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Tuesday, March 25, 2014

Cost plus a percentage of cost contracts

Generally speaking, the government can enter into any kind of contract it wants, with the proviso here that I refer to the types of price incentives the government desires to incorporate into a contract. And I add that there may be conditions placed on many types of such incentives. But the one type of price incentive contract that seems to extract uniform rejection in US procurement law is a cost-plus-percentage-of-cost contact.

I was reminded of this when I read a story about a contract the Government of Guam is proposing, considering or playing hot-potato with. (Actually, it remains a political mystery whether the government is proposing it or not; let's just say it is on some kind of agenda of someone somewhere and involves the highest levels of the Guam executive and legislative concerns as well as those of the Guam Federal District Court, but that's another story.)

Here's the story with the critical part pertinent to this post:

‘GRRP plan too expensive’
The 214-page draft agreement negotiated between GRRP and the Guam Economic Development Authority would contract GRRP to build a waste-to-energy plant and manage the island’s solid waste, if implemented. Though it is dated Dec. 13, 2013, it only came to light last week.

“Waste-to-energy, when done properly, is another way to make the landfill last longer. However, waste-to-energy will not be inexpensive if GovGuam goes down this road. To suggest it will actually reduce the cost of the system and the rates of solid waste customers is either badly mistaken or intentionally misleading,” said David Manning, the federal receiver's representative.

Under the agreement, GRRP would receive at least $125 million in bond money from bonds authorized by GovGuam to build a waste-to-energy plant. Under a cost-plus provision of the agreement, GRRP would be entitled to a 15 percent fee on the cost of the construction. This amounts to $18.75 million on construction costs of $125 million.
The pertinent part, obviously, is the suggestion that this contract proposes "a cost-plus provision", where the "plus" is "a 15 percent fee on the cost of construction."

The federal government regulations discuss contract types and their selection in FAR Part 16. Cost reimbursement contracts are covered in Part 16.3. Incentive contracts are covered generally in FAR Part 16.4. "The cost-plus-a-percentage-of-cost system of contracting shall not be used" (FAR Part 16.102(c)).

Guam law, based in the ABA Model Procurement Code, is much less descriptive or as complicated as the FAR. It simply says,
"Subject to the limitations of this Section, any type of contract which will promote the best interest of the Territory may be used; provided that the use of cost-plus-a-percentage-of-cost contract is prohibited. A cost-reimbursement contract may be used only when a determination is made in writing that such contract is likely to be less costly to the Territory than any other type or that it is impracticable to obtain the supplies, services or construction required except under such contract." (5 GCA Section 5235.)
The genesis of the aversion to cost plus a percentage of cost pricing appears to have taken form in the days before Pearl Harbor when the US was anticipating war, but was informed by circumstances from the First World War, as mentioned in a US Supreme Court case, MUSCHANY ET AL. v. UNITED STATES 324 US 49, 1945, an interesting case.

The case involved the condemnation of land by the US by eminent domain, and the contract with an agent to obtain options in contemplation of condemnation. The agent's fee was a 5% commission to be withheld from the proceeds due the landowners. As the opinion described,
"There were a large number of landowners in the required area. Options were obtained from 270, including the petitioners, and with one exception the options were accepted by the Government at the optioned price. Almost half of the contracts were closed by acceptance of deeds and payment of the price. Criticism of the prices and manner of purchase developed and the War Department repudiated the remaining contracts and turned to condemnation. The repudiation followed upon the conclusion among other things that the contracts violated the statutory provision against the cost-plus-a-percentage-of-cost system of contracting, and were contrary to public policy because of the contingent interest of McDowell, which was antagonistic to the Government."
The Court then discussed the law:
"Prior to the present war emergency the Secretary of War had broad powers to acquire land for military purposes by purchase at prices deemed reasonable by him or by condemnation. There were no restrictions as to the manner in which he should exercise this power to purchase, but his power to contract for construction work was sharply limited by statute. These restrictions, if continued, would have seriously impeded the War Department's preparation for war. Thereupon Congress passed the act of July 2, 1940, which removed certain of these prior statutory restrictions. The act did, however, restrict the broad powers conferred therein by prohibiting the use of cost-plus-a-percentage-of-cost contracts; use of cost-plus-a-fixed-fee contracts was expressly approved by the act. The question is raised as to whether the prohibition of cost-plus-a-percentage-of-cost contracts applies to the War Department's purchase of these lands with appropriations for the fiscal year 1941.

We are of the opinion that the first section of the act of July 2, 1940 indicates that the purchase of land by the War Department is subject to the provisions of that section; therefore, the proviso in the section which prohibits use of the cost-plus-a-percentage-of-cost system of contracting must be taken to apply to purchases of land.

Our next inquiry is as to whether the contract with the vendors violates this prohibition against cost-plus-a-percentage-of-cost contracts. Evidently the proviso was inserted to avoid the abuses which were prevalent before and during the first World War from the Government's guarantee of cost plus a profit to contractors.

The purpose of Congress was to protect the Government against the sort of exploitation so easily accomplished under cost-plus-a-percentage-of-cost contracts under which the Government contracts and is bound to pay costs, undetermined at the time the contract is made and to be incurred in the future, plus a commission based on a percentage of these future costs. The evil of such contracts is that the profit of the other party to the contract increases in proportion to that other party's costs expended in the performance. The danger guarded against by the Congressional prohibition was the incentive to a government contractor who already had a binding contract with the Government for payment of undetermined future costs to pay liberally for reimbursable items because higher costs meant a higher fee to him, his profit being determined by a percentage of cost."

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