Inflation, now reaching levels not seen in four decades, has suddenly become a major factor in government contracting. While no American is immune from this de facto tax, inflation is felt unequally, impacting the rich and the poor in different ways. The same can be said of government contractors with a similar division between the haves and have-nots. The Department of Defense (DOD) may need to act soon and use existing law to smooth out some of the effects of this disparity, otherwise the current round of inflation could negatively impact the defense industrial base and future innovation for decades to come.

DOD unfortunately is sticking its head in the sand and pretending there is not a problem. This most recently manifested itself when the head of DOD’s contracting outlined the department’s policy on adjusting contracts to address the consequences of the worst inflation since the Carter administration. As my AEI colleagues have written elsewhere, the Biden administration is trying to downplay and ignore the budgetary impact of rising prices. In that mindset they have clearly been joined by the House Appropriations Committee whose proposed defense bills do not even pretend to make up for inflation. Within those constraints, defense civil servants had little choice than to say DOD will only address price increases depending on how any original contract was structured.

That is great if
you are one of the few large defense prime contractors (the contractor haves) that
primarily live off of cost-reimbursable contracts. In federal contracting as in
Orwell’s Animal Farm, some animals
are more equal than others. These companies are guaranteed to be reimbursed for
their actual costs. As those costs go up, not only is their inflation risk covered,
but their profit margins are protected. In fact, total profits will grow even larger
as these companies will be paid the same profit rate on new inflated costs. If
you happen to be lucky enough to have a preponderance of cost-reimbursable or other
incentive-type contracts where the government shares the risk, you will be made
whole.

For contractor “have
nots” with firm, fixed-price contracts and subcontracts, that’s another story. DOD’s
new policy is if a company was not smarter than the Federal Reserve, the
Department of Treasury, and DOD itself and did not see inflation coming years
ago, they are out of luck. Never mind that both the Democratically controlled
legislative and executive branches missed the crazy idea that fiscal and
monetary indiscipline amplified by war in Ukraine and a pandemic that disrupted
supply chains could actually lead to inflation.

The companies
that signed up to government fixed-price contracts before the economy was
unexpectedly undermined are the commercial, non-traditional, and small
businesses who form the backbone of future innovation in the Department of
Defense. These firms are the ones willing to take a risk to sell to the
government on a fixed-price basis because they believe they can outcompete the
lethargic defense giants, if only given a chance. A kind of spirit that DOD
desperately needs more of.

Now, because of extraordinary
circumstances, these companies are getting hammered, not by technological
failure, but by rising prices. This is having a significant impact on small
businesses with fixed-price contracts like the company I recently heard from that
is seeing parts and material price increases of over 100 percent. This is not
sustainable. Some of these companies will stop performing, go out of business,
and leave the government holding the bag. Many others, while still able to meet
their contractual obligations, are going to lose a lot of money and be weakened,
unable to compete with China who vastly subsidizes its industrial base.

Unlike in China,
US companies do have a choice of whether to work with the government. After
getting burned by inflation, watching the defense primes continue to prosper,
and with DOD showing them no flexibility to address unanticipated and extraordinary
economic circumstances from supply chain disruptions and labor shortages, now is
a good time for non-traditional and small-business firms to consider getting
out of the defense market, especially if they are treated better in the
commercial market. That is not in DOD’s interest.

If there ever was
a compelling case to use “extraordinary contractual relief” authorized in Public
Law 85-804, now is the time. This law, passed in 1958, allows the government to
adjust contracts in exceptional circumstances to “facilitate the national
defense.” The administration should consider using this authority to provide a
one-time inflation adjustment to those contractor “have nots” with fixed-price
contracts who are negatively impacted by the extraordinary circumstances that
led to the rise in inflation. Moving forward, while future inflation will be difficult
to price, at least each side now knows that it is a real factor again and can
negotiate new contracts from a more realistic position.

The post Defense Inflation and the Need for Extraordinary Contractual Relief appeared first on American Enterprise Institute – AEI.