CHAPTER

24

EQUITABLE ADJUSTMENTS

The government owes the contractor more money at many points in the contract administration process. Changes or modifications to the contract present the most common situation where an equitable adjustment has to be made. But there are other points in the process as well: differing site conditions, variations in estimated quantities, and delay.

When the government owes the contractor money, the government should make an equitable adjustment of the contract. Notice the word equitable. The idea is that any adjustment to the contract that the government makes must be fair, equitable, and reasonable.

But as the voluminous litigation over equitable adjustments shows, reasonable people can be miles apart on what’s equitable. Amid all these opinions about equitable adjustment, there are several basic principles that the government and the contractor have to follow.

    What is the starting point for calculating an equitable adjustment?

The most basic starting point in determining an equitable adjustment is cost. An equitable adjustment is based on cost. This presents two seemingly valid arguments that contractors would like to make. The first argument, from a contractor’s perspective, is that changes in the basic contract should be based on the price at which the item was bid in the basic contract. For example, if a contractor won the contract by bidding a price of $300 per fire sprinkler head, it seems reasonable to the contractor to get paid $300 per sprinkler head if the government issues a modification for more sprinkler heads.

But that’s not the law. The law says that equitable adjustments are based on cost—the cost to the contractor for the additional items. If the contractor actually pays $100 for the heads, that’s what the contractor starts with for an equitable adjustment.

A second argument contractors like to make is that an equitable adjustment should be based on the value of the change, not the price. Obviously, there can be a big difference. For example, in the classic case that established the “cost, not value” principle, the contractor was told to change the brick to be used on a building. Instead of a basic brick, the government wanted a decorative brick. The contractor managed to get the premium brick at the price of the basic brick. So when the contractor asked for an equitable adjustment for the change in brick, the contractor wanted to be paid for the value of the brick, say $3 per brick, rather than the actual cost of the brick, say $1 per brick. Incidentally, the contractor got that price because it managed to get a good deal at the quarry.

The contractor had an interesting argument. The contractor argued that its company had increased the value of the government building by using the better brick. So it would be unjust enrichment of the government if the government paid the basic brick price for the premium brick. A second argument the contractor made was that the government should pay the value of the brick as the basis for the equitable adjustment so that contractors are encouraged to use smart business techniques in carrying out changes. Paying the contractor for the value of the item would do that, in the contractor’s view.

Neither of these arguments was successful. The court ruled that the starting point of any equitable adjustment was the actual cost of the item to the contractor.

Cost, however, is simply the starting point. The fact that a contractor actually spends a specified amount for an item doesn’t end the discussion. There’s the concept of reasonable cost. A contractor could have bought snow shovels in the middle of a blizzard, when prices would be higher, when it should have bought them in September. The government will pay for a cost only if the cost is reasonable. And the burden is on the contractor, not the government, to prove that the cost is reasonable.

    How much profit should a contractor make on an equitable adjustment?

A second component of an equitable adjustment is profit. A contractor is entitled to profit on an equitable adjustment. There are some exceptions to this. For example, an equitable adjustment to a contractor for a suspension of work cannot include profit because the suspension of work clause on its face says that profit should be excluded from any equitable adjustment under that clause.

How much profit should a contractor make on an equitable adjustment? The standard answer is that a contractor should make the same profit on the equitable adjustment as on the underlying contract.

There are, however, exceptions that allow the profit to be higher or lower depending on the circumstances. For example, a contract started out with relatively easy work. A contractor would unload container ships several times a week. Then after Desert Storm began, the work increased significantly. Sometimes there would be two or three ships a day to unload. As a result of this great increase in work, the contractor had to hire more people and had to set up more complex accounting systems. When the government made an equitable adjustment to the contract to pay for this extra work, it did not want to pay a higher profit. The contractor took the case to a board, which found that the contractor was entitled to a higher profit. The contractor got a higher percentage profit than on the underlying contract because the work had become more difficult.

On the other hand, where a modification to a contract is a relatively simple task with very little risk and very little effort on the contractor’s part, the government has an argument for putting a lower profit on the equitable adjustment.

