(Editor’s Note. There are more reasons than ever for contractors to become capable of identifying and quantifying contract modifications or in everyday terms, changes to existing contracts. Severe federal budget constraints, efforts to obtain more for less or need for new arrangements such as consolidating work for some and deleting work for others create a variety of change scenarios that contractors need to be able to identify and quantify to maximize their profitability. We have addressed this issue in the past but more acceptable techniques are now available. We have decided to write a two part article in order to provide some detailed useful information when it comes to preparing a request for equitable adjustment to contract prices or a subsequent claim rather than a mere overview of this important topic. We are using Darrell Oyer’s text on Cost Based Pricing and our own experiences helping clients prepare and negotiate requests for equitable price adjustments.)
Change scenarios may be a result of a unilateral change by the government, agreed to changes by both parties where compensation is negotiated or those where the buyer does not believe there is any entitlement to more money but the seller does, resulting in a constructive change to the contract. The last scenario results in a request for additional compensation called a request for an equitable adjustment (REA) which if not resolved by the parties evolves into a claim.
If the modified work has already been performed then it is similar to pricing cost type work where actual costs will need to be identified. If there is a deletion of work then several pricing issues arise. Other times a constructive change may cause a delay in performing the work where then other cost issues come into play such as idle capacity, unabsorbed overhead and price escalation.
Like any proposal, there are several elements of costs that need to be included in an REA – direct labor, both hours and rates, direct material and subcontracts, other direct costs, applicable indirect costs and profit. We will address issues related to each one of these categories where direct labor and direct materials and subcontracts are discussed here.
Direct Labor Hours
When the contract work has already occurred, then the issue becomes identifying how many additional hours were required because of the modification. However, establishing what the actual hours for the modification is usually involves an estimate since the hours for the modification are usually not segregated. There are many reasons for this – the contractor may not have been aware at the time there was a constructive change, there may have been a reluctance to press for an REA or there was lack of knowledge about what is a changed condition.
Despite the difficulty, a modification usually involves additional work (e.g. larger crews, overtime payment, acquiring different employees with different skills, time to identity the changes). For deleted work under a change, direct labor hours may be reduced but hours also tend to increase because of inefficiencies of remaining labor.
Cost accounting standards (and their duplications in the FAR) need to be considered. CAS 401, requiring consistency in pricing and accounting for labor, require the same labor categories used to price a modification must be used in recording the costs of the modification – if they are different, then a CAS 401 violation can be asserted. CAS 402, which addresses consistency in direct versus indirect costing, requires that a labor category that is normally indirect must not be charged direct under a modification. Under many circumstances such indirect costs are actually direct so the contractor needs to show there were differing circumstances justifying the different treatment.
Supporting documentation is difficult for contractors and often a bone of contention with auditors who audit the REAs. Ideally, time records would provide a record of the extra hours caused by the mod. When possible, a contractor should establish separate project numbers to collect the additional hours and to distinguish it from the non-modified work. Compliance with these time records are often a major problem where constant monitoring of employee compliance needs to be in place.
Timesheets alone are usually not sufficient documentation. Estimates are usually required based on employees’ knowledge of what they were working on when the mod events kicked in. Employees need to be interviewed where memories may be far less than perfect or they may either exaggerate or underestimate hours involved. Signed statements by employees is usually a good idea because if it turns out they were inaccurate or change their mind later the contractor has the statement it relied on for its estimate. In addition, employee memories may be enhanced by employee calendars, notes, log books, emails, etc. Also documents independent of the employee can be helpful such as travel records, visitor logs, meeting minutes, correspondences, activity reports, etc.
When prospective pricing is called for, providing an estimate of hours is best left to technical people who have a sound understanding of the labor needed to produce the product or service. If the item is produced for the first time the technical personnel will rely on drawings or the proposal. If it was produced previously, there is likely considerable data available on how many hours are needed such as estimates on previous contracts if actuals are close to estimated hours.
Be aware that auditors and/or a price analysts like to review history. They may compare actual and estimated hours for previous items. If actual hours are consistently close to estimates the reviewer may conclude the mod’s estimates are reliable. If actual hours turn out to be less than budgeted hours for historical items they may conclude there are no damages because actual hours will likely be less than estimates. If actual hours are greater the reviewer may opine the estimates are not reliable and question them. You will need to show that comparisons of actual to budgeted hours are not an accurate measurement of damagers caused by the mod.
Loss of Efficiency. Case law has long provided that contractors are entitled to recover additional costs caused by a government’s delay or disruption of costs. Where there is no other comparable work to transfer employees to contractors are entitled to costs which could not be avoided by good management. Sometimes a delay may not completely stop a contractor but can significantly impede its work and reduce efficiencies of its labor. For example, cases or our experience have allowed costs for such activities as interruption of sequencing of jobs, additional rework caused by less efficient labor, changed conditions requiring movement to other facilities, delay caused movement of work into winter, where freezing weather reduces efficiencies. To recover these costs the contractor must prove the government caused the delays and that those government-caused delays impacted other work.
