How to Mitigate Inflation as a Government Contractor
A Government Contractor’s Guide to Mitigating the Current Inflation
The Department of Defense (DoD) issued a report on May 25, 2022, titled “Guidance on Inflation and Economic Price Adjustments” (the “Guidance”). The Guidance notes that the current economic environment requires a deep analysis and understanding of how inflation affects government contracts. As inflation surges to the highest level in the past 40 years, the associated risks must be managed for prospective DoD contracts.
As a consequence of the heightened inflation, contractors performing under fixed price contracts are forced to bear the risk of increased costs, lowering profit margins. As such, there has been renewed interest in using Economic Price Adjustment (EPA) clauses.
In this article, we will discuss how to recognize cost increases, how inflation impacts profitability, strategies to mitigate inflation risk, and more.
The Guidance released provides information on appropriately recognizing cost increases due to inflation by noting the importance of using independent and recognized sources as the basis for measurement in EPA clauses. As noted in the Guidance, inflation measurement should include indices that are not too large or diverse so that they remain relevant to the contract. Contractors are encouraged to closely review this guidance prior to negotiations or entering new contracts to understand the importance of EPA clauses and how they reduce inflation risk. For further information and expertise regarding inflation risk mitigation strategies, contact Ryan & Wetmore today.
How Does Inflation Impact Profit?
While each industry is different, government contractors are not an exception to inflation. In fact, government contractors / the entire contracting industry face the many risks associated with rising inflation rates. As such, government contracts may be particularly interested in profit margin preservation.
Inflation has proved many economists and pundits wrong in recent months, but we have modeled one possible scenario below, showing the effects of changing inflation over the next four years. The model assumes engineer direct labor starts at $65 in 2021 with a fully-loaded wrap rate of 168.3%, a built-in mark-up of 5%, and an annual allowed price increase of 2%. This scenario is based on a 9% inflation rate in 2022, roughly in line with recent inflation numbers as of the date this article was written, and inflation is projected to fall to about 3.5% in mid 2023 and about 2% by 2024 by Trading Economics global macro models and analysts. The model assumes that inflation stabilizes at 2% annually after 2024. The following scenario depicts the importance of implementing inflation risk mitigation strategies to preserve profit margins while performing on government contracts.
Since the inflation exceeds the 2% price increase in the company’s contracts, the contractor’s profit margin falls as costs rise faster than revenue. The government contractor’s profit margin dips below the break-even point, represented by the dotted line at 0%. After 2023, inflation matches the price increase, causing the government contractor to run at a loss.
Varying inflation rates still present a risk to a contractor’s profit margins. Therefore, it is now more important than ever to implement inflation risk mitigation strategies and to review current contracts for any EPA clauses.
What is an EPA Clause?
EPA clauses are used to protect either the contractor or the government against large fluctuations in labor or materials costs or to provide contract price adjustments if there are changes in the contractor’s established price. As such, EPA clauses are used to equitably balance risk between the government and the contractor.
EPA clauses are appropriate to use when:
- The contract has an extended period of performance with the anticipation that significant costs will be incurred beyond year 1 of performance.
- The amount adjusted is substantial.
- The economic variables for labor and material costs are unstable and do not permit a reasonable division of risk.
As such, concerns regarding inflation have sparked a potential need to include EPA clauses in future contracts.
Bad News for Existing Contracts
The Guidance does not offer much hope for contractors performing on existing fixed price contracts. Without an applicable contract clause – in this case, an EPA clause that authorizes price adjustments due to inflation – there is no authority to provide relief under a firm fixed price contract. This reinforces the policy that without an applicable contract clause or change, COs may not consider requests for equitable adjustment.
EPA Clauses in New Government Contracts
As demonstrated in the above model, the surging inflation rates may bring about a variety of scenarios for government contractors. In preparation for the volatile economic environment, the Guidance provides hope to contractors currently negotiating contracts as contracting officers (COs) now have more direction and information on crafting EPA clauses in new contracts. Therefore, there is a potential for the inclusion of EPA clauses that will equitably balance inflation risk between the Government and contractors.
Which Contractors Should Take Advantage of the EPA Clause?
The Guidance highlights that EPA clauses might be most appropriate for contracts that will be performed after the next 6 months. Though this guidance provides COs with no new level of authority, it may make it easier to urge them to include this clause.
Should Contractors Create an EPA Clause when Expecting New Contracts?
Aside from the encouragement of using an EPA clause, the Guidance also provides direction on how to craft an EPA clause. Several key factors to consider include selection of an index to measure inflation against cost components, the scope of the EPA, upwards and downward price adjustment, and the establishment of new pricing formulas. Contractors who are anticipating new contracts or are currently negotiating a contract should consider how these key factors impact their revenue and cost streams. Contractors awaiting new contracts should take advantage of the EPA clause as this opportunity does not exist for existing contracts.
