Abstract
Additional resources in this section:
Many executives and contract managers focus on the wrong issue when structuring their approaches to cost-reimbursement contracting: the key issue is not accounting:
In cost-reimbursement contracts, contractors do present their incurred performance “costs” to the other party for reimbursement. This causes contractors to immediately focus on tasks associated with how to collect, display, and present those “costs.”
By contrast, in fixed priced contracts, contractors must make binding, pre-award representations to the other party for a fixed price. This forces management to focus on how to perform the promised tasks at a low cost that is within or below the fixed price.
The above distinction frequently causes commentators to stress the supreme importance of cost accounting issues on cost-reimbursement contracting. For example, the cost-reimbursement contractor must consider:
What rules govern the reimbursement of specific types of costs?
What costs are not reimbursable?
What accounting structure for collecting and displaying costs must a contractor have in place? After all, that is how a contractor is paid.
Of course, cost reimbursement contracts do raise important accounting issues. But, government agencies often only declare 1% or less of contractors incurred costs (IRS deductible business expenses) unallowable under cost-reimbursement accounting rules Source. Therefore, there must be other more pressing issues for management’s attention, and there are. They are very similar to the performance related issues for fixed priced contracts, with some important twists in the road.
A. Our View of The Key Issues.
A thoughtful management approach to the real issues in cost-reimbursement contracting should take priority: business, economic, and political issues should be at the forefront of all cost reimbursement contract analysis. These issues are all driven by numerous political considerations. Accounting is an issue for specialists, and of secondary importance.
Cost-reimbursement contract executives and managers must focus on the following critical questions:
What are the customer’s expectations about performance time, and the contract’s technical requirements? Are they realistic? Can the customer’s expectations be met, and if not, how can the contractor diplomatically persuade the customer that its specific expectations are unrealistic?
Can the company perform the work within the cost goals set forth in the contract? If not, what positions will it take when asking for increased funding? Will such requests be granted, or will the customer be mad and perhaps not provide funding, thereby effectively “terminating” the program work?
What overall economic and political forces are driving the customer? Does the company understand them? Are they consistent with its contract rights? Can the company effectively use such forces or turn them to its favor?
Why is the company performing this work? Does it have definable short-term objectives?
What are the long-term corporate benefits in providing such low-profit work? Has the company incorporated the resulting benefits into its corporate long-term strategic plans?
And, perhaps most importantly: given the high-risk technical work to be performed, at often a lower profit, has the company fully protected its right to recover all of its current performance costs? A contractor should recover all of its costs less only minor disallowances under every cost-type contract vehicle used. This cost recovery should never be doubted. This assured recovery of all costs incurred makes up in some ways for the lower profit margins and other risks inherent in cost-reimbursement jobs.
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As you can see, each of the foregoing issues has nothing to do with accounting.
B. Government vs. Commercial Cost Reimbursement Contracts.
Making decisions in this area requires some appreciation of the modern origins of the current cost-type contract. The performance of high dollar, large-scale, cost-reimbursement contracts has principally been done for the federal government. It buys over $600 billion in supplies and services yearly, and a significant portion of that dollar volume is done on a cost-reimbursement contract basis.
Since World War II, this massive procurement activity has led the federal government to develop detailed procedures on how to administer cost-reimbursement contracts. More importantly, it has given federal contractors a 60-year opportunity to test those procedures and learn the methods to deal with reasonable and unreasonable actions by the government under such contracts.
C. The Pure Commercial Connection
Today it is not unusual to see many large and risk prone commercial contracts, including those for power plants, production facilities, environmental remediation projects, or other large commercial construction, supply, and service contracts, being performed on a cost-reimbursement basis. This occurs in purely commercial contract settings, as well as in situations that will eventually involve government funding obligations.
As examined below, there are reasons – largely political (or politically correct) – for the performance of this cost-reimbursement contracting.
