be calculated and applied to a delay situation. Specifically, as labor costs increase, so do the corresponding home-office costs. Thus, by calculating this ratio and applying it to the amount of labor expenses incurred during a delay period, the amount of damages due to the delay can also be calculated. Since this is a ratio formula, it does not develop a daily home-office overhead rate but rather calculates a lump sum cost. Illustration 9-11 contains a sample application of the Ernstrom method.

ILLUSTRATION 9-11: Enstrom Method

Manshul method

The Manshul method or formula³⁹ has also been referred to as the direct cost allocation method. It is derived from the various courts in the state of New York. New York civil courts have often rejected Eichleay, instead developing a substitute method of calculating overhead with the Manshul method. Rather than a daily overhead rate, it uses the bid home-office overhead rate multiplied by the cost of work performed during the delay period to determine the overhead amount. Illustration 9-12 contains a sample application of the Manshul method.

Emden method

The Emden formula⁴⁰ is a creature of the Canadian courts. Its approach is similar to Eichleay in that it attempts to allocate total company overhead to a project on first a proportionate basis and then a daily basis. It uses both overhead and profit costs as part of the calculation and then multiplies the result by the amount of customer-caused delay incurred. Illustration 9-13 contains a sample application of the Emden method.

ILLUSTRATION 9-12: Manshul Method
Manshul Construction Corp. v. Dormitory Authority, 436 N.Y.S.2d 724 (App. Div.) (1981).

ILLUSTRATION 9-13: Emden Method
Alfred McAlpine Homes North, Ltd. v. Property & Land Contractors, Ltd. 76 BLR 59 (1995).

Extended Overhead

The term extended overhead is used to refer to additional jobsite and home-office overhead costs incurred as a direct result of a delay of critical construction activities that extend the period of overall contract performance. According to the DCAM, “Many courts have used the terms ‘extended overhead’ and ‘unabsorbed overhead’ interchangeably, but careful examination and comparison of their meanings reveal their difference.”⁴¹ Unabsorbed overhead occurs when increased costs are allocated to other contracts because of work stoppage occurring on a delayed contract. The term extended overhead applies to contract changes that usually extend the period of performance. Overhead on increased direct costs related to the change is recovered through an indirect rate computed in accordance with the contractor’s established accounting practices. Illustration 9-14 illustrates this cost concept.

The vertical broken line separates two accounting periods (years). The horizontal scale represents: (1) continued or unimpacted work in year 1, (2) delayed work not performed in year 1, (3) the delayed work from year 1 now to be performed in year 2, and (4) the work in year 2 other than the delay impact. As with Illustrations 9-1 and 9-2, the medium gray area is the avoidable direct and variable indirect costs in year 1; the light gray area is the fixed costs that are unavoidable and thus allocated to the work actually performed in year 1; and the light gray area is the additional fixed overhead that will be allocated to the delayed work in year 2. When the overhead cost rate is greater in year 2, this means that the delayed work will be allocated more overhead because of the delay from year 1 to year 2. This is represented by the dark gray area.

ILLUSTRATION 9-14: Impact of Delayed Work—Extended Overhead

Over-Recovery Concerns

When unabsorbed indirect costs are claimed, the government is concerned that these costs not also be recovered elsewhere. For example, the indirect-cost rates for flexibly priced contracts (e.g., cost-reimbursable, incentive) will include these unabsorbed indirect costs as well. A contractor need not adjust indirect cost submission to reflect the claimed unabsorbed indirect costs, but should delay agreement on rates until the issue of unabsorbed indirect costs is settled. Otherwise, issues of violations of the Truth-in-Negotiations Act and double recovery could arise.

PROFIT

Profit is a company’s reward for adequately performing contractual responsibilities. (The FAR uses the term profit for fixed-price contracts and fee for cost-reimbursement contracts. In this discussion, the term profit includes both FAR terms.) In modifications, profit may be impacted in numerous ways. The same profit may be proper, a greater profit may be justified, or a lesser profit might be appropriate. The FAR contains contractual and statutorily imposed limitations on the amount of profit a contractor may receive.