What Should Contractors with Fixed-Price Contracts Do?
Firm fixed price contracts with a significant material component will also be hit hard as components may have increased in price exponentially. Contractors are encouraged to meet with their attorneys to review the contract and discuss potential remedies. The DoD has noted that though a current contract does not formally include an EPA clause, any language that addresses potential contract cost or price adjustments due to inflation is essentially an EPA clause. As such, contractors should give careful consideration and search for similar language in existing contracts.
Contractors may also consider submitting a request for equitable adjustment through a proposal to the contracting officer. This is beneficial for various situations and can be applied to more than inflation as contractors at times may be required to move their work to a new location with higher labor costs. Therefore, other tactics such as a Changes clause may provide additional relief during periods of high inflation.
Change in Contract Conditions
At times, government agencies are permitted to alter the terms and conditions that exist in government contracts. This is allowed under a Changes clause and can be done when an agency’s contracting officer issues a formal declaration that specifies the nature of the change. Change orders are recognized as a way to overcome certain deficiencies within a contract that causes contractors employed under the terms to spend time and money performing unsatisfactory work.
From this, a contractor who has been performing work under an error-containing contract may be able to recover the money spent as if the work was performed under a new directed change. As such, contractors do not suffer losses due to following faulty instructions.
Inflation Risk Mitigation Strategies
As described above, contractors have been exposed to heightened risk as inflation continues to surge. Government contractors who are aiming to find ways to mitigate the risks associated with rising costs are encouraged to review and implement the steps below:
- Have your attorney review your contracts. There may be an EPA clause within the contract or similar language that will allow for an equitable balance of inflation risk.
- Prepare your human resources or admin department for the potential risk of employees leaving the company. Prepare a backlog of replacements and understand the onboarding and security clearance requirements associated with new hires.
- The HR department should also aim to understand the number of positions currently filled and the capacity of the contract.
- Understand how to attract and retain key talent in today’s competitive market. Rising labor costs coupled with high turnover rates will increase risks associated with inflation. This can be done by connecting recruitment to business development and by analyzing the hiring market.
- Analyze your spending to gain visibility into spending habits of major departments.
- Find the differentiation between strategic and non-strategic expenses. Keep in mind the longterm impacts of potential cost-cutting and whether they are aligned with the company’s mission and vision.
- Analyze ROI and identify where certain projects may need to be pulled back for cost-saving purposes.
- Review and understand what drives higher costs within the company. What are the underlying reasons critical costs fluctuate?
- Discover where automation in the workflow can eliminate labor needs and free up employees to perform other tasks.
- Identify ways to strengthen your pricing power. Find differentiators against your competition.
- Evaluate your supply chain and the risks associated with acquiring materials. Consider establishing alternative or multiple chains.
- Create a contract matrix listing all clauses in the contract including contract modifications. For certain situations, the government agency may require more workers performing on a contract. As such, a contract modification may be needed to adjust for the cost of hiring additional workers.
- Create a grid of all contracts, by T&M (Time & Material), Cost Plus, and Firm Fixed Price to determine where inflation poses the most risk.
- Forecast different inflation scenarios to gain an understanding of what will occur if wages increase exponentially or if there is a supply chain disruption. See the example scenario provided above.
- Understand how your costs move. If you grow your revenue base, then your cost pools get larger and your overhead and general and administrative costs as a percentage of labor should decrease.
- Prepare three-year budgets with different parameters and variables. Budgets should include a fixed and variable cost budget as part of the process. Also, meet with your finance team to review different models and budgets.
- Reduce overhead, general and administrative, and variable costs.
Government contractors are encouraged to review and understand the implications of the Guidance before bidding on new contracts and searching for relief under current contracts. Furthermore, contractors are encouraged to urge COs to add EPA clauses to new contracts. For contractors with existing contracts, it will be beneficial to review the clauses contained in the contract for any equitable adjustment relief or similar language.
Analysis of the cost components that will become the most unstable due to inflation should also be conducted to lower inflation risk. Contractors should aim to analyze overall business performance and cash flows to understand where room for improvement and opportunities are. Furthermore, analyzing your capital structure may provide further insight into better managing costs while also allowing room for growth.
Though inflation risk and its associated consequences are on the rise, contractors may find some form of relief on future contracts through EPA clauses and through analysis and assessment of key business areas. For further information or expertise, contact Ryan & Wetmore.
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About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Rosie Cheng
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.
About Jack Ramsey
Jack Ramsey is a Finance Consultant at Ryan and Wetmore. He focuses on government contractor services as well as research and analysis of the economic, tax, and regulatory environment. Jack graduated from American University with a Bachelor of Science in Economics.