Today’s political and budgetary environment will most likely lead to changes in procurement priorities and reduced government spending levels. These realities, reflected in contract terminations for convenience, will first impact prime contractors and, to protect their own interests, create a flowdown of contract changes to the subcontractor level.
Terminations, for convenience or default, are for the convenience of the government, not the contractor, and are not limited to situations where the subject supplies or services are no longer needed. Some factors that can trigger a termination include:
- Inadequate funding (i.e. reduced or eliminated budgets),
- A deteriorating government/contractor relationship, or
- Cost overruns and the government’s/prime contractor’s failure to agree to contract restructuring.
Terminations for convenience are covered by a myriad of Federal Acquisition Regulations (FAR) clauses at FAR 52.249-1 through FAR 52.249-7. Even when specifically deleted by the contracting parties, a termination for convenience is read into contracts and subcontracts as a matter of law known as the Christian Doctrine.
When confronted with contract termination, the contractor/subcontractor must immediately stop work on the terminated portion of the contract, terminate all open subcontracts, and protect and preserve any property of the government until disposal directions are received. Unless authorized in writing by the terminating CO (TCO), any work performed after receipt of the notification of contract termination is performed at the contractor’s risk. Charge numbers should be established to document any cost incurred as a result of, and after receipt of, the termination notice.
Subcontracts are the responsibility of the prime contractor, and the prime contractor serves as the TCO in place of the government’s assigned TCO. Subcontractors have no termination rights against the government. Their termination responsibility is to their prime contractor.
When a contract is terminated, the contractor/subcontractor must determine how certain costs were to be recovered had the contract gone to completion (e.g., discrete contract line items or amortized across all items) and what profit levels were anticipated. From this analysis, the contractor can determine if it is receiving fair compensation for the work that was actually completed on the terminated contract.
Both FAR 31.205-42, “Termination Costs,” and the Defense Contract Audit Agency (DCAA) Contract Audit Manual recognize that terminations for convenience are unique and completely disrupt the contractor’s basic assumptions in planning for and costing contract work. They also recognize that it is appropriate to apply sound business judgment in determining what is considered fair compensation to a contractor and that the mechanical, by-the-book application of the cost principles may be inappropriate.
This recognition is grounded in the policy of fairness contained in the termination section of FAR 49.201(a), which states:
A settlement should compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly. In a given case, various methods may be equally appropriate for arriving at fair compensation. The use of business judgment, as distinguished from strict accounting principles, is the heart of a settlement.
The termination settlement proposal is prepared in an effort to recover the cost of the harm instilled on the contractor or subcontractor as a result of the termination for convenience. The contractor is to submit the termination settlement proposal no later than one year after the effective date of the termination, unless extended in writing by the CO. No recovery of harm is granted for those contracts terminated for default.
Full or Partial Termination
The government may terminate the contract either in full or only a portion of the contract not yet performed. A full termination allows for the preparation of a termination settlement proposal to recover costs for the work done and those costs incurred as a result of the termination. A partial termination may require not only a settlement proposal to recover those costs incurred as a result of the termination, but the preparation of a request for equitable adjustment (REA) to recover the termination’s impact on delivered items prior to the termination and undelivered items not terminated. If the termination was preceded by a stop work order (SWO) or other compensable delay, an REA should be prepared to cover the unrecovered costs resulting from the SWO (e.g., delay costs, unabsorbed overhead, severance costs, etc.).
Specific Cost Considerations:
Recovering Termination Inventory
Residual materials at the time of termination are to be inventoried, physically segregated in a secure area, and properly valued based on standard or actual costs. Complete termination inventory schedules are to be submitted within 120 days after the effective date of the termination, unless extended in writing by the CO.
Reclassification of Indirect Costs as Direct
A major area where this “fair compensation” policy comes into play is in the reclassification of contract costs normally recovered as indirect (e.g., part of an overhead cost pool) to a direct contract cost. These indirect costs—incurred specifically for the benefit of the terminated contract, but similar to other costs normally classified as indirect and incurred specifically for other contracts—would be recovered through the application of the indirect cost overhead rates to the applicable direct allocation base. Once the contract is terminated, the contractor loses its ability to recover these costs, which are forced to be either allocated to other contracts, where they were not planned, in a relationship that is not causal and/or beneficial, due to the termination of the direct cost allocation base, or absorbed into a planned profit level that has also been reduced due to the termination. Neither case is fair to the contractor.
