Pricing Changes and Claims in Government Contracts
Gregory L Fordham
Last Updated March 2012
In today's world, change is inevitable. So, the success of any operation can depend on how well it handles change.
Managing change is nothing new to government contracts. The government has been changing its contractual requirements since the early days of the republic. Over the years, mechanisms were put in place that permit the government to successfully manage a changing environment. Consequently, contractors should expect changes and recognize that they are part of their contractual landscape. The challenge, therefore, is not to avoid changes but simply how to identify changes when they occur and insure that the contract price is properly adjusted. This is particularly true in the case of contract terminations where a contractor's recovery could be needlessly reduced if the contract price has not been properly adjusted to match the actual scope of work performed. (see, Termination for Convenience of Government Contracts for more information on contract terminations.
The Changes clause is a required contract clause and is perhaps the best known clause in all of government contracting. Simply, it empowers the Contracting Officer with the ability to make changes within the general scope of work. In return the government promises to make an equitable adjustment in the contract price and schedule.
It should be noted that the contract places this authority with the government's Contracting Officer (CO). Although commercial businessmen may perceive all government employees as agents of the government with the ability to make decisions, generally only the CO has the authority to bind the government and make changes to the contract. This limitation is significant, since if unheeded contractors could find themselves without recourse for compensation for any work performed that was not authorized by the CO.
In addition, contractors should realize that even COs have constraints over their authority. Since the government is not responsible for the acts of its COs if they have exceeded their actual authority, contractors would be well advised to confirm that the government employees making contractual decisions have the authority to do so. Contractors can make this confirmation by requesting to see the government employee's SF1402 or warrant.
Purpose Many reasons can be cited for why the Changes clause has evolved. Its primary benefit is that it provides the government with the ability to address changing conditions as they occur without the need for soliciting new proposals. This ability is not unfettered, however, since the new work must be within the scope of the original contract and the change order cannot be a means to circumvent the competitive process.
General Scope of work Under the clause the CO is permitted to make changes within the general scope of work. This usually is limited to:
- The designs, drawings and specifications;
- Method of shipment or packing; or
- Place of delivery.
Since there are slight differences in the clause depending on the contract type or contracting effort such as time and materials, fixed-price, construction, or supply contracts, the ability of the CO to make changes within the general scope of work can differ with the situation.
The limitations imposed by the Changes clause do not necessarily limit the CO's authority to change the contract but rather it simply limits the applicability of the Changes clause. For example, the Changes clause usually does not permit the CO to make reductions in quantity to the contract. Nevertheless, the CO still has this capability under the Termination for Convenience clause.
Equitable Adjustment The Changes clause, as do many other contract clauses, requires the CO to make an equitable adjustment to the contract price, if the work is changed. The fact that the Changes clause requires an equitable adjustment is significant, since the term equitable adjustment has special meaning in government contracting. The term has been interpreted to include a provision for profit.
This compares to a relatively few other contract clauses such as the Government Delay of Work or the Suspension of Work clauses that simply require the CO to make an adjustment to the contract price. Accordingly, these other clauses would require only a reimbursement of the contractor's costs without a provision for profit.
Since the Changes clause entitles the contractor to recover profit with its price adjustment, a dispute often occurs about whether a particular event is governed by the Changes clause or one of these other clauses. Fortunately, these other clauses are self eliminating and apply only if the event cannot be covered by the Changes clause or some other clause that would also recognize a provision for profit.
The Written Order The Changes clause requires the CO to make any changes to the contract in writing. Such changes are formal changes.
In addition, Federal common law has evolved such that for the Changes clause to operate all that is currently required is for the CO to order the contractor, orally or in writing, to perform work that was not part of the contractually required effort. To interpret the clause otherwise would be senseless if the CO was not inclined to issue the written modification yet the contractor was required to continue performance under the contract's dispute clause. Thus, this forms the basis for the concept of the "constructive" change.
Notice The Changes clause requires the contractor to "assert its right" to an adjustment under the clause within 30 days from the receipt of the written order. Even so, the CO can still consider the contractor's claim anytime prior to final payment.
