Termination costs are guided by the cost principle at FAR §§31.205-42. In the cost principle, eight types of costs are identified that may be included in the contractor's termination settlement proposal.
The costs of items reasonably usable on the contractor's other work are not allowable costs of a termination. Thus, in order for the costs of common items to be allowable costs of a termination, they must be in excess of the reasonable quantitative requirements of other work. Furthermore, in order for them to be usable on other work, they must be suitable for use in the contractor's normal course of business. Thus, even if they are items normally used in the contractor's industry they do not qualify as common items if they are not normally used in the contractor's normal course of business. Finally, even if the items were inventoried by the contractor prior to the receipt of the contract, the items should not be considered common items if they are of no value to the contractor subsequent to the termination.
Costs continuing after termination
Costs that cannot be discontinued immediately after the effective date of termination are generally allowable costs of a termination as long as they are not attributable to the negligent or willful failure of the contractor to discontinue those costs. These costs can include idled facilities costs; the costs of deactivating, reassigning, returning, or relocating employees; severance payments required by law, agreement, or established company policy; the costs of early retirement; the costs of completing parts in order to avoid loss; costs incurred while the contractor determines how to terminate the contract; and plant reconversion costs if their exclusion would be inequitable.
Initial costs include various types of non-recurring costs, such as excessive spoilage, idle time, reduced productivity, and increased training costs encountered in the early period of performance. They also include various preparatory costs, such as plant rearrangement and alterations; management and plant organization; and manufacturing and production engineering. A contractor's bid and proposal costs can even be claimed if proper adjustments are made.
Loss of useful value
The costs associated with the loss of useful value for special tooling, special test equipment, and special machinery are also allowable costs of the termination. The definitions provided in FAR §45.101 should be used in determining whether these items exist under the contract. The treatment of these items as either a direct or indirect cost is not a determinant factor to their existence.
Rental under unexpired leases
Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when it can be shown that they have been reasonably necessary for the performance of the terminated contract, provided that the amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable and that the contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such leases.
Alterations of leased property
The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for the performance of the contract.
Accounting, legal, clerical, and similar expenses necessary for the preparation and presentation of the proposal to the contracting officer are allowable, as are the costs of terminating and settling any subcontracts. In addition, the costs of inventorying, storing, transporting, protecting, and disposing of any termination property are also allowable. The indirect costs associated with the salary and wages incurred as settlement expenses are also allowable. Frequently, these indirect costs are limited to payroll taxes, fringe benefits, occupancy costs, and the costs of immediate supervision; however, the allowable indirect costs are not absolutely limited to those areas.
Even the costs of outside consultants are recoverable as settlement expenses. As a result of that recoverability, it may be more advantageous to utilize outsiders instead of pulling employees from their normal duties and disrupting day-to-day activities. On the other hand, if the termination is substantial, settlement efforts are a way to keep employees active and get them paid while waiting for the next project to come through. In fact, there are provisions for partial payment while preparing the termination settlement proposal.
The prime contractor and each subcontractor are responsible for prompt settlement of their respective subcontractors. Contractors are required to settle with subcontractors in general conformity with the policies and principles relating to settlement of prime contracts. Thus, subcontractor settlements are generally allowable provided that the settlement is not more favorable than what the subcontractor would have been able to obtain had it contracted directly with the government. This requirement includes a prohibition against permitting the prime contractor to recover anticipatory profits or consequential damages that were included in a subcontractor's settlement proposal.
If the subcontractor obtains a final judgment against the prime contractor, however, the judgment should be treated by the government's TCO as a cost of settling the terminated subcontract. In this case, the final judgment amount can include consequential damages and anticipatory profits provided that the prime contractor had made reasonable efforts to include a termination clause or similar language prohibiting the recovery of consequential damages or anticipatory profits in the subcontract.
Generally, the Government's TCO must approve or ratify any prime contractor settlements with subcontractors. The TCO, however, may, after written request from the prime contractor, give written authorization to the prime contractor to settle terminated subcontract proposals of $100,000 or less without approval or ratification. For contracts awarded prior to January 22, 1991, the threshold is $25,000.
While the government reserves the right to approve or ratify first-tier subcontractor termination settlement proposals, no such requirement exists for lower-tier subcontracts. Instead, each level of subcontractors and the prime contractor must submit certifications that there is no known information about lower-tier subcontract settlements that would serve to cast doubt on the reasonableness or allocability of the settlements to the terminated portion of the prime contract.
Clearly, the settlement of subcontracts can be extensive and expensive. Consequently, it is only appropriate that indirect costs may be allocated to the amount of settlements with subcontractors. Contractors should be careful, however, to avoid any double counting of costs arising from both subcontractor settlements and its own termination settlement costs.
Unabsorbed overhead is the misallocation of indirect costs to final cost objectives other than those for which the costs were incurred. This can occur when indirect costs are allocated using a cost base that is unexpectedly reduced because of a change. The change that is most often associated with unabsorbed overhead is a performance delay, but a termination may also yield similar results.
Unabsorbed overhead is not an allowable termination cost because, whether correctly or incorrectly, it is not considered to be a cost of terminating the work. Unabsorbed overhead would be an allowable cost of any unsettled change proposals, however. Particularly if the termination was preceded by a Stop Work Order--as is often the case.
While unabsorbed overhead is not an allowable termination cost, many of the costs that otherwise comprise unabsorbed overhead can be recovered through other means. The termination cost principle recognizes that terminations represent an unusual circumstance that can warrant special treatment. This language, in essence, opens the door for contractors to change their cost allocation procedures on-the-fly. Similar opportunity exists even on terminated contracts that are covered by Cost Accounting Standards. Thus, contractors may successfully recover the costs comprising unabsorbed overhead by designing methods for allocating as a direct cost of the terminated contract as much as possible of the otherwise indirect costs.
The contractor is entitled to a reasonable profit on its termination costs. Considering, however, that profit may not be given on the cost of terminated subcontracts or settlement expenses, the contractor may need to segregate various costs so that profit may be appropriately calculated.
Prime contractors should submit their termination settlement proposals within one year of the termination date. Extensions in time to submit the termination settlement proposal may be requested by the contractor and may be granted by the terminating contracting officer.
Within the one-year time period, the prime contractor should have also received subcontractor termination settlement proposals. Therefore, when including a termination clause in subcontracts and purchase orders, the prime contractor should have imposed a shorter period of time for receiving termination settlement proposals than it has for submitting its own proposal.
The government has the authority to audit the prime contractor's termination settlement proposal under several contract clauses. Principally, these clauses are the Audit-Negotiation or Audit-Sealed Bidding clauses. Although contractors are required to include these clauses in their subcontracts, the government may not have subcontract audit privileges if these clauses or similar language are omitted from the subcontract.
Termination of a contract is not a simple matter. Contractors should expect to expend considerable effort in settling a terminated contract. The effort associated with understanding the consequences to the organization and then maximizing the recovery of costs associated with those consequences will prove substantial. Satisfying the responsibilities relative to subcontract settlement will also be expensive and time consuming.
All of these costs are recoverable. Furthermore, interim proposals may be submitted and partial payments requested. Thus, government financing is available for as much as 90 percent of the allowable costs incurred prior to final settlement.
Although a Contracting Officer may use his discretion in determining the amount of partial payments, that discretion must be reasonably exercised and directed at protecting the government's financial interest. Because the government will almost always have some amount of financial liability to the contractor, a Contracting Officer that denies the requests for partial payments will most likely abuse his authority and entitle the contractor to recover interest on the unpaid partial payment.
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This advice is general in nature and is not to be construed as legal advice.