Many of the business and political issues and responses discussed herein are similar to commercial, government, subcontract, or cost-reimbursement contracting. Such similarities are of course subject to the presence of specialized terms in individual contracts that can, and do at times, change the rules discussed in these materials. Be alert for such specialized contractual terms that may alter expectations.
Lessons learned from the performance of cost-reimbursement contracts with the federal government provide commercial contractors with a “leg up” in determining how a commercial customer (or government prime contractor) will react under various circumstances during performance.
Remember that some of your counterparts in the government or commercial procurement side (or even in your own company) may not yet grasp many of the points explored in this text. These issues often need to be explained to such individuals in a professional, diplomatic fashion.
D. The Uniqueness of the Cost-Reimbursement Contract.
One of the most difficult problems that company management and Government personnel initially face is distinguishing between fixed priced and cost-reimbursement contract performance obligations.
Again, this does not mean simply identifying and accounting for allowable job costs. It does include the identification of the obligation of a party to proceed with cost-reimbursement work versus fixed priced work at various points during performance:
When must a company spend its own funds?
What if technical results from a contractor’s performance are unacceptable?
When should the company wait for Government funding?
What are the political forces driving all of these decisions?
1. The “Labeling” of Contracts - A Caution.
Unfortunately, distinguishing between cost-type and fixed priced contract performance obligations is further complicated by the fact that the terms of the parties’ original contract documents are often unclear in defining each parties obligations, as well as unclear in stating whether the contract is of the cost-reimbursement type or not.
The contract type “block” on the front page of the contract on this point should definitely not be relied upon.
2. Cost-Type Contract Scope of Coverage.
The following issues, discussed below, are relevant in examining a cost type contract’s scope of coverage:
What are the parties’ essential performance obligations under a cost-reimbursement contract?
How are these different from a fixed price contract?
Are some contracts unclear as to whether obligations are really fixed priced or cost-reimbursement? (Yes, often!)
Is there a relationship between the type of specifications used in the contract, and determining whether a fixed priced or cost-reimbursement contract is actually involved? (Yes!)
E. The Politics of It All.
Two dictionary explanations of the term “political” and “politics” set out the correct frame of reference for our analysis:
“Prudently or artfully contrived; expedient, as a plan, action, remark, etc.”
“Factional scheming for power.”
[Webster’s New World Dictionary, 2d College Ed. 1974 & paperback Ed. 1990]
There is nothing at all wrong with utilizing political approaches to contract issues. And, it is wrong to ignore the fact that politics do exist and even control the outcome of many contract performance situations. To ignore such influences would be extraordinarily unrealistic and contrary to a company’s business interests.
Often “politically correct” statements and contract approaches, which can be disingenuous, compound the difficulty in understanding what is really happening during contract performance.
F. The Federal Acquisition Regulations.
The Federal Acquisition Regulations contain generalized guidance on when federal government agencies should use cost type contracts:
Cost-reimbursement contracts are suitable for use only when uncertainties involved in contract performance do not permit costs to be estimated with sufficient accuracy to use any type of fixed-price contract. [48 C.F.R. 16.301-2]
These regulations focus on using cost-type contracts for complex requirements that are not capable of being priced with adequate certainty. This is a good and operative goal.
There are many contract professionals who accept these goals at face value. We believe that a more searching examination is in order: For example, why were these regulations written, and what issues are underlying these directives?
However, do not lose sight of the overall positive advantages to both sides in using cost-type contracts. With proper administration, there should be:
1. Virtually No Disputes.
All effort should be focused on obtaining the result that the government desires – costs expended within reason are not an issue.
2. Greater Flexibility in Pursuit of Contract Goals.
There is no need to “establish” a contract “position” as to who is responsible for paying for “extra work” under the contract. All work done is paid for. All reasonable work and approaches can be pursued.
3. Partnership With Your Customer.
As all work is paid for the customer and contract personnel can work as a team on all issues. Both sides often have much to contribute to ensure that work is successfully performed. Knowing that all costs are reimbursable encourages openness and the sharing of data, approaches, and limitations.
