Among the numerous government

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3 Cost limitations in government contracts Among the numerous government contract general provisions, the Limitation of Cost (LOC) clause has been the subject of significant disputes litigation over the years. These disputes center on whether a contractor is entitled to payment of overrun costs in excess of a contract s cost limitation absent required notice to the government prior to their incurrence. These cases generally arise when a contractor, having failed to provide timely notice under the LOC clause, asserts a request for overrun costs in excess of the limitation and the contracting officer refuses to allow such costs. Despite the significant volume of litigation in this area, the procurement regulations have never provided the guidance needed by both government and industry to administer the LOC clause effectively. As a result, both parties must rely on judicial rulings of the courts and boards for direction. Therefore, the purpose of this article is to provide an understanding of the LOC clause, the relative rights of the parties, and to offer some advice concerning this complex area of contract administration. The Limitation of Cost Clause Federal Acquisition Regulation (FAR) states that cost-reimbursement contracts provide for payment of allowable incurred costs to the extent prescribed in the contract. These contracts establish an estimate of total cost for the purposes of obligating funds and establishing a ceiling that the contractor may not exceed, except at its own risk, without the approval of the contracting officer. Fully-funded costreimbursement contracts are subject to the LOC clause, which provides that the government is not obligated to reimburse the contractor for costs incurred in excess of the contract s total estimated cost, and that the contractor is not obligated to continue performance unless the parties agree to a revised estimate and the government funds the increased costs. The basic provisions of FAR , Limitation of Cost, seem reasonably clear. The contractor is required to provide the contracting officer with written notice whenever the contractor has reason to believe that costs to be incurred in the next 60 days, when added to all costs previously incurred, will exceed 75 percent of the contract estimated cost. Written notice is also required whenever the contractor has reason to believe that the total cost for performance of the contract, exclusive of any fee, will either be greater than or substantially less 34 Contract Management May 2010

4 Cost limitations in government contracts than the contract estimated cost. The notification must include the contractor s revised estimate of the total cost of performance. Unless specifically overcome by other contract provisions, the government is not obligated to reimburse the contractor for any costs in excess of the estimated total, and the contractor is not obligated to continue performance under the contract without written notification from the contracting officer of the increased estimate. Similarly, the Limitation of Funds (LOF) clause is used in incrementally-funded cost-reimbursement contracts. 1 Under this clause, the government is not required to reimburse the contractor for costs incurred in excess of the amount allotted to the contract, and the contractor is not obligated to continue performance until the contracting officer notifies the contractor in writing that the amount allotted to the contract has been increased. In addition, the Timeand-Materials Payments clause 2 contains similar requirements. These clauses will be used interchangeably with the LOC clause in the following discussion. The basic purpose for the LOC clause is to provide the government an option for the action to be taken when notified by the contractor that additional funds will be required to complete the work. In exercising this option, the government takes several matters into consideration. An important consideration is whether additional funds are available to obligate to the project. