Equitably Adjusting Partially Terminated Contracts
Is any relief available to a contractor when a partial termination results in increased costs?
by James L. McGovern, CPA/CFF, CVA, Fellow
A fundamental tenet of federal government contracting is the government's right to terminate a contract for its convenience (T for C). The T for C clause is held to be present in all contracts covered by the Federal Acquisition Regulation (FAR) whether it is actually written into the contract or merely held to be so via the Christian Doctrine.1 A contracting officer can choose to completely or partially terminate a contract for convenience. When the government chooses to exercise its right to terminate for convenience, it is generally held that the contractor is entitled to recover allowable incurred costs allocable to the terminated portion of a contract plus a reasonable profit on the work performed.
But what about the effect of a partial termination on the non-terminated or continued portion of the contract? Is any relief available to a contractor when a partial termination results in increased costs? It is out of the government's right to partially terminate a contract for convenience that the contractor's right to an equitable adjustment on the non-terminated portion of a contract often arises. The basic premise at work here is that although the government has a legal right to terminate for convenience, if a partial termination has the effect of increasing of the cost of the non-terminated portion of a contract, the contractor is entitled to an equitable adjustment for those increased costs plus allocable overhead and a reasonable profit.
The intent of this article is to identify the types of costs that often increase due to partial terminations, and to discuss ways of measuring and recovering those increased costs. Although many of the issues that will be addressed may apply to many different types of contracts, the focus here will be on firm-fixed price (FFP) contracts.
When a contract is partially terminated for convenience, there are four common results that may require an equitable adjustment: increased material costs, increased labor costs, unabsorbed fixed direct costs, and unabsorbed overhead. The first area to examine is material costs. As a general rule, materials and parts purchased in large quantities are less expensive on a per unit basis than the same materials and parts purchased in smaller quantities-commonly known as a quantity discount.
In bidding on a contract, an intelligent contractor will use the best pricing available if it expects to be the low bidder. Thus, when bidding on a contract requiririg500 units of part "x," a contractor will include the cost of purchasing part "x" in a quantity of 500 if the 500 unit price is better than the price for smaller quantities. The cost of the 500 units of part "x" would be allocated on a pro rata basis to the total units being solicited. For example, if 500 units of part "x" cost $40 each and the solicitation calls for 500 assemblies, the contractor's bid will include $40 per unit for part "x" or a total of $20,000.
Now let us assume the contractor was awarded the contract, but before ordering 500 units of part "x" the contract is partially terminated by 200 assemblies. The contractor has not incurred any cost for part "x" yet, so no adjustment is needed, right? Not necessarily. The contractor would still be obligated to build 300 assemblies, and it is likely that the unit cost for 300 units of part "x" would be higher than the unit cost for the 500 units originally anticipated when the contractor bid the job. If the unit cost for 300 units of part "x" turned out to be $50 per unit, the contractor would be entitled to an equitable adjustment of $10 ($50-$40) per unit plus applicable overhead and profit.
Had the contractor already purchased and received 500 units of part "x" before the partial termination, no equitable adjustment would have been necessary because, assuming there were no first article or funding limitations at issue, the cost of the excess 200 units of part "x" would have been recovered as part of the contractor's termination settlement.
In our example, the order for part "x" had not been placed yet and thus there were no incurred costs to be included on the termination settlement proposal. Had the order been placed but not delivered, it is likely that the cost of the 200 excess units would have been recovered on the prime contractor's termination settlement proposal via submission and settlement of the vendor's subcontract settlement proposal.
INCREASED LABOR COST
Increased labor cost often is another result of partial terminations. This is generally the result of "lost learning." The basic concept of learning in a production situation is that as an individual performs repetitive tasks, he will become increasingly efficient as he continues to perform. In other words, it will take an individual less time to perform a task on his 100th attempt than on his first try.