G. Cost-Reimbursement Contracting vs. Fixed Priced Contracting.
A true cost-reimbursement contract is conceptually difficult for many people to accept. This is particularly true for executives and managers of prime contractors, vendors, or the federal agency involved (the party placing the contract).
So, what performance is properly expected from the contractor? And, at what cost?
1. Essential Duties.
Reduced to its most simplistic form, a cost-reimbursement contract obligates the contractor to:
a. expend funds for the other party;
b. perform that expenditure in a reasonably competent fashion; and
c. attempt (only attempt) to obtain a designated result through the expenditure.
It is nothing more. It is simply a “best efforts” undertaking by the performing party with no guarantees, and often no precise performance standards. As you can see, this is very confusing for both sides when debating a contractor’s performance results for a difficult, and often an ill-defined technical task.
2. Reasonable Competence in Performance.
The assumption behind a cost-reimbursement contract is that the agency’s/buyer’s money will be spent competently, although the case law indicates that even that is not a particularly strong requirement. The cost reimbursement contractor is paid for routine scrap, rework, mistakes, errors, and other acts of simple worker negligence.
Cost reimbursement should be in doubt only when performance problems approach gross negligence. And, these issues are virtually never formally decided because the politics of the situation often demand a quick trade-off and the prompt resolution of performance disputes.
3. Case Law Summary – Government and Commercial.
In the existing case law discussing cost type contracts, many cases allow the reimbursement of all costs incurred in the manufacturing of commercial goods, or in the construction of homes or buildings, etc.
These cases often define “cost-plus” commercial contracts as those requiring the reimbursement of all costs spent during the term of the contract to the seller. There are also government contract decisions that are similarly favorable to “sellers” or prime contractors.
Absent express contract language to the contrary, the costs of rework, extra work, the correction of defective specifications, and other similar costs, are reimbursable as direct costs under cost-type contracts.
The courts have held that the risk that such “extra” costs will be encountered is generally allocated to the buyer in cost-reimbursement contracts. Examples of commercial cases so defining the burden of such risks associated with “cost-plus” contracts include the following:
Continental Copper & Steel Industries v. Bloom, 96 A.2d 75, 139 Conn. 700 (1953);
Midwest Environmental Consulting & Remediation Services, Inc. v. Peoples Bank of Bloomington, 620 N.E. 2d 469, 251 Ill. App. 256 (1993);
Grothe v. Erickson, 59 N.W.2d 368, 157 Neb. 248 (1953); and
Finn v. Krumroy Construction Co., 589 N.E.2d 58, 68 Ohio App. 3d 480 (1990).
The decision in McDonnell Douglas Corp. v. United States, 37 Fed. Cl. 295, 16 FPD 14 (1997) is one example of a government contract case that discusses the differing contractual obligations with respect to fixed priced contracts and cost-reimbursement contracts. In describing the “best efforts” standard of cost reimbursement contracting the Court stated as follows:
Contractual duties differ markedly between fixed-price contracts and cost-reimbursement contracts. The "best efforts" standard summarizes the. . . basic nature of the cost-reimbursement contract. .Unlike a fixed-price contract, under which the contractor is obligated to deliver the material or service for the stated price, a cost-reimbursement contract merely requires the contractor to use its best efforts to provide the goods or services at the stated price.
If despite its best efforts, the contractor cannot meet the contractual requirements, the government has obtained precisely what it bargained for, namely, the contractor's best efforts. The contractor, therefore, is entitled to receive or retain its costs for what it has done. The government's only right is to the product or services, plans, and equipment for which the contractor was or will be paid under the contract. . . General Dynamics Corp. v. United States, 229 Ct.Cl. 399, 410-411, 671 F.2d 474 (1982) (dicta). Thus, the focus of a cost-reimbursement contract is contractor input, not output.
