We could write several thousand words about the importance of effective subcontractor management, because we consider it to be the number one most important factor that determines whether or not a program executes on time, on schedule, and within the contractual quality envelope. Indeed, we have already written thousands of words on this topic, having previously posted several articles bearing on it. (If you are interested in those articles, the site has a keyword search feature.)

We have also written several thousand words about the importance of documenting why the prices paid to subcontractors were reasonable in amount. We dedicated a series of four articles to the obstacles facing Kellogg Brown & Root Services (KBR) as it attempted to prove the price it had paid one of its largest LOGCAP subcontractors, Tamimi, for dining support services at Camp Anaconda, Iraq, was reasonable in amount—and thus reimbursable under its cost-type prime contract with the U.S. Army. It cost KBR about $30 million (by our reckoning) for its failure to prove the prices it had negotiated with Tamimi were reasonable. We discussed some lessons learned from Judge Miller’s decision. Among those lessons learned we asserted that—

• KBR had the ability to determine the best subcontract type, to conduct (and document) negotiations and, thus, to be prepared to demonstrate why Tamimi’s prices were fair and reasonable. Ultimately, KBR was not able convince Judge Miller that it had done a good job in those areas.

• … acquisition personnel need to own subcontractor source selection and award decisions. In this case, KBR’s Operations personnel ran roughshod over KBR’s Purchasing System policies and procedures in the name of expediency and troop support. … KBR personnel obviously did not work as a coherent team, and let organizational silos get in the way….

We mention the foregoing because KBR recently lost another case at the Court of Federal Claims, for similar reasons.

We are not going to spend a lot of time discussing the facts that led to the dispute over subcontractor pricing. As was the case with Tamimi, KBR was supporting the Army in Southwest Asia by providing dining services. In the words of Judge Miller, resolving the dispute between KBR and the Army “calls for reconciliation of the prime contractor’s burden to provide reasonable justification—years after the fact—for claimed costs that were passed through to the prime contractor under fixed-price contracts with the reality that the costs were incurred during the exigencies of war.”

One subcontract (called the “SK 465 subcontract”) was awarded pursuant to competition. That is to say, a Request for Proposals was issued, multiple proposals were received from potential subcontractors, the proposals were evaluated, and a winner was selected. Normally—and when properly documented—those circumstances are considered sufficient to demonstrate that the price paid to the winner is fair and reasonable. ABC International Group (“ABC”) was the winner of the SK 465 subcontract.

Unfortunately for KBR, although its evaluation of the bidders showed that ABC was the low bidder (which is why it was selected), there was an error in the evaluation spreadsheet prepared by the KBR Subcontract Administration team. Instead of being $100,000 lower than the next lower competitor (Eurest), the reality was that ABC’s proposed price was $1 million higher than Eurest’s bid. The error was not discovered during the “green sheet” management review and, indeed, was not discovered until after the subcontract had been awarded to ABC. In addition, the KBR Pre-Negotiation Memorandum (PNM) was acknowledged (by both parties to the litigation) to be “inadequate” and poorly documented/supported.

Oops!

Because the Army kept changing its projected personnel counts, the SK 465 subcontract was based on bands of headcounts (“headbands”), with a fixed price per head based on what headband the headcount fell in. Indeed, the Army changed its personnel count, the type of dining facility to be constructed, and the location of the dining facility itself. The Army’s changes in its direction to KBR led KBR to change its direction to ABC, resulting in change orders to the SK 465 subcontract. ABC’s change order prices formed a significant basis for the Army’s assertion that the subcontract pricing was unreasonable.

One of the problems was that ABC’s change order pricing was determined by KBR to be reasonable, based on a comparison to ABC’s original pricing (which had been determined to be fair and reasonable based on the competition). This would normally be an acceptable practice—assuming that the original proposal price analysis had been done well. But in this case, since the original proposal evaluation had been flawed, the comparison to it in order to determine the reasonableness of the proposed change order pricing was invalid.

