Calculating Fixed Cost Damages from Delay

1 INTRODUCTION

Probably the most troublesome and difficult part of delay and disruption claims is the quantification of indirect costs associated with the delay and the extended performance period of the delayed contract work. Other elements of such claims appear to have been fairly well resolved. Liability, for instance, has been reduced to essentially a three-part test, a showing that (1) the government caused a compensable delay or disruption in the contractor's performance, (2) during the period of delay or disruption, the contractor remained on "standby," and (3) the contractor was unable to take on additional work during the period of delay or disruption. Calculating direct contract costs attributable to the delay, e.g., standby labor, equipment rentals, material cost escalation and equipment use rates for owned equipment are fairly routine procedures once the basic facts are known. But quantification of the indirect costs (home office overhead, G&A, etc.) is still a contentious matter after more than fifty years of litigating this issue before the boards and courts.

In the absence of a rational method consistent with contract risk allocations and cost principles, various methods for determining indirect costs associated with delay and disruption have evolved, the Eichleay method being the one most frequently used. That method
essentially provides for the calculation of a daily rate of overhead applicable to the contract for the entire period of the contracts performance. It is imprecise, admits irrelevant factors, and results in repricing the original contract work. Yet, it is this method that the Federal Circuit in Wickham Contracting Co., Inc. v. Fisher, 12 F.3d 1574 proclaimed the only method to be used in calculating the indirect costs associated with compensable delays.

The Wickham decision is a grave disappointment and the wrong it has wrought is apparent to anyone who will look for a moment at logic and facts instead of blindly accepting legal precedent. That part of the decision which held that use of the Eichleay formula is the only means for determining delay damages regarding fixed costs (unabsorbed overhead) is quoted below to demonstrate its obvious flaws.

In sum, because it is impossible to determine the amount of unabsorbed overhead caused by the delay of any particular contract, and because the Eichleay formula provides an equitable method of compensating a contractor for unabsorbed overhead without costing taxpayers more than they should pay, we hold that the Eichleay formula is the exclusive means for compensating a contractor for unabsorbed overhead when it otherwise meets the Eichleay prerequisites.

If it were impossible to determine the amount of unabsorbed overhead caused by delay of any particular contract, as the Wickham court proclaims, the court was in no position to make any further judgments about delay damages, admittedly having no knowledge of such. The amount could have been zero, one million, or even a negative amount. Lord Kelvin, a man with a far greater reputation for erudition than the Wickham court, once said, "When you can measure what you are speaking about; and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind." But with unsatisfactory knowledge the Wickham court went on.

In an illogical statement, the court proclaimed that the Eichleay formula provides an equitable method of compensating a contractor

for unabsorbed overhead. How can such a definitive conclusion regarding quantum be reached when there is admittedly no knowledge of the facts, their determination being impossible according to the court? How much should the taxpayer pay? Again, without any knowledge of the facts, which are impossible to ascertain according to the court, the court has proclaimed the taxpayers not overcharged by the use of Eichleay. If the amount of damage cannot be ascertained, what amount is in excess of that amount or less than that amount? From where does such knowledge come if not from the facts? How does the court move from a complete vacuum to such concrete knowledge?

The definitive statement that Eichleay is the exclusive means for compensating a contractor for delay damages (unabsorbed overhead) can only be viewed as a closed door to any further intrusions on the court's limited capacity for understanding delay damages.

The gross irreverence for logic in the court's decision in the Wickham case requires that the subject of indirect costs associated with contract delay and disruption be thoroughly explored not only to discredit that decision but to establish an equitable means of determining delay damages with respect to indirect costs. This can be done by observing the basic elements of fixed-price contracting and the contract cost principles.

2 INDIRECT COSTS, ALLOCATIONS AND PRICING

Fixed costs are at the heart of the "unabsorbed overhead"' issue. The unabsorbed overhead that Eichleay and other formulae attempt to price are essentially fixed costs. Therefore, a brief review of some characteristics of indirect fixed costs and how fixed costs are allocated and priced in firm-fixed-price contracts is necessary before continuing with a discussion of the effect of delay on fixed costs. What they are, why they are incurred, and how they behave in relation to other costs is discussed here together with how they can be priced in contracts.

