A primer on progress payments: impact of increase from 80% to 90% for COVID-19

Recently, the Pentagon announced that it will increase progress payments to bolster contractor cash flow during the COVID-19 crisis. For small businesses, progress payments increased from 90 to 95 percent, and for other businesses the rate went from 80 to 90 percent. This post will provide a primer on progress payments.

Normally, under a fixed price contract the customer does not pay the supplier until product delivery. In order to execute, contractors may have to find financing and incur interest payments, which ultimately pass-through to the customer in higher prices.

Many defense contracts are large in dollar amount and require long-lead times. In order to help contractors avoid financing costs, the government provides a continuing source of revenue throughout contract performance — i.e., progress payments. These are calculated as a percentage of the total cost incurred/paid under the contract.

The government may make progress payments to the contractor no more frequently than once a month. At the end of an accounting period, the contractor will tally up its costs under the contract and submit a Standard Form 1443. The government will then pay the contractor a certain percentage of those costs, usually within a month of submission.

There are three major buckets of costs:

1. Paid costs. These are costs already paid by the firm to execute the contract. It includes the cost or parts and materials taken from inventory.
2. Incurred costs. These are costs agreed to be paid, but not yet paid. They can only be reimbursed under progress payments if they are made in the “regular course of business” (not completely defined). But this includes materials, labor, travel, indirect costs, some types of fringe (defined benefit costs are treated differently than defined contribution), cost of money, profit sharing, and stock ownership plans.
3. Subcontractor costs. The government encourages prime contractors to pay their subcontractors progress payments as well to support the supply chain. The government will reimburse 100 percent of subcontractor progress payments. For example, if a subcontractor incurred $1 million in the performance of its fixed price subcontract and the prime pays it $800K, then the government will reimburse the prime for the $800K. Progress payments to subcontractors are “pass-throughs.” If the subcontract is a cost-reimbursable, then the costs paid by the prime to the sub are treated as a paid cost, like labor or piece parts.

Unallowable costs, of course, are not included in progress payments. There are some other nuances, particularly on incurred costs. See FAR 51.232-16 Progress Payments clause, and FAR 32.503-2 through -5 for supervision and administration of progress payments.

Example: Let’s say a large contractor receives a fixed price contract worth $10 million, where the deliverable is due in 24 months. Moreover, subcontractors take on 30 percent of the total costs. Let’s suppose both prime and subcontractors incur costs according to a Rayleigh distribution.

Naturally, increasing progress payments from 80 to 90 percent provides contractors a cash-flow advantage. The prime extends the increased payments down to subcontractors, but that doesn’t affect their cash-flow. So from the prime’s perspective, the increased progress payments only provides an advantage for non-subcontracted costs.

On their paid/incurred costs, the prime gets more revenue, faster. In the first month, the prime gets nearly $6K more with 90 percent progress payments than 80 percent. As contract execution ramps up, the advantage increases to more than $55K per month. The month before contract delivery, the prime has accumulated nearly $700K in additional revenue (i.e., 10 percent of non-subcontracted costs — the subcontractors accumulate nearly $300K in additional revenue, or 10 percent of their costs). When the product is delivered, the government pays the rest of the amount.