Greg Tharp, who has written excellent articles for us recently, offers this two-part series about cost recovery for commercial item contracts. He starts with this question…
Have you ever tried to calculate cost recovery in commercial item contracts when contracts are terminated for convenience and the government is seeking to compensate contractors fairly for the portion of the contract not completed. It’s difficult no matter what side of the aisle you are on – government or contractor.
Even if you consult well-known standards like the Financial Accounting Standards Board (FASB)1 and the U.S. Federal Acquisition Regulation (FAR)2 – which I have done almost with a microscope -- and yet, I’ve discovered I still needed to read between the lines and do a bit of interpreting to accurately calculate present value. I’ve learned a lot and hopefully you will too.
Part 1 reflects my research showing that you can calculate present value of commercial item contracts and clauses using the FASB concept statement number 73 and FAR. I describe net present value clauses in Part 2 of this series to give deeper insight. And to create uniformity (perhaps a bit of sanity too), I discovered that you need to first define the various valuation (estimates of value or worth) methods for cost recovery specific to each acquisition you are handling.
Past performance defines estimate of value
Because I could not locate any hard and fast rule on determining value of terminated contracts in the FAR, I used past performance as a basis for doing that. Past performance is an acceptable method identified in the FASB Concept Statement number 7 and should be applied by all contractors to all types of contracts they may have with the government.
For example, suppose I am a contractor and the government informs me that my contract is terminated, and I have 10 percent of the contract to complete. This leaves me wondering how the remaining 10 percent should be valued. I also must consider how likely or probable my engineers or other technical personnel estimate completing the remaining portion of the contract.
This is called past performance valuations and entails simply multiplying the remaining amount of the contract after termination by the chances of completing the contract. For instance, if there is USD $100 million left on a contract for a supercomputer and the probability or chances of recovering the USD $100 million is 10%, the actual cost to complete the contract is $10 Million.
You must use past performance any time it is impossible for you to obtain prices of comparable commercial items. For example, purchasing a stapler for a contingency operation combat zone would mean you would need to use past performance to determine present valuation, because you have no other cost comparisons to rely on. You would also use past performance valuations to respond to such instances as these:
- defense or recovery from cyber, nuclear, biological, chemical, or radiological attack;
- emergency assistance recovery required under the Stafford Act for major natural disasters like hurricanes; or
- humanitarian or peacekeeping operations.
Regardless of the amount proffered, you might not be able to obtain other commercial item pricing documents, such as commercial item price lists, for valuation purposes. This would apply to such an urgent situation that the contract must be terminated and another contractor selected. In such a case, it would be impractical to gather other commercial item pricing sources for comparison.
For example, let’s say you are facing the dilemma of having to buy a custom Humvee for a warzone, but Kelly Bluebook does not provide a price baseline for military Humvees designed to withstand battlefield conditions. Plus, Humvees available might be too dangerous to operate. Also, sole source acquisitions other than contingency operations may exist. But even so, the same valuation procedure would apply.
A unique system could be just about anything, ranging from a weapons system to a supercomputer. Thus, you might need to use a fuzzy net cash flow4 to determine present value of the commercial item, because the difference between present value and fuzzy net cash flow is that fuzzy net cash accounts for other variables impacting valuation -- such as operating time -- which may provide a more accurate projection of present value for complex commercial items.
So, how then could you calculate cash flow?
The formula to calculate cash flow, based on Maravas et. al.5 is:
cash flow = time savings + operating cost savings + accident savings* + environmental savings – investment cost* – operation and maintenance cost.
*accident savings includes manpower plus facilities damage and is determined by the contractor subject to verification by government auditors.
*Investment cost is the cost of acquiring the commercial item, including research and development expenses. Time savings includes manpower as well as facilities overhead and other incurred direct and indirect costs.
The lack of empirical data and use of fuzzy cash flow might increase or decrease the burden to government and industry. FASB collects data for each year of operation which might be reduced or increased by a certain percentage. Variables of time savings might also be reduced or increased by a certain percentage to determine the valuation of cash flow. This quantifies risk inherent in the commercial item system.
