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Inflationary Pressure

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According to the Department of Defense publication “Inflation and Escalation Best Practices for Cost Analysis,” estimates for future project costs must address (1) inflation, (2) real price change (RPC), and (3) escalation. Each of those terms has an official DoD definition, which we provide below:

Inflation means “a rise in the general price level over time, which is an economy-wide average over all goods and services transacted. Inflation represents a decrease in the value of money (i.e., the dollar), due to an increase in the supply of money and credit relative to available goods, resulting in a rise in the general price level.” The definition of “inflation” continues, as follows:

Key to the definition of inflation is that it measures the economy-wide change in price as opposed to the change in price of any specific good or service. The inflation index used in Federal budgeting is the Gross Domestic Product Chain-Type Price Index, known more commonly as the GDP Price Index …. The Bureau of Economic Analysis (BEA) of the Department of Commerce develops the index based on value-added prices of all final goods and services (sometimes referred to as a ‘market basket’) produced on US soil. It includes investment goods, consumption goods, services, and products exported overseas.

(Footnotes omitted)

Real price change (RPC) refers to the price movement of specific goods and services rather than to economy-wide changes. “While inflation affects all prices in the same proportion, prices for specific goods and services may change at different rates due to real price change …. Positive real price change indicates that the item has become more expensive relative to an economy-wide basket of goods and services …. The label ‘real’ in real price change refers to the fact that it is measured in inflation-adjusted dollars, also known as ‘real dollars.’

The DoD publication lists several factors that may drive RPC, including: market shifts; changes in the supplies of specific materials; changes to cost of doing business (e.g., overhead rates), for either contractors or the government; economies or diseconomies of scale; changes in the mix of the workforce, such as labor categories or skill levels; changes to inputs to production; rate effects and learning effects; technological change, such as increased automation of a production process.

Escalation is “the combined effect of inflation and real price change, as defined in the previous two sections.” According to the DoD: “Escalation may be positive, negative, or zero; since inflation is usually positive in a growing economy, the direction of escalation depends primarily on the magnitude and sign of real price change …. Escalation may also be equal to inflation in two cases: the market basket may be so broad that it approximates the entire economy (which, by definition, experiences inflation only), or the market basket experiences no real price change relative to the economy as a whole.”

Having defined our terms, let us offer the opinion that, when DCAA auditors and DCMA contracting officers negotiate escalation factors in a contractor’s proposal, they tend to focus on inflation and ignore RPC. Contractors are very aware of RPC. For example, contractors understand that the cost of labor has skyrocketed in recent months—especially in certain areas, such as software developers. Costs of certain goods and materials have similarly skyrocketed. However, when government auditors and analysts look at a contractor’s escalation rates, they tend to compare the proposed escalation only to inflation indices (e.g., Global Insight). Thus, there is tension because the cost of every good or service is increasing at the average, overall rate.

Everybody knows that inflation is on the rise. Even the Department of Defense acknowledges it. In May, 2022, the Principal Director, Defense Pricing and Estimating, issued a memo addressing the impacts of inflation on existing contract prices as well as on new contracts. The memo was, uh, unfortunate. Yes. That’s the term. Unfortunate.

First, the memo utterly ignored RPC, but maybe that’s because it was written by people who didn’t understand cost analysis. So, let’s call that a “nit.”

Second—and far more importantly—the memo utterly missed the point. It stuck to legalese and missed the true impact of cost escalation risks on the Department’s supply chain—and therefore the risks to the Department’s mission.

What do we mean?

The memo outlined Department policy with respect to firm, fixed-price contracts, using language that might as well have been lifted straight out of the FAR. The memo said—

… contractors performing under firm-fixed-price (FFP) contracts generally must bear the risk of cost increases, including those due to inflation. In the absence of an applicable contract clause, such as an EPA clause authorizing a contract price adjustment as a result of inflation, there is no authority for providing contractual relief for unanticipated inflation under an FFP contract. We are fielding questions about the possibility of using requests for equitable adjustment (REAs) under FFP contracts to address unanticipated inflation. REAs entail a contractor’s proposal to the CO seeking an equitable adjustment to the contract terms based on a contracting officer-directed change within the scope of the contract, in the areas defined by the applicable Changes clause, or by another contract clause that authorizes an equitable adjustment based on specific actions taken. Since cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change, COs should not agree to contractor REAs submitted in response to changed economic conditions.

Sure, go there. That’s a nice legal position, but when your mid-tier and lower-tier suppliers—and your small business suppliers—begin to go bankrupt because the costs of performing the contracts exceed their available cash flow, and your “reprocurement costs” associated with Terminations for Default are meaningless because the suppliers are bankrupt and can’t pay—and in many cases there will be no other suppliers to perform in any case—and when your programs start to fall behind schedule and now you have to report Nunn-McCurdy breaches to Congress … well. At that point you will realize—far too late—that your lawyers’ advice wasn’t so smart after all, because you didn’t deliver your weapon systems and your contractor services to your warfighters, even though you adhered to contractual policies and procedures.