    When work is taken from a contract and different work is added, how is that priced?

Pricing modifications that reduce the amount of work a contractor is to do can be tricky. The first step is to calculate what the original work would have cost. In these so-called “deductive changes,” the principle to keep in mind is that the change should keep the contractor in the same position, in terms of profit, that the contractor would have been if the work originally contracted for had been carried out.

This can have some strange results. For example, the government started out wanting a buried electrical wire system but changed to a less expensive overhead wire system. The government said the original system would have cost the contractor $60,000 and the modified, overhead system would cost $20,000 so the government deducted $40,000 from the contract. The only problem for the contractor was that the contractor had made a bad bid for this part of the contract. The electrical subcontractor had left out some equipment. As a result, the contractor bid $34,000 for what the government said was a $60,000 job. So naturally, the contractor objected to the government deducting so much money. As the contractor put it, the government was taking $40,000 from its contract and making it pay $6,000 of its own money for doing the modification work.

The argument has superficial appeal because it seems unfair. The problem, however, is not the government’s “would have cost” approach. The problem is that the contractor made a bad bid. If the contractor had carried out the original work, the contractor would have lost a lot of money. And since the contract started out with a bad bid, the loss in that bad bid has to be carried over to the modification.

From that viewpoint, it’s hard to feel sorry for the contractor. As a practical matter, the contractor would have lost a lot of money doing the original work since the original work would cost $60,000 and the contractor bid only $34,000. So the contractor would have lost $26,000 doing the original work.

Fortunately for contractors that make good bids, a very profitable contract that is modified by deducting a very profitable item has to maintain the same profit percentage on the new work. For example, if a contractor can win a bid by pricing a $7 item at $12—a huge profit margin—this $5 profit margin would get carried over into any modification in the contract.

The would-have-cost principle, however, is often difficult to apply. What if the original work had allowed the contractor to keep the income from work to be done? Since that work won’t be done, the income won’t be made. Is the contractor’s loss of income to be considered a damage of the modification for which a contractor should be compensated?

No. For example, a contract allowed the contractor to keep the money from the sale of rock excavated from the site where a building was being built. But problems developed with the use of approved disposal sites for the rock. So a modification to the contract was made. Rock would no longer be disposed of off-site. Instead, it would be used on-site as fill. As a result, the contractor could no longer sell the rock. When the time came to put a price on the equitable adjustment, the contractor wanted to get credit for the loss of income it experienced now that the rock would not be disposed of off-site and sold, bringing in additional income.

The government was against giving the contractor money for this loss of income. It argued that the changes clause promised the contractor payment for the increased cost of performance, meaning, to the government, only the out-of-pocket costs associated with a modification. The government did not believe that a loss of income was a cost of performance. The government also argued that the loss of income was speculative, in that it would be hard to establish how much money the contractor would have made selling the rock on the private market.

The board agreed with the government that the modification could not address the amount of income allegedly lost from the nonsale of the rock. It agreed with the government’s argument that the amount of loss would be too remote and speculative to be recovered. “In general, losses related to other, unrelated contracts and related to general loss of business may not be recovered as part of an equitable adjustment.” The board concluded that the loss of income amount could not be considered part of the equitable adjustment (SAE Americon, PSBCA No. 3866, March 31, 2000).

    Sometimes the same kind of government action can be compensated under various clauses, with different dollar consequences. How does this work?

The deductive changes discussed above are one example of that. In a deductive change order, the government takes work off a contract, But there’s another way the government can take work off a contract: It can do a partial termination for convenience that terminates or reduces the work under the contract. So the same kind of government activity, reducing work under the contract, can be done under either of two clauses.

What is the difference if one clause is used rather than the other? The lawyers and accountants will care if the government uses a deductive change order and not a partial termination for convenience. The reason they care is that their fees for helping a contractor prepare a partial termination for convenience settlement proposal are costs that the government must pay to the contractor under a partial termination for convenience. But if a deductive change order is used, the costs of the accountants and lawyers probably would not be paid for by the government.