This concept is widely accepted throughout the manufacturing and construction arenas where engineers have developed standard learning curves for use in estimating labor costs. For purposes of this discussion it is enough to simply understand the basic concept of learning. That is, people generally become more proficient as they produce more units. For this article, the term lost learning is meant to define the cost of learning that is not achieved due to a reduction in the number of units produced as would happen with a partial termination for convenience.
Consider the following illustration. A contractor receives a solicitation to build 100 widgets. In preparing its bid, the contractor estimates it will take its employees on average 10 hours per unit to build 100 units. The contractor realizes that it will take more than 10 hours each to build the early units but also figures it will take less than 10 hours each to build the later units because as they produce more units, the employees will learn to build them faster. On average, though, the contractor believes 10 hours each is a good estimate and therefore that is the cost built into the bid for labor.
Now let us assume that early in the contract the government decides it does not need 100 widgets anymore. In fact, it decides it needs only 50 widgets, so it issues a partial T for C. Also, assume that the contractor has done no work on the 50 terminated units and little on the continued units either. What should the contractor do?
The answer is that it should request an equitable adjustment for lost learning, because since it is now only producing 50 units, the unit cost for labor will be more than if it had been allowed to produce the original 100 units. Remember, the basic premise is that the early units will take longer to build than the later units. If the last 50 units are canceled, the contractor will not be able to achieve the full amount of learning that it expected to achieve by producing the later units at less than 10 hours per unit. It will still be required to produce the higher cost early units, but that is why it is entitled to an equitable adjustment.
To complete the example, if the contractor can show that the first 50 units will take an average 13 hours per unit, it will be entitled to an equitable adjustment equal to the cost of three hours per unit (13-10) plus applicable overhead and profit.
The question may arise, what if the contractor had already shipped the 50 non-terminated units at the original price before the last 50 units were terminated? The answer is, the contractor is still entitled to compensation either via an equitable adjustment to the previously delivered units or via a termination settlement proposal. Either vehicle can be used, although I would recommend the equitable adjustment route on the premise that because the units are already shipped, the contractor would probably get paid sooner than it would if the costs were included as part of a termination settlement proposal.
UNABSORBED FIXED DIRECT COSTS
Another common result of partial terminations is that fixed direct costs are not completely absorbed. When less than the originally contracted quantity is produced, the contractor is left with unabsorbed fixed costs unless it is granted an equitable adjustment or it finds another contract to which the costs can be justifiably allocated.
An example of such a fixed direct cost would be special tooling. If a contractor purchases a special tool specifically for use on a particular contract and the contract is subsequently partially terminated, part of the cost of that special tool would go unabsorbed unless the contractor either received an equitable adjustment for the non-terminated portion of the contract or the contractor found another productive use for the tool.
To illustrate, assume a contractor needs a $10,000 special tool it plans to use on a contract for the production of 200 helicopter gears. The tool is special because this particular contractor has no other use for the tool other than the subject contract. Furthermore, assume the contractor has built the cost of the special tool into the contract price by including $50 per unit for tooling into its bid for the 200 helicopter gears.
If the government decides to partially terminate this contract by 80 units before the tool is paid for, the contract will be left with $4,000 of unabsorbed fixed costs unless an equitable adjustment is granted to increase the price of the continued 120 units. The equitable adjustment required would include the cost of the special tool which should have been absorbed by the terminated units plus allocable overhead and profit. In this example the equitable adjustment should be $4,000 (80 x $50) plus overhead and profit.
If the partial termination occurred after the contractor had already incurred the cost of the special tool, the contractor could recover its costs via an equitable adjustment as described above or via a termination settlement proposal—the recovered amount should be the same. Therefore, which method is better would depend on which method was likely to result in quicker actual payment.
This area is the most controversial of all. Few topics in the contracting arena have received as much attention. Terminated contracts often are troubled by delays, but unabsorbed overhead resulting from contract delays will not be discussed here—only unabsorbed overhead resulting directly from the partial termination of a contract for convenience.