Not incidentally, delivering goods, services and weapon systems to the warfighters is, fundamentally, the entire job of the Department of Defense’s back office.

The memo seemingly ignores history, when inflationary pressures (among other factors) led to the United States Government bailing-out Lockheed via an Act of Congress. Don’t believe us? Google it. One salient fact was the imminent insolvency of Rolls-Royce, maker of aircraft engines. One report summarized the situation thusly: “If the engine supplier for the L-1011 was bankrupt, the contract for the RB.211-22 engine would be nullified.” Now, perhaps the crisis was driven by technical challenges in fixed-price development contracts, but the salient fact is that the contracts were fixed-price, and the contractors couldn’t absorb the associated losses. If the supply chain collapsed, the prime contractor (i.e., Lockheed) was toast.

There’s more in that May, 2022, memo about how to craft and negotiate Economic Price Adjustment (EPA) clauses in new contract awards, but every word of that guidance tells savvy readers that the authors never read the DoD’s publication on the topic—the publication we linked to in the first sentence of this article. If they’d read, and absorbed, the guidance in the publication, they wouldn’t be talking solely about inflation, they’d be talking about RPC, as well.

We guess the agency lawyers missed that one.

Anyway, perhaps having received feedback similar to ours, or perhaps after waking up in the morning, realizing what a bad idea the first memo was, a second memo was issued, which revised the first memo. While not admitting any missteps were previously made, the second memo walked-back some of the policy positions that had been taken, “[b]ased on feedback from the Department’s acquisition executives about how inflation is presently affecting the Defense Industrial Base and contractors’ ability to perform under existing firm-fixed-price contracts.”

The revised memo provides contracting officers with some flexibility—

… there may be circumstances where an accommodation can be reached by mutual agreement of the contracting parties, perhaps to address acute impacts on small business and other suppliers. For example, provided adequate consideration is obtained for the Government, such an accommodation may take the form of schedule relief or otherwise amending contractual requirements.

The revised memo also notes that—

For extraordinary circumstances where contractors have sought or may seek an upward adjustment to the price of an existing firm-fixed- price contract to account for current economic conditions, each of the Secretaries of Defense, Army, Navy and Air Force has authority under Public Law 85-804, as implemented by Part 50 of the Federal Acquisition Regulation (FAR) and the Defense FAR Supplement (DFARS), to afford Extraordinary Contractual Relief. While the law and regulation have established stringent criteria, the Department will consider contractor requests to employ this authority, subject, of course, to available funding.

Which is nice, but if you read closely, you’ll see that any extraordinary relief is limited by the amount of “available funding.” Meaning that it will essentially take an Act of Congress to grant it.

Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.” Here we are, fifty years after the Lockheed bailout and loan guarantees, and we have seemingly learned nothing. The mission is in jeopardy and, rather than addressing the real problem—which is that DoD is lacks the flexibility to quickly adapt to changing economic conditions—we have seemingly put the attorneys in charge.

In my view, we need to put the attorneys and policy-wonks on the back-burner right now, and get the practical business-people in positions to make tough decisions. But, you know, that’s just one opinion.

Last Updated on Monday, 19 September 2022 20:12
 

Defense Industrial Base Vulnerabilities

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Recent headlines:

April 11, 2022 – “JetBlue Crewmember Union Blasts Management 'Incompetence at the Highest Levels'” (Link). “’ "They’ve mismanaged their hiring, they’ve mismanaged the logistics of their company, of their system, and here we are with all of these massive problems," [Union President] Samuelsen said.”

May, 2022 – “Supply Chain, Labor Woes Confound Military, Industrial Base” (National Defense). “A nationwide labor shortage and problems with the supply chain continue to disrupt the delivery of materiel to the military and its industrial partners, logisticians at a recent conference said. … [According to the Vice Commander of Naval Supply Systems] “About 80 percent of his command’s suppliers are ‘single-source,’ meaning there is no other company that can produce the item.”

June 8 – “Boeing Can’t Find Enough Workers to Build the New Airforce One” (Defense One). “The company blames an ultra-competitive labor market, but also the high-level security clearances each employee needs since the program involves classified information about the president's travel procedures.”

June 10 – “Major Weapon Projects Face Delays” (Defense One). GAO’s annual assessment of 59 major DoD weapon programs did not paint a pretty picture. “More than half of the 59 programs reviewed reported ‘industrial base risks,’ but most ‘did not plan for an industrial base assessment … to be conducted specific to their program.’”

June 15 – “Boeing on the Hunt for Engineers and Talent, from Arlington to Brazil” (Aviation Week). “Boeing’s hunt for new engineering talent is taking it from suburban Washington to Brazil as it seeks to attract and retain a new generation of workers after the COVID-19 pandemic and production missteps.”

