In response to industry-wide questions about price adjustments for economic inflation, the Department of Defense (DoD) has released guidance about when and how contracting officers may provide financial relief to contractors working on fixed-price contracts. The guidance generally discourages contracting officers from granting adjustments under the Changes clause due solely to inflation. But it does not completely close the door to adjustments, and it offers modest options for fixed-price contracts that contain an economic price adjustment clause. Moreover, DoD encourages contracting officers to consider inserting economic price adjustment clauses in new solicitations.

This blog post summarizes DoD’s guidance, explains the mechanics of economic price adjustment clauses, and offers views about evaluating other grounds for relief.

DoD’s Guidance for Existing Fixed-Price Contracts

DoD’s guidance recognizes that “inflation is impacting several segments of our economy” and has caused increased costs of performance for many contractors. Those increases have eroded the profit margin of contractors working under fixed-price contracts, which are generally not subject to any price “adjustment on the basis of the contractor’s cost experience in performing the contract.” See FAR 16.202-1.

As an exception to that general rule, contracting officers may award an equitable adjustment to a fixed-price contract in cases covered by the standard Changes clause at FAR 52.243-1, or other cases where a specific clause grants a right to equitable adjustment. DoD explains that it has been “fielding questions about the possibility of using requests for equitable adjustment (REAs)” under the standard Changes clause to help contractors “address unanticipated inflation.”

Unfortunately, DoD’s guidance takes a narrow view of the standard Changes clause in fixed-price contracts. DoD explains that the Changes clause permits adjustments when there is “a contracting officer-directed change within the scope of the contract, in the areas defined by the applicable Changes clause, or by another contract clause that authorizes an equitable adjustment based on specific actions taken.” The guidance goes on to state that “since cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change, COs should not agree to contractor REAs submitted in response to changed economic conditions.” In other words, DoD’s guidance discourages contracting officers from granting equitable adjustments based purely on inflation.

That said, the guidance leaves open the possibility of inflation-related claims when a contracting officer has directed changes within the scope of the clause. That could include situations where a contracting officer directs a different method of performance because of changed economic conditions (e.g., directions to use a component other than the one specified or to meet a different schedule of performance). Indeed, contractors experiencing increased costs should think broadly about potentially changes caused by the contracting officer, which could open the door to adjustments.

Economic Price Adjustment Clauses: An Option for Relief

DoD’s guidance does offer a modest solution for contractors with fixed-price agreements — it encourages contracting officers to provide relief under “economic price adjustment” clauses, often referred to as EPAs.

The FAR provides a list of standard EPA clauses, allowing for economic price adjustments — i.e., an increase or decrease in contract price — upon the occurrence of a specified trigger event. Generally, price adjustments are based on changes in (1) agreed-upon or otherwise established catalog or market prices of specific items; (2) actual costs of labor or material that the contractor experiences during performance; or (3) contractually-specified cost indexes of labor or material relevant to the contractor’s performance. See FAR 16.203-1(a).

EPA clauses can thus account for unexpected cost increases due to inflation, and can allow contractors to seek an adjustment. However, most existing fixed-price contracts do not include an EPA clause, rendering this potential remedy unavailable to contractors in many cases. In addition, EPA clauses are not a silver bullet for contractors, because they normally cap price adjustments at a pre-set amount. For example, the standard EPA clause for supplies provides that the “aggregate of the increases in any contract unit price under this clause shall not exceed 10 percent of the original contract unit price.” FAR 52.216-2(c)(1).

DoD’s guidance recommends that going forward contracting officers consider including EPAs in new solicitations. DoD explains that “[i]ncluding an EPA clause may enable a contractor to accept a fixed-price contract without having to develop pricing based on worst case projections to cover the cost risk attributable to unstable market conditions because of the EPA clause’s built-in mechanism to mitigate such risk.”

In specific, DoD indicates that contracting officers should consider preparing tailored EPA clauses based on an economic index, such as “the Bureau of Labor Statistics (BLS) Producer Price Index series; the Employment Cost Index for wages and salaries, benefits, and compensation costs for aerospace industries; and the North American Industry Classification System (NAICS) Product Codes.”

The guidance provides four key suggestions for contracting officers to consider when drafting EPA clauses in new solicitations and contracts: (1) allow both upward and downward price adjustments; (2) incorporate ceilings and floors on adjustments of a similar magnitude; (3) use carefully selected indices that are broadly exposed to the market, but narrow enough as to be relevant to contract performance; and (4) clearly describe the events that trigger a price adjustment, and the mechanism through which such price adjustment will be calculated. DoD points to further guidance for contracting officers drafting these provisions at DFARS PGI 216.203-4.

Contractors Should Be Mindful of Regulatory Requirements for EPA Clauses

DoD’s willingness to use EPA clauses going forward to address the current inflationary period should be welcome development for the defense contracting community. At the same time, contractors should know that EPAs come with special regulatory burdens, and they should be prepared to account for those burdens before accepting an EPA clause. There are three key issues to consider.

First, EPA clauses allow for a price adjustment only when specified conditions are met (i.e., the market price of a specified widget increases). Therefore, EPA clauses must be drafted to provide clear and unambiguous conditions for when the government must grant an adjustment. If a solicitation contains a confusing or vague EPA clause, contractors should consider raising the issue with the contracting officer, and may even want to consider whether a pre-award protest is appropriate.

Second, EPA clauses often require contractors to disclose financial or sales information to the government. The FAR states that “[i]n contracts that do not require submission of certified cost or pricing data, the contracting officer shall obtain adequate data to establish the base level from which adjustment will be made and may require verification of data submitted.” FAR 16.203-2(b) (emphasis added). However, in all cases the government must be reasonable — contractors may have options for pushing back against draft EPA clauses that include onerous disclosure obligations.

Third, EPAs cut both ways. A contractor may be able to claim an upward adjustment if costs increase, but the government normally has a right to claim a downward adjustment if costs decrease during contract performance.

Conclusion

DoD’s recent guidance suggests that the agency is not keen on taking retroactive action to combat inflationary pressure felt by contractors performing on fixed-price contracts. However, moving forward, we expect to see an increased number of index-based EPAs in fixed-price solicitations and contracts, dividing the risk of further inflation between contractors and the government. Rising costs are a thorny issue without a one-size-fits-all approach. While custom-tailored EPAs have their upside, there is an inherent risk associated with their lack of standardization, and we advise contractors to proceed with caution when negotiating and reviewing such clauses.