Inflation: Impact on Government Contractors

Jun 28, 2022

The global economy is gradually emerging from the aftershocks of the pandemic, and some growth is back, but so is inflation. Inflation is a general increase in prices and a corresponding drop in the purchasing value of money. A general rise in prices gradually reduces the purchasing power of consumers. It affects the economy in multiple ways. According to a new report released by the Bureau of Labor Statistics (BLS), the annual inflation rate in the US in May was 8.6% – the highest since 1981 (measured by the consumer price index). Other metrics used to measure inflation indicate considerable increases over the past year.

These rising prices create problems in national economies worldwide, especially in the United States. For many small business contractors working with the government, inflation threatens to impact contract performance, costs, and ability to perform work. It has also affected the government contracting marketplace at large, resulting in the government taking some measures for its mitigation.

This blog explains everything a government contractor needs to know about the rising trend causing apprehension in the government contracting sector.

What is Causing the Inflation?

The ongoing inflation trend has been attributed to many causes, including the COVID-19 pandemic, lockdowns and restrictions, the Russian-Ukraine war, China’s belt and road initiative, and the expenditure of trillions of public dollars in the United States on entitlement programs. Whatever the cause, many small business contractors are feeling its impact on the growing workforce, materials, and product shortages.

Impacts on Government Contractors

Inflation is Affecting Ongoing Contracts:
Many ongoing contracts awarded and priced over the past 18 to 24 months are currently more expensive to perform than anticipated. Contractors with Firm-Fixed Price (FFP) contracts are most likely to face the pressures of inflation due to these contracts’ fixed, lump-sum nature. The contractor absorbs the risks and costs of performance in these types of contracts. Due to the tightly regulated nature of the federal contracting sector, small business contractors are unable to pass on inflation-related cost increases to the government. It can negatively affect the margins and overall profitability. Without the flexibility to raise the cost of their services, such government contractors often operate at losses, threatening the flow of goods and services required to support the government’s programs.

Rising Prices of Supplies/Services:
The price of goods is increasing, making supplies costlier. The transportation cost of the supplies is going up as well. Supplies and services that contractors are required to provide to the government under various contracts are now costlier than they were at the time of bid preparation and negotiation.

Workforce Shortages:
The labor price is rising, and many positions are funded but not filled with personnel. Additionally, many employees working under government contracts are considering switching to the commercial market due to higher pay. These factors are causing a workforce shortage for government contractors. JPMorgan Chase’s 2022 Business Leaders Outlook survey found the worker shortage is the biggest challenge business leaders face across the country, with 68% saying their employees are now working more.

Steps Taken by the Government

Memorandum Released by the Department of Defense (DoD):
On May 25, 2022, DoD put out a memorandum providing “Guidance on Inflation and Economic Price Adjustments.” The memo provides guidance about when and how Contracting Officers (COs) may provide financial relief to contractors in case of fixed-price contracts (FFP). In this memo, DoD acknowledges that “under cost-reimbursement type contracts, the government bears the risk of increased costs, including those due to inflation.” However, for FFP contracts, DoD notes that the contractor “generally must bear the risk of cost increases, including those due to inflation” and that COs should not be using requests for equitable adjustment to resolve the impact of inflation on the contractors with such FFP contracts. In summary, the memo generally discourages contracting officers from providing adjustments under the Changes clause in case of inflation. But it leaves the door open to adjustments and offers some options for fixed-price contracts that include an Economic Price Adjustment (EPA) clause. Moreover, DoD encourages contracting officers to consider inserting EPA clauses in new solicitations.

GSA’s Industry Feedback on Inflation:
In March, the General Services Administration asked for industry feedback on inflation on supply chain disruptions. The agency tied them to economic price adjustment or EPA. Normally, a contractor can ask for three or four of such adjustments per year to deal with unanticipated increased costs or prices that are too difficult for the company to bear.

What is the Way Out For Contractors?

Rethinking Contracts:
Contractors should consider rethinking their mix of contracts and focus on those with reasonable risks and incentives for better performance. Cost-type contracts can provide the most protection in these times, while FFP contracts may not, in most cases. In the past, companies normally desired a larger percentage of fixed-price work and were willing to absorb the risks due to the potential upsides of such contracts. Cost-plus contracts were less desirable since savings went back to the government in such contracts. In this inflationary environment, however, companies with FFP work are experiencing the opposite.

EPA Clauses to the Rescue:
When reviewing prospective RFPs/RFQs that do not include an EPA clause, consider asking the government to include them during the Q&A process. EPA clauses can account for unexpected cost increases due to inflation and allow a government contractor to seek an adjustment. DoD’s willingness to use EPA clauses to address the current inflationary period is a welcome development for defense contractors. At the same time, contractors should know that EPAs bring special regulatory burdens and should be prepared for those burdens before accepting an EPA clause.

Retaining Talent through Incentives:
Contractors can counter workforce shortages by retaining top talent. It can be done through employee incentives empowering key personnel weathering in today’s challenging financial environment. Some mid-tier contractors have provided proactive salary adjustments or paid one-time bonuses at year-end to retain key employees.

Making Up for Losses in the Future:
Kevin Barnett, an expert author at PilieroMazza PLLC, recommends that contractors consider raising prices for future contracts to compensate for the increased inflationary costs incurred on current contracts.

It’s a difficult situation for small businesses, but with the right mitigation strategies, they can survive and weather the storm until the economy recovers from its ongoing inflationary pressures and returns to normalcy.

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