Significant Cost Recovery Issues in Termination for Convenience Cases

by James L. McGovern, CPA/CFF, CVA, Fellow

Terminations for convenience involve a number of cost recovery issues that are of importance to contracting and termination contracting officers. Proper handling of these issues will lead to fair compensation for both parties.

Federal government contractors today exist in an era where they can no longer comfortably expect their contracts to run through completion. Rapidly evolving technologies, budget constraints, and redefined missions all have forced government agencies to reassess their needs and in many cases to terminate existing contracts when such is determined to be in the government's best interest.government

The right of the government to terminate a contract for convenience whenever it is deemed to be in its best interest is a basic tenet of federal government contracting. The Federal Acquisition Regulation (FAR) mandates that all government contracts include a termination for convenience clause, and absent bad faith on the part of the government, these clauses routinely are upheld by the courts and boards of appeal. It also is a provision unique to government contracts. In no other area of contract law has one party been given such complete authority to escape from contractual obligations.¹

Given the government's virtually unrestricted right to terminate for convenience and increased likelihood that the government will need to exercise this right, it is important for contractors and terminating contracting officers (TCO) to understand not only the basic rights and obligations of the parties but also the many cost recovery issues that often arise out of terminations for convenience. Failure to understand the significant cost recovery issues could result in a contractor's recovering less than a fair settlement. On the other hand, if the TCO does not understand these issues, the result could be overpayment on the government's behalf.

FAR 49.201 (a) states:

A settlement should compensate the contractor fairly for work done and preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly. In a given case, various methods may be equally appropriate for arriving at fair compensation. The use of business judgment, as distinguished from strict accounting principles, is the heart of a settlement.

Despite or perhaps because of the guiding language at FAR 49.201(a), contractors and contracting officers (CO) often find themselves unable to agree on what constitutes fair compensation. Historically, there have been a number of specific cost recovery issues that often create roadblocks to reaching a negotiated settlement which both parties can comfortably call fair compensation. This article will address the issues that concern costs incurred before termination such as pre-contract costs; initial, starting load, and preparatory costs; first article risk; common inventory; conversion of indirect costs; and defective work. A future article will address the issues that concern costs incurred after termination such as unexpired leases, severance pay, unabsorbed overhead, plant restoration and rearrangement, loss of useful value, idled facilities, profit or loss, and settlement expenses.

COSTS INCURRED BEFORE TERMINATION

It is a common mistake to consider a terminated, fixed-price contract to have been converted to a cost-reimbursement contract. Although it is true that a contractor generally is entitled to recover costs incurred and preparations made for the terminated work, such is not automatic. Furthermore, conversion to a cost-reimbursement contract would require strict application of FAR Part 31, "Contract Cost Principles and Procedure's." Such a result could be undesirable from a contractor's point of view because of the cost allowability and allocability restrictions imposed by the cost principles.² As noted above, FAR 49.201 (a) clearly provides that, in some cases, strict adherence to the accounting principles is not required.

PRE-CONTRACT COSTS

Many people are surprised to learn that, under certain circumstances, costs incurred before the award of a contract can be recoverable in a termination for convenience settlement. Such costs can include, but are not limited to, preproduction labor and engineering, hiring and training expenses, and advance purchases and subcontract commitments. Bid and proposal (B&P) costs generally are not recoverable as direct pre-contract costs, however, because B&P costs normally are required to be allocated indirectly over all of a contractor's work. Pre-contract costs are addressed, albeit briefly, at FAR 31.205-32. The pre-contract cost principle prescribes three tests that must all be met in order for costs incurred before the award of a contract to be considered allowable. To be allowable, pre-contract costs:

1. Must be incurred before the effective date of the contract pursuant to the negotiation and in anticipation of award of the contract,
2. Must be incurred in order to comply with the proposed contract delivery schedule, and
3. Must have been allowable if incurred after award.

The third test usually does not cause many disputes. Barring unusual or extenuating circumstances, expressly unallowable costs such as entertainment expenses or contributions would not be recoverable regardless of when they were incurred. The first two tests, however, often do provoke dispute. The phrases "pursuant to," "in anticipation of," and "in order to comply with" are open to interpretation. Practically speaking, the decision comes down to a question of reasonableness. If the contractor can show that otherwise allowable costs were incurred during negotiations and that such was reasonably necessary to meet the proposed delivery schedule, the costs should be recoverable.

The question of whether the costs were incurred in anticipation of award usually is moot in a termination case because the fact that the contract eventually was awarded makes it extremely difficult to argue that the contractor was not reasonably anticipating award. In most cases, the costs in dispute were incurred over several months just before contract award. Although there have been cases where costs incurred much earlier have been allowed, including one case where costs incurred up to two years before contract award were allowed,³ such is the exception rather than the rule. It is much more common for contractors to seek and recover costs for no more than several months before award. The farther back from contract award the costs were incurred, the more difficult it becomes to satisfy the tests.