In addition, the KBR Subcontract Administration team’s change order analysis suffered from other problems. As Judge Miller wrote, “Essentially, Mr. Nasery’s methodology justified a quadrupling of the total price because he doubled not only the number of troops to be served, multiplied by the rate per person, but also the per-person rate.”

Oops!

In November, 2007, DCAA issued a “Form 1” suspending payment of “certain costs that KBR paid to ABC pursuant to [Change Order 1] such as costs for dining equipment, the facility lease, reefers, generators, labor, and consumables”—for a total of $11.3 million. A year later (December, 2008), DCAA supplemented its original Form 1 and increased the amount of the suspended costs to $12.5 million. The revised Form 1 was received by KBR in July 2009. (No reason was provided for the seven month delay.)

The DCAA told KBR that its subcontractor payments were considered unreasonable—

… because KBR[] performed an inadequate analysis related to (i) the prices for higher headcount bands, and (ii) the costs of building a new DFAC facility. In addition, KBR[] billed costs using a headband that was significantly higher than the actual headcount served.

In January, 2008, DCAA issued another Form 1, suspending “$783,342 of KBR’s direct costs, indirect costs, and fee.” KBR remitted this amount to the U.S. Treasury. However, in May, 2010, DCAA revised its Form 1, lowering the amount of suspended costs to $698,779. The U.S. Government did not refund to KBR the difference (i.e., the excess amount of suspended costs).

(As an aside, this is a good example of why giving DCAA the authority to suspend contractor costs at its discretion often leads to an abuse of that authority, since DCAA auditors are not held accountable for injuries to the contractor from their errors.)

In deciding the appeal, Judge Miller wrote the following regarding cost reasonableness—

While the court considers the violence in Iraq as a circumstance bearing on the reasonableness of the agreed-upon prices, the court emphasizes that the determination is not what the court considers to be reasonable; rather, the court will examine whether plaintiff’s evidence supports the claimed amounts as reasonable.

[Emphasis added.]

Using that standard, Judge Miller found that KBR did not meet its burden, writing—

KBR has not shown that it employed sound business practices and acted as a reasonably prudent business in accepting ABC’s proposed prices for CO 1. The court accepts KBR’s decision not to hold a competition [for the changed work] as reasonable, given the sense of urgency conveyed by Major Hunter and the Army. That urgency, however, is insufficient to justify the acceptance of unreasonable prices. Moreover, while it does appear that KBR—whether pursuant to its request or not—received additional information from ABC supporting the prices in the latter’s proposal, this, too, is insufficient to establish reasonableness. This information did not illuminate the costs of the components that ABC would provide; rather, the documents that Mr. Al-Awadi submitted to Mr. Nasery in July 2004 merely identified the numbers of each component that would be provided, the number of laborers for each job title that would be necessary, the layout of the new DFAC, and a schedule of materials to be used.

[Emphasis added.]

However, KBR did win on some items. It was awarded $4.2 million for erroneously suspended costs that were never refunded (as well as for some undisputed cost items), and it was awarded the disputed dining facility costs (because Judge Miller found KBR’s price justification to be persuasive for that element). It also prevailed on the second Form 1 issue, which turned on an interpretation of subcontract payment terms. That said, by our reckoning ineffective subcontractor management cost KBR more than $8 million.

Astute readers may have noticed that we’ve recently spent significant verbiage discussing the Contracting Officer Final Decision and how the CoFD factors in to making claims against the Government, and they may have wondered why. We have nothing to say, and can neither confirm nor deny. (** Whistles innocently **)

Here’s more of the same.

Recently, the Court of Appeals, Federal Circuit, issued an opinion in the matter of Tip Top Construction v. Donahoe, Postmaster General. The opinion discussed a number of issues that are of interest and relevance, including whether change order proposal preparation costs should be treated as direct or indirect costs, whether a contract clause can create mutual agreement between the contracting parties regarding the allowability of proposal preparation costs, whether the cost of outside consultants and attorneys can be recovered in the price of a change order, and how such costs should be supported.