June 19 – “'Travel Armageddon' as flight delays, cancellations pile up: What's going on?” (USAToday). “[Travel Agency CEO] Ferrara said the loss of skilled positions, such as pilots and aircrew, is ‘really what's driving’ all of the airline issues. Pilot unions at Delta, American and Southwest have said airlines haven't been quick enough to replace pilots who retired or took leaves of absences when the pandemic began. ‘We're in a boom time for travel. We're blowing away all records all previous years. So you've got this surge in demand, and you've got limitations on staffing,’ Ferrara said.

July, 2022 – “Energetics Workforce is Graying Out” (National Defense). [‘Energetics’ is the thing that makes kinetic weapons kinetic, FYI.] “… one of the most pressing concerns among government and industry is developing the future workforce. Nowhere is that challenge greater that in the field of energetic materials—the chemicals used to make propellants, pyrotechnics and explosives.” And: “Panelists identified other factors that turn candidates away from the energetics industry such as outdated facilities, excessive bureaucracy—even in small tasks like purchasing needed materials—and jobs located in areas with little to offer young professionals and their families.”

In a survey sponsored by the National Defense Industrial Association (NDIA), and reported in the June, 2022, edition of National Defense magazine, 78% of respondents said the availability of skilled labor was a moderate or significant problem for them. 63% said the same for availability of cleared labor (hello, Boeing). Clearly, the current situation is not just a defense industrial base problem. It’s a pervasive problem across many industries. But the situation affects national security. Without workers (cleared or not), and without effective supply chains, defense programs are at risk of failure.

The same article in National Defense (written by Stephanie Halcrow and Nicholas Jones) offered some solutions to address the problems facing the defense industrial base. Among those possible solutions were:

  • Accelerate acquisition reform, including reforming the budget progress and implementing a two-year budget and appropriations cycle, and creating a new appropriations category (“color of money”) for software acquisitions.

  • Reform DoD’s approach to intellectual property rights

  • Increase the simplified acquisition threshold

  • Budget stability. (“72 percent of respondents said ‘the uncertain prospect of continuing volumes of business’ was a moderate or significant deterrence to devoting significant amounts of capacity to military production, up from 60 percent [in the previous year’s survey].”)

  • Maintaining innovation.

There were other suggested fixes, but you get the idea.

The sad thing about the list above is that nothing is new. All of these “prescriptions” have been suggested before—some many times before—in the previous decade or even longer. There’s nothing new here.

Before somebody tries to fix the serious problems facing not only the defense industry, but all of US industry, perhaps its time to do a root cause analysis.

If one were to perform such a root cause analysis, we believe the results might include the following:

  • Excessive focus on the short term in favor of long-term planning, especially amongst publicly traded companies where executive bonuses are tied to stock price.

  • Excessive emphasis on expense reduction at the expense of the overall mission. For example, an undue focus on “just-in-time” logistics that only saves money when the supply chain is working at 100%. Otherwise, the focus creates unacceptable levels of risk—especially when the supply chain is in jeopardy.

  • Excessive focus on controlling labor costs rather than a willingness to pay market wages—and even premiums for in-demand skillsets and clearances. The “human capital” crisis was predicted more than twenty years ago; yet corporate leadership appears to have failed to take effective action to mitigate it. Things are only going to get worse from here. Netflix famously issued its 120 -slide PowerPoint deck about how to manage a workforce in 2009—more than a decade ago. Why have defense contractors failed to implement its innovative practices?

Fundamentally, the root cause of many of the vulnerabilities facing the defense industrial base is a short-sighted leadership culture coupled with too many disincentives that impede change and adoption of new practices. There is a noticeable lack of accountability for poor leadership decisions; instead, huge bonuses are awarded even in the face of failure.

You want to change things? Change the leadership culture.

 

Legal Structures Can Influence Cost Allocations

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Most of the time, cost allocations for a government contractor don’t care about legal structures. Legal structures are the province of lawyers and tax accountants, for the most part. When we talk about FAR and CAS allocation requirements, we talk about functions and activities, and home offices and segments and business units. We talk about cost objectives—both intermediate and final. We don’t talk about the legal structure of the corporate entity. One legal entity or one hundred: it really doesn’t affect how costs are collected and allocated to places where the costs get collected and billed.

Most of the time.

Recently, though, a dispute at the Civilian Board of Contract Appeals (CBCA) turned on a contractor’s legal structure. The dispute involved payment of taxes to the Afghanistan government. Having dealt with the topic in the past (to a small extent) I was interested in what the Board thought of the situation. What I learned, when reading the case, was that the Board seemed to be frustrated by the lack of information and facts. In particular, the Board seemed to be frustrated and confused over the Appellant’s legal structure.

(If you’re going to read the rest of this blog article, I suspect you will be similarly frustrated. You may want to keep a separate list of all the legal entities involved.)

The Appellant, International Development Solutions, LLC (IDS), provided security services to the Department of State in the country of Afghanistan. According to IDS, the Afghani government imposed taxes on it based on the contract work it had performed in country. The Board wrote that IDS “seeks payment for three years of tax and penalty payments under cost-reimbursement provisions of two task orders.”

