If Budget Sequestration Trims Your Contract: What Contractors Need to Know About Partial Terminations and Deductive Changes

If Budget Sequestration Trims Your Contract: What Contractors Need to Know About Partial Terminations and Deductive Changes: Guest Authors: Neil H. O’Donnell and Dennis J. Callahan, Rogers Jospeh O’Donnell, PC, writes:

By definition, budget sequestration is a ham-handed approach to cutting federal spending.  Even if sequestration is somehow averted, however, there can be little doubt that FY 2013 will see a particularly severe round of belt tightening in federal contracting.  In addition to delaying procurements and forgoing the exercise of contract options, federal agencies likely will become more aggressive in pruning the amount of goods and services called for under existing contracts.

How such deletions of work are characterized often falls into a large grey area, and, indeed, the BCAs and courts have not even settled upon a firm standard for distinguishing between partial terminations and deductive changes.

The different recovery rules governing each type of work deletion determines how the contract price will be adjusted to account for the deleted items, and which costs will be allowed.  These differences can significantly impact the contractor’s recovery.

Whether the contract is profitable typically determines which form of work deletion is better for the contractor’s bottom line.  Here’s the rule of thumb:  If the contract generates significant profits, the contractor will be better off if the deletion of work is classified as a deductive change.  But, if the contract is a money loser, it will be to the contractor’s advantage if the deletion is treated as a partial termination.


Measures of Recovery for Partial Terminations and Deductive Changes

Terminations for Convenience are designed to leave the contractor in the same position it would have been in had the parties initially contracted for the reduced amount of work.  On a profitable contract, the contractor is allowed a “reasonable” profit on the work performed, an unwelcome standard where the work already accomplished has proved to be highly profitable.  But where a partially terminated contract is in a loss position, the contractor can cut its losses by not taking additional losses on the unprofitable deleted work.

By contrast, recovery under the Changes clause reduces the contract price by the contractor’s cost of the deleted work and the profit attributable to that work.  Thus, on a highly profitable contract subjected to a deductive change, the contractor can bank its profits on the performed portion of the contract, without a reduction to a “reasonable” rate.  Conversely, if the contractor is in a loss position it will bear the full brunt of the anticipated losses on the entire contract, because the contract price will be reduced by the (high) cost of performing the deleted work, leaving the contractor in the same loss position it would have been in had the contract been completed.

In an earlier paper, we illustrated with hypothetical scenarios the potentially significant differences in recovery depending on how the work deletion is characterized.  If such cuts are inevitable, contractors would be well served to appreciate early on the very different potential impact to the project’s bottom line of these competing characterizations as they frame the work deletion in their negotiations with the contracting officer.

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