INITIAL, STARTING LOAD AND PREPARATORY COSTS

In many situations it is common for a contractor to incur greater costs early in production than will be incurred in the later stages of production. This generally is more pronounced in contracts that require significant amounts of labor, but it also occurs in contracts with up-front, nonrecurring costs such as tooling or engineering. Other examples, given at FAR 31.205-42 (c), of the types of costs incurred either before starting production or early in production are

• • Excessive spoilage due to inexperienced labor,
  • Idle time due to changing production methods,
  • Training,
  • Excess labor due to lack of familiarity or experience with the product, materials, or process,
  • Plant rearrangement and alterations,
  • Management and personnel organization, and
  • Production planning.

Often when these kinds of costs are incurred, they can be difficult to recover in a termination settlement because of the manner in which they have been accounted for or because they appear excessive to the TCO.

There usually is not much difficulty in reaching agreement on the nonrecurring expenses such as engineering, training, or tooling. The difficulty usually centers around the "excess" or "inefficient" labor issues. This particularly is so when some of the production units have been delivered before termination. The termination clauses state that a contractor is to be paid the contract price for completed supplies or services accepted by the government.

If labor costs were higher on the earlier units than they would have been on the later units that were terminated, however, the contractor will suffer unless it is allowed to recover the "excess" labor costs. TCOs often will argue that labor incurred on completed units is not allocable to the terminated portion of the contract and, therefore, is not recoverable. The courts and boards of appeal, however, generally have allowed recovery where such costs can be reasonably identified. In some instances contractors have been allowed to recover these costs as part of the termination settlement, whereas in others, contractors have recovered such costs via an equitable adjustment to the unterminated portion of the contract.

In either case, the key is in identifying the cost with reasonable specificity. Unless a contractor can produce documentation such as bid workpapers that clearly indicate expected early excesses or inefficiencies, it can be difficult to convince the TCO that efficiency would have improved and these costs would have been absorbed had production run through completion. Standard learning curves can be of help but only if the contractor can show that it actually relies on such or at least that it is industry practice to do so. Actual historical evidence of learning on the subject contract or similar contracts is the most persuasive.

COSTS INCURRED BEFORE FIRST ARTICLE APPROVAL

Both of the standard first article clauses state:

Before first article approval, the acquisition of materials or components for, or the commencement of production of, the balance of the contract quantity is at the sole risk of the Contractor. Before first article approval, the costs thereof shall not be allocable to this contract for (1) progress payments, or (2) termination settlements if the contract is terminated for the convenience of the Government.⁴ (Emphasis added)

Although this provision may appear fairly straightforward, it often is the subject of dispute.

The intent of first article risk provision clearly is to protect the government from becoming liable for the cost of production units before the contractor proves it can produce the subject item. Yet the intent to protect the government often conflicts with other, ultimately overriding contractual requirements. Specifically, the requirement that the contractor actually produce the first article (s) and the requirement that the contractor be able to meet the contract delivery schedule often conflict with the first article risk provision. Thus while the courts and boards of appeal generally have applied the risk provision strictly in most cases a number of exceptions to the rule have developed over the years.

The exceptions cited most often are:

(1) where production costs needed to be incurred before first article approval to meet the contract delivery schedule,

(2) where suppliers insisted on minimum order quantities in excess of the first article requirements,

(3) where suppliers would provide any quantity of material, but the price was affected to the degree that such was tantamount to a minimum buy requirement, and

(4) where the CO, by his or her actions, effectively waives the risk provision.

The first exception typically arises in cases where the contract includes both a first article requirement and a tight delivery schedule for the production units. In this situation the contractor often must order production materials and perhaps even incur some initial production costs to meet the required production delivery schedule. In a perfect world, both parties would realize that these requirements conflict before it becomes a problem. In that instance, the contract could be modified to allow necessary expenditures in advance of first article approval. In fact Alternate II ofFARc1auses 52.209- 3 and 52.209-4 specifically provides for such.

To successfully use the second or third exceptions a contractor should be prepared to provide convincing evidence of the minimum buy requirements. Quotes, purchase orders, and invoices indicating minimum buy requirements or pricing tantamount to minimum buy requirements generally are acceptable. To that extent, contemporaneous documents generally are far more convincing than documents obtained after the contract has been terminated. Therefore, while recovery of minimum buy purchases is not necessarily dependent on contemporaneous documentation, it certainly would be prudent of contractors to obtain such as a regular practice.

The fourth exception probably is the rarest and usually the hardest to prove. Absent written direction or other overt action from the CO encouraging the contractor to incur production costs before first article approval, it is unlikely the contractor will be successful invoking this exception. Thus if a contractor believes the CO is encouraging advance expenditures, the contractor should immediately request written direction from the CO.

COMMON ITEMS

Another area of frequent dispute concerns common items. The dispute invariably centers on differing interpretations of what constitutes common items. FAR 31.205-42 (a) states, in part, that "The costs of items reasonably usable on the contractor's other work shall not be allowable unless the contractor submits evidence that the items could not be retained at cost without sustaining a loss ... " It is this sentence that causes the most problems. Contractors generally have a far narrower definition of what is reasonably usable than TCOs do.