There is also a fine article written by Ralph Nash in the May 1966 George Washington Law Review at p. 693, entitled, “Risk Allocation in Government Contracts,” which anyone examining this particular issue should review.
4. Fee Alteration Issues.
Coupled with the foregoing performance obligations, the cost-reimbursement contract often contains very broad statements of work to be accomplished. These should not affect cost recovery, but can sometimes affect fee recovery.
To recover more fee on a cost-type contract, a contractor must show that the government required work in addition to the original “scope” of the contract. The contract’s “scope” is often very broadly stated, and therefore broad coverage requires broad work effort by the contractor. It is thus difficult for the contractor to argue that the work being required by the customer is beyond the original “scope” previously agreed to when the contract was awarded.
As a practical matter, this is the only way to receive more fee – i.e., to argue that “constructive” changes to the original work scope are being ordered. It can be done, but it is often difficult.
Again, in a cost-reimbursement contract, the contractor should be recovering all of its costs (less minor disallowances). Accordingly, only the amount of the fee should be at risk during contract performance. There should never be “cost claims for extra work” on cost-type contracts. Only extra fee disputes should occur. Stated more bluntly: only profit/fee (say 6% to 10%) should be at risk – never full cost recovery.
The contractor should also never assume that its unilateral decision to expend more costs will mean it will recover more fee: under the terms of most cost-reimbursement contracts, the expenditure of more costs effectively results in a reduced fee. More cost also irritates the government customer because it must pay more.
Finally, from a business point of view, more cost (with no increased fee) means at least an erosion of margin on the job. This has negative investor implications and presents future bidding/proposal problems for the contractor with the same customer on a new or follow-on contract.
5. Work Stoppage.
The most surprising thing about a cost-reimbursement contract to many executives and managers is that a contractor – the prime, subcontractor, or the seller - has an absolute right; indeed some would say an obligation to stop work as it approaches the full expenditure of funding that has been applied to the contract.
(We say “applied to the contract” to avoid terms such as “allocated,” “partially or fully funded,” “incrementally funded”, and the like, all of which are terms of art, which may or may not have significance depending upon the particular contract clause used.)
The obligation of the contractor to stop work - or have more funds applied to the contract to continue work - is an essential part of the cost reimbursement bargain between the parties. It is the only leverage point the contract provides to the contractor, yet most contractors are in a muddle about how to use this most important tool.
a. Source of Right to Stop Work.
The right to stop work comes from the contract and the FAR. Consider the following language from the government’s regulations (FAR § 32.704) implementing the applicable clauses:
(a)(1) When a contract contains the clause at 52.232-20, Limitation of Cost; 52.232-21, Limitation of Cost (Facilities); or 52.232-22, Limitation of Funds, the contracting officer, upon learning that the contractor is approaching the estimated cost of the contract or the limit of the funds allotted, shall promptly obtain funding and programming information pertinent to the contract’s continuation and notify the contractor in writing that –
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(iv)(A) The Government is considering whether to allot additional funds or increase the estimated cost, (B) the contractor is entitled by the contract terms to stop work when the funding or cost limit is reached, and (C) any work beyond the funding or cost limit will be at the contractor’s risk.
Is there anything unclear about the underlined language above? Absolutely not! Commercial cost-reimbursement contracts contain (or should contain) similar language. The contractor must have a corporate strategy for using this stop-work right in a professional, even-handed fashion. This is the contractor’s most important leverage point in contract performance/funding issues.
b. Notice of Overrun.
Note also that the Limitation of Cost Clause, FAR § 52.232.20, and the Limitation of Funds Clause, FAR § 52.232-22, require that a contractor provide advance notice to the government agency (buyer) that an overrun is likely, as well as sixty days advance notice before a contractor’s funds are seventy-five percent expended.
These notice issues are not something to be ignored by contractors until the last minute. They present important opportunities to educate the customer concerning major progress on the program, and why the addition of funding is in the government’s interests (as well as the contractor’s).
c. Contractors Who Ignore This Clause.