FAR 31.205-32, “Pre-contract Costs,” provides that:
Pre-contract costs means costs incurred before the effective date of the contract directly pursuant to the negotiation and in anticipation of the contract award when such incurrence is necessary to comply with the proposed contract delivery schedule. Such costs are allowable to the extent that they would have been allowable if incurred after the date of the contract.
For a cost to qualify as a “pre-contract” cost, it must meet the criteria established for the incurrence of such costs in the first sentence of the cost principle. In other words, all of the following conditions must be met:
- The cost must be incurred directly pursuant to the contract’s negotiation,
- The cost must be incurred in anticipation of contract award, and
- The cost incurrence was necessary to meet the proposed contract delivery schedule.
To ensure cost recovery, the contractor should obtain agreement with the CO prior to the incurrence of the costs in question. This advance agreement will avoid disallowance or dispute over a cost’s recovery in the event of a termination.
Special Tooling and Test Equipment Costs
Special tooling and test equipment are defined at FAR 2.101. If special tooling or test equipment costs are included in negotiated end item prices, the amount claimed as part of the termination settlement must not include those costs already recovered as a part of end item prices paid.
Bid and Proposal Costs
Bid and proposal costs, unless a specified part of the contract’s statement of work, are generally recovered through the indirect application of a general and administrative rate to total cost input. These costs are incurred in anticipation of a contract award and would have been amortized through completion of the awarded contract work.
Basically, there is a loss of general and administrative cost absorption (i.e., misallocated overhead) when the contract is terminated, the contractor loses the ability to amortize these bid and proposal expenses, which will adversely impact anticipated contractor profits on non-terminated contracts. Recovery of bid and proposal costs, in the event of contract termination, is dependent on the contractor having accumulated them in designated projects or accounts established for that purpose.
Pre-contract Plant Alteration and Rearrangement Costs
Tight delivery requirements may dictate that the contractor make alterations or rearrangements to its existing facilities prior to contract award. If this is required, the contractor should be certain to segregate these costs in its books and records and document why performance of these efforts prior to contract award was critical to meet the anticipated contract delivery requirements.
Initial/Preparatory Contract Costs
Initial or preparatory costs are those costs incurred in preparing for the performance of the contract. FAR 31.205-42(c) establishes the allowability of certain initial and preparatory contract costs in the event of termination. These costs include:
- Starting load costs not fully absorbed because of termination are nonrecurring labor, material, and related costs incurred in the early part of production.
- Initial/Preparatory costs incurred in preparing to perform the terminated contract.
Starting load costs include such costs as – excessive spoilage or scrap due to inexperienced labor, idle time, subnormal production due to testing and changing production methods (e.g., learning), training and the lack of operator or employee familiarity or experience with product, materials or manufacturing processes (e.g., loss of efficiency).
The concept behind the recovery of these starting load costs is founded in the establishment of average prices on fixed-price contracts with these costs being spread over the total number of deliverables. Due to these types of costs, a contractor will lose money in the early phases of the contract that will be offset by lower production costs later in contract performance.
Initial Plant Alteration and Rearrangement Costs
The termination of a contract removes the contractor’s ability to recover these expenses through the normal absorption process. Any unrecovered expenses should be removed from the indirect cost pools in which they are accumulated, or the asset account in which they have been recorded, and included in the termination proposal as a direct cost.
Initial Management and Personnel Organization Costs
A contract award that significantly increases a contractor’s need for additional personnel or personnel with specific expertise generally requires an up-front expenditure on employment advertising, recruiting, interviewing, hiring, and relocation. Under normal circumstances, these costs would be included as indirect costs. When a contract is terminated, however, the contractor loses this ability to recover these costs. To ensure recovery, the contractor should remove unrecovered costs from the indirect cost pool in which they have been recorded and include them as a direct cost in the termination proposal.
