Limitation of Costs and Limitation of Funds - Part IV

Today we finish up our series on Limitation of Costs and Limitation of Funds clauses found in cost-reimbursable contracts. These clauses are more than perfunctory. Contractors that take them lightly or fail to consider them at all are at risk for incurring costs that will not be reimbursed. As we will illustrate in a moment, the courts typically side with the Government in disputes involving the application of these clauses.

The Government is not obligated to reimburse a contractor for any cost in excess of the costs and/or funds allocated to a contract. Nor is the contractor obligated to continue performance or incur any costs in excess of the estimated contract costs and/or funds allocated. The purpose of the Limitation of Costs/Funds clauses are designed to give the Government advance notice of potential cost overruns. Boards of contract appeals as well as the Court of Claims have ruled in numerous cases that an inadequate accounting or management information system is not a valid excuse for not providing the notice required by the clause.

For example, in Datatex Inc., the contractor asserted that it was unaware when contract costs exceeded 75 percent of total estimated costs because actual overhead rates could not be determined until after contract completion and Government audit. No notice was give to the Government until settlement of final overhead rates (10 months after contract completion), at which time the contractor requested a contract modification to fund the contract overrun. The contractor's request was rejected. In concluding that the contractor should have been able to foresee that its costs would exceed the contract ceiling, the ASBCA (Armed Services Board of Contract Appeals) stated that a contractor is obligated to maintain an accounting and financial reporting system adequate to apprise the contractor of a possible overrun before the overrun occurs.

A similar case involved SAI Comsystems who claimed that the Government's failure to make a timely audit excused the contractor's lack of notice and thus obligated the Government to provide additional funding. The Board did not agree, noting that a contractor has a responsibility to maintain reasonable records, in order to be able to ascertain when costs will approach the contract ceiling and to be able to cease performance in an orderly manner prior to reaching that level.

Although these clauses explicitly relieve the Government from any obligation to reimburse costs incurred in excess of the estimated (or funded) cost, that does not mean that such overruns are never paid. The contracting officer has discretionary authority to do so. In cases where the overrun is clearly a result of unforeseen circumstances or the Government has a great need for the "product", contracting officers can sometimes be prevailed upon to add additional funding to the contract. However, this should be considered a "long shot" insofar as seeking funding. In a case involving Research Applications, Inc., the board stated that "it was not the circumstances but appellant's own choice that produced the cost overrun as well as the lack of information on which a proper notice could have been based".

Limitation of Costs and Limitation of Funds - Part III

For the past couple of days, we've been discussing the Limitation of Costs and Limitation of Funds clauses that appear in cost reimbursable Government contracts. In Part I, we discussed the fundamental requirements of the two similar clauses. In Part II, we discussed the data and analysis required to comply with clauses. We also indicated that the ability to comply is one of the evaluation factors when the Government comes in to perform a pre-award accounting system survey of your company. Failure to demonstrate the ability to comply can make the difference between winning and losing a bid.

Today we want to address the issue of indirect rates. Indirect rates are used in determining historical costs and in estimating the monthly "spend rate". One question we're asked frequently concerns the appropriate rate to use in these calculations. Contractors typically have different indirect expense rates for different purposes. There's nothing wrong with this practice. It's not like having multiple sets of books. Its simply necessary given the vagaries of Government contracting. For example:

• Actual rates - these are the final year-end rates or the rates calculated at some interim period. It could be a monthly, three, six, or nine month period.
• Forecasted rates - these are rates used in estimating future contracts. These rates are heavily influenced by the size of a particular bid. A large contract will typically reduces indirect rates. Forecasted rates should not be used to book or bill costs.
• Billing rates - these are rates that have been approved by the Government for billing purposes. They should represent the contractors best estimate of the final year-end rates. Contractors have a duty to monitor these rates and revise them as appropriate.
• Booking rates - In a perfect world, booking rates and billing rates should be the same. However, the process for adjusting billing rates and obtaining Government approval is cumbersome, time consuming, and subject to the whims of auditors (like when they make arbitrary reductions to "protect the Government's interests"). Sometimes contractors find that the billing rates no longer reflect the best estimate of the final year-end rates but, for various reasons, cannot get the Government to approve revised billing rates. In these cases, contractors must use a more realistic set of rates in order to reasonably estimate contract costs for Limitation of Costs and Limitation of Funds purposes.