There are hundreds of decided cases in which the contractor ignored the clause language, discussed above, and actually exceeded the cost limit. The government then, for whatever reason, did not add funding to the contract. Contractors lose almost all of these cases.
Of course, the government agency can waive – after-the-fact – the requirements of the clause. But, can your company take the risk that it may not? The answer is no, in almost all instances.
Some major weapons systems contractors with large amounts of cost-type work for the same agency might consider a one to three-month lapse in funding tolerable (they actually do this). But, even they will tell you it is risky business. Their business people lose sleep over whether the agency will really catch-up on the funding. The government agency has no obligation to do so: it may justifiably let funding lapse. The program/contract dies at that point.
6. Summary.
a. Contrast to Fixed Price Contract.
Note how completely the foregoing differs from what you know about fixed priced contracts. There, a contractor agrees to a fixed price, and is expected to complete the work no matter what it costs. If they spend less to complete, the company gets to keep the added profit. The contrast to cost-reimbursement obligations is startling.
b. Summary re Cost-Reimbursement Contract Obligations.
Some individuals would say that a cost-reimbursement contract is nothing more than an obligation to make reasonable expenditures of the government’s (or other party’s) money. When the money is about to run out, give notice, and remember to stop work until additional funds are added to the contract.
This may be correct legally and contractually. However, it totally ignores the politics and economics of the situation, which we discuss next.
H. Areas of Management Challenge in Cost-Reimbursement Contracts.
As defined above, situations are “political” when they are “artfully contrived” or involve “expedient action”. Such political approaches are certainly in evidence in the award and performance of a cost-type contract, and the decision to add or not add more funding.
This award and performance are taking place to artfully obscure what may be the real concerns and the real objectives of the parties. The cost-type contract may be “expedient” or “artful” to accomplish something. That may not be the publicly stated reasons behind the use of a cost-type contract, nor may it necessarily be the best way to proceed.
Difficult political and economic issues often underlie the real life situations in which a cost-reimbursement contract is awarded and performed. For one thing, these political and economic issues tend to totally stand the contractor’s legal/contractual rights on its head.
For example, if a contractor insists on getting more money added to the contract or being paid for non-compliant work, the agency may well cancel the contract. The agency has every right to do so. The contractor has no remedies. It gets paid for what it spent, and the contract simply ends.
Thus, the parties start performance at what is really a standoff. This stand-off continues until the work is completed or the contract is canceled: ask for more money – the government might give it – or might cancel the contract and/or the program. It may all depend on the current “appearance” of the situation, contract performance, and other related issues.
And, the government knows it holds the funds. Therefore, it may ask the contractor for an infinite number of “free things” before it commits to adding more funds. Many contractors will agree to provide some or all of these extra “things” at no cost.
What happened to the contractor’s absolute right to more funds as discussed in earlier sections? It has been taken over and trumped by the current politics of the situation.
As discussed below, some contractors may perform so poorly or their situation may be so precarious, that it needs to provide services or items for “free” simply to survive. The upcoming battle over further funding of the F-35 program is a good example that bears watching.
1. Political Issues Forcing the Award of Cost-Reimbursement Contracts.
In the first place, there was a reason that a cost-reimbursement contract was awarded, and that generally has political bases. The cost- type contract was not necessarily awarded because it was the “best” way to proceed. Contractors need to remember this in developing their performance plans.
Cost-reimbursement contracts are often awarded because:
The agency and the contractor, together or separately, are unsure or indeed completely insecure about whether they have adequate specifications or technology in hand to do the work on a fixed price basis. By itself, this is a perfectly appropriate reason to use a cost-type contract. But often there is more at issue.
The failure of performance on a fixed priced contract, leading to a default termination or a termination for convenience, is politically embarrassing to the agency and the contractor. The agency may lose future funding. The contractor may lose future business. Cost-type contracting removes these issues.