For a contractor to assert its right to an equitable adjustment does not mean that the contractor has to submit its claim. Rather, the contractor simply must notify the CO that it considers the work to be a change under the Changes clause for which the contractor will be submitting a Request for Equitable Adjustment (REA).
As with the requirement for a written order, the notice requirement has lost some of its significance over the years. Since the clause permits the CO to consider any claim prior to final payment, a contractor's claim is considered timely so long as its is filed prior to final payment.
A contractor's failure to submit the claim promptly is not without some penalty, however. Since the purpose for the notice provision was to ensure timely resolution of the events while they were freshly in the minds of the parties concerned, a contractor can be subject to higher burdens of proof when the claim is not timely filed. Consequently, the government can raise a defense to a contractor's claim by claiming that it was prejudiced in its defense of the claim by the contractor's late submission. If the government should raise such a defense, however, it bears the burden of proof to show that it was prejudiced.
It should be noted that once a CO has reviewed a contractor's claim, the government has constructively waived the notice requirement and accepted the contractor's claim as timely even if submitted after final payment. Therefore, if the CO wishes to enforce the notice provision it must reject any submission prior to accepting it.
Effect The effect of the Changes clause is that it permits contractors to submit their leanest bids stripped of all contingencies with the confidence that should the unforeseen be required the government will equitably adjust the contract price. In turn, the government also benefits since it need not pay prices for work not actually required by the solicitation.
Many are familiar with the old adage about bidding low and making it up on the changes. To some extent such a practice is precisely what the changes clause encourages. Consequently, contractors should not feel bad that their bids are "competitively" priced and stripped bare of anything not actually described or required in the solicitation.
When people think of contract changes they typically think in terms of an order to perform new work or work that is different from what was proposed. In actuality, changes can come in a variety of flavors.
There are two types of changes that are encountered regularly by contractors but frequently go unnoticed. These are defective specifications and differences in interpretation.
Defective Specifications All too frequently contractors find themselves facing a situation where they cannot perform the contract either because the square peg will not fit in the round hole or because flubber has not yet been invented. In such situations, contractors are often confronted with the notion that since they signed the contract they are now totally responsible for its execution.
While contractors must perform their contractual duties, the process of contracting imposes duties to both parties. With regard to specifications its is usually the duty of the party providing the specification to provide specifications that are reasonably free from defects. Consequently, if the government provides specifications where the square peg will not fit in the round hole then the government has failed to perform its contractual duty and the consequence of that failure is with the government and not the contractor.
Fortunately the Changes clause provides the government with a means to cure the defect without breaching the contract so that the square peg can be made to fit into the round hole. Once the defect is cured and a change issued the contractor under the Changes clause would be entitled to receive an equitable adjustment.
Even if the government fails to issue a change curing the defect this does not relieve the government of its responsibility to make an equitable adjustment to the contract if the government requires the contractor to continue performance under the contract. This is true because the government's direction to continue performance in the case of defective specifications is a change to the contract, since performance to defective specifications is different from performance to defect free specifications--the basis on which the contract was formed.
Differences in Interpretation Another situation where contractors typically find themselves is where their interpretation of the contract requirements are different from the government's. In such cases, the government frequently blames the contractor for making the mistake and then requires the contractor to perform in accordance with the "correct" interpretation. Nevertheless, this too is often a change under the Changes clause for which the contractor is entitled to an equitable adjustment.
Words are conventional symbols with standardized meanings. Their usage in a contract is to manifest the mutual intentions of the parties. There is a presumption that the party supplying the contract language may have an intention as to its meaning that could not be evident from the plain meaning of the language but a contractor is not expected to possess clairvoyance when interpreting a contract. Consequently, the undisclosed intention of the party drafting the contract language is not relevant to the interpretation problem and, as a result, the language will generally be interpreted against the party who drafted it if the other party has based its performance on a reasonable interpretation..
Thus, in a situation of interpretational differences, the contractor need only make a reasonable interpretation of the contract's requirements based on the prevailing meaning of its terms. If what the government requires is different from the contractor's reasonable interpretation then it is a change under the contract for which the contractor is entitled to an equitable adjustment.
The objective of the priced change is to place the contractor in the same profit or loss position that it would have occupied had the change never occurred. Thus, an equitable adjustment is simply a corrective measure designed to keep contractors whole when the buyer modifies the contract.
