Why is the contract type prohibited?

By PWG on Wednesday, July 11, 2001 - 09:50 am:

Because that type of contract would encourage wasteful spending rather than fiscal responsibility. The higher the cost a company incurs, the more profit they would make. The Government wants to encourage cost savings not cost escalation.

By Eric Ottinger on Wednesday, July 11, 2001 - 09:55 am:

Anon,

U.S. Supreme Court,

MUSCHANY ET AL. v. UNITED STATES; ANDREWS ET AL. v. SAME., (Feb. 05, 1945)

"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 means a higher fee to him, his profit being determined by a percentage of cost. Congress certainly did not intend to prevent a party who was merely submitting a bid to the Government from computing the amount of his bid by taking into consideration his costs and then adding a certain percentage of the cost as his profit, the resulting sum bid being fixed in amount and not subject to change. Congress, by changing the original prohibition in the act from one outlawing any “cost-plus” system of contracting so as to expressly authorize use of a “cost-plus-a-fixed-fee” form of contract, indicated it did not care how the contractor computed his fee or profit so long as the fee or profit was finally and conclusively fixed in amount at the time when the Government became bound to pay it by its acceptance of the bid. By eliminating the risk of loss and permitting the guarantee of a satisfactory but fixed fee, Congress sought prompt performance and lower over-all expenditures for contracts in a rising labor and commodity market than would be offered by contractors who were compelled themselves to assume the risk of these unpredictable costs."

By Roger Miller on Wednesday, July 11, 2001 - 10:45 am:

So in layman terms - If a contractor purchase material for 50.00 the Government would give him a percentage of the 50.00. It base the contractor's fee on the amount of funds it expends. So, rather than paying 10.00 for the material he would pay 50.00 to increase his profit. Is this the right understanding. Eric and Bob you guys are really great, but remember I am stll learning, and you have been very helpful.

By Eric Ottinger on Wednesday, July 11, 2001 - 11:07 am:

Roger,

I would say that you have done a good job of summarizing what the Supreme Court had to say.

This goes back to the period after WWI when defense contractors had a bad reputation. ("Merchants of Death," "war profiteer," etc.) It is interesting that Congress initially intended to prohibit all cost type contracts.

Evidently some wise heads advised Congress that it would be very hard to fight a war in the future if all contracts were strictly fixed price.

To understand CPPC you must read Cibinic and Nash. It is important to understand that it is the CPPC "system" which is illegal, and any contract which works like a CPPC, very likely is a CPPC.

On the other hand, because auditors consider it a coup to allege outright illegality, auditors (and other amateurs) often find CPPC in situations which are entirely legal.

As long as the fee is subject to negotiation there is no CPPC. As long as the fee may be more of less, depending on the contractor's ability to control costs, there is no CPPC.

Eric

By bob antonio on Wednesday, July 11, 2001 - 11:38 am:

Roger:

The key Court and Comptroller General decisions provide a three or four-step process for the identification of an illegal cost-plus-a-percentage-of-cost system of contracing. If anything meets the steps outlined, then it is illegal.

I do not have access to information I am looking for but the illegal contract is not always obvious.

By Eric Ottinger on Wednesday, July 11, 2001 - 01:18 pm:

Roger and Bob,

Correction: “more of less” should have been “more or less.”

The four tests are in the Deskbook.

Title: Contract Pricing Reference Guide; Volume 3; Cost Analysis; 13 June 2000

Cost-Plus-Percentage-Cost ( CPPC ).

“Beware! The CPPC contract is illegal in Government contracting. A CPPC contract can occur in any situation where the contractor is allowed to increase fee by increasing cost, thereby creating a negative cost control incentive. If the answers to the following four questions are yes, you have a CPPC contract.
• Will fee be paid based on a predetermined percentage fee rate instead of an identified dollar value?
• Will the predetermined percentage fee rate be applied to actual future performance costs?
• Is the contractor’s fee entitlement uncertain at the time of contract pricing?
• Will the contractor’s fee entitlement increase as performance costs increase?”


A “situation where the contractor is allowed to increase fee by increasing cost” describes almost every situation in government contracting, excepting a cost contract with no fee or a cost contract in an overrun condition.