During the first years a cash flow system is put in place, the investment costs -- such the cost of component commercial items -- may exist even though no benefits or maintenance costs exist. In later years, based on contractor-provided data, the following benefits can result:
- time savings,
- operational cost savings,
- environmental savings, and
- operation and maintenance costs.
The cash flow system becomes unsustainable when investment cost (e.g. cost of replacement parts) outweighs the benefits and savings of the project. Since it is unknown how risky a project will be, cash flow is calculated from the previous formula and will be multiplied by the probability of the unique system’s capability to benefit from the present value of a system over time. In FASB Concept Statement number 73 (page 21), the expected present value of a system is the total sum of all present values accrued.
For example, let’s say:
- The present value of a system being 10% successful is $95.24 in the first year, year 1;
- This increases to $541.64 when the probability increases to 60% in year 2;
- This then decreases to $255.48 when the probability decreases to 30% in year 3.
Therefore, the total expected value is $892.36 which equals the three-year total. If the contract was 30% complete at the time of termination, the contractor is entitled to recover 30% of $892.36 for contracted work performed prior to termination -- or $267.71.
Watson, the IBM supercomputer6 used in the popular television series Jeopardy7 is a unique system and great example of present value. In year 1, Watson would be unsustainable, because of tweaks needed for its algorithm; thus, a 10% success rate is assigned to Watson. For the purpose of this example let’s say Watson is valued at $95.24 million in year 1 and the next year, the probability increases to 60% because the kinks in the algorithm are now solved. This results in $541.64 million which increases the value to $892.36 million in year 3. If the contract to build Watson was terminated when it was 30% completed, the contractor would have been entitled to recover 30% of $892.36 million -- the amount of contract work performed prior to termination.
Why use fuzzy net cash flow?
An objective of the FAR is to “minimize administrative costs” as documented in FAR 1.102. The estimated cash flow method to calculate estimated cost to complete a contract is a consistent method. Thus, it reduces the need to allow for contracting officer oversight and legal scrutiny of commercial item contracts using fuzzy net cash flow. Currently, no contractors use fuzzy net cash flow since it is not mentioned in the FAR.
But, inevitably, court decisions will differ on the same sets of facts if contractors use different present value analysis techniques or none at all, and this creates uncertainty as to amount of cost to be recovered. Contractors using the estimated cash flow method may see courts finding fair compensation in terminations for convenience court cases because of how the generally accepted method to calculate net present value is inconsistently used.
FAR 12.403(d)(1)(i)(a)8 states that the percentage of the contract price reflecting percentage of work performed is the amount that the contractor should be paid when terminating a contract for convenience. Specific wording states in part:
…Termination for the Government’s convenience. When a contracting officer terminates a contract for commercial items for the Government’s convenience, the contractor shall be paid the percentage of the contract price reflecting the percentage of the work performed prior to the notice of the termination for fixed-price or fixed price with economic price adjustment contracts…
But the question remains: Why not use FASB and fussy net cash flow?
It is smart to use FASB Concepts Statement number 7 after calculating a fuzzy net cash flow for complex commercial item acquisitions.
- It reduces the overall administrative burden for contract administration, because it is a well-known, consistent and trusted technique being used today.
- It also reduces the overall administrative burden for contract administration.
It is unknown if the present value will hold up to scrutiny by the Armed Services Board of Contracting Appeals and other courts due to the lack of cases which address these issues. There is a lack of empirical evidence or existing literature regarding the use of fuzzy value in commercial item contracts since these methods have not been tried in the field yet.
- FASB Concept statements
- FARFederal Acquisition Regulation
- FASB Statement Number 7
- Cost Recovery in Commercial item Contracts, Greg Tharp
- Alexander Maravas & John-Paris Pantouvakis. “Project cash flow analysis in the presence of uncertainty in activity duration and cost.”Copyright © 2011 Elsevier Ltd and IPMA. All rights reserved.
- Watson IBM Supercomputer definition.
- Jeopardytelevision series
- Legal Information Institute 48 CFR 12.403 - Termination