Revisiting an Old Nemesis: Cost-Plus-A-Percentage-of-Cost Contracts

 

We recently had a healthy discussion in NASPO ValuePoint about an old “nemesis” of procurement professionals.  The prohibition on cost-plus-a-percentage-cost (CPPC) contracts has been a bedrock principle in federal contracting for decades and was included in the ABA Model Procurement Code (MPC) for States and Local Government’s first edition in the late 1970s.  It persisted in the 2000 revision and remains a prohibition in many state and local governments’ statutes and ordinances.

 

It arose in the context of ValuePoint’s cooperative procurements because there was an unfortunate reference to “cost-plus” in a proposal.  That got the attention of potential users of our master agreements and started a robust dialogue.  When master agreements are priced by resellers—as they often are—with a percentage on top of manufacturers’ catalog pricing, are they CPPC contracts?  Let’s dig a little deeper into the policy.

 

CPPC is defined by Contract Management Body of Knowledge (CMBOK) of the National Contract Management Association (NCMA) as “a contract type that bases the contractor’s fee on the amount of funds it expends.”  The reason for the prohibition is quite simple really.  If a public entity commits to paying a contractor using a percentage above costs, there is no incentive for controlling costs.  Said another way, the more the underlying costs, the greater the fee and profit of the contractor.

 

A cost reimbursement contract, though, is a very specific type of contract.  The CMBOK defines it this way, “A type of contract that provides for payment of allocable incurred costs, to the extent prescribed in the contract.” Allowability means costs are properly allocated to the contract, reasonable, and not made unallowable by cost principles. An example might be the allowability of reimbursement of fines.  Cost reimbursement contracts provide for payment of some indirect costs that are allocated to the contract.  So, a portion of home office overhead is charged to the contract using an approved allocation methodology, sometimes the percentage of the contract receipts compared to all the other company’s sales.  But if an environmental fine is levied on the home office for a violation of an environmental regulation during contract performance, no portion of that amount is payable by the government under the cost allowability rules.  That cost is considered unallowable.

 

Cost-type contracts that reimburse contractors for their performance costs usually have a fee (the profit).  The usual fee structures are negotiated fixed fee or incentive fee. But as in the MPC, a percentage fee computed on costs of performance is prohibited in the federal government.

 

Because the MPC evolved from federal contracting practices, decisions and opinions from federal judicial and administrative bodies often are persuasive in interpreting its provisions.  The Comptroller General of the United States’ usual guidelines in determining whether a contract constitutes a cost-plus-a percentage-of-cost system of contracting include (1) whether payment is at a predetermined rate; (2) whether this rate is applied to actual performance costs; (3) whether the contractor’s entitlement is uncertain at the time of contracting; and (4) whether it increases commensurately with increased performance costs.  In the Matter of the Department of Labor – Request for Advance Decision, GAO No. B-211213, April 21, 1983, available at https://www.gao.gov/assets/450/446900.pdf.  The policy behind the prohibition is to eliminate the perverse incentive for contractors being reimbursed for their costs to increase costs of performance so they can increase profits computed using a percentage of those costs. “The ‘Evil’ of this system is that contractors have an incentive to pay liberally for reimbursable items, because higher costs mean higher profits.”  In the Matter of the Department of State – Method of Payment Provisions, GAO No. B-196556, August 5, 1986, available at https://www.gao.gov/products/440993.

 

The Federal Transit Administration (FTA), a key federal funding agency for many states and local governments, has often noted that there is confusion about how contracts are priced and whether an executed contract is a cost reimbursement contract where governments are contractually obligated to reimburse contractors for their costs of performance.  Negotiating contracts based on fixed rates for profit and overhead does not convert even a cost-plus-fixed-fee contract into an impermissible contract, because the contractual obligation to pay is not based on a percentage of the incurred costs.  Time and material contracts likewise are not impermissible CPPC contracts even though overhead and profit rates are used to negotiate those fixed-price contract rates.  Even change orders in construction can be negotiated using percentage profit targets and overhead, and that pricing methodology does not convert the fixed-price change order into an impermissible CPCC contract type.  (See the FTA website about cost-plus-percentage-cost contract prohibitions at  https://www.transit.dot.gov/funding/procurement/third-party-procurement/cost-plus-percentage-cost-contracts)

 

The fact that a ValuePoint master agreement uses a markup provision to compete and price the agreements does not make the master agreement orders cost-plus contracts.  Section 16 of the NASPO ValuePoint Master Agreement Terms and Conditions makes purchasing entities individual customers, with their purchase order or other ordering instrument the means of creating the financial commitment. Section 21 states that no work may begin without a valid purchase order or other commitment voucher creating the financial obligation of the purchasing entity.  Thus, a contract is not entered until the order is placed by a purchasing entity.  The contract type is “fixed price,” not cost reimbursement.  Using the GAO tests for CPPC, the payments are not based on actual performance costs.  Moreover, the contractor’s entitlement is certain at the time of contracting, i.e. when the order is placed. Thus, neither the master agreement nor orders placed under it are cost-plus-a-percentage-of-cost contracts.

 

This post is not intended to substitute for legal advice needed by a state or other potential participating entity.  While this analysis applies common principles, individual states or other jurisdictions may have other, more restrictive governing laws.  But at the very least, we’d advise offerors proposing on NASPO ValuePoint and other cooperative solicitations: Don’t use the term “cost-plus” in your proposals!

 

About the Author

 

Richard Pennington is a retired U.S. Air Force judge advocate who specialized in federal government contracting.  He previously served as a Colorado assistant attorney general (fiscal and procurement law) and director of the Colorado Division of Finance and Procurement.  Richard is the author of Seeing Excellence: Learning from Great Procurement Teams.