Article

Cost Plus a Percentage of Cost Contracts

October 15, 2018

By: John Ford, Senior Consultant, Government Contractor Services Group

Recently, I wrote an article that appeared in the August 2018 edition of Contract Management Magazine published by the National Contract Management Association (NCMA). That article addressed a contractor’s obligation to manage its subcontractors. In that article, I discussed the prohibition against the use of cost plus a percentage of cost (“CPPC”) subcontracts. In this regard, I identified the criteria for determining the existence of a CPPC contract as stated by the U.S. Government Accountability Office (“GAO”) and adopted by the Court of Appeals for the Federal Circuit. These criteria are:

  1. payment is on a predetermined percentage rate;
  2. the predetermined percentage 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.

It should be noted that nowhere in this statement is there an indication that they are applicable only to profit or fee. Following this, I stated in the article that:

It is a common misperception that a CPPC contract only exists if the fee or profit is based on a stated percentage of costs incurred. However, a CPPC contract can occur if indirect costs are stated as a percentage of base costs and are not adjusted to reflect the actual indirect costs incurred by the contractor. Thus, if a prime contractor awards a cost reimbursement subcontract where indirect costs are recovered at a stated percentage of base costs, that subcontract would be a CPPC subcontract if the indirect costs are not adjusted based upon actual indirect costs incurred.  Similarly, if the prime contractor awards a T&M subcontract that permits indirect costs to be allocated to the subcontract at a stated percentage of material cost, that subcontract will also be a CPPC if the indirect costs are not adjusted based upon actual cost incurred.

Since that article appeared, I have received inquiries concerning the correctness of this statement. This blog is to expand upon this statement.

The seminal GAO decision on this point is B-126794 which is a letter dated January 27, 1956, addressed to the Secretary of Defense. In that letter, the GAO stated:

WE HAVE GIVEN CONSIDERABLE STUDY TO THE MANNER IN WHICH THE MILITARY SERVICES HAVE BEEN CONTRACTING FOR THE PAYMENT OF INDIRECT COSTS UNDER COST-TYPE CONTRACTS WITH BOTH NONPROFIT AND COMMERCIAL ORGANIZATIONS. FOR INSTANCE, WE HAVE NOTED THAT THE MAJORITY OF RESEARCH CONTRACTS CONTAIN PROVISIONS FOR THE PAYMENT OF OVERHEAD BASED ON A STIPULATED PERCENTAGE OF DIRECT LABOR OR OTHER COSTS INCURRED UNDER THE CONTRACTS, IN LIEU OF REIMBURSEMENT OF THE ACTUAL COSTS OF OVERHEAD. . . .  WE HAVE CONCLUDED THAT AN AGREEMENT TO PAY OVERHEAD IN THIS MANNER MAKES THE CONTRACT ONE FOR PAYMENT ON A COST-PLUS-A- PERCENTAGE-OF-COST BASIS.

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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. . .  SUCH FIXED RATES ARE INCONSISTENT WITH THE BASIC PRINCIPLES OF A COST-TYPE CONTRACT IN THAT THEY WILL NOT NORMALLY RESULT IN REIMBURSEMENT OF THE ACTUAL COST. . . .

ON THE OTHER HAND, WE SEE NO OBJECTION TO THE USE OF PROVISIONAL PERCENTAGE RATES SUBJECT TO RETROACTIVE ADJUSTMENT OF THE CHARGES TO ACTUAL COSTS.  (Capitalization in the original)

From this, it should be clear that a CPPC contract can occur if indirect cost rates are fixed and not subject to adjustment based on actual costs. However, an exception applies to R&D contracts with educational institutions. In accordance with 41 U.S.C. §4708, predetermined indirect cost rates may be used for such contracts. In this regard, see FAR 52.216-15 and 42.705-3(b).