(Actually, the temptation to increase cost, with or without an increase in fee, is also corrupting. Defense contractors will be motivated to increase costs just for the purpose of keeping their employees working and paid. Small firms can get along with zero or a very small profit if the principals are being paid well with direct and indirect cost dollars.)

The four tests were established by the Comp. Gen. It is important to understand that any contract which conforms exactly to the four tests is an illegal CPPC. It doesn’t follow that every illegal CPPC will conform exactly to the four tests. (See Cibinic and Nash.)

Eric

By bob antonio on Wednesday, July 11, 2001 - 02:31 pm:

Eric:

I do not have my materials with me but I believe the Deskbook is incorrect in its terminology. I think the word "fee" may be absent from the decisions because it covers more than fee. However, I am speaking off of the top of my head. If I get a chance tonight, I will check.

By Eric Ottinger on Wednesday, July 11, 2001 - 02:54 pm:

Bob,

I think the key is the following in Muschany:

“[Congress] did not care how the contractor computed his fee or profit so long as the fee or profit was finally and conclusively fixed in amount at the time when the Government became bound to pay it by its acceptance of the bid. By eliminating the risk of loss and permitting the guarantee of a satisfactory but fixed fee, Congress sought prompt performance and lower over-all expenditures for contracts …”

Although the Supreme Courts talks about “fee or profit,” in the context of our normal Part 16 contract types, it is only fee that should remain fixed.

I don’t like the Pricing Guide language because it is the kind of loose, inexact logic that allows auditors to casually accuse buying offices of an illegality.

Eric

By bob antonio on Wednesday, July 11, 2001 - 06:22 pm:

I did a good deal of research on this years ago and the oversight that appears to be made by the pricing manual authors is that the illegal contract is linited to fee. It also includes, if I remember correctly, overhead and general and administrative costs. Actually, any percentage attached to a cost or costs may end up as a problem. I cannot remember the bizarre conditions for this to happen. However, I am quite sure there is at least one case on this.

I would have to do a good deal of research on what I did years ago but there are numerous areas for a serious scholar to do research and write an article on the subject.

Is it worth someone's time to worry about this illegal system of contracting? Probably not. I have never seen one. It is a near hopeless search looking for them. I have seen a claim that an agency was systematically doing this around 1980. However, I do not know where the documents are for that either.

By Vern Edwards on Thursday, July 12, 2001 - 06:31 am:

The CPPC prohibition is not limited to fee. See 35 Comp. Gen. 434 (1956):

"The fixed percentage rates specified in the subject contracts were intended to represent payment for reimbursable indirect costs and were not intended to enhance the net return to the contractor. Nevertheless, inasmuch as the amount paid as reimbursement for overhead will diminish or increase in proportion to the direct costs incurred rather than the overhead incurred by the contractor, we are of the opinion that the contracts violate the express prohibition against the cost-plus-a-percentage-of-cost system of contracting and, therefore, are illegal."

The GAO has cited that decision as recently as 1993. See the Comptroller's letter to Mr. James K. White, Assistant General Counsel for Finance and Litigation, Office of the General Counsel, Department of Commerce, dated September 21, 1993, B-252378.

By bob antonio on Thursday, July 12, 2001 - 07:29 am:

Vern:

Thanks. I have a list of cases somewhere at home. That is very much like the one I was hoping to find.

By Eric Ottinger on Thursday, July 12, 2001 - 09:43 pm:

Bob and Vern,

I see your point.

The rate may be any percentage factor applied to actual costs, not just fee.

However, I don’t think you will see a CPPC issue unless the factor includes some element of additional profit for the contractor.

See Cibinic and Nash, “Formation of Government Contracts” Third Edition, pages 1067 and 1068.

“Neither the board nor the court found that payment of material handling costs as a percentage of material costs was proscribed as long as the material handling costs were excluded from the contractor’s overhead [to assure that there would not be any double counting].”

“The problem created by contracts where one type of costs is paid on a percentage basis is that such compensation may be greater than the actual costs incurred by the contractor, with the result that part of this compensation will be additional profit.”

Alisa Corporation AGBCA No. 84-193-1, June 9, 1994, is a recent case where a contract was determined to be void ab initio.

If CPPC is a very rare occurrence, it is probably because this is an issue where everybody is highly sensitized. I would not say that it is unimportant.

