Have you ever tried to draft a statement of work (SOW) only to find out that no uniform clause exists for determining net present value in commercial item contracts? Did you know the Federal Acquisition Regulations System1 also known as FAR is what the United States Government uses when drafting a statement of work (SOW)?
The SOW aims to provide the roadmap for contractors desiring to do business with the U.S. Government. Clauses within the SOW should dictate how commercial item contracts should be valued, but without a clause in the statement of work, it is difficult for both contractors and the U.S. Government to agree on how to value commercial items. Why is that and what can we do?
Will net present value (NPV) be of help?
Imagine trying to buy a warship or hire a consultant for your organization without knowing what one costs. To achieve uniformity in valuing commercial item contracts, you can use the NPV clause which is defined as “the present value of the cash flows.”2 An NPV analysis can be used to value commercial item contracts based on the business judgement of contracting officers.
Although, as a contracting officer you may be able to use the NPV clause as a type of analytical strategy, you can also use the NPV to value commercial item contracts terminated for convenience. However, NPV is not commonly used in practice because of the lack of professional literature on the existence of an NPV clause for commercial item contracts.
Also, if you read FAR 12.403(d)(i)(B(ii)3 on Acquisition.gov, you’ll discover how it states in part “The contractor may demonstrate such charges using its standing record system.” When referencing charges, it is referring to the amount that a contractor can recover for the unfinished portion of the contract. An example is when the government purchases a lawnmower for $200 and the contract is 70% complete. But that fails to solve the question about how to value the remaining 30% of the contract or $60.
Not only that but contractors look at things with different lenses. Some contractors may use NPV to value the 30% unfinished portion of the contract while other contractors may use selected GAAP (generally accepted accounting principles) methods to value the 30% unfinished portion of the contract. This inconsistency results from the FAR not dictating a specific method that contractors must use when valuing the unfinished portion of terminated contracts.
And because contractors are unpredictable as to how they will value terminated contracts, different courts may render different decisions on the same facts, because the word “may” in the FAR allows contractors to select which one of the different valuation methodologies they wish to use.
For example, Contractor A producing a lawnmower for the government may use last in, first out (LIFO) approach to value its inventory of lawnmower parts while Contractor B producing the same lawnmower for a different government agency may use first in, first out (FIFO) to value its inventory. Both LIFO and FIFO are inventory methods allowed under GAAP, however they yield different valuations for inventory remaining in the contract which results in different amounts being paid to the contractor for the remaining part of the contract. And, to complicate things further, different valuation methods are not just restricted to inventory but also apply to overhead and direct and indirect labor. This is commonly referred to as the actual cost method.
Since the FAR requires, “coordination, simplicity and uniformity in the Federal acquisition process” an alternative to the actual cost method must be designed to satisfy this requirement. NPV is simply the present value of cash flows expected to be generated from the portion of the lawnmower (30%) that is not completed when contract is terminated.
A lawnmower manufactured by the Company A and Company B would generate the same cash flow because the same level of supply and demand exists for the lawnmower regardless of how much each company actually spent in manufacturing the lawn mower. This uniform approach is fair to both Company A and Company B, and reduces the chance that one of the contractors would return to the government and claim they were not treated fairly, because another company received more money based on actual costs for the same lawnmower contract.
Also, court decisions will differ on the same sets of facts if contractors used GAAP (such as actual cost) as a way to determine fair compensation merely because the term “may” is being used in applicable clauses. The term “may” implies potential doubt as to whether the contractor should use net present value analysis as promogulated by GAAP. A contractor using the NPV clause is fairly compensated in terminations for convenience because the word “shall” does not appear in the wording of the clause.
Therefore, considering all of the above, we need to incorporate through the FAR a net present value clause into statements of work.
Alternative 1: The term NPV shall mean present value of cash payments generated by a commercial item(s) clause shall be calculated using a discount rate determined by an actuary selected by the government and determined in accordance with GAAP. To determine probability of recovery in a commercial item contract, an alternatives analysis can be performed, and contractors shall calculate cost recovery or charges from commercial item terminations based on the NPV.