The Board found that IDS had not provided sufficient evidence that it had actually incurred the costs associated with those tax payments, or that the tax payments related to the two task orders. A particular concern of the Board seemed to be the lack of transparency of the legal structure of the contractor—a lack of transparency that was exacerbated by testimony.

Legal entities mentioned during the case included: ACADEMI Training Center, Inc.; ACADEMI LLC; Constellis Holdings LLC; and Constellis LLC. The Board was clearly confused in trying to trace the relationships between the entities.

It was undisputed that the Department of State awarded a contract to IDS in 2010, and that IDS provided the services under the contract. The two task orders at issue were worth $400 million. It seemed that the corporate headquarters of IDS was located in McLean, Virginia.

Then things got murky.

Less than two years later (May, 2012)—

… a person signing as director of contracts for “ACADEMI” wrote to the State Department contracting officer [stating], ‘As of May 10, 2012, ACADEMI Training Center, Inc. (‘ACADEMI’), previously the 49% owner of [IDS], purchased the remaining 51% membership interest . . . to become the sole owner. ACADEMI now requests a novation of the 2010 contract and associated task orders ‘from its subsidiary, IDS, to itself’.

(Footnotes and internal citations omitted, as always.)

Thus, it appears that IDS was, itself, a partially owned subsidiary of an entity called ACADEMI Training Center, Inc. (“ACADEMI”) when it won the original contract. Was that disclosed to the Department of State prior to contract award? We don’t know. Was a 49 percent ownership enough to exert control over IDS? Again, we don’t know.

But we do know that, less than two years later, ACADEMI purchased the remaining 51% of the ‘membership interest’ of IDS. (N.B.: According to the Board, “it appears that a Delaware limited liability company has ‘member’ interests rather than ‘stock’ shares.) Purchased from whom? We don’t know.

After the purchase of the remaining membership interests, IDS was 100% owned by ACADEMI and ACADEMI requested that the State Department acknowledge that ownership through a novation. A novation, of course, “is the act of replacing a contract with another contractual obligation, requiring the consent of all parties involved.” Novations are discussed at FAR 42.12. Let’s quote from that FAR Subpart, below—

The Government may, when in its interest, recognize a third party as the successor in interest to a Government contract when the third party’s interest in the contract arises out of the transfer of-

(1) All the contractor’s assets; or

(2) The entire portion of the assets involved in performing the contract. … Examples of such transactions include, but are not limited to-

(i) Sale of these assets with a provision for assuming liabilities;

(ii) Transfer of these assets incident to a merger or corporate consolidation; and

(iii) Incorporation of a proprietorship or partnership, or formation of a partnership.

(b) A novation agreement is unnecessary when there is a change in the ownership of a contractor as a result of a stock purchase, with no legal change in the contracting party, and when that contracting party remains in control of the assets and is the party performing the contract. However, whether there is a purchase of assets or a stock purchase, there may be issues related to the change in ownership that appropriately should be addressed in a formal agreement between the contractor and the Government (see 42.1203(e)).

(c) When it is in the Government’s interest not to concur in the transfer of a contract from one company to another company, the original contractor remains under contractual obligation to the Government, and the contract may be terminated for reasons of default, should the original contractor not perform.

(Emphasis added.)

As we highlighted above, there is no need to process a novation agreement when there is a stock purchase with no change in the contracting party. Indeed, that is the rationale used by the contracting officer to reject the request for novation, writing “Given that IDS still exists . . . and has all of the necessary resources and support of ACADEMI to continue fully meeting its contractual obligations . . . no action [by] the Government is required. Therefore, IDS should continue to fulfill its contractual obligation as agreed to under the [2010] contract.”

The murk continued to grow, as the Board wrote in its decision.

Notwithstanding State’s July 2012 letter, IDS contends that ‘following denial of the requested novation . . . ACADEMI Training Center, Inc. became prime contractor and real party in interest . . . . In the alternative, IDS remained prime contractor with ACADEMI Training Center, Inc. as subcontractor[.]’ By contrast, a former board member and ‘lead investor’ of a company he called simply ‘Academi’ testified at the hearing, when asked ‘which entity still legally held the . . . contract and the task orders’ after July 2012, ‘Well, since [the contract] wasn’t novated IDS did. And the only way to get that out to a different name was if they [State] agreed to novate it.’

The Board was getting frustrating at the lack of opacity. The Board’s frustration was expressed in Footnote #3.

The record is rife with ambiguity and confusion as to which entity witnesses meant when they referred to ‘Academi.’ The former board member testified when asked to clarify to which board he belonged, ‘That was, well, there’s so many names of these companies. At the time I believe it was Academi. . . . It was Xe Services, and then Academi, and then Constellis. For that period of time [2010 to 2013] I don’t think Constellis was relevant. It was Academi.’ He was asked on cross-examination, ‘[D]id you purchase an interest in one of the entities with the name Academi?’ He answered, ‘I believe Academi was formed as successor entity or it was renamed. I can’t remember to be honest with you.’ Asked when he acquired an interest in ‘Academi LLC,’ he testified, ‘I don’t know if we ever acquired that entity. I believe we created that entity . . . at the end of 2011.’ Asked to distinguish ‘between Academi LLC and Academi Training Center,’ he testified, ‘If those two entities exist, which I trust they do because you’re referring to them,’ the latter ‘would have been [only] the actual training center in Moyock, North Carolina.’ We gather from this that by ‘Academi’ this witness primarily meant ACADEMI LLC.