2.1 The nature of fixed costs

Fixed costs are generally the costs a contractor incurs by maintaining a capacity for doing work, e.g., plant, machinery, equipment and administrative staff. The contractor's capacity that generates these costs is "fixed" in that it tends to remain at a constant level over a given period. The commitment to incur such costs is usually made prior to entering a contract and their recovery is more an

entrepreneurial risk rather than a contract risk. Fixed costs accrue with the passage of time regardless of the level of activity of direct costs. Thus, they are independent of direct costs and are called indirect costs.

It should be noted, however, that some fixed costs may be treated as direct costs depending upon the contractor's selection of costing practices. For instance, depreciation of machinery which represents a fixed cost by the definition given above, may be allocated to final cost objectives on a units-of-production basis. Such treatment gives the depreciation the appearance of being a direct cost.

2.2 Allocation and use of fixed capacity

A contractor's actual fixed capacity to support work with its physical plant and equipment, administrative staff, etc. is allocated to contracts in the planning or work scheduling process and when changes are made to the schedule. The capacity is actually used or consumed with the passage of time and not necessarily with the performance of the contract work. Time passes and costs accrue whether sitting idle or productively engaged. Thus, the allocation of a contractor's actual capacity is not dependent on the incurrence of direct costs. With no direct costs being incurred, a contract scheduled for performance but delayed can be consuming capacity the same as if were not delayed.

2.3 Pricing fixed capacity costs

In the context of a competitively bid fixed-price contract, the contractor's objective is to recover all direct costs dollar-for-dollar and then to get as much more as is possible in the circumstances. Whether the amount in excess of the direct cost estimate is called overhead, G&A, or profit is immaterial. If the contractor can receive any amount above direct costs, the contract is profitable in the economic sense. Consequently, the costs representing fixed capacity can be priced at whatever amount the contractor wants to price them. That price is not dependent upon cost allocations but is dependent upon the contractor's estimation of the competition and the customer's willingness to pay.

However, in the context of cost-based pricing, negotiated contracts and changes to sealed bid contracts, the contractor is required to comply with the provisions of FAR Part 3 1. Included there is the method by which indirect costs shall be allocated to base costs. FAR 31.203(c) states in part that, "All items properly includable in an indirect cost base should bear a pro rata share of indirect costs ..........” Thus, in cost based pricing actions, price is related to or dependent upon costs, costs which are determined and allocated according to FAR Part 31.

2.4 The contractor's risk of capacity estimate

In contracting to provide goods or services, the contractor has essentially agreed to deliver something in a given period requiring labor and material, together with the use of a facility and necessary management to perform the work. The facility (plant, equipment, etc.) and the necessary management are to be provided over the stated period of performance. (The period of performance traditionally has been considered so fundamental that it was not within the scope of the Changes clause.) Accordingly, the contractor allocates a portion of its fixed capacity over a stated period to the contract effort. The contractor assumes the risk that this portion of capacity for the given period is sufficient to accomplish the work, the same as it assumes the risk that estimated labor and material will be sufficient in amount.

2.5 Allocation of fixed costs

There can be a difference between allocation of fixed costs to contracts and the allocation of actual fixed capacity to perform the work. For instance, if the required work actually needed 1/5th of the contractor's capacity over a period of six months, in a year it would have used 1/10th of the capacity available. Assuming that this contract is the only one worked on during the entire year, it would have allocated to it the entire year's indirect costs. So actual capacity utilized is 1/10th while cost of capacity allocated is 10/10ths. The difference occurs because the method used for allocation is based on absorption costing which results in all indirect costs being allocated to (or absorbed by) base costs (direct labor, material, etc.) incurred in the period. Thus, if in a given period there was one active contract and one delayed contract, the active contract would be allocated all fixed costs in the period. So while both contracts would have been consuming capacity (the delayed one by having capacity reserved for its resumption), the active one would appear to have used all the

capacity by itself So the allocation of fixed costs, using absorption costing concepts, is obviously not representative of the physical use of the fixed capacity.

