On May 25, 2022, the Department of Defense (DoD) released Guidance on Inflation and Economic Price Adjustments (the Memo) amid growing concerns on the impact of inflation on government contractors. The Memo follows repeated requests by Congress and industry alike for DoD to take precautions against the potential effects of inflation. 

First, the Memo provides guidance to assist contracting officers (COs) in understanding whether it is appropriate to recognize cost increases due to inflation under existing contracts. It notes the treatment of any potential cost increase is dependent on the contract type:

• Under cost reimbursement contracts, the government bears the burden of increased costs due to inflation. The Memo directs contractors to promptly notify COs when incurred costs approach the applicable limit pursuant to Federal Acquisition Regulation (FAR) 52.232-20, Limitation of Cost or FAR 52.232-22, Limitation of Funds. The government may increase the contracting funding accordingly; otherwise, the contractor is not obligated to perform beyond the funded amount.
• Under fixed-price incentive contracts, DoD may adjust the contract's target profit by application of the contract share ratio to the costs over the target cost.
• Under fixed-price with economic price adjustment (EPA) contracts, DoD will bear the cost risk of inflation up to the limit specified in the EPA clause. 
• Under firm-fixed-price (FFP) contracts, the Memo states that contractors must bear the risk of increased costs due to inflation, absent the presence of an EPA or similar clause that would allow for a price adjustment. While DoD notes that it is "fielding questions about the possibility of using requests for equitable adjustment (REAs) under FFP contracts to address unanticipated inflation," it concludes COs are "not to agree to contractor REAs submitted in response to changed economic conditions." 

Second, the Memo offers considerations for the proper use of EPA clauses for new contracts negotiated during this time of high inflation. Pursuant to FAR 16.203-2, COs may utilize an EPA clause in fixed-price contracts when (i) there is serious doubt concerning the stability of market or labor conditions that will exist during an extended period of contract performance, and (ii) contingencies that would otherwise be included in the contract price can be identified and covered separately in the contract. Any price adjustment is based on labor and material costs and should be limited to contingencies beyond the contractor's control, such as inflation.

The Memo states that an EPA clause "may be an appropriate tool to equitably balance the risk of inflation between the Government and contractor" and may enable contractors to accept a fixed-price contract without having to develop pricing based on worst case projections of inflation. The guidance should prompt COs to make more liberal use of EPA clauses in fixed-price contracts going forward — welcome news to contractors. In detailing the use of EPA clauses to combat inflation, the DoD cites several considerations:

• Contract period of performance length should be a primary factor in determining whether the use of an EPA clause is appropriate. See Defense Federal Acquisition Regulation Supplement (DFARS) 216.203-4(1)(ii) (limiting the use of EPA clauses to when "delivery of performance will not be completed within 6 months after contract award"); FAR 16.203-4(d)(1)(i) (limiting the use of EPA clauses based on cost indices of labor and material to contracts "with an extended period of performance"). 
• To measure inflation, the CO should use an independent, recognized index that is closely related to the cost components judged to be most unstable.
• The scope of the EPA clause should be limited to those costs mostly likely to be impacted by inflation and should exclude costs unlikely to be affected, such as depreciation and labor costs for which a union agreement exists.
• The EPA clause should base contract price adjustments on pre-established formulas and should clearly explain the timing and mechanics of any price adjustment. 

Takeaways

DoD's guidance is mixed news for government contractors. On the one hand, for new contracts, contractors can take solace that COs should be increasingly receptive to including an EPA clause in fixed-price contracts to alleviate the effects of inflation. On the other hand, the Memo provides little relief to contractors with existing firm-fixed-price contracts — specifically the guidance that REAs due to inflation will not be considered. Those contractors are left to review their existing contracts for any clause that may authorize a price adjustment or base an REA for increased costs not on inflation but on some government direction that can be read as a change. 

For more information about DoD's guidance on inflation and the use of EPA clauses, please contact one of the Miller & Chevalier attorneys listed below.

Jason N. Workmaster, jworkmaster@milchev.com, 202-656-5893

Alex L. Sarria, asarria@milchev.com, 202-626-5822

Connor W. Farrell, cfarrell@milchev.com, 202-626-5925

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