Various clauses can affect how the government pays for the delay. In a construction project, for example, delay can be paid for under any one of three clauses. The delay can be paid for under the suspension of work clause, the differing site conditions clause, or the changes clause.

Under the suspension of work clause, the government pays only for delay that stretches out to an unreasonable amount of time. In addition, the suspension of work clause does not pay a contractor profit.

Delay can also be paid for under the changes clause. For example, if a contractor wastes time working with a defective government specification, that delay can be paid for under the changes clause. The advantage of using the changes clause here is that under a defective specification delay claim, all delay attributed to the defective specification is compensable. No consideration is given to what amount of delay is reasonable and what amount of delay is unreasonable. All delay, reasonable or unreasonable, attributable to a defective specification is compensable.

Delay can also be paid for under the differing site conditions clause. When differing site conditions are encountered (for example, discovering harder rock than the government anticipated at a construction site), a contractor can get paid more for doing more work associated with the harder rock. But what typically happens when harder rock is discovered is that the project gets delayed for some period of time to allow the government to decide what to do about the rock. Once the government decides what to do, it will tell the contractor how to proceed. While the government is considering how to fix the problem, there’s usually a period of delay. When the government implements the fix, it will use the changes clause.

Typically under the changes clause, the equitable adjustment includes profit. So in calculating an equitable adjustment for differing site conditions, it’s possible for the government to inappropriately add profit to the delay. However, delay under the differing site conditions clause (that is, the delay that occurs before the differing site conditions are fixed) should be compensated using the suspension of work clause, which does not allow profit on top of the delay.

    Can an equitable adjustment include the costs of a consultant like a lawyer or an accountant?

It depends on how the consultant is used. But the FAR clearly makes these costs allowable. In FAR 31.205-33, the term professional and consultant services is defined as

A CO must consider the following factors in FAR 31.205-33:

1.   The nature and scope of the service rendered in relation to the service required

2.   The necessity of contracting for the service, considering the contractor’s capability in the particular area

3.   The past pattern of acquiring such services and their costs, particularly in the years prior to the award of government contracts

4.   The impact of government contracts on the contractor’s business

5.   Whether the proportion of government work to the contractor’s total business is such as to influence the contractor in favor of incurring the cost, particularly when the services rendered are not of a continuing nature and have little relationship to work under government contracts

6.   Whether the service can be performed more economically by employment rather than by contracting

7.   The qualifications of the individual or concern rendering the service and the customary fee charged, especially on nongovernment contracts

8.   Adequacy of the contractual agreement for the service (e.g., description of the service, estimate of time required, rate of compensation, termination provisions).

The focus of the U.S. Court of Appeals for the Federal Circuit is much simpler: benefit to the contract. “Costs incurred in connection with contract performance or contract administration should ordinarily be recoverable because they normally ‘benefit’ the contract purpose” (citing Singer Co. v. United States, 568 F.2d 695, 721 (Ct. Cl. 1977)) and “reimbursement of [these costs is] in the best interest of the United States” (citing H. Rep. No. 169). Benefit to the contract purpose, whether in its work performance or administration, is therefore a prerequisite for allowability.

One common government response to a contractor’s desire to get consultant costs back directly, as a direct cost, is that consultant costs, like attorneys’ fees, are included in a company’s overhead and indirect cost pool. But classifying these costs as indirect would be unfair. As one board of contract appeals has stated: “We have previously held that legal fees and other costs incurred in preparing and submitting contract claims to the CO are allocable as direct costs of the contract to which they relate, and that “to regard the expenses as indirect costs would … unfairly and inequitably burden other contracts.”

Sometimes whether consultant costs will be allowed is right in the contract. For example, a government lease provision promising payment of costs for seismic work may include, as a direct cost, the costs of an attorney who worked with local government authorities to ensure compliance with local seismic requirements. A modification allowed a contractor to be reimbursed “for the cost of the seismic work” associated with the alteration and expansion of a post office. During the course of the seismic work, attorneys were needed to work out problems the city had with the retrofit. When the work was completed, the landlord tried to get the attorneys’ fees reimbursed. These costs were found to be reasonable costs incurred in the course of performance, and the contractor was entitled to recover them.