Even if actual CPPC contracts are rare, I have seen the issue raised frequently enough by audit types, reviewers and other kibitzers. It is worthwhile to get Cibinic and Nash out and read carefully, for self-protection, if nothing else.

Personal Opinion: We put a little too much weight on the four criteria. More attention should be paid to Muschany.

In this era of creative contracting some clever fellow is going to contrive a contract with a sliding fee, in which the fee increases as the cost increases, in which however, fee isn’t an exact percentage of the cost. At that point, the Comp. Gen. or somebody is going to dig up Program Resources, Inc., ASBCA No. 21656, November 8, 1977.

“It is inherent in cost-plus-fixed-fee contracts that before the fixed fee may be increased or decreased there must be some change in the scope or nature of the work to be performed by the contractor. A contract in which the fee increases or decreases in proportion to the reimbursable cost of the work is a ‘cost-plus-percentage of cost’ contract and is prohibited by law.”

Going back to the pricing guide, I don’t believe that every “situation” “where the contractor is allowed to increase fee by increasing cost” is going to be CPPC. (If that were true, we would never include additional fee in an equitable adjustment.) I do believe that every “contract” which provides that fee will increase, in whatever proportion, merely because the cost increases, is very likely not legal.

“[Congress] did not care how the contractor computed his fee or profit so long as the fee or profit was finally and conclusively fixed in amount at the time when the Government became bound to pay it by its acceptance of the bid.” (Muschany)


I would like to nominate Tero Tek International, Inc. for “Most likely to get everyone confused and be reversed on appeal.”

Tero Tek International, Inc., (Feb. 10, 1988) No. B-228548., February 10, 1988

“We find that the travel reimbursement portion of the contract does not constitute a CPPC contract. … Here, condition number 3, that the contractor’s entitlement is uncertain at the time of contracting, is not met. The contract limits the cost of travel to rates established in various Federal Travel Regulations. Further, the contract also provides that all travel requests by the contractor are subject to prior governmental approval. Thus, we cannot conclude this is a CPPC contract since the contractor’s entitlement is not uncertain at the time of contracting.”


The contractor’s projected travel costs are certain (or “not uncertain”) merely because the government specifies the rates in the JTR and the government approves the contractor’s travel.

Huh.

Eric

By Vern Edwards on Thursday, July 12, 2001 - 11:29 pm:

Eric:

It is precisely the four criteria to which we should pay attention. You can't put too much weight on them. The criteria were established by the GAO, it's the GAO that is most likely to rule on any CPPC issue, and the GAO has adhered to the four criteria for at least 46 years. Here is how they articulated those criteria in 1975:

"WE HAVE RENDERED DECISIONS INVOLVING THE ISSUE OF WHETHER CERTAIN TYPES OF CONTRACTUAL ARRANGEMENTS CONSTITUTED PROHIBITED COST-PLUS-A-PERCENTAGE-OF-COSTS ARRANGEMENTS. CF. 35 COMP.GEN. 434 (1956); 38 ID. 38 (1958); AND 46 ID. 612 (1967). THE GUIDELINES APPLICABLE TO THIS CONSIDERATION ARE: (1) PAYMENT IS ON A PREDETERMINED PERCENTAGE RATE; (2) THE PREDETERMINED PERCENTAGE RATE IS APPLIED TO ACTUAL PERFORMANCE COSTS; (3) CONTRACTOR'S ENTITLEMENT IS UNCERTAIN AT THE TIME OF CONTRACTING; AND (4) CONTRACTOR'S ENTITLEMENT INCREASES COMMENSURATELY WITH INCREASED PERFORMANCE COSTS."

35 Comp.Gen. 434 (1956). (Forgive the capital letters; that's the way the decision was printed.)

Here is the way the GAO articulated the four criteria 37 years later:

"Our Office uses the following criteria to determine whether a method of payment represents a prohibited cost-plus-a-percentage-of-cost arrangement:

(1) Payment is at a pre-determined rate,

(2) the pre-determined rate is applied to actual performance costs,

(3) the contractor's entitlement is uncertain at the time of contracting, and

(4) the contractor's entitlement increases commensurately with increased performance costs."

B-252378 (1993).

Stick with the four criteria and you won't have any trouble.