To enhance the prospects of recovery of these expenses, the contractor should make sure that it fully documents such expenses, and that hiring and relocation benefits provided to employees are consistent with established company policy. Payments in excess of established policy must be fully documented and explained.
Recruiting, interviewing, and hiring costs should indicate all of the individuals involved, whether they were actually hired or not. The number of personnel recruited and hired should be supported by the particular requirements of the contract awarded. The contractor should also fully document in-house personnel assigned to work on the awarded contract and the replacement personnel that were hired to fill vacated positions.
Initial Training Costs
Unrecovered training costs specifically incurred in support of the terminated contract should be included in the termination settlement proposal. Care should be taken to document the employees involved, types of training provided, training dates, training costs, and the necessity of providing this training.
If these types of costs are normally included as indirect costs, care should be taken to remove any of these costs included in the termination settlement proposal as direct costs from overhead to preclude double recovery. Training provided prior to contract award should be documented as to its impact on contract delivery to support its incurrence.
Severance Costs/Dismissal Wages
Severance costs or dismissal wages are those paid to an employee for involuntary separation. To be recoverable, these costs must be either required by:
- Employee-employer agreement, or
- Established policy or practice that implies an employee-employer agreement.
Normal severance is the consequence of doing business. Whether it has actually been paid or has been accrued, it is an allowable expense to be allocated over all contracts and included in indirect/overhead recovery. Normal severance is not allowable as a direct cost in termination proposals. Abnormal or mass severance, resulting from the termination of a given contract, is recoverable as part of a termination proposal on a case-by-case basis. While estimates may be used in interim proposals, final settlements should be based on actual severance costs paid.
Each employee severed and included in the settlement proposal should be evaluated to determine the amount the employee actually worked on the terminated contract, regardless of whether or not he or she can be used to perform other work. Detailed explanations will have to be provided when an employee who actually worked on the terminated contract is not severed but transferred to another effort, resulting in the severance of employees who didn’t actually work on the contract. These costs should also be included in the termination proposal.
The recovery of unexpired lease and alterations to leased properties is specifically addressed in the termination costs clauses at FAR 31.205-42(e) and (f), as shown below.
- Rental under unexpired leases. Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when shown to have been reasonably necessary for the performance of the terminated contract, if—
- The amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable; and
- The contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such lease.
- Alterations of leased property. The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for performing the contract.
The contractor must prove that the leased property and the cost of any lease improvements were necessary for the performance of the contract. Also the amounts claimed should be reasonable for the period involved. The contractor must also show the reasonableness of its efforts to terminate, assign, settle, or reduce lease costs claimed.
Idle Facilities and Idle Capacity
The allowability of idle facility and idle capacity costs are covered under FAR 31.205-17, “Idle Facilities and Idle Capacity Costs.” The term idle facilities denotes “plants or any potion thereof (including land integral to the operation), equipment, individually or collectively, or any other tangible capital asset, wherever located, and whether owned or leased by the contractor,” that becomes completely unused and excess to the contractor’s current needs. Idle capacity means “the unused capacity of partially used facilities”; it is the difference between the operating efficiencies that could be achieved under normal operations and the operating efficiencies actually achieved under delayed, disrupted, or changed conditions.
The costs associated with idle facilities or idle capacity include such things as maintenance, repair, housing, rent, and other related costs, e.g., property taxes, insurance, and depreciation. Idle facility costs cannot be recovered unless the facilities “are necessary to meet fluctuations in workload; or…were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen.”
Idle capacity costs are considered as part of the cost of doing business, and such costs are recoverable provided the capacity is necessary or was originally reasonable, and is not subject to reduction or elimination. These costs are generally considered as indirect costs and care must be taken to remove any of the costs claimed from applicable indirect cost pools to eliminate double recovery.
Idle facility or idle capacity costs are recoverable after contract termination for a period of at least one year. The contractor must show that it is actively trying to use the facilities or capacity, or to eliminate it through sale, lease, etc.