Here’s the story as we understand it—keeping in mind that we are not attorneys and you should obtain legal advice from competent counsel if you are dealing with these issues.

Tip Top Construction received an ID/IQ type contract from the U.S. Postal Service, in which work to be performed would be issued via Work Order. The process of issuing a Work Order included: (1) a Joint Scope Meeting, (2) preparation of a Detailed Scope of Work, (3) submission of a firm fixed-price proposal in response to the Detailed Scope of Work, (4) acceptance of the proposed price, and (5) issuance of the Work Order at the accepted price. The contract contained a clause that prohibited recovery of proposal preparation costs, stating “The contractor shall not recover any costs arising out of or related to the development of the work order including but not limited to the costs to review the Detailed Scope of Work or prepare a Price Proposal Package . . . .” In addition, the contract contained a Changes clause worded very much like the same FAR contract clause (52.243-1).

Pursuant to the foregoing, the USPS issued a Work Order (valued at $229.7K) to Tip Top to replace the air conditioning system at the Main Post Office on an island in the Virgin Islands. During performance, an issue arose regarding the type of refrigerant to be used in the replacement system. Ultimately, the USPS directed Tip Top to use the refrigerant type it wanted (with an associated change in the type of equipment) and to submit a proposal for the additional cost of the changed work. The value of Tip Top’s change order proposal was $28,838. The USPS directed Tip Top to proceed with the changed work, “for a price to be determined later but not to exceed $28,838.43.”

For the next nine months, “Tip Top and the Postal Service discussed pricing of the changed work.” That is to say, the parties spent nine months and an unknown number of hours discussing less than $30,000. And yet, after nine months, there was no agreement and nobody got fired. It’s a wonderful world, right? Now we understand why the USPS is losing so much money.

According to the Appellate decision—

The critical issue in the negotiations was whether Tip Top was entitled to recover the costs it incurred in preparing the $28,838.43 estimate that Mr. Diaz [Tip Top’s outside consultant] submitted to Mr. Morales [the USPS Construction Manager] on October 18, 2009.

During that nine month period, the USPS Contracting Officer sought guidance from his superiors on the sticking point, asking, “If one of our JOC Contractor firms hires a firm to do their cost estimating for proposals and modifications is the cost . . . considered an overhead charge or does it become a direct or indirect billable cost?” The answer received was that “The cost is an overhead charge and not a billable cost.”

By this time, Tip Top had retained outside counsel to assist in negotiations and its bills were mounting. Finally, at the end of nine months, it submitted a claim under the Contract Disputes Act for $34,553.77. As the Court noted, the claim was comprised of—

… (i) Tip Top’s subcontractor’s price for the change (in the amount of $18,757.43, plus 10% profit, 4% insurance, and 4% gross receipts tax, for a subtotal of $22,133.77); (ii) $9,655 for ‘Preparation Costs & Extended Overhead’; and (iii) $2,745 for ‘Legal Fees.’

So now we have to modify our previous statement. We can see that the parties spent nine months and an unknown number labor hours discussing less than $10,000. And there was no agreement and nobody got fired. And now there was a formal claim, to boot. And the price of your postage was just increased, and now you understand why.

The USPS Contracting Officer issued a Final Decision, granting an equitable adjustment in the amount of $22,133.77, but denied the remainder of the claim, on the grounds that (1) recovery of proposal preparation costs was prohibited by the contract clause, and (2) it was unreasonable for Tip Top to spend $6,705 to prepare a change order valued at $22,100. On appeal to the Postal Service Board of Contract Appeals (PSBCA), Tip Top was granted an additional $2,565 for costs it paid to its outside consultant (Mr. Diaz) for the period ending October 15, 2009 (which is the date on which the USPS accepted Tip Top’s proposal “for a price to be determined later ….”