It was unclear as to whether IDS even existed. The Board’s decision included this quote from testimony—

Q And how were payments from the State Department handled . . . after the State Department rejected the proposed novation?

A Well, they continued to pay IDS, because it held the contract. So, that’s the entity they paid. It was paid literally to an account that was only set up to receive payments. And then those payments were transferred to Academi, because Academi paid all the bills. And we had all the—incurred a lot of costs. Being a wholly owned entity it was more of a balance sheet checking account mission for us, and more headaches.

That sounds like an accountant testifying, doesn’t it? It seems that nobody cares about the accounting workload when they start playing legal and tax games with the corporate structure. (But perhaps we digress.)

Now Constellis comes into play. As the Board wrote—

Another witness for IDS, who said he had been vice president of financial compliance since November 2020 of an entity he called simply ‘Constellis’ (see below), testified based on his knowledge of ‘Constellis’ records:

Q As of or after the Department declined to sign the proposed novation agreement, what changes, if any, were made to the IDS accounting system?

A There are no changes made to the IDS accounting system per se. However, from, you know, flow of funds there’s a slight change. For example, invoices continued to be generated from IDS. The State Department would make payments to an IDS bank account, but . . . [t]hose funds that went into the IDS receipts account would be swept into an Academi account out of which disbursements were made.

Q Could you describe that a little bit more, what you meant when you said that the payments were deposited in an IDS account and then swept into the Academi account?

A Yes. Due in part to the fact that the contracts were not novated, the original contract was awarded to IDS. And so, the company then maintained that structure adding IDS, the legal entity, that would invoice the State Department. The remittance went to a legacy IDS bank account. But then, after Academi acquired them, they converted that account to what’s referred to as a zero balance account, meaning that funds would come into that account but then get swept into a master Academi account and reimbursements on behalf of the company would go into the Academi account.

Q And, just to clarify, you referenced a zero balance account. Which company had what you referred to as the zero balance account?

A So, the IDS bank account, essentially, was the zero balance account, meaning that payments would be made into that, wired into that account, but they were transferred into an Academi account.

The lack of transparency caused the presiding judge to get involved.

JUDGE CHADWICK: . . . Does there currently exist an entity called Academi LLC?

THE WITNESS: Yes, sir. A legal entity, Academi LLC.

JUDGE CHADWICK: Does that Academi LLC, does that own Academi Training Center LLC?

THE WITNESS: Again, I’d have to look at the—or that’s more a question for our legal team, in terms of that structure.

JUDGE CHADWICK: Is there an entity currently in existence called Constellis LLC?

THE WITNESS: Yes, Your Honor.

JUDGE CHADWICK: Is there also something called Constellis Holdings, with some corporate designator?

THE WITNESS: Yes, Your Honor.

JUDGE CHADWICK: What, if any, ownership relationship exists between Constellis LLC and Constellis Holdings?

THE WITNESS: Actually, I can’t confirm what the—I mean, you have the umbrella company and I’m embarrassed to say I forget which one is the umbrella company with all the affiliates below it.

JUDGE CHADWICK: . . . As between Constellis LLC and Academi LLC, does one own the other?

THE WITNESS: Constellis is the holding company of Academi LLC, is my understanding.

JUDGE CHADWICK: Okay, but you just said Constellis again, and we’re not clear—it sounds to me from your previous answer, you said Constellis, but you may not be sure whether you mean Constellis Holdings or Constellis LLC.

THE WITNESS: That is correct. It’s a complex legal structure.

Turning to the entity that was taxed by the Afghani government, the record was similarly muddied. For example—

In approximately 2017, Afghanistan issued assessments of taxes and penalties to ACADEMI LLC for Afghan tax years 1389 to 1394 (roughly March 2010 to March 2015). The taxpayer used an outside lawyer based in Washington, D.C., to address the tax issues. The lawyer testified in the hearing that his client in the engagement was ‘Constellis Holdings.’ Throughout his testimony, he referred to the taxpayer as ‘Academi.’ …

Bank records show that in January, April, May, and July 2017 and July and September 2018, Academi LLC and Constellis Holdings LLC wired six payments denominated in dollars to the Afghan Ministry of Finance. Academi LLC made the first three payments; Constellis Holdings LLC made the last three. Each transfer record lists the ‘Debit Account Name’ as ‘Academi Training Center Inc [sic] AP [accounts payable].’