Plant Reconversion Costs
FAR 31.205-31 covers the allowability of plant reconversion costs after contract termination. It states:
Plant reconversion costs are those incurred in restoring or rehabilitating the contractor’s facilities to approximately the same condition existing immediately before the start of the government contract, fair wear and tear excepted. Reconversion costs are unallowable except for the cost of removing government property and the restoration or rehabilitation costs caused by such removal. However, in special circumstances where equity so dictates, additional costs may be allowed to the extent agreed upon before costs are incurred. Care should be exercised to avoid duplication through allowance as contingencies, additional profit or fee, or in other contracts.
In general, the government considers reconversion costs as costs that would have been incurred whether the contract was terminated or ran to completion and not recoverable in a termination settlement proposal. A case can be made that the pricing of a fixed-price contract included these reconversion costs and its termination eliminated the chance to recover those costs allocable to the terminated portion of the contract.
The preparation, submission, and prompt resolution of a termination settlement proposal made to the cognizant TCO requires a dedication of time and a particular expertise not generally available within most organizations. To remain competitive, particularly in today’s downsizing environment, companies have taken to outsourcing the majority of these efforts. These costs, whether generated internally or externally, prior to the time that a claim arises under the Contract Disputes Act, are allowable.
The types of costs generally included in this category include: accounting, legal, clerical effort, and similar costs reasonably necessary for the preparation and presentation, including supporting data, of proposals to the TCO. Additionally, FAR 31.205-33(d) provides that these types of costs are allowable when considering: (1) the necessity of contracting for the service, considering the contractor’s capabilities; (2) the qualifications of the individual or concern rendering the service and the customary fees charged; and (3) that the fees charged are not contingent upon the recovery of the costs from the government.
Separate charge numbers or projects should be opened to collect these costs. Internally, personnel whose functions are normally considered as indirect can charge these activities as direct costs, but they must be removed from the indirect cost pool where they would normally be accumulated. If external support is utilized, it is extremely important that the efforts of these outside personnel be fully documented and identified to the particular termination settlement proposal being prepared. Broad-based invoices that read “For work performed in the month of December 2008” are not acceptable.
Profit is generally only granted on preparations made and work done on the terminated portion of the contract. No profit is granted on settlement expenses. Anticipatory profits or consequential damages resulting from the termination are unallowable. Additionally, no profit is granted if the contractor would have suffered a loss on the contract. In case of a loss, an adjustment is made to the costs included in the settlement proposal to reflect the percentage of loss (i.e., the loss ratio) anticipated had the contract not been terminated.
Factors to be considered in determining the amount of profit to be awarded include:
- The extent and difficulty of the work actually performed prior to the date of termination (remember that profit is also averaged in the case of fixed-price contracts),
- The amount and sources of capital employed,
- The extent of risk assumed,
- Contractor or subcontractor efficiency during performance of the contract and in performing termination-related activities, and
- The profit that would have been earned if the contract had not been terminated (this could be an upward or downward adjustment).
When submitting your termination settlement proposal, profit is generally determined based on the negotiated profit level adjusted for losses, disposals, and other credits; advance or progress payments; and any other prior payments under the contract.
Contract Loss Factor
If a fixed-price contract is anticipated to result in a loss, a loss ratio is calculated. The loss ratio is equal to the total contract price (a), divided by the total cost incurred to the date of termination, plus the estimated cost to complete the contract (b). Therefore,
- If (a) < (b), the completed contract would have suffered a loss. Any termination settlement recovery will be reduced by the loss ratio. However, no reduction will be made to the contract price for accepted items.
- If (a) > (b), the contract would have been profitable and no loss adjustment would be made.
This loss ratio if used to adjust the amounts of requested termination costs to reflect the fact that the contract was in a loss position.
Ultimately, the contractor/subcontractor is responsible for preparing a well-documented, supportable settlement proposal. In most cases a contract termination, full or partial, does not come as a surprise. Contractors and subcontractors need to be prepared. Think “out of the box” as so clearly stated by Winston Churchill – “Gentlemen, we have run out of money. Now we have to start thinking.”