Many in the contracting arena believe the government is never responsible for unabsorbed overhead resulting from T for C. This is because the courts and boards have long and consistently held that general indirect costs that continue after termination are not allocable to the terminated contract but are simply continuing business costs unrelated to the terminated work (i.e., unabsorbed overhead costs, which the contractor incurs at its own risk.2 ) The courts and boards of contract appeal have refused to hold the government to be a guarantor of a contractor's overhead rates.3
For completely terminated contracts the above holds true, and it is only under exceptional circumstances that unabsorbed overhead is recovered. Partially terminated fixed price contracts are another matter, however. When a contract is partially terminated for convenience, the contractor is entitled to an equitable adjustment which may include unabsorbed overhead to cover the increased costs of work not terminated.4
As an example, if, due to a partial termination, the continued portion of the contract must absorb an additional amount of overhead, the contractor is entitled to an equitable adjustment. It must be noted,' however, that the contractor will not be able to recover all of the overhead which was to be absorbed by the terminated portion of the contract. The boards and courts have held that the contractor is entitled to recover the increased cost of the non-terminated portion of the contract but not the increased cost of the contractor's other work. That is, the overhead left unabsorbed by a partially terminated contract must be allocated over all of the contractor's work and not just to the continued portion of the subject contract.
Thus, the amount of an equitable adjustment depends on several factors including the amount of work terminated, the amount of work to be completed, and the amount of other work that a contractor has. Obviously, if a contractor has little other work, the equitable adjustment will be much greater than if the contractor has a great deal of other work.
To illustrate, consider the following example. Contractor A is awarded a $1,000,000 contract which when combined with its other contracts gives it $10,000,000 in contracts to be performed in the current fiscal year. Contractor B also is awarded a $1,000,000 contract, but when it is combined with B's other contracts, B now has only $2,000,000 of work to be performed in the current year. For comparison purposes, assume both contractors expect to absorb $500,000 of fixed overhead with the new contracts. If both contracts are partially terminated by $600,000, how much overhead will each contractor be entitled to recover via an equitable adjustment according to the courts and boards?
The answer is as follows. Although both contractors will have $300,000 of unabsorbed overhead (($500,000-$1,000,000) x $600,000), Contractor A will be entitled to recover only $12,766 (($400,000-$9,400,000) x $300,000) whereas Contractor B will be entitled to recover $85,714 (($400,000-$1,400,000) x $300,000). Clearly the determining factor in this case is the fact that Contractor A had much more other work to which the unabsorbed overhead would be allocated. Thus, contractors must closely examine their overall situations before determining whether to pursue such an equitable adjustment.
Partial terminations are a fact of life for those who do business with the federal government. In an era of shrinking budgets and cutbacks, the use of both complete and partial terminations will remain a prominent weapon of choice for those charged with effecting the cutbacks and meeting the budgets. Therefore, it is imperative for contractors to be aware of the impacts partial terminations can cause and their rights to equitable adjustment of the affected contracts.
1. Under the Christian Doctrine, if a significant clause is required to be included in a government contract, the contract will be read to include it even though the clause does not actually appear in the document. (return to cited text)
2. Kulish, Jon N., and Donald C. Holmes, "Maximizing Cost Recovery in Convenience Terminations: Part II." Government Contract Costs, Pricing & Accounting Report. March 1990, p. 11. See Nolan Bros.,Inc. v. U.S., 437 F.2d 1371 (Ct. CI. 1971);Celesco Industries, ASBCA 22460,84-2 BCA17295; Hewitt Contracting, ENGBCA 4596,83-2 BCA 16816. (return to cited text)
3. Kulish and Holmes, supra note 2. See Technology, Inc., ASBCA 14083, 71-2 BCA 8956. See Rishe, Government Contract Costs (Fed.Pub. Inc. 1984), p. 23-19.4. (return to cited text)
4. Kulish and Holmes, supra note 2. See Wheeler Bros., Inc., ASBCA•20465, 79-1BCA 13642; Fairchild Stratos Corp., ASBCA 9169,67-1 BCA 6225, aff'd on reconsideration,68-1 BCA 7053. (return to cited text)
This article originally appeared in the January 1995 edition of Contract Management magazine