There's a certain amount of judgment involved in determining which rates should be used for Limitation of Costs/Limitation of Funds analyses. Commonly for purposes of calculating incurred costs, completed years should be calculated using "actual rates" while current year costs should be calculated using "billing rates" or "booking rates", whichever is the most accurate estimate of the final year end rates. Future year costs should be calculated using "forecasted rates" where the allocation bases can be estimated with a reasonable degree of certainty.

Limitation of Costs and Limitation of Funds - Part II

In yesterday's posting, we introduced two clauses that appear in cost-type contracts that require contractors to notify the Government as it's actual cost approach the amount that has be funded for work under the contract. Under a cost-reimbursable contract, the Government has no liability to reimburse costs that exceed the amount funded and the contractor has no responsibility to continue performance once contract funds are exhausted.

In order to make meaningful comparisons of actual costs to the amount(s) funded, contractors need systems that can provide that information. The accounting software cannot do it all unless contractors are prepared to shell out big bucks for an "enterprise" system (e.g. Deltek Costpoint). For small contractors however, the cost of those systems is prohibitive. The good news is that most accounting software plus Excel plus discipline will work just fine

Lets take a look at what it takes to meet the requirements of the Limitation of Costs clause. The clause requires that contractors notify the Government 90 days before incurring 75 percent of estimated contract costs. Calculating 75 percent of contract costs is easy. Figuring out when you will arrive at that figure is more challenging. There are a number of approaches one could take. Any approach however requires the following data:

• the monthly budget for the contract
• incurred cost to date
• schedule of commitments (open purchase orders), including subcontracts
• future "spend" rate

The purpose of the monthly budget for this analyses is to track "actual" costs against budgeted costs so that variances can be analyzed and corrective actions can be taken if needed. Variances will affect future spending, one way or another.

"Commitments" are often overlooked by contractors. Businesses issue purchase orders for goods and services. The cost of purchases made under those orders however, are not booked until an invoice is received. Therefore, contractors need to factor unfilled orders (or, commitments) into their analyses.

The future spend rate should be calculated by month and reflect management's best estimate of how progress is to proceed on the contract. It is perhaps one of the most challenging aspects of the Limitation of Cost analysis.

Tomorrow we will look at the impact that indirect expense rates have on this analysis.

Limitation of Costs and Limitation of Funds

All cost-reimbursable contracts contain the Limitation of Costs clause (FAR 52.232-20) or the Limitation of Funds clause (FAR 52.232-22) or usually both clauses. They are similar; the former applies to fully funded contracts and the latter applies to incrementally funded contracts.

Limitation of costs applies to fully funded cost reimbursement contracts. The clause requires a contractor to notify the Government when it expects in the next 60 days to have spent 75 percent of the estimated cost, or expect expenses to be greater or substantially less than previously estimated. The clause allows variations in the number of days, between 30 and 90 days and variations in the percentage between 75 and 85 percent.

Limitation of funds applies to incrementally-funded cost-reimbursement contracts. Contractors must notify the Government that it is coming to the end of obligated funding, and send notification to the contracting officer that obligated funds will be spent within the next 60 days.

In order to comply with these clauses - to know when the specified thresholds have been met - contractors must have an adequate accounting system. An adequate accounting system must meet many criteria but insofar as these clauses are concerned, the accounting data must be current, "booked" indirect expense rates must be reasonably accurate and someone must be monitoring actual costs against estimated costs.

The SF Form 1408, Preaward Survey of Prospective Contractor Accounting System, is used by the Government to assess the adequacy of contractor accounting systems. One of the elements on this form asks whether the accounting system provides the financial information necessary to comply with these clauses. If not,   there is a strong likelihood that the contractor will be disqualified from bidding on contracts.