Analysis: Some long-term contracts put government at a disadvantage

Two scholars suggested in a new study that three major Cabinet-level departments rely extensively on long-term, fixed-price contracts for complex products, which puts the contractor in a position to bargain for favorable contract terms to the government's detriment.

Federal officials have turned more often to fixed-price contracts because they are thought to lower costs and reduce the risk on the government, Trevor Brown, associate professor at The Ohio State University’s John Glenn School of Public Affairs, said in an interview Sept. 5.

The article was published the September/October issue of the Public Administration Review.

In researching contracts awarded from 2004 to 2008, Brown and Yong Woon Kim, the lead author of the study who earned his doctorate from the university, found the departments of Defense, Homeland Security, and Health and Human Services have increased their use of fixed-price contracts, which should lead to savings. But problems are arising years after the initial awards.

Officials often dramatically extend or modify short-term, fixed-price contracts, risking cost overruns, delivery delays and diminished product quality even for simple products and services.

“The data suggest that in some cases what appear to be short term, competitively bid fixed-price contracts have been changed through negotiations over time into long term, sole-source contracts,” Brown said in an interview with FCW.

Brown and Kim referenced a defense contract as an example. In 2004, Fort Lee Virginia entered into a one-year contract for trash collection and recycling at a firm fixed-price of $250,834. Two years later, officials modified the contract into a 10-year, $4.6 million contract without going through a competitive bid process.

This is common among the three departments. The average contract value at HHS grows from around $250,000 to just over $500,000 through modifications. At DOD, the value grows from just under $500,000 to around $2 million through modifications. At DHS, the value grows from around $300,000 to around $2.3 million through modifications.

“My intuition is many of these agencies are test-driving a supplier over the first couple of years. If they’re happy with the quality, rather than go back to the market, they just re-up the incumbent supplier over the long term,” Brown said.

It is possible that other agencies engage in similar behavior. The researchers studied only the three agencies they wrote about.

Robert Burton, a partner at the Venable law firm and former deputy administrator at the Office of Federal Procurement Policy, agreed, saying contractors will ask for modifications to their firm-fixed-price contracts as requirements become clearer and expectations change.

“The government may think it has a firm-fixed-price contract but it doesn’t always end up that way,” he said.

That’s what makes well-defined requirements so essential, said Roger Waldron, president of the Coalition for Government Procurement and former lawyer at the General Services Administration. However, the government still has issues with developing clear requirements. The contracting officer and the program manager need to spell out precisely what’s needed to avoid a changing contract with increasing prices and overgrown work.

“As a general rule of thumb, the level of uncertainty regarding a requirement is the key principle used to decide what contract type is most suited for a particular requirement,” Joe Jordan, administrator of the Office of Federal Procurement Policy in the Office of Management and Budget, said Sept. 5.

In their article, Brown and Kim write that DHS, and to a degree DOD, relied heavily on short-term contracts with fixed prices when they purchased simple services, such as auditing and equipment repair. For complex products, such as program management and computer system development services, the departments opted for longer term contracts that came with increasing costs due to modifications. That leaves the initial estimates for work far below the ultimate value of the contract.

For instance, the average ultimate value of a contract after being modified is less than $500,000 for landscaping and waste collection. On the other hand, the average modified ultimate contract values jumped significantly higher for complex services. The three departments modified contracts by between $1.5 million and $4 million for computer systems and more than $3.5 million for program management services.

“This may reflect the power of the vendor to raise costs and extend the length of the contract under scarce market conditions. Alternatively, it may reflect a collaborative partnership between the two parties under a ‘relational’ contract,” they write.

The budget influence on contracts

Budgetary challenges are influencing decisions about contract type too, Waldron said.

The Obama administration has pushed firm-fixed-price contracts as a means of lessening the government’s risk on a project.

The Federal Acquisition Regulation “includes a long-standing preference for fixed-price contracts over cost-type contracts--a preference this administration has reiterated--because the risk of performance is borne by the contractor and therefore provides greater incentive than cost-reimbursement contracts for the contractor to control costs and perform efficiently,” Jordan said.

Despite the risk, vendors may see a fixed price as the better option. Essentially, a fixed-price comes with just that, a fixed price. A contract based on time and materials or billable labor hours isn’t set. For agencies though, the firm-fixed-price contract reduces flexibility for negotiations.

“If I’m billing somebody for their time, I can say stop. For a firm-fixed-price contract, the money is already obligated,” Waldron said. For a company, “there’s less to worry about.”

These days though, companies will sign either riskier firm-fixed-price contracts or the less risky cost-reimbursement contracts. Under cost-reimbursement contracts, companies are reimbursed based on allowable costs instead of the delivery of a completed product or service.

“Companies are perfectly willing [to sign] because they want to get the work,” Burton said.

Companies may have to increase their costs to offset the lack of a bonus payment for good performance, which come with the cost-plus-award-fee type of contract, Brown said.

The Justice Department joined a lawsuit alleging that The Gallup Organization gave the government inflated estimates of the number of hours that it would take to perform its services, even though it had separate and lower internal estimates of the number of hours that would be required. “Contractors must understand that it is unlawful to use inflated estimates to obtain higher contract prices,” Stuart Delery, acting assistant attorney general for the department’s civil division, said in August.

Furthermore, the budget is pushing agency officials to consider low price, technically acceptable contracts as the most feasible. That type of contract emphasizes costs, as long as a bid meets the minimum requirements for the project.

Waldron and other experts are concerned that it’s not always a fair tradeoff. Indeed, considering the best value may lead to a high initial cost but a superior result.

The two—low price technically acceptable contracts and best value procurements—stand opposite of each other, although these days they may be blurred, according to Burton.

An agency may label its solicitation as a best value procurement, wherein officials will consider various aspects of a bid, such as who will perform the work and how it will be reviewed.

However, Burton said, “Everything is driving people to look at price.” Nevertheless, agencies won’t drop the best value procurement tag because it sounds good, he added.

As for the research, Brown and Kim warn of the upper hand that companies can gain when negotiating long-term, costly contracts.

“In these circumstances, contract managers and agency executives would be wise to consider the risks of cost growth and contract delay that result from lock-in,” they write.

To manage the risks, they recommend officials should enter into short-term, cost-reimbursement contracts and then move to a fixed-price arrangement in later rounds of renegotiation.