Since October 2020, inflation in the United States has seen its fastest increase in more than 30 years. In the last year alone, inflation has remained as high as 8.6%. This hike has impacted everything from diesel to steel. In the construction industry, the higher prices of goods and services directly affect how contractors draft their construction contracts.

The Department of Defense (DoD) has taken note of this dramatic price increase and recently issued guidance to its commanding officers and the procurement community. On May 5, 2022, DoD issued a memorandum titled “Guidance on Inflation and Economic Price Adjustments.” The stated purpose of the memo is “to assist COs to understand whether it is appropriate to recognize cost increases due to inflation under existing contracts as well as offer considerations for the proper use of EPA when entering into new contracts.” DoD’s memo responds to contractor and contracting officer concerns about the sudden and unexpected cost increases in labor and materials.

Economic Price Adjustments, or EPAs, are adjustments to a stated contract price upon the occurrence of certain contingencies. FAR 16.203-1. They are of three general types – (1) adjustments based on established prices, (2) adjustments based on actual costs of labor or material, or (3) adjustments based on cost indexes of labor or material. Id. Because EPAs allow for adjustments in a contract price, EPA clauses allow a contractor to recover unanticipated increases in its project costs. For example, FAR 52.216-4, Economic Price Adjustment-Labor and Material, authorizes a contractor to recover for increases in the cost of material or labor. Such recovery is available when costs increase more than 3%, with a maximum recovery of 10% of the original contract price. See also FAR 52.216-2 through FAR 52.216-4. These EPA clauses provide contractors with relief and protection from issues such as dramatic inflation. EPA clauses, however, are not included in all contracts.

In its memo, DoD encourages the use of EPA clauses where appropriate. DoD first explains that the treatment of inflation depends on the type of contract at issue, i.e., whether cost-reimbursable or fixed price. For cost-reimbursable contracts, inflation is an assumed part of the risk borne by the Government. Those contracts typically include notice clauses for cost increases and are governed by regulations such as FAR 52.232-20, Limitation of Cost, or FAR 52.232-22, Limitation of Funds. Once the contractor provides notice to the Government of the increased cost, the contractor can stop working unless and until the Government increases the contract funds to cover those costs. These types of contracts provide the most protection for a contractor in the current inflation environment because, as long as the contractor meets the notice requirements, it has contractual protection to recoup its costs if they suddenly spike.

DoD identifies two other types of contracts: fixed-price incentive firm (or FPIF) contracts and fixed-price contracts with economic price adjustment (or FPEPA) contracts.

FPIF contracts specify a target cost, a target profit, and a target price, which is a combination of the cost and profit. FPIF contracts also set forth a price ceiling. The contractor’s actual costs are recognized up to that ceiling. Still, if they differ from the target cost, the profit is adjusted by applying a profit adjustment formula, also known as a “share ratio” or “sharing arrangement” to any costs over or under the target. Because the formula is agreed-upon ahead of time, the Government and the contractor have better knowledge of their respective exposures if costs fluctuate.

FPEPA contracts include an EPA clause that seeks to mitigate cost risks to both the contractor and the Government due to contingencies beyond the contractor’s control, such as unanticipated inflation. Typically, the clause will state that the Government will bear the cost risk up to a specified amount. Like the FPIF, the contracting parties are better prepared for fluctuations in the market because they establish cost boundaries ahead of time.

Compared with cost-reimbursement, FPIF, or FPEPA contracts, in a firm-fixed-price (FFP) contract, the contractor, rather than the Government, generally bears the risk of cost increases due to inflation. This risk exists because FFP contracts are drafted as they sound, with a “firm fixed price” without any sharing arrangement or price adjustment clause. In the absence of a contract clause that allows the contract price to increase due to inflation, the contractor is typically left to incur cost increases, which generally erode the contractor’s profit.

To avoid an inequitable cost burden on the contractor due to unanticipated inflation, the DoD responded to a proposal for a contractor under an FFP contract to submit a request for equitable adjustment (REA). REAs are contractor proposals to a contracting officer requesting an equitable adjustment in the contract via a contracting officer-directed change. DoD, however, explicitly advised against using REAs to address inflation because inflation is not a change caused by the Government.

For current and future contracts, and depending on the length of the contract, DoD recommends that contracting officers include EPA clauses in their contracts to account for “unstable market conditions.” The length of the contract is important because the FAR limits the use of EPA clauses to those where the work will be done six months out from the contract start date (DFARS 216.203-4(1)(ii)(based on established prices or actual labor and material costs) or for extended performance contracts where significant costs are incurred one year after the work starts (FAR 16.203-4(d)(1)(i)(based on cost indices of labor and material).

In addition to the timing of the contract, DoD cautions contracting officers who draft EPA clauses to consider the type of cost involved, noting that EPA clauses should be limited to costs that are more likely to be impacted by inflation compared with those that are not. The memo cites labor costs under a union agreement for an FFP subcontract as well as profit as examples of such non-impacted costs. The memo further advises that the index used to measure inflation for the EPA clause should be thoughtfully chosen, and “the CO should take care to use an index that is closely related to the cost components judged to be most unstable.” DoD then cites a few examples of appropriate indices – the Bureau of Labor Statistics Producer Price Index, the Employment Cost Index, and the North American Industry Classification System Product Codes.

DoD next outlines the parameters of an “appropriate” EPA clause with the overarching goal of fairness to both parties. Such a clause will (1) allow for adjustment of the contract price up or down; (2) use the same index to both establish and adjust the negotiated price in the clause; and (3) include the same range or magnitude of adjustment on both the ceiling and floor prices if both are in the contract. The purpose of the EPA clause is to work out the contract price adjustment ahead of time, before the impact of inflation, rather than enable the parties to reopen negotiations on the contract.

DoD noted that best practices for contracting officers include consulting legal counsel, reviewing guidance in the FAR, and consulting local offices and agencies. The memo concludes with a reminder that EPA clauses invoke contingent liabilities, which must be administratively reserved as commitments.

Notably, DoD clarified that its guidance be more broadly applied to any contract provision that alters the price of a contract because of changes in the economy, not just EPA clauses. Therefore, contractors who work outside the world of Government contracts can also use this guidance to craft and include EPAs when negotiating contracts with private owners or other state or local public agencies. Contractors can apply the same parameters identified by the DoD (i.e., up and down price adjustment, similar bases of price measurement, and equal ranges of adjustment on the high and low price points) to balance the goals of equity and fairness with risk mitigation in a currently volatile market.

Watt Tieder is one of the largest construction boutique law firms in the United States, with a diverse and experienced team of attorneys representing many of the world’s leading corporations, developers and contractors on both domestic and international projects. We represent more than half of the Top 30 Engineering News Record contractors and most of the nation’s top sureties. With offices in six cities in the United States, the firm is a dynamic, mid-size boutique that provides knowledgeable and practical legal representation to the construction, surety, government contracts and bankruptcy industries world-wide.

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