Here’s Director of Defense Pricing and Contracting John Tenaglia at giving a keynote address at the Pricing Summit:
At the heart of the memo is the need to really encourage contracting officers to use economic price adjustment. There is a reluctance certainly to use economic price adjustment and there hasn’t been a need. It’s an example of an area where we probably are adding complexity to any given contract. It’s certainly an area that, if not done properly, will likely result in litigation down the road where we have ambiguity. How do you go about doing an adjustment? If that’s not clear, that’ll eventually play out in a litigation setting and none of us want that.
Probably the most significant part of the memo was perhaps the part that talked about requests for equitable adjustment for existing fixed price contracts. We tried to choose the words in such a way that didn’t come across as tone-deaf or callous to the situation, but from a contract law standpoint, there’s just not the avenue to use the REA process to reopen fixed price contracts for inflation.
The Congressional Budget Office’s May 2022 outlook showed the GDP Price Index, a measure of inflation, as jumping to 5.7 percent in FY 2022 and then falling back down to 3.1 percent in FY 2023 with a quick return to 2.1 percent into the future.
Perhaps that’s the “most likely” outcome, but certainly no one really knows. It seems to imply that the Federal Reserve will put the breaks on the economy, yet somehow they also expect GDP to grow 10.4 percent in FY 2022 (4.4 percent in real terms, or without inflation) and 6.3 percent in FY 2023 (3.0 percent real).
By April 2022, GDP in nominal dollars was just 5.1 percent higher than at the start of FY 2022. The projection is that between April 2022 through September 2022, GDP will continue going at the same rate in did in the first half of FY 2022. That was before the rate hikes. Since the start of April 2022, the S&P 500 has fallen 15.8 percent. We’ll see if the economy can hold the line and actually grow at the same time the Fed controls inflation.
Now, the real issue is what is going on with prices specific to weapon systems, their materials, piece parts, labor, etc. If we look at the Producer’s Price Index for final demand of finished goods, nominal growth before the pandemic was about 1 percent, falling to -3.2 percent by end of May 2022, then jumping to 8.7 percent and 16.7 percent by the end of May 2021 and May 2022. 16.7 percent is a much higher figure than the 6 or 7 percent growth we’ve been seeing for inflation at-large.
However, is we zoom in on PPI for “Other aircraft parts and equipment mfg”, the pandemic actually accelerated price escalation to 2.6 percent and it has fallen to 0.7 percent and 1.6 percent in May 2021 and May 2022. As you can tell, what prices are changing and how much is an important question. But aircraft parts might have a time lag due to the pandemic relative to other industries like shipbuilding, electronics, and so forth. Electrical equipment, for example, averaged 1 percent growth pre-pandemic and hit 19.8 percent growth in the year to May 2022.
This complexity and whether defense prices reflect public data will make economic price adjustments based on cost indexes and established prices difficult to adjudicate, and so I can imagine litigation stemming from interpretation. It will be important to select specific reference measures and apply them to specific cost elements over specific periods of time so there is no room for interpretation.
EPA clauses based on actual labor or material costs have their own challenges. There will be a proposed cost based on a quote or estimate, and then you can match up that labor category or material SKU to the incurred cost down the line. But what happens if material types or quantities change due to requirements change? Or what happens if contractors don’t have the accounting systems to disclose that data? And finally, does this “cost-plus” aspect of certain cost elements lead the vendor to discount cost control in favor of timely parts deliveries?
On the Request for Equitable Adjustment — presumably when government requires national security vendors to keep working, the additional cost of safety measures are reasonable for the REA process. The government “directed” a change, in a way. But inflation was not a contracting officer directed change.
When you think about the Covid-19 case of staying open, USD A&S declared contractors “critical infrastructure” on March 20 and I think some of that was tied to an executive order. I don’t remember contracting officers directing the contractors do to anything — they just kept working.
Similarly, the executive decision to lockdown other parts of the economy and congressional decision to inject massive stimulus directly led to higher inflation. Even though contracting officers directed no change, did not the government in some ways direct the change that resulted in higher-than-anticipated costs?
At any rate, Congress won’t likely give an inflation supplemental. So if contractors don’t “eat” inflation through lower or negative profit (when they had been asking for more long-term fixed price contracts in the past), then covering those costs would mean less funding available for new capabilities — precisely when DoD needs those capabilities the most.
One opportunity is to use expiring funds. Between FY 2013 and FY 2018, an average of $13.5 billion in funds got cancelled. These were either obligated but unexpended (e.g., a cost-plus contract underrunning), or remained unobligated. If these funds could be resurrected for compensating inflation in a global settlement way, that could be an opportunity for Congress without requiring new appropriations.
Putting that to the side, here was an interesting tid-bit from DPC Tenaglia:
Right now, we’re in the markup season for the Congress. The armed services committees are going through their markup process. I would say my staff is spending a significant amount of time responding to what we call requests for informal views. Last month, I think we processed 50 different views requested by professional staff members asking for our opinion about how a proposed legislative bill language might be received by the department.
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