DoD Issues Guidance on Inflation and Economic Price Adjustments: What Contractors Need to Know

The current high inflation rate is adversely affecting the economy, and government contracting is no exception. Consequently, on May 25, 2022, DoD issued a memorandum to help contracting officers understand when it is appropriate to recognize contractor cost increases attributable to inflation and the proper use of economic price adjustment clauses when awarding new contracts.

Existing contracts

The memorandum starts by noting that, for existing contracts, the treatment of cost increases caused by inflation is dependent on the contract type. On cost reimbursement contracts, the government bears the risk of cost increases due to inflation, up to the funded amount of the contract. On fixed-price-incentive fee contracts with firm targets, the contractor is protected from cost increases up to the target cost. On fixed-price contracts with an economic price adjustment (EPA) clause, the contractor may be protected depending on the exact wording of the EPA clause.

However, the news is not as good for contractors with firm fixed price contracts. The memorandum initially notes that per the FAR, contractors performing under firm fixed price contracts assume the risk of cost increases due to inflation. In addition, the memorandum clearly stated that contracting officers should not agree to a request for equitable adjustment based on cost increases attributable to inflation as opposed to an actual increase in the scope of work.

New FFP contracts

This may be an example of locking the barn door after the house has escaped, but the memorandum acknowledges that in times of high inflation, an EPA clause “may be an appropriate tool to equitably balance the risk of inflation between the government and the contractor.” Per the memorandum, an EPA may enable the contractor to accept an FFP contract without having to price the worst case scenario, due to the protection offered by the EPA clause.

However, an EPA clause may not be suitable for every FFP contract. For instance, per DFARS 216.203-4, EPA clauses should only be used when the period of performance exceeds 6 months. Per FAR 16.203-4, EPA clauses are only appropriate when “significant costs will be incurred beyond one year after performance begins.”

Even if an EPA clause is appropriate, contracting officers must:

• Use independent, recognized sources as the basis for measurement of inflation in EPA clauses.
• Use an inflation index that is closely related to the cost components judged to be the most unstable.
• Limit the EPA clause to only the cost components likely to be impacted by economic fluctuations. Cost increases that are not attributable to inflation should not be subject to the EPA clause, nor should the EPA clause be used to increase profit.
• Consider establishing a floor and ceiling for adjustments under the EPA clause.
• Ensure that the contingency allowances covered by the EPA clause are not already included in the base contract price.
• Ensure the EPA clause allows for both upward and downward adjustments to the price upon the occurrence of the specified contingencies.

This last point is important in that contractors who are pricing fixed price contracts at the current inflated rates may find that once inflation slows, the EPA clause will be used to reduce their contract price.

Contact Aprio’s Government Contracting team to schedule a consultation and discuss how these matters affect your business.