Alternative 2 applies to commercial items purchased using debt financing. The term NPV shall mean present value of cash payments generated by a commercial item(s) clause, due in the future to be reduced by a discount rate equal to 100% of the Applicable Federal Rate (as defined in Code Section 1274(d).) Contractors shall calculate cost recovery or charges from commercial item terminations based on NPV. Probability of recovery in a commercial item contract shall be determined by analyzing alternatives to the initial analysis.
Example of net present value clause
Using Alternative 1, an acquisition would be valued at $61,446 today assuming a return of $10,000 per year over 10 years having a discount rate of 10%. Without using net present value, the present value of the acquisition at year 10 would be $3,855. If the contract is terminated prior to completion without using net present value when it is 70% completed, the contractor would be entitled to recover $2,698.50 compared with $43,012.20 recovery, using net present value. It is not practical to provide an example of Alternative 2 because the AFR changes from month to month within a given year.
It is unknown if the present value clause in either Alternative 1 or 2 will hold up to scrutiny by the Armed Services Board of Contracting Appeals and other courts due to how few court cases actually address these issues. Not enough empirical evidence exists, and literature is insufficient to evaluate the usage of present value in commercial item contracts, because these methods have not been tried in the field yet.
Internal Revenue Code4 Section (IRC) 1274(d) applies to debt instruments which are publicly traded or issued for publicly traded property, such as government property. As noted in IRC 1275(a)(1), a debt instrument includes:
- The daily portion of original issue discount for any day shall be determined under section 1272(a) (without regard to paragraph (7) thereof and without regard to section 1273(a)(3)). (C)
- If an obligor of a short-term debt (as defined in section 26 U.S. Code 1283(a)(1)(A) – Definitions and Special Rules) uses the cash receipts and disbursements method of accounting, then the original discount (and any other interest payable) on such debt shall be deductible only when the discount or interest is paid.An example of a debt may be a loan from a bank to a contractor.
Conversely, a contractor who does not use the net present value clause risks a court not finding fair compensation in terminations for convenience cases because the word “may” is used in FAR 12.403(d)(i)(B)(ii).
A final policy benefit is to consistently enforce the use present value in termination of commercial item contracts. The definition of NPV, either in alternative 1 or alternative 2 above, and their uniform application, gives contractors a clear path to the Board of Contracting Appeals or the Federal Court of Claims. This “minimizes administrative operating costs” as required in FAR 1.102, by having government spend less time and money in oversight functions (such as audit) to ensure that contracting officers fairly compensate contractors in terminations since it is mandatory, not optional to do so.
So what if present value has not been determined?
Using present value reduces the overall administrative burden for contract administration, because it is most consistently used and understood. Using two present value clauses will assist contracting officers in determining the present value of commercial item contracts and getting a variety of policy benefits of the FAR. Mandatory usage of NPV clauses provides uniformity and a framework to base your negotiations upon.
- FARFederal Acquisition Regulation
- Harvard Business Review
- Gov 12.403 Termination
- Internal Revenue Code
Greg Tharp, MLS, Adv. Cert., MCAC Biography
Greg Tharp has over 15 years of experience as a librarian and researcher, including research positions with Harvard Medical School and Tufts University. He previously served as a member of the State of Connecticut Library Advisory Council on Library Planning and Development. He is a member of the American Library Association, Massachusetts Library Association, ARMA International, IAACM, and the National Contract Management Association. Tharp’s area of expertise is information policy.
Tharp holds an Master’s Certificate in Acquisitions and Contract Management from American Graduate University, an Advanced Certificate in Archives Management from Simmons University, a Master of Library Science from Southern Connecticut State University, and a Bachelor of Science from Sacred Heart University where he was elected to Phi Eta Sigma and received the Passion for Learning Award. Additionally, he received acquisitions training at Defense Acquisitions University, Federal Acquisitions Institute, and the University of Virginia. He also received human resources training at HR University.