Since an equitable adjustment is a corrective measure designed to keep contractors whole when the buyer modifies the contract, the measure of damages for the contractor is the increased costs experienced by the contractor as a result of the change. Consequently, the reasonableness of a cost incurred is not limited to the value received by the buyer for the work performed nor the amount that would have been incurred by another contractor.
Since changes are often caused by conditions that are unexpected and unusual, a contractor's normal accounting procedures may not produce equitable results. Fortunately, a contractor's normal accounting procedures can be bypassed when the situation warrants. Thus, contractors typically have great latitude to deviate from their normal accounting procedures. In some cases, reasonable estimates may be all that are available.
Consequently, pricing changes is not necessarily a simple matter, particularly where deletions, inefficiencies or delays are involved. Pricing changes can require complex models accompanied by sturdy justifications if the full consequences of a change are to be equitably captured.
Because of the complexities that can arise contractors are fortunate that the pricing is not required to be performed with great precision. All that is required is that the contractor be compensated fairly. The fact that the amount cannot be determined with great precision is not a defense against the contractor's price adjustment. Indeed, the one who invites contract changes bears the risk that those changes cannot be priced precisely.
Deletive Changes involving the deletion of work can prove to be especially trouble some. The issue is should a deletive change be priced under the Changes clause or under the Termination for Convenience clause as a partial termination.
Although the partial termination approach is perhaps the most correct method, the manner in which deletive changes have been handled is widespread. When the deletion has involved reductions in quantity the termination clause has been used. When the deletion involved reductions in the scope of work as a result of changes to the designs or specifications, the Changes clause has been used. (see Termination for Convenience of Government Contracts for more information about contract terminations.)
The confusion over the pricing method continues still further when the Changes clause is used as the basis for adjusting deleted work. If the item is separately priced and a segregable work element then the contract price can be adjusted by simply deleting the segregable item at its item price.
Whether an item is segregable is not an easily apparent determination. The mere fact that the item is separately priced is not indicative. In fact, it is probably unlikely that an item will be segregable, particularly in a manufacturing situation, although in a construction situation separate buildings have been determined to be segregable items.
When an item is not segregable, the contractor can use the principles of a partial termination to offset the loss of work with a higher price on the remaining work as a result of lowered production volumes with the corresponding lower allocation base over which to spread fixed costs or unamortized contract startup costs. So, if the item is not segregable then the contract price should be reduced by the amount of cost that the contractor saved by not having to perform the work but offset by the increased cost of performing the remaining work.
Inefficiency The costs of inefficiencies resulting from lost learning, work site crowding, acceleration, inadequate supervision, etc. can also be difficult to quantify with precision. The most accepted method involves comparisons of work efficiency before and after the changed condition, although other methods including modified total cost can also be used if the circumstances require it.
Delays Contract delays are often the effect of contract changes such as when the design of a product or building are changed with resulting delays to manufacture or construction. In addition, there are other "changes" to the contract resulting from delays by a variety of other clauses like the:
- Stop Work Order clause,
- Protest After Award clause,
- Delay of Work clause,
- Suspension of Work clause,
- Differing Site Conditions clause, and
- Government Furnished Property clause to name some of the most common.
But all of these change a contractor's work when the contractor is ordered to totally or partially suspend its performance. Consequently, all of these contract clauses expressly promise some form of contract price adjustment when they are invoked by the government buyer.
Delay situations provide contractors with complicated quantification situations. At stake is the contractor's fixed costs. Even though variable costs may be reduced or mitigated during a delay, a contractor's fixed costs allocable to the contract continue for a longer period of time as a result of the delay.
The problem in these situations is that the normal method used by the contractor for allocating fixed costs such as overhead is useless, since during a delay the allocation base is usually diminished or non-existent. For that reason, contractors must develop appropriate surrogates for performing the allocation process. Although there have been many accepted surrogates for performing the allocation, the current accepted method is known as the Eichleay formula and utilizes contract billings as the surrogate base for allocating fixed costs.