A basic feature of profit guidelines (which contractors hope is being addressed and possibly changed, because they believe risk, not cost, should drive profit) is that government contracts usually are driven by cost, whereas commercial transactions generally are driven by price. The result of this business arrangement is that a considerably lower level of profit is derived by contractors from government contracts than from commercial ones. That is not to say that as a buying public we are being overcharged for commercial items. Rather, it simply means that the government profit guidelines generally do not provide a reasonable profit to contractors.

Because of this fact of government contract transactions, some contractors will not do business with the government. This reluctance has created two distinct industrial bases, one commercial and one governmental. Many companies are either 100-percent commercial or 100-percent government in their contracts, although there are instances where the product/service mix is both commercial and government. Many times, this is the result of a company’s ability to use some of its products in the commercial marketplace that were originally designed or developed for the government.

Despite the generally lower profits from doing business with the government, many companies continue to seek government contracts. The reasons vary from performing the work for the sake of national defense to being enmeshed in government business and unable to break out of it. As an example of the former, some contractors are owned and operated by former military personnel who continue their dedication to national defense in a new role after departure from the military. As an example of the latter, companies come to depend on the business volume created by government sales and do not find it easy to discontinue government work. Other companies, such as research firms, may plan on incurring certain costs anyway, so they decide they might as well have some of the research costs absorbed by performing on contracts. Whatever the reason, government contractors are many and varied and have a variety of reasons other than profit for conducting governmental business.

When the nature or extent of a contract’s performance is altered in some significant way, the contractor often will be eligible for compensation commensurate with the change in the form of an equitable adjustment. An adjustment in price is equitable when some occurrence or change affecting performance of the contract is generated by the government customer. The underlying principle is that the contracting party affected by the change or modification should be placed in the same economic position in which it would have been had the change or modification not occurred.⁴² The measure of damages should not be the value received by the government but rather the altered position in which the contractor is placed because of the modification.⁴³ This theory is known as leave them where you find them. The name is derived from a decision that stated the purpose of the equitable adjustment: “to leave the parties in the same position cost-wise and profit-wise as they would have occupied had there been no change, preserving to each as nearly as possible the advantages and disadvantages of their bargain.”⁴⁴

In pricing the additional work required by the change or modification, the contractor is generally allowed the reasonable cost of the additional work: “the cost that [it] would have been for any prudent contractor similarly situated,”⁴⁵ plus the cost of a reasonable and customary allowance for profit.⁴⁶ The contractor is deemed entitled to his fair profit because this “is only a fair reward or return in recognition of the fact that the changes did take place and were performed. Without the payment of a profit which is fair under the circumstances, the Government would be getting something for nothing and the contractor would not truly be made whole.”⁴⁷ Thus, even if a contractor originally bids a job at no profit, he will be entitled to obtain a fair profit on additional work.⁴⁸

The profit on the original contract work unaffected by the change is left untouched. An equitable adjustment should not be used to reprice a contract which threatens a loss. However, an allowance for profit will nonetheless be made on additional work, whether or not the contractor is losing money on the contract.⁴⁹ Furthermore, the government cannot use an equitable adjustment to take an extra-high profit away from a contractor.⁵⁰

The contractor may recover profit on both direct and indirect costs for extra work actually performed.⁵¹ However, it generally has been held that a contractor may not recover for anticipated but unearned profits.⁵² A contractor may increase profit on the unchanged work if it can establish that the changed work increases the risk on the entire contract, not just the changed work.⁵³

The actual amount of profit that a contractor may recover is tied to the extent of the additional work required of the contractor and the nature of the risks involved. Generally, where the contract modifications or changes cause relatively minor alterations, the same profit rate that was included in the original contract should be applied to the change. If more major changes are involved, however, the parties will negotiate an amount of profit that equitably reflects the extent of the change.

For example, if the modification or change results in more difficult performance requirements than those in the original contract, the contractor should receive a higher rate of profit than that set forth in the original agreement.⁵⁴ Conversely, if the new work is less difficult than that originally called for, the rate of profit should be lower than the rate in the original contract.⁵⁵

Generally, a contractor should be entitled to a profit rate on its incurred costs for the changed or additional work that is equal to its historical rate of profit on similar projects. The reasoning behind this, as stated earlier, is that the purpose of an equitable adjustment is to place the contractor in the same position in which it would have been but for the government-caused changes leading to the adjustment.