The parties may not understand the total work scope (unexpected occurrences are likely) well enough to commit to a fixed priced job. That is an appropriate reason to use a cost type contract. But, repeatedly adding funds by modifications to a fixed priced contract, through the use of change orders for “unexpected occurrences”, presents the political embarrassment that neither the agency nor the contractor can manage the project. The cost -type contract largely eliminates this.
Only limited funds are now available, but more are expected. The placement of the cost-type contract is an opportunity for the agency and contractor to show some progress on a project, even though it may be small.
Outside political forces (and events) are pressing for the work to proceed very rapidly, without detailed planning. Something must be done. If it is not, the media or Congress – or both – will be screaming!
There is absolutely no time to do the procurement mechanics of a fixed priced contract; money must be applied to the tasks simply to get work started (or completed if a larger task – i.e., Gulf War(s)/Afghanistan Campaign, Hurricane Relief Efforts, etc.). It is embarrassing not to accomplish something because more planning is needed (even to get it done correctly!).
All of the above issues seldom operate alone – rather they can often interact to force the utilization of a cost-reimbursement contract.
It is almost always these types of political and economic issues that force the award of a cost-reimbursement contract. Although agency regulations spell out when each type of contract should be used, the real decision is often politically motivated. It is, therefore, no surprise that politics continually affect whether the contract will continue or end during its performance stage. Both parties to the contract make statements that are simply “expedient”. They may not be the real reasons behind the actions taken.
2. Political Issues in Performance.
As would be expected, the award of the cost-reimbursement contract hardly ends the politics of the situation. “Expedient” action and position taking continue into performance: while the obligations to discontinue performance when funding is no longer available may be perfectly clear, the exact opposite may occur during real life performance stages:
The agency may pressure the contractor as follows: if the contractor does not meet its original budget for costs expended, the program will be canceled or curtailed. The agency has the right to do this. But, the budget may have been unrealistically low or impacted by later government actions. It does not matter – the agency may cancel.
The agency may say it does not have sufficient funding for the next three months, but it expects to get additional funding. Will the contractor proceed without funds with the assurance that additional funds will be paid if received? It is common to even record a contract modification that funds will be paid if received (anticipatory cost clause). Why doesn’t the agency have funds? This often results from its lack of planning, or the failure to deal with Congress in a timely fashion. In effect, this becomes the contractor’s problem.
The contractor may be pressed to cost share in overruns, i.e. not bill for all of its costs, and assume certain tasks on its own account. Does this seem right when the contractor was originally promised full cost-reimbursement?
The contractor may be pressed to pay itself for correcting work on units that are deemed “unsatisfactory”. Cost-type contracts pay for ordinary deficiencies. Why is the bargain being changed after award?
The contractor may be pressed to pay for performance “redeeming” or “improvement” features out of its own pocket. The contract does not require this. But, the contractor’s performance may have been embarrassingly bad and the agency may also have been publicly embarrassed. The media or Congress is screaming about why this contractor is being paid anything!
This list goes on and on. There is no limit to what the agency may ask for. There is no limit as to how a contractor may respond – rationally or irrationally.
3. Public Perceptions Are Often Wrong About Cost Reimbursement Contracts.
Neither the media nor the public understands why a cost-type contract is being utilized or its obligations. The following specific and real- world examples are helpful in showing the confusion that often exists in understanding cost-type contracts.
a. Rebuilding Iraq Example.
The excerpts that follow are from respected news sources in June 2003, shortly after the first major cost-type contracts to rebuild Iraq were awarded. Note that the public, including Congress and the news media, seemed surprised and confused by the use of cost- type contracts.
Their misunderstanding of existing contract management and political issues are profound, as the discussion below shows. Think of how you would cut through this confusion if you needed to make an upper management presentation on these issues:
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Nobody knows how much it will ultimately cost to fix Iraq. In that climate of uncertainty, the U.S. Agency for International Development opted for a cost-plus, fixed-fee deal - a contract often used by governments to exert some control over costs and give the contractor incentive to engage in open-ended work.