Furthermore, allocation of fixed costs is only an accounting construct. Allocation of fixed costs to contracts generally is not based on a causal relationship since fixed costs usually predate the contract and are not influenced by contract activity. Therefore, allocation of fixed costs to contracts does not increase the cost of contracts. Fixed costs are beneficial to contracts but not necessarily in proportion to the costs allocated to them by the accepted method of allocation, particularly when some part of the allocated fixed cost represents more capacity than is required for performance. Again, allocation of fixed costs to contracts by absorption costing methods provides no indication of fixed capacity used by the contract.

However, the allocation method described in the FAR at 31.203 requires that indirect costs in total be allocated to the total base costs. But this allocation method is made necessary only when cost-based pricing is required.

2.6 Contribution margin

The amount by which the contract price exceeds the direct costs of performing the contract is "contribution margin." That amount is a contribution toward recovering fixed costs and providing profit. Usually no one contract will yield a contribution margin sufficient to cover the contractor's entire fixed costs. Each contract makes some contribution toward this end and when there are enough contracts making a contribution, a profit ultimately will be achieved by the contracting entity.

2.7 Absorption of overhead by the basic contract

Since the contractor's fixed capacity is defined by volume and time (capacity is limited to a certain volume of work in a given period), capacity is specifically identified with the volume requirements of the contract and the contract performance schedule. Thus, an identifiable segment of the capacity is specifically related to the contract. Identifying a specific segment of capacity for the exclusive use of the contract results in absorption of the costs of that capacity by the contract. Whether or not work is performed in the scheduled time frame for performance does not change the allocation of capacity that was made for the benefit of the contract. Thus, whether or not direct costs were incurred in the scheduled time frame is irrelevant to the absorption of fixed costs.

2.8 Unabsorbed overhead

The term "unabsorbed overhead" has been frequently used to describe the concept of a contractor's "loss” in a delay situation. It is a flawed attempt to express the contractor's loss of its expectation interest of timely recovering that part of the contract price which represents "contribution margin."

Unabsorbed overhead is a term appropriately used managerially and analytically in comparing actual performance with budgeted performance generally in a manufacturing environment. Where all projections start with a sales budget of a proprietary product and work down through the estimated production costs, including indirect costs, to produce a total budget for the projected sales volume, the term "unabsorbed overhead” describes a consequence of overhead absorption by base costs being less than budgeted or expected, usually due to a decrease in base costs. In many manufacturing environments, production takes place ahead of sales. All activity is the consequence of projected sales. The use of capacity for one product or an other is a management prerogative not a contractual obligation. To make those decisions, constant analysis is required of the effects of changed volume on the projections. Unabsorbed overhead is a product of those analyses and the effect of unabsorbed overhead has animmediately understandable relationship to the income statement. Thus, the term is good one for the purpose intended.

Allocation of capacity to a contract is an obligation under the contract, unlike a proprietary manufacturing situation where it is only the result of a managerial decision. Overhead (fixed costs) is absorbed by a contract with finality at the time of award to the contractor and additionally by changes to the contract, including delay.

It matters not that the price is more or less than the cost of the capacity needed to perform the contract. The capacity remains allocated whether the contract is delayed or being performed, therefore, the fixed costs of that capacity remain absorbed by the contract.

3 IMPACT OF DELAY ON FIXED COSTS

3.1 The basic consequence

Putting aside all of the other events that can accompany a delay, e.g., acceleration, changes - additive and deductive, and partial or complete termination, and looking only at the delay and later completion of the original work, delay damages, in terms of fixed costs, can be clearly ascertained. Since fixed indirect costs are not immediately affected by the level of activity, i.e., they will be there in the same amount regardless of contract performance or delay, there are only two things that can happen to fixed costs because of delay:

1. Recovery of fixed costs will be delayed by delay in billing, and

2. Allocation of fixed costs to the contract will
be changed by:
a. Extending the period of performance, or

b. Changing the distribution in the planned period


The calculations to determine these costs can be performed with the same precision as are any other calculations for increased costs from delays. Furthermore, the delay costs can be calculated on the bases of contract law and FAR cost principles without having to resort to spurious formulae.

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