Also, loss of efficiency from government caused delays and interruptions can result in failure to take advantage of the so-called improvement or learning curve benefits. The curve is usually expressed as a savings of labor hours (though dollars can also be used) as production of an item or provision of an activity is increased that usually result in improvements and efficiencies. In its audits of proposals, DCAA auditors are instructed to look for proposed lower hours caused from the learning curve and it has software, accessible by contractors, to compute such learning curve effects.
Also costs of idle labor (as well as idle capacity discussed below) are generally allowable contract mod costs. Fear of expensive firing and rehiring, loosing valuable skills, remote site locations and expensive mobilization efforts are common justifications for not laying off employees and accepting idle labor costs. Care should be taken creating “busy work” for idle labor where some auditors may conclude any work they performed is valid company business and hence not allocable to the modified contract.
Direct Labor Rates
Labor rates can also increase due to such factors as different skills may be required for the modified work or increased need for more workers may cause rates to increase due to local shortages of labor.
If the work has already been performed actual rates should be used. If the mod is for future work, then estimates of the rates will need to be made and justified to auditors. For either actual or estimated work, contractors are allowed to use various composite or average rates computations – for example, average rates within departments, across departments, across labor categories and even standard costs have been accepted for purposes of mod costing as long as proposed wages are reasonably consistent with skill levels needed. Cases have allowed fringe benefits such as payroll taxes, insurance, etc. to be included as direct costs provided any “double counting” is avoided (e.g. these costs are removed from overhead that may be added to relevant direct costs). Other miscellaneous labor costs may also be charged to a contract such as job site expenses, supervision and non-productive labor as well as idle labor. Effort to avoid “double counting” needs to be taken where these costs need to be eliminated from relevant overhead and G&A pools. We have seen some auditors insist not only the labor costs being charged to the mod must be removed from the pools but all the same categories of labor costs must be removed and charged directly to other contract work so judgment should be used to decide whether to charge these miscellaneous labor costs directly to a mod.
Labor rate escalation. Delays may require work be performed in later periods than originally anticipated. For estimated work, use of an escalation factor is appropriate. If the company has either a union contract or history of escalation of rates for labor categories being proposed that should provide ample documentation for a selected rate escalation. DCAA uses very expensive surveys which are not practical for most contractors to use. In our experience, escalation rates of 3% or less are generally not challenged by DCAA so either use that rate or if higher, be able to justify it by prior experience.
Direct Materials and Subcontracts
Direct materials includes raw materials, purchased parts and subcontracted items needed to manufacture or assemble a completed product. A direct material cost is the cost of material used to make a product and for mods is directly associated with the change in the product. It should generally be significant enough to justify accounting treatment of the cost. As in the other costs we are discussing, we are addressing either costs that have been incurred which involves examination of books and records or costs that will be incurred where estimates need to be reviewed.
There will likely be either increases or decreases in material costs where many factors should be considered such as: (1) elimination or addition of work that may require more, less or different materials (2) new material requirements may require minimum buys (3) market prices may have changed (4) different quantity will affect unit prices
(5) schedule changes may require premium costs (e.g.
accelerated delivery) (6) cancellation charges for previous orders (7) increased costs for later purchases result in material price increases and (8) costs of storage for materials that were planned to be used earlier.
For incurred costs, the actual costs of labor, equipment and materials is usually presumed to be reasonable and hence used as the basis for the REA. Estimated costs are a different story. A contractor or subcontractor will support its costs usually by preparing a priced billed of materials which are, in turn, based on quotes from suppliers or charges from inventory. Attrition in the form of scrap, spoilage, rework, pilferage, yields and obsolete materials need to all be considered. Though veteran contractors will likely have methods in place to charge material overhead – transportation, handling, inspection, storage, insurance – newer contractors will need to establish rates to apply to direct material costs to be able to recover these costs.
Finally, prime contractors or upper-tier subcontractors will need to have in place a way to assure their subcontractors’ costs are adequately supported. Cost or pricing data will need to be requested and reviewed and a decision to use its in-house resources, government resources (it’s questionable whether auditors or other government reps are now responsible) or experienced third party auditors will need to be made.
Intercompany Transfers
FAR 31.205-36 places certain restrictions on the pricing of work performed by other divisions of a company that is under common control. When the item is considered to be a commercial item then it is transferred at a price based on its catalog or market price. That price then should be adjusted for quantities or actual cost of modifications that may be required by the contract change. Sometimes it may be a company practice to establish intercompany transfers at a price that is neither a cost nor commercial selling price but somewhere in between. This transfer price is higher than the manufacturing costs but less than the commercial selling price based on the logic that certain commercial selling costs would not be applicable to a transfer such as credit reviews, financing, bad debt losses, and sales expenses).
(We will address other direct costs, allocations of indirect costs and profit considerations in Part 2 of this article).
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