When unexpected costs surface

Although most government contracts are fixed-price, many contracts are awarded

on a cost- reimbursement basis. Typically, under those contracts — often

large ones — the contractor receives compensation from the government for

the entire cost of performing the contract plus a "fee" or profit.

The costs that the contractor may recover include the direct costs of

labor and materials and an allocable share of the contractor's indirect

costs for such things as overhead. Moreover, the contractor is entitled

to payment for those costs even when the final cost extends far beyond what

the contractor and agency expected when the contract was signed.

To ensure that costs don't get too far out of line, the government includes

a standard "limitation of cost" clause in almost all its cost-reimbursement

contracts. This clause requires a contractor to notify the buying agency

when the costs incurred are about to reach a specified portion of the estimated

total, usually 75 percent. It enables the agency to decide whether to downsize

the project or commit more money to fit the original work plan.

If a contractor fails to give the required notice, the government is

freed from any obligation to reimburse for cost overruns.

But there is an important exception to this rule. If the contractor's

failure to provide due notice resulted from reasons impossible to foresee,

the government must reimburse it for its full costs. (See General Electric

Co. v. United States.)

This exception provides some protection to the contractor for unexpected

overruns. However, the burden of proof is on the contractor to demonstrate

that its failure to give notice was for reasons that could not be foreseen.

A common problem that occurs involves a contractor's indirect costs.

Each contract performed during a contractor's fiscal year must bear a fair

share of all indirect costs incurred during that year. Because of that,

it is necessary to wait until the end of the contractor's fiscal year to

determine the final indirect cost rates for that year. But contractors need

to be paid more often than once a year.

To overcome this dilemma, the government allows contractors to use provisional

rates for billing during the year, with adjustments as needed once final

indirect rates can be determined. But the use of provisional rates can conflict

with the "limitation of costs" clause.

In Farradyne Inc., the contract appeals board for the Transportation

Department ruled that an agency was not required to reimburse a contractor's

expenses beyond the original estimate because the cause of the overrun was

reasonably foreseeable. The board said the contractor knew the provisional

rates it was using were wrong but did nothing to remedy the situation.

By contrast, in Dames & M, the contract appeals board for the Interior

Department found that a contractor's failure to give notice of an overrun

was excused because the overrun resulted from contractor disruptions due

to an unexpected military conflict, among other causes.

And in Dynamic Concepts Inc., the Armed Services Board of Contract Appeals

forgave a contractor's failure to provide proper notice because the contracting

officer was aware there was an overrun and the contractor was continuing

to perform the contract.

Those cases show that companies performing cost-reimbursement contracts

need to carefully monitor their costs to ensure that they don't get stuck

with the bill when things get more expensive than expected.

Peckinpaugh is corporate counsel for DynCorp, Reston, Va.