Notably, the PSBCA ruled that the contract clause in question did not bar recovery of change order proposal preparation fees. As the Court of Appeals (Federal Circuit) wrote—

The Postal Service had urged that the provision in Contract Clause B.309 barred recovery of the costs Tip Top sought. The Board rejected this argument. The Board stated that Clause B.309 did not apply to Tip Top’s claim because the clause only barred recovery of contractor costs incurred in reviewing a Detailed Scope of Work. This, the Board stated, was ‘a process exclusive to award of the original work order.’ … The Board continued that it was the changes clause of the contract that governed Tip Top’s claim for an equitable adjustment resulting from the Postal Service’s change order. The Board ruled that Tip Top had met the requirements for recovery under this clause as far as the $2,565 in costs relating to Mr. Diaz’s work prior to October 15, 2009 were concerned. The Board stated that the costs were compensable because they represented ‘an increase in [Tip Top’s] direct cost of performance due to the change.’

Thus, the PSBCA clearly ruled that the costs of preparing the change order proposal were allowable direct costs pursuant to the contract’s Changes clause. However, the PSBCA did not grant Tip Top the remainder of its claim, which consisted of “Mr. Diaz’s fees and overhead costs after October 15, 2009 until he left the job in March of 2010 [and] legal fees … for work done during the period April 21 through June 8, 2010.” The PSBCA denied Tip Top recovery of these costs because—

… the negotiations between Tip Top and the Postal Service after October 15, 2009, relating to recovery of Tip Top’s estimating costs, which resulted in work by Mr. Diaz and outside counsel, ‘had nothing to do with performance of the changed work or genuine contract administration and were solely directed at trying to convince the contracting officer to accept [Tip Top’s] figure for the change and maximizing [Tip Top’s] monetary recovery.’ … The Board concluded: ‘[O]nce the substitute equipment was approved, nothing remained to be negotiated except the price. There is no evidence that the parties’ negotiations addressed an extended delivery schedule or any other changes to contract performance requirements.’ … The Board also found that Tip Top had not adequately documented Mr. Diaz’s charges, stating, ‘As the consultant likely was working on other project matters, it was incumbent upon [Tip Top] to identify hours, if any, spent on the equipment change issue, and it has not done so.’

Tip Top appealed the PSBCA decision to the Court of Appeals (Federal Circuit), who had this to say—

The question is whether costs arising from negotiations relating to the price of the changed work are recoverable in this case because they constituted part of the increased costs arising from the change directed by the Postal Service. … In short, both the PSBCA and the government take the position that reasonable contract administration costs arising in the setting of a change order are recoverable. We do not disagree. It seems to us proper that if a change order requires a contractor to incur contract administration costs, those costs are recoverable to the extent they are reasonable. Thus, the dispute depends on whether the costs are classified as general contract administration costs or claim preparation costs. …

In our view, both the costs of Mr. Diaz’s work between October 15, 2009, and March 8, 2010, and counsel’s fees through June 8, 2010, were incurred ‘for the genuine purpose of materially furthering the negotiation process.’ [Citing Bill Strong, 49 F.3d at 1550.] … Only on June 18, 2010, did negotiations finally end when Tip Top submitted its claim under the CDA. Simply because the negotiations related to the price of the change does not serve to remove the associated costs from the realm of negotiation and genuine contract administration costs. Consideration of price is a legitimate part of the change order process. In holding otherwise, the Board, we believe, erred.

The Appellate Court also found that there was sufficient evidence that the costs being claimed by Tip Top were incurred for the purposes stated. Tip Top was entitled to the additional $9,835 it had sought, plus interest on its claim pursuant to the CDA.

So, readers, it took an Appellate Court to decide a quantum of less than $10,000—a quantum that should have been quickly negotiated and settled by the USPS Contracting Officer. Instead, the $10,000 remained a matter of dispute for nine months, and was a matter of litigation for more than two years. And to our knowledge, nobody got fired.

And the Postal Service is losing money by the bucketful while cutting back service and raising the price of postage. And now you understand why.