There are 3 important causes of loss profit (or loss fee) litigation in government contracts. Loss profit calculations are based primarily on a contract and a defined period of time (i.e. contract term). Scope creep, subcontractor disputes, and delays are the most common causes of loss profits/fees when performing work on federal contracts. All stem from a failure to clarify contract or subcontract language before work begins and/or during the contract performance (i.e. modifications and change orders).
Scope creep ensues when the customer begins to request work that is not specified in the original contract, task order or subsequent modifications. T&M contracts tend to be less affected by scope creep due in part that all work is billed by the hour and materials requested by the customer are passed through. Albeit, they are still at risk of loss profits due to the lack of clear agreement as to the payment of the additional number of hours to be billed and/or written requests for additional materials and other direct costs. A significant impact of scope creep falls on firm fixed price contracts and cost reimbursable contracts with caps on fee or profit. When I say firm fixed price, we’re not talking about Fixed Price Level of Effort (FPLOE) as these contracts are issued as a roundabout way of issuing a T&M contract. FPLOE contracts, like T&M contracts and task orders may create a loss profit scenario due to caps on the amount of hours allowed in the contract and if there are no clear definitive milestone or deliverables that must be met.
Loss profits are realized when the government requests changes to the contract scope that they feel are in line with the current contract, but do not provide any additional funding or man-hours into the contract. In this case, your loss profits would be:
Hours for additional work not in contract scope = Scope Creep Hours
Scope creep hours X negotiated T&M billing rates for those labor categories = LOSS PROFITS
In some cases, and depending on the language in the contract clauses, you may be only able to claim the actual cost of the direct labor to perform the additional work plus applicable indirect burdens.
Cost of additional work requested on a fixed price contract or additional deliverables + applicable burdens = LOSS PROFITS
Since circumstances vary, one may argue that a company is also entitled to the average realizable fee on those contract costs, as well.
Subcontractor disputes with prime contractor
Subcontractor and prime contractor disputes have probably gone on since the beginning of time. They are no different in the world of government contracts. Typically, the subcontractor was used in the bidding proposal for a significant portion of work, then when it is contract performance time, the subcontractor’s portion is cut back significantly. In this situation, loss profits would be calculated as the profits on the work promised but not granted. In addition, a claim may be made for the salaries of employees hired and being paid to sit on the bench for the promised work. If the contract has ended, the period under review and used in the calculation would be the entire subcontract period. Moreover, some states may take into consideration mitigating factors such as the ability to put those employees on another contract. In this case, the loss profits from contract A would be reduced by the profit earned on those employees moved to contract B.
Delays in contract performance by the government, prime contractors or even subcontractors can be cause for loss profits. Loss profits or loss fees are experienced in contract delays when payroll, benefits and other costs of operations must still be paid in order to stand ready to continue on a project when it “restarts”. Also the cost of replacing people that could not be financially support during the delay can be cause for loss profit litigation.
The key to avoiding the need to engage in loss profits litigation is to make sure to carefully read your contract and have an attorney review it as well. Also, understand, with certainty, the scope of the work to be performed. Any changes outside of the scope should be made in writing including the exact change in work, amounts to be paid, and any limitations. If you do wish to pursue litigation, engage a CPA certified in forensic financials to assist with calculating whether it is worth your while.