In summary, the government of Afghanistan levied taxes against ACADEMI LLC. The taxpayer was ACADEMI. The payments were made to the Afghani government by two legal entities: Academi LLC and Constellis Holdings LLC. The payments were then recorded as costs of Academi Training Center Inc.

Thus, when IDS submitted claims for $36.7 million related to those tax payments, the Board was naturally confused. As a Footnote stated—

The Constellis witness testified that the organization internally ‘allocated’ the tax payments to the two task orders ‘[o]n a revenue basis, so, basically, as mentioned, within the system they accumulate revenue for their respective task orders. And so, it’s kind of pro rata allocation.’ IDS does not rely on this testimony, which we understand to mean that the organization had already decided that the payments related to the two task orders and chose an accounting method to record that conclusion.

It should not be surprising to our readers to learn that the CBCA found that IDS had not incurred any costs, either on its own or via allocation from a home office. “We further find no basis to allocate the payments made to Afghanistan by the two holding companies to IDS’s performance of task orders 9 and 11. … IDS’s failure to meet its ‘burden of proving’ that the claimed ‘costs were . . . allocable to this [particular] contract’ and the task orders is an independent basis to deny relief.” The Board continued, writing—

Were we able to find that IDS incurred the costs and that they were allocable, substantial doubt as to IDS’s entitlement to reimbursement would remain. Among other issues, although we know ACADEMI LLC and Constellis Holdings LLC settled assessments by the Afghan Government of taxes and penalties, we fundamentally do not know why those companies did so. The Board learned nothing, via expert testimony or otherwise, about the tax laws of Afghanistan in this case. We do not know on what basis in Afghan law the Afghan officials issued the demands to ACADEMI LLC to begin with. … As there is ‘no presumption of reasonableness . . . simply because [a contractor] incurred . . . costs,’ this would be a challenging record on which to show reasonableness, even without reaching the issue of allowability under the task orders.

So, yeah. No.

Which brings us back to our initial thoughts. Legal structures don’t normally impact on government contract cost accounting concerns—until they do. Taxes are one area in which cost accounting is impacted, since legal entities are taxable entities.

As government contract cost accountants, it’s important to be able to trace tax payments from the legal entity making them to the cost accounting entity in which costs are being accumulated (and/or allocated). In that regard, see the cost principle at FAR 31.205-41, CAS 403, and the DCAA Selected Areas of Cost Guidebook (Chapter 68). Those reference sources lead to an inescapable conclusion that proper and compliant allocation of tax payments is a complex undertaking.

Don’t make the effort to properly allocate tax payments even more difficult by creating complex, opaque, legal structures.

Last Updated on Tuesday, 05 April 2022 16:47
 

Defective Pricing and Statute of Limitations

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Recently, the Armed Services Board of Contract Appeals (ASBCA) entertained a motion of summary judgment in a matter involving alleged defective pricing. The Board’s discussion is interesting and we thought we’d share with our readers.

First, a couple of level-setting recaps:

  1. Defective pricing occurs whenever a contractor fails to disclose “all facts that, as of the date of agreement on the price of a contract . . . a prudent buyer or seller would reasonably expect to affect price negotiations significantly. Such term does not include information that is judgmental, but does include the factual information from which a judgment was derived.” (Quoting from the decision, which quotes from 10 U.S.C. § 2306a(h)(1).)

As we’ve posted before, the Truthful Cost or Pricing Data Act, which used to be the Truth in Negotiations Act (TINA), is a disclosure requirement, not a use requirement. The contractor’s basis of estimate doesn’t matter. What matters is that the contractor actually disclosed to the government all relevant facts and circumstances that would reasonably be expected to affect price negotiations significantly.

The contractor is required to certify that all cost or pricing data that was disclosed is “accurate, complete, and current.” If the contractor certifies as such, but the government believes the certification was inaccurate (because some or all cost or pricing data was not accurate, complete, or current as disclosed) then the contractor has “defectively priced” its contract.

In a defective pricing claim the government is required to prove that: (1) the information in dispute is ‘cost or pricing data’; (2) the cost or pricing data was not meaningfully disclosed; and (3) the government relied to its detriment upon the inaccurate, noncurrent or incomplete data presented by the contractor.

FAR contract clause 52.215-10 provides the remedy for defective pricing. In addition to the contractual remedy, we’ve noted in prior articles that the government may elect to pursue an allegation of violation of the False Claims act with respect to invoices submitted for a contract that was defectively priced.

In other words, it’s kind of a big deal.

  1. The Contract Disputes Act (CDA) contains a Statute of Limitations that a contractor may raise as an affirmative defense, asserting that a government’s claim for damages (related to defective pricing or other issues) is untimely. According to the CDA, claims must be submitted within six years after the accrual of the claim. “Claim accrual” is defined in FAR 33.201 as being “the date when all events, that fix the alleged liability of either the Government or the contractor and permit assertion of the claim, were known or should have been known.” (Emphasis added.)

