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Posted on Thursday, March 10, 2016

The Best Way to Negotiate a Fair Profit on Equitable Adjustments

When the government changes a contractor’s work, the contractor is entitled to an equitable adjustment under the Changes clause for not only any increased costs but also for profit on those costs.

Negotiating a fair profit presents a problem. The typical contractor is reluctant to harm its relationship with its customer, particularly in this time of dwindling agency budgets. The result is often that the contractor agrees to profit being based on one of two low-profit approaches: the loss-leader profit percentage the contractor used to win the contract or the profit percentage a contracting officer says is typical and not controversial for the agency.

FAR, however, rejects both approaches: “Negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages to total estimated costs do not provide proper motivation for optimum contract performance.” FAR 15.404-4(a)(3).

Case law agrees with FAR, explaining that, even though a contractor wins with loss-leader profit figures, “a contractor is not then generally bound to those markups for all and any subsequent changed work…a change is priced separately as an equitable adjustment and as such is to reflect the normal costs and markups for the work.” Flathead Contractors, LLC, v. USDA, CBCA No. 118-R, October 2, 2007.

FAR demands, instead, that profit act as “a motivator for efficient and effective contract performance” and makes profit depend generally on contractor effort and contract cost-risk.

For example, there is more “contractor effort” required for removing asbestos from a room than for painting the room. Profit then should be higher on an equitable adjustment for the asbestos removal work. There is also more “contract cost-risk” in fixed-price work than in cost-plus-fixed-fee work because the contractor is responsible for any overruns on a fixed-price contract. Profit, therefore, should be higher for fixed-price work.

Moreover, although federal law limits profit on a cost-reimbursement contract’s estimated costs, there is no federal law limiting profit on fixed-price work.

Clearly, profit is not a dirty word in FAR. The government is supposed to use profit to motivate quality contractor performance based on contractor effort and contract cost-risk. When it bases equitable adjustment profit on loss-leader percentages or agency-accepted percentages, the government does not motivate contractors nor comply with FAR.

Contractors should use the FAR profit principles in negotiating a fair profit on an equitable adjustment. These principles provide a profit rationale that the government must by law consider.

Terrence O’Connor is the Director of Government Contracts for Berenzweig Leonard, LLP, a business law firm in the D.C. region. Terry can be reached at toconnor@berenzweiglaw.com.

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