This is a prime example of where business judgment, as required in FAR 49.201 (a), is required. The key to determining what is reasonably usable is taking into consideration both the contractor's plans for current and near-term production and the contractor's existing inventory. Sometimes a contractor may have a current or future need for the same items included in termination inventory. If the contractor already has enough of the particular items in stock to meet its current and near-term needs, however, the inventory is not common because it would not be reasonably usable. Speculation has no place here, unless there is clear evidence that the contractor can in fact use the inventory in the near future without suffering a loss, the inventory should not be considered common. The fact that a contractor has used certain items in the past is not proof that such will be used in the future. This is particularly true with "job shop" contractors that do not produce anything without a current contract.

Common mistakes made in this area include the failure to recognize that military specification parts frequently are subject to revisions which render inventory obsolete and the assumption that basic hardware and/ or raw materials are common by definition. Nuts, bolts, and steel may be common in the sense they have many uses and are used by many contractors; however, they are not common items unless they meet the requirements discussed above.

CONVERSION OF INDIRECT COSTS

In the normal course of business, contractors incur both direct and indirect costs. Direct costs typically are charged to a contract as they are incurred while indirect costs are charged to an overhead pool first and later allocated to various contracts based on a predetermined method of allocation. In most accounting systems indirect costs are allocated over some direct cost base such as direct labor, direct materials, or total direct costs.

When a contract is terminated for convenience, an immediate result is typically the elimination of the particular contract's direct cost base over which the contractor expected to allocate indirect costs. In some cases, this will result in the terminated contract absorbing less than its fair share of incurred indirect costs unless those indirect costs are converted and charged directly to the terminated contract. Consider the following example: a contractor incurs $10,000 of design engineering on a contract which is terminated for convenience a quarter of the way into the contract. It is the contractor's regular practice to charge all design engineering to an overhead pool which is allocated on the basis of direct manufacturing labor. Since only 25 percent the expected direct manufacturing labor has been incurred, the contractor will not recover all $10,000 of design engineering using its regular allocation method.

In the above example, the contractor should consider seeking recovery of the entire cost of the design engineering effort by reclassifying the cost as a direct cost. In doing so, the contractor must be careful also to adjust the overhead pool to eliminate all other design engineering to avoid duplicate recovery. In other words, it would not be permissible to recover design engineering efforts for the terminated contract on a direct basis plus a share of similar design engineering efforts for other contracts on an indirect basis.

That said, TCOs should not expand the rule beyond the specific type of cost in question. For instance, in this example, it would not be appropriate to require the contractor to remove all engineering costs from the overhead pool. It should remove only the cost of design engineering efforts that are substantially the same as those incurred on the terminated contract.

The courts and boards of appeal have regularly approved of such reclassifications, citing the fair compensation principle as justification. Other common types of cost that have been recovered this way include, but are not limited to, tooling, purchasing, and subcontract administration.

DEFECTIVE WORK

One of the more contentious areas of termination costs involves defective work and non-specification products. Government representatives frequently object to the concept of paying for work that in its present state would not be considered acceptable, their logic being that the government would not accept defective, or non-specification work on a completed .contract, so why should such be acceptable on a terminated contract?

The answer lies in the fact that a termination for convenience takes away a contractor's ability to correct defects or otherwise bring the work product into conformance with the specifications. The general rule has been that if a contract is terminated before the contractor was able to correct deficiencies, the costs should be recoverable unless they were incurred as the result of the contractor's negligence or folly. The fact that defective work can be allowable does not shield the contractor from the potential application of an adjustment for loss if the government can show that corrective actions would place the contract into a loss position. Adjustments for loss will be addressed in detail in a future article.

It should be noted that over the years there have been a few cases where the government has successfully applied offsets to terminated construction contracts for corrective work. In those instances, however, the contractors had already agreed to perform corrective work or agreed that some payment for corrective work was due to the government.

QUEST FOR COMMON GROUND

Terminations for convenience are a fact of life in government contracting. It is a risk every contractor accepts when it chooses to do business with the government. In exchange for this extraordinary right, the government agrees to compensate a contractor fairly for work performed and preparations made for terminated portions of contracts. This article has addressed many of the issues concerning costs incurred before termination which historically have made agreeing on fair compensation difficult. A subsequent article will address the issues concerning costs incurred after termination. I hope that by examining these issues, contractors and TCOs will be able to reach common ground sooner and without resorting to the disputes process.

ENDNOTES

1. John Cibinic Jr., and Ralph C. Nash Jr., Administration of Government Contracts (Washington, D.C.: The George Washington University, 1985). (return to cited text)

2. Government Contract Costs, Pricing & Accounting Report, Issue 89-7, Federal Publications Inc. (return to cited text)

3. Codex Corp. v. U.S., 226 Ct. Cl. 693 (1981). (return to cited text)

4. FAR 52.209-3 (g) and FAR 52.209-4(g). (return to cited text)

This article originally appeared in the April 1997 edition of Contract Management magazine