We have written quite a bit about the CDA Statute of Limitations on this blog. There does not seem to be a bright line (at least to us, who are not attorneys). Instead, when the Statute of Limitations clock starts to run seems to be dependent on the facts and circumstances of the situation.

Okay. With the foregoing established, let’s talk about the appeal of AAI Corporation, doing business as Textron Systems, Unmanned Systems (Textron).

Textron sells unmanned aircraft systems (UAS) to the US Army under various contract. At issue here is Full Rate Production (FRP) contract IV. Obviously, there were previous contracts, including FRP I, II, and III. In other words, Textron had a wealth of contractual cost performance history to draw upon—i.e., the company had quite a lot of potential cost or pricing data to disclose.

According to the decision regarding dueling motions for summary judgment, “On January 11, 2006, the Army requested that Textron submit an FRP IV proposal for 11 TUAV systems by January 31, 2006. Subsequent amendments requested alternate pricing for 10 and 9 systems. Textron submitted a timely proposal.” In other words, the Army gave Textron less than a month to prepare and submit a proposal that ended up being worth more than $87 million dollars.

In order to meet that quite challenging deadline, Textron had to cut some corners. In particular, Textron informed its Army customer that—

… it based its labor and material costs on the FRP III Supplemental contract, which it had been awarded seven months earlier. Its FRP IV proposal stated that it had applied a 91.66% adjustment factor to account for the reduction in the number of systems from 12 in the FRP III Supplemental contract to 11 in FRP IV, and additional adjustment factors for 10 and 9 systems. Textron refers to this as its ‘parametric’ approach. After applying the adjustment factor, Textron then increased its prices to account for cost escalation

(Internal citations omitted, as always.)

In other words, in order to meet the really rather ridiculous timeline, Textron apparently based its FRP IV proposal on the cost or pricing data that it had recently submitted for the FRP III Supplemental contract. We say “apparently” because the wording is less than clear: it seems that Textron based its proposed price on what it had recently bid rather than, say, actual costs incurred under other FRPs or actual costs incurred so far under the FRP III Supplemental contract.

Basing a bid on a previous bid, rather than actual costs of previous work, is always going to be risky.

Anyway, that’s what Textron seems to have done. It took its last bid and made some mathematical adjustments and that was what it submitted to the Army that formed the basis of the $87 Million dollar contract award.

Along the way, DCAA took a look at Textron’s proposal and determined it to be good enough for negotiations. Negotiations were concluded in April, 2006.

Notably, DCAA did not look at what Textron did not submit. (Remember, TINA is a disclosure requirement, not a use requirement.) What Textron did not submit became the basis of a future defective pricing assertion.

As the ASBCA decision told us—

Nearly 11 years later, on March 8, 2017, contracting officer (CO) Gregory Wilson issued a final decision in which he determined that the government was entitled to a price adjustment of $7,190,376, plus interest, based on his conclusion that Textron had provided the government defective pricing. The CO based the final decision in large part upon a DCAA audit report dated January 8, 2014

There were three specific allegations of defective pricing, as follows.

  1. The POP payload (quantity 36). Textron proposed, and the government agreed to, a price of $181,558 per unit, which was an escalated price. However, at the time (as the government alleged), Textron had in its possession a subcontract that established a unit price of $165,855. Textron did not disclose its firm subcontractor pricing to the government.

  2. Ground control shelter costs. Textron apparently double-counted the costs of its shelters in the January 2006 cost proposal. As a result, the government agreed to a price that was $415,800 higher than it would have, had the shelter costs not be overstated.

  3. Inflated labor costs. As noted above, Textron used prior bid data, as adjusted. It did not use actual costs. In particular, it did not use historical labor costs. Since it didn’t use its actual cost history, it didn’t consider that information to be cost or pricing data worth submitting to the Army. Well, it turns out (according to the ASBCA decision) that “prior to submission of its FRP IV proposal, Textron had conducted an analysis of its actual labor hours per system produced for prior FRP lots, and compared them to its hours bid for the FRP IV system. Textron presented a document containing this information to its upper management on January 24, 2006, one week before submission of its FRP IV proposal.” Textron did not disclose the existence of this analysis to the Army negotiators.

Textron moved for summary judgment on the affirmative defense that the CDA Statute of Limitations made the government’s claim time-barred. On two of the three allegations, the court did not agree with Textron.

With respect to the POP payload, “[t]he record lacks undisputed facts to support a finding that in 2006 the CO knew or should have known about the actual $165,855 price because Textron failed to disclose it to him and he had no apparent way to learn of it on his own. Textron has not proposed a credible alternate date for the running of the statute prior to DCAA’s receipt of the relevant documents in 2013.” To Textron’s argument that it had disclosed its methodology to the CO, and that was sufficient to comply with TINA requirements, the Board disagreed, writing “The government has made a plausible case that Textron’s success in locking in a $165,855 price would have affected negotiations significantly.”

With respect to the labor costs, “The parties cannot be in roughly equal positions if one side has an analysis that distills years of data and the other does not.”

