Who Pays When the Estimate Is Wrong
A cost-plus-fixed-fee contract for prototype development has an estimated cost of $8,000,000, a fixed fee of $600,000, and total funds obligated to the total estimated cost plus fee. Nine months in, the contractor has billed $6,400,000 and reports an internal estimate at completion of $9,300,000. The drivers are a subcontractor price increase and $180,000 spent on an off-site employee recognition event, including individual gifts to 60 employees. The contractor sent no notice of the projected overrun; the administrative contracting officer learned of it from an audit lead. The contractor has asked the contracting officer to process a modification raising the ceiling and to approve the recognition event as allowable, and wants an answer within ten days.
1. What notice obligation applied, was it met, and what are the consequences of the contractor's silence?
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Under the Limitation of Cost clause (FAR 52.232-20), the contractor must notify the contracting officer in writing when it has reason to believe that, within the next 60 days, incurred and expected costs will exceed 75 percent of the estimated cost, or that the estimated cost will be substantially exceeded. Here 75 percent of $8,000,000 is $6,000,000; the contractor passed that threshold on its way to $6,400,000 incurred, and its own EAC shows a $1,300,000 overrun. No notice was given.
Consequences:
- The government is not obligated to reimburse costs above the estimated cost; costs incurred after the contractor should have notified are at the contractor's risk.
- The contractor was not obligated to continue performance beyond the estimated cost, and the government was entitled to know early enough to decide whether to fund more, descope, or terminate.
- The failure is a management and performance factor and should be raised in the contractor's performance assessment.
The contracting officer should require an immediate written notice, a current EAC with supporting data, and a decision by the program office on whether the remaining work is worth additional funding. If it is, a bilateral modification raises the estimated cost and adjusts fee only to the extent the change in work justifies it.
2. How should the contracting officer treat the $180,000 recognition event and gifts in the incurred cost submission?
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Apply the standard allowability test first: reasonable, allocable, and consistent with the terms of the contract, with the contractor bearing the burden of demonstrating allowability through adequate records.
- Employee morale costs. Employee morale and welfare costs, such as a modest recognition event, can be allowable as a direct or indirect cost when reasonable in amount and allocable to the contract. The controlling question is reasonableness: $180,000 for roughly 60 employees is $3,000 per person, which on its face invites scrutiny and probably cannot be sustained in full.
- Entertainment and gifts. Social or ceremonial activities and personal gifts sit much closer to entertainment and diversion, which are unallowable. A gift to each employee is generally treated as compensation or as an unallowable social cost unless it is part of a formal, pre-existing awards program that pays reasonable amounts for documented achievement.
Action: require a breakout of venue, meals, entertainment, and gifts; disallow the entertainment and gift components; require the contractor to remove unallowable amounts from billings and from its indirect cost pools and to account for them as unallowable in accordance with its disclosed practices. Because the contract is cost-reimbursement, an unallowable dollar comes straight out of the government's reimbursement, so the correction should be made in the current voucher, not deferred to audit.
3. The contractor argues that the subcontractor's price increase was unforeseeable and that the government therefore owes an equitable adjustment to raise the estimated cost and fee. Is that correct?
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No. A cost-reimbursement contract is not a cost guarantee and not a price warranty.
The government assumes the risk of allowable, allocable, reasonable costs incurred in performing the statement of work within the estimated cost. It does not assume the risk of costs above the estimated cost. Raising the estimated cost is a funding and requirements decision, not an entitlement triggered by an unpleasant surprise.
What the contracting officer should do:
- Require the contractor to distinguish costs attributable to changed work or government direction (which can support an equitable adjustment) from ordinary cost growth (which cannot).
- Decide whether to fund an increase, and document the basis; a supplemental agreement is needed to raise estimated cost and fee.
- If the government declines, tell the contractor in writing where the limit lies; the contractor may not keep incurring costs above the estimated cost and expect reimbursement.
- Consider whether the remaining scope is still achievable; if the requirement is no longer viable, a partial termination for convenience may be the sounder outcome than throwing money at a failing estimate, with settlement limited to work actually performed.
The subcontractor's pricing risk was the contractor's to manage; the subcontract terms and any flow-down of the Changes clause determine whether the contractor can pass a change through, not the mere size of the increase.