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But within such limits, there is potential for abuse since the contractor has no incentive to contain expenses. Most cost-plus deals stipulate a certain amount for the jobs performed, which may include equipment, labor, transportation, legal costs, clerical support and so on - all under the very general category of “overhead.” But overhead can be inflated to increase profits. Imagine that a contractor needs to buy 10 bulldozers or 1,000 PCs to finish a job. Should the cost be laid to the first customer or amortized over several jobs? This kind of accounting dispute says Michael Garvin, a professor of civil engineering at Columbia University, often happens in cost-plus deals.
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Vardi, Desert Storm, Forbes, June 23, 2003, p. 66 (Discussing Bechtel’s Iraqi Contract.)
Let us examine the foregoing quote and see what makes sense and what does not:
1. The first paragraph is a good overview of why cost-type, fixed fee contracts are used, but the reason for their use is not to “exert some control over costs…”
2. The analysis then completely falls apart in the second paragraph:
Contrary to the article, the contractor always has an incentive to control costs - if it does not, there may be no future funding or follow-on contracts.
Cost-type contracts often do not “stipulate a certain amount for the job to be performed…” That would be a fixed price contract.
While “overhead” calculations can be a problem, the government’s accounting rules, IRS depreciation standards, and trade association publications generally resolve such issues as the time period for the depreciation of equipment.
The type of equipment listed in the article will often be directly charged for a cost-type contract such as this. Also, the PCs will be useless after several years on the contract. The bulldozers may have some residual value, which can be readily accounted for under existing accounting rules.
The article assumes that if an error is made, the government cannot later get part of its payments back once a contractor has been paid. We know the government can almost always get its money back.
There is plenty of room for abuse under cost-type contracts - but the big money is not in overhead “inflation”. Remember the 1% overall disallowance rate?
The biggest potential for abuse is inefficiency in spending direct labor (and associated overhead) to do tasks that do not need to be done, or that could have been done with say one-third the hours if planned properly. Both contractors and government agencies can be involved in such abuse.
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Now to show you how far away from fact reporting on cost reimbursement can go, considering the following quote:
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The technical term of Logcap (Logistics Civil Augmentation Program) is “cost-reimbursement, indefinite quantity,” or “cost-plus,” meaning KBR spends whatever it believes necessary to get a job done, then adds from 1 to 9 percent as profit. There’s practically no limit on how lucrative Logcap can be, and as the awarding of the Iraqi oil-field contract - by KBR, to KBR - demonstrates, Logcap can become a generator of yet more contracts. Nothing like it exists elsewhere in government. That KBR wrote the oil-field plan wasn’t considered by the Army a disqualifying conflict of interest - in fact, just the opposite.
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Baum, Nation Builders for Hire, New York Times Magazine, June 22, 2003, p. 34 (discussing Kellogg Brown & Root’s Iraq oil field contract with the U.S. Army Corp. of Engineers).
This seemed to be written to tear down cost-type contracting and the contractor involved, as opposed to giving a more even-handed analysis:
The statement - “meaning KBR spends whatever it believes necessary to get the job done…” [emphasis added] - shows a fundamental misunderstanding of the topics already reviewed.
The statement “there’s practically no limit on how lucrative Logcap can be…,” would be disputed by most reputable contractors. There are numerous limitations, as these materials show, plus a “1 to 9” profit would hardly impress most contractors, government or commercial.
The statements that “Logcap can become a generator of yet more contracts” and “[n]othing like it exists elsewhere in government” simply show a lack of understanding. Every contractor’s performance should generate some percentage of follow-on contracts - or it would be out of business.
And, finally the statement “That KBR wrote the oil-field plan wasn’t considered by the Army a disqualifying conflict of interest…” shows a lack of knowledge as to Organizational Conflict Regulations. This situation is not a conflict for a systems developer and has not been for years under the long established government-wide procurement rules.