A contractor's challenges for pricing a contract delay are not limited to the pricing method. The subject also involves numerous proofs if the contractor is to show entitlement. Despite the challenges, delay claims are worth pursuing, since delay damages can often dwarf all other aspects of the contractor's changes claim. Because delay claims involve these numerous proofs that can often be complex and highly theoretical, contractors are best advised to seek the advice of experts for this kind of contract quantification.
The costs incurred by a contractor to prepare and settle its price adjustment have been the focus of much debate over the years. Some government organizations have tried to characterize these expenses as the cost of claims against the government and, therefore, unallowable under the cost principles. Fortunately, those attempts by the government at avoiding its responsibilities have been largely unsuccessful.
As a general rule a contractor's costs of preparing and negotiating its changes claim are recoverable as direct costs of the contract. This condition exists until there is a dispute. Until the dispute exists, these costs are viewed simply as contract administration expenses. In one case, however, the distinction of a dispute was made when the contractor pursued its claim after the contract was virtually complete and so the claims process was not viewed as part of routine contract administration. As a result it was viewed as a claim against the government.
Under the Changes clause the government has a duty to equitably adjust the contract price when it modifies the work to be performed by the contractor. This duty is discharged through performance when a modification has been negotiated for those costs or when the contractor executes a release.
The negotiation of a modification or execution of a release is not unbounded, however. The extent to which both of these documents discharges the government's duty is generally narrowly construed and limited only to those items specifically covered or subject of the negotiation. Thus, a contractor that negotiates a change but fails to recognize the impact of that change on future performance is not necessarily precluded form further recovery.
The relationship between a subcontractor and its prime or upper tier subcontractor will generally be governed by commercial law. Government contracts can place some unusual twists in that standard rule; however, particularly with respect to the interpretation of the Changes clause.
To government contractors the Changes clause is known to have special meaning, especially if what has been included in the subcontract is a flowdown of the standard Changes clause from the Federal Acquisition Regulations. In such cases, state and federal courts have not hesitated to adopt the Federal common law interpretations of the Changes clause, since where the parties to a contract adopt a standard and oft-construed clause, it is only logical that their intent is also to adopt the interpretation that accompanies it.
Changes are not the occasional blip on the contracts radar screen. Rather they are as integral to the contracting process as submitting invoices for payment. This fact is not new, since government contracts have always encouraged a "change" mentality as evidenced by the long time presence of the Changes clause.
What is new is greater competitive pressures. In times past contractor estimating techniques along with limited competition allowed considerable room for the unanticipated so that in the end there was not a perceived need to pursue changes. As competitive pressures increase, however, contractor estimating techniques will be forced to reflect prices that barely meet the solicitations's actual requirements. Contract administration will then become more sales oriented, since each change represents a sole-source revenue generating opportunity.
The task ahead is not as easy as one might expect. Recognizing changes is not always easy in the slow boil of contract performance. Seemingly small and insignificant changes frequently have colossal consequences that lack visible indicators. So, while many changes are as routine as clock work there are those that will require substantial prowess. For those occasions a contractor is best advised to develop a good resource. The payoff is worthwhile, however. Since the work will be done and the costs will be incurred regardless, the only question is will there be any revenue. From such a perspective every dollar recovered by a claim has a corresponding effect on the company's bottom line. Thus, when one considers how many contracts it takes to have a corresponding effect on the bottom line, it becomes clear why the pursuit of claims is so important and so worthwhile. In the average business, a contractor would have to win contracts ten times the size of the claim to have the same bottom line effect on the company.
The payback analysis is dependent on sound quantification, however. So, managing changes is not simply a liability analysis. Recognizing liability without adequately recognizing its financial consequence is not helpful. Also, litigation techniques are not suited for successful settlement. Indeed, settlement is a sales opportunity and sales techniques designed to overcome objections are what is needed. Overcoming objections often means that the contractor must do both his own job in identifying and quantifying the change as well as assisting the government representative in performing theirs. Litigators would often dismiss such an approach as simply free discovery but then proposal preparation costs are recoverable while litigation costs typically are not.
So while some find the pursuit of claims to be objectionable, they are a design feature of the government contracting machinery. For many companies to survive these highly competitive times, they will have to adopt a strategy that recognizes the role of claims because to do otherwise will be to forego life as a government contractor.