With respect to the shelter costs, “It is undisputed that in 2006 the government had all of the information upon which it would base its claim, namely the proposal itself. The government’s claim was merely the result of DCAA’s analysis of that proposal.” Further, “Even if the government did not immediately grasp the problem with the numbers in Textron’s proposal, it had six years to scrutinize it more closely. Claim accrual is not suspended simply because the government failed to appreciate the significance of what the contractor furnished.”

Summary judgment was granted to Textron on the shelter cost issue; it was denied on the other two issues. At this point, either the parties will negotiate a settlement or else they will proceed to a trial on the merits.

The lesson here is that, no matter what proposal methodology a contractor uses, it still must comply with the TINA requirement to disclose all relevant cost or pricing data—even if that data is not used in its proposal. Facts deemed relevant to price negotiations that are not provided to the government are going to create problems down the road. In this case, even though the contract was awarded in 2006, the government was not prevented from asserting its claims in 2017.

Last Updated on Sunday, 29 May 2022 08:01
 

Retain Evidence

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A recent ASBCA decision contains a reminder that contractors should retain evidence and other documentation, even stuff that might not seem to matter now—but will matter in any dispute that goes to litigation.

Strategic Technology Institute, Inc. (STi) had received its first cost-type contract from the US Navy in 2008. As required by contract terms (i.e., clause 52.216-7), STI timely submitted its proposals to establish final billing rates (commonly called an Incurred Cost Proposal or ICP) for the two years of contract performance.

Allegedly.

STi asserted that it timely submitted its ICPs; however, the government—particularly DCAA—had no record of receipt. STi (allegedly) submitted its proposals but no auditors ever showed up to audit the submissions. The situation stayed that way until 2014.

In July, 2014, “DCAA was auditing STi’s 2010 ICP, which would have been submitted in June 2011 -- three years earlier. The auditor found reference to 2008 and 2009 costs, and requested from STi copies of its 2009 and earlier ICPs. STi promptly provided the 2008 and 2009 submissions to DCAA. At this point in July 2014, the 2008 ICP had been prepared five years earlier.”

DCAA audited 2008 and 2009 and, based on that audit report, three years later the DCMA contracting officer issued a Final Decision demanding $1.1 million. The COFD was issued in November, 2018—"over nine years after the 2008 ICP was prepared, but less than four-and-a-half years after DCAA requested the ICPs from STi in July 2014.”

Before the Board, STi argued that the government’s claims were time-barred by the Contract Disputes Act’s six-year Statute of Limitations. The Board didn’t buy that argument—primarily because STi was unable to provide any evidence that it had actually submitted the proposals when the company said it had done so. Moreover, STi said that the passage of time prevented the company from actually disputing the government claim. Thus, if the Statute of Limitation argument failed, the company had nothing else to faill back on.

The argument failed.

The Board’s decision stated—

We hold that the contract required STi to submit its ICPs, and that STi has not established, by a preponderance of the evidence, that it submitted its ICP prior to July 2014. Additionally, we hold that the government did not know and had no reason to know of its claims against STi until it received the 2008 and 2009 ICPs in July 2014. Accordingly, we sustain the government’s claim, reject STi’s statute of limitation defense and deny the appeals.

The lesson here is simple: retain evidence that the proposals were submitted. Do not rely on the government agreeing with you as to when (and if) they were submitted. Obtain confirmation. Print out the confirmation and retain it in your ICP support files.

You have ICP support files, don’t you?

You are going to experience turnover in personnel. You are going to have documents sent to storage or otherwise purged. Consequently, you are going to want to have robust files related to all significant decisions made during the account “scrub” and proposal preparation process.

If you don’t have such files, you risk ending up as STi did, with no ability to dispute DCAA’s audit findings, because you simply lack the documentary evidence to disagree with them. Not a great place to be in, is it?

I remember when we went to support the government audit of our 1986 proposal to establish final billing rates. This was back in the day when general ledgers were printed out, bound, and retained. We had taken all the old general ledgers and put them in an unused room, awaiting audit. When the audit finally came (in the late 1990’s—please don’t ask why it took so long), we went to pull the 1986 general ledger to show the auditors how our ICP reconciled … only to find that somebody had “cleaned” the office by throwing out all the documents that we had carefully retained.

What did we expect was going to happen? The office was unused, and filled with papers more than a decade old. Of course somebody was going to clean up the mess! (Or so it was explained to us.)

Anyway, that made the audit support of the 1986 ICP rather challenging, to say the least.

Don’t be like STi or like the company I worked for in the late 1990’s. Retain your documents. Label them. Ensure they are not thrown away.

If you do all that, your audit will go better, I’m sure.

 

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Newsflash

Effective January 1, 2019, Nick Sanders has been named as Editor of two reference books published by LexisNexis. The first book is Matthew Bender’s Accounting for Government Contracts: The Federal Acquisition Regulation. The second book is Matthew Bender’s Accounting for Government Contracts: The Cost Accounting Standards. Nick replaces Darrell Oyer, who has edited those books for many years.