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Once again, the media’s lack of information, and desire to criticize without the facts (political objectives?) misses the real points that need public oversight: the actual selection of cost-type work, the management of that work, and the efficiency in performance by both the government agency and the contractor. These are the areas that urgently need attention and public debate. They receive little or none.
b. Aerospace Example:
Press reports of Lockheed’s problems with an air defense system under development also show serious management and political problems in a real world setting. We have underlined the three most important issues to focus on in the following news report.
Is this a cost-reimbursement contract issue, a management issue, a political issue, or all of the above? Is what Lockheed is doing wise?
Lockheed—Pentagon Agreement is Revised. New York Times, Wednesday, July 29, 1998, p. D8.
WASHINGTON, July 28 (Bloomberg News) – The Lockheed Martin Corporation agreed today to pay the Defense Department up to $75 million if failures continue in tests of an antimissile system, Lockheed, and the Government said.
The agreement includes a provision for the Lockheed Martin Missiles and Space to win back a portion of any fees for missile failures.
The Theater High Altitude Area Defense System, known as THAAD, has failed five times to intercept a ballistic missile in tests, though portions of the system have performed well in flight tests.
Lockheed has not lost money because of the failures because the contract required the Pentagon to pay for any failures. That arrangement ends with the new agreement.
The agreement comes as several Congressional committees have made deep cuts in President Clinton’s $822 million fiscal year 1999 request for THAAD’s development. Congress is likely to direct the Pentagon to bring in a second contractor if the failures continue.
THAAD is to be a mobile system of missile batteries and ground radar designed to destroy short-range ballistic missiles.
The top THAAD subcontractors are the Raytheon Company, which makes the ground radar, and TRW, Inc., which is making the communications system.
Our response to the foregoing is as follows:
This is a cost-reimbursement contract; Lockheed has been paid for prior failures. That is proper; that is why this is a cost-reimbursement contract in the first place: because of the extraordinary risk of performance failure. The risk is too large for the contractor to bear cost-wise.
But, now political issues have arisen – the agency is under media and congressional pressure. It will not continue the program unless Lockheed agrees to downward adjustments in cost recovery (capped at $75 million downward) if there are more failures. (The government is in effect converting the contract to a partially fixed price undertaking. Or, some would say, cost-type, but with a fixed loss.)
And, the agency is threatening to bring in a second contractor to “fix” the failures (a common tactic): you will lose this contract/program unless you agree to the agency’s demands.
The agency has thus exercised its contractual and political rights to stop the program unless….
Lockheed has wisely responded with a political (not a contract) solution – we will pay for the costs for any more failures up to $75 million and then ...
This has proven to be a smart move for Lockheed… The program continued.
There is always a “then”…and “a next” negotiation in situations such as this. It never ends unless performance significantly improves or the job is finally finished.
Conclusion
We have now come full circle. The mechanics of what is written in a cost-reimbursement contract, and how the contract is supposed to operate, may, as a practical matter, have nothing to do with the pressure and obligations that company management feels in terms of performance and cost obligations because of politics (and their company’s economic situation).
This is a critical distinction to understand in order to properly manage a cost-reimbursement contract for any party to it: government or commercial, prime or subcontract, government official or owner. The contract at some point means nothing; politics and the ability to negotiate mean everything.
We are not raising this as a right or wrong issue. We are simply raising it so that you understand that the politics of a situation may be completely different than the contractual and legal obligations of a situation.
Company management and agency personnel need to know what their contractual and legal obligations are so they can decide whether they want to let politics and economics override their right to stop performance and/or their ability to seek additional funding. Management can legally say in almost all cases – no funding, no work. That is often the wrong political and economic decision.
Lockheed recognized that in the above factual situation, and wisely negotiated a “politically correct” resolution to save its program. By contrast, the Iraq contractors appear to have simply ignored criticism as to their contracts. Doing nothing is always an attractive alternative when responding would simply make matters worse.