This is somewhat analogous to recovery of lost profits following a breach, where these may be recovered when it has been established that: (1) the loss was the proximate result of the breach, (2) the loss of profits caused by the breach was within the contemplation of the parties because the loss was foreseeable or because the defaulting party had knowledge of special circumstances at the time of contracting, and (3) a sufficient basis exists for estimating the amount of lost profits with reasonable certainty.⁵⁶ Modifications for lost profits must be definitely established.⁵⁷ The purpose of an equitable adjustment is to safeguard a contractor against increased costs engendered by postaward conditions different from those to which it bid.⁵⁸

The government has argued that the profit on costs resulting from its own breach should be limited to the rate included in original bid price.⁵⁹ In Rumsfeld v. Applied Companies, Inc., the US Court of Appeals rejected this argument because the rate did not reflect the additional margin that the contractor expected to earn based on increased productivity on the project, finding that the government’s breach directly caused a diversion of the contractor’s resources from its other endeavors, and thus, but for the breach, the normal contractor profit would have been earned on the diverted amount. In determining the reasonable profit to which that the contractor was entitled as the result of the breach that caused it to divert resources and personnel from its other operations, the Court used the profit rate that the contractor historically earned.

If certain delays or changes increase a contractor’s risks, the profit rate should be increased accordingly. For example, where the government reduced a contract price under the Variation in Estimated Quantities clause, the contractor received a higher percentage of profit than had been originally contracted, because the lower contract price reduced the range of the contractor’s margin of error and thus increased its risks.⁶⁰ A contractor was allowed greater profit for additional work required, because the contractor financed the performance of the work with its own capital instead of financing it by borrowings or progress payments.⁶¹

All federal government agencies are subject to prescribed guidelines for profit analysis and computation in specified circumstances. However, some construction agencies have attempted to resolve the issue of profit by including language in their standard form contracts. For example, the Federal Highway Administration has used a single, flat rate of 15 percent of labor and material for both overhead and profit. The National Park Service once allowed an amount not to exceed 15 percent of actual necessary costs for both overhead and profit. Both agencies apply these standard rates on cases where an agreement cannot be reached on a fixed-price adjustment before the change work is performed. State and local governments also attempt to set limits by law or regulation.

Notes

1. T.C. Bateson Constr. Co., ASBCA No. 6028, 1963 BCA ¶3692 (1963).

2. Kaiser Industries Corp. v. United States, 169 Ct. Cl. 310, 340 F.2d 322 (1965).

3. B.J. Lucarelli & Co., Inc., ASBCA No. 8422 (1964).

4. Structural Restoration Co., ASBCA No. 8747, 8756, 65-2 BCA ¶4975 (1965).

5. Jordan & Nobles Constr. Co. v. General Services Administration, GSBCA No. 8349, et al., 91-1 BCA ¶23659 (1990).

6. Continental Elec. Mfg. Co., ASBCA No. 14749, 71-2 BCA ¶9108.

7. International Builders of Florida, Inc., FAACAP No. 67-5, 69-1 24.04[A], BCA ¶17706 (1969); T.C. Bateson Constr. Co., ASBCA No. 6028, 1963 BCA ¶3692 (1963); Eisen-Magers Constr. Co., ASBCA No. 4694 (1959).

8. Keco Industries, Inc., ASBCA No. 15184, 15547, 72-2 BCA ¶9576 (1972).

9. Ibid.

10. FAR 31.202(h).

11. J.R. Pope, Inc., DOT CAB No. 78-55, 80-2 BCA ¶14562 (1980).

12. Air Flite Components, Inc., FAA CAB No. 67-1 BCA ¶6188.

13. Kurz & Root Co., ASBCA No. 11436, 68-1 BCA ¶6916.

14. FAR 31.205-26(b).

15. FAR 31.205-26(e).

16. Teledyne Industries, Inc., ASBCA No. 20900, 77-1. BCA ¶12416.

17. Ibid.

18. FAR 31.105(d)(2)(i)(A).

19. FAR 31.105(d)(2)(i)(B).

20. L.L. Hall Constr. Co. v. United States, 379 F.2d 559 (Ct. Cl. 1966).

21. FAR 31.105(d)(2)(i)(C).

22. L.L. Hall Constr. Co. v. United States, 379 F.2d 559 (Ct. Cl. 1966).

23. EP 1110-1-8, US Army Corps of Engineers, Ownership & Operating Expense Schedule. Available at: http://www.nww.usace.army.mil/html/OFFICES/Ed/C/ep_current.asp.

24. Melka Marine, Inc. v. United States, 41 Fed. Cl. 122 (1998).

25. L.L. Hall Constr. Co. v. United States, 379 F.2d 559 (Ct. Cl. 1966).

26. Cornell Wrecking Co. v. United States, 184 Cl. Ct. 289, 291 (1968).

27. FAR 31.205-11(a).

28. FAR 31.205-17(b).

29. FAR 31.205-17(b)(2).

30. FAR 31.205-17(c).

31. Eichleay Corp., ASBCA No. 5183, 60-2 BCA ¶2688 (1960).

32. Allegheny Sportswear Co., ASBCA No. 4163, 58-1 BCA ¶1684 (1958).

33. Lite Manufacturing Co., ASBCA No. 4755, 58-2 BCA ¶2009 (1958).

34. Essex Electro Engineers, Inc., ASBCA No. 21066, 79-2 BCA ¶14035 (1979).

35. Carteret Work Uniforms, Inc., ASBCA No. 1647, 6 CCF §61651-1951 (1954).

36. Essex Electro Engineers, Inc., ASBCA No. 21066, 79-2 BCA ¶14035 (1979).

37. J.F. Finnegan, Ltd. v. Sheffield City Council, 43 Build. L.R. 124 (Q.B. 1989).

38. The Construction Lawyer 3, no. 1 (1982).

39. Manshul Construction Corp. v. Dormitory Authority, 436 N.Y.S.2d 724 (App. Div.) (1981).

40. Alfred McAlpine Homes North, Ltd. v. Property & Land Contractors, Ltd. 76 BLR 59 (1995).

41. DCAM 12-603, Extended Overhead versus Unabsorbed Overhead.

42. New York Shipbuilding Co., ASBCA No. 16164, 76-2 BCA ¶11979 (1976).

43. Bruce Constr. Corp. v. United States, 324 F.2d 516, 518 (Ct. Cl. 1963).

44. Montag-Halvorson-Cascade-Austin, ENGBCA 1075 (1958).

45. United States v. Pickett’s Food Service, 360 F.2d 338, 343 (5th Cir. 1966).

46. United States v. Callahan Walker Constr. Co., 317 US 56, 61 (1942).

47. New York Shipbuilding Co., ASBCA No. 16164, 76-2 BCA ¶11979 (1976).

48. Keco Industries, Inc., ASBCA No. 15184, 15547, 72-2 BCA ¶9576 (1972).

49. G.M. Co. Mfg. Inc., ASBCA No. 2883, 57-2 BCA ¶1505 (1957).

50. Keco Industries, Inc., ASBCA No. 15184, 15547, 72-2 BCA ¶9576 (1972).

51. Kemmons- Wilson, Inc. (Florida) & South Patton, Inc., A Joint Venture, ASBCA No. 16167, 72-2 BCA ¶9689 (1972).

52. General Builders Supply Co. v. United States, 409 F.2d 246, 249 (Ct. Cl. 1969).

53. Slingsby Aviation Ltd., ASBCA No. 50473, 03-1 BCA. ¶32252 (2003).

54. American Pipe & Steel Corp., ASBCA No. 7899, 1964 BCA (CCH) ¶4058 (1964).

55. Cimarron Constr. Co. & Williams Bros., ENGBCA No. 2862, 69-2 BCA ¶8003 (1969).

56. Energy Capital Corp. v. United States, 302 F.3d 1314, 1325 (Fed. Cir. 2002).

57. Rumsfeld v. Applied Companies, Inc., 325 F.3d 1328 (Fed. Cir. 2003).

58. Atherton Constr., Inc., ASBCA No. 56040 (2008).

59. Tecom, Inc. v. United States, 86 Fed. Cl. 437 (2009).

60. Carvel Walker, ENGBCA No. 3744, 78-1 BCA ¶13005 (1977).

61. Keco Industries, Inc., ASBCA No. 15184, 15547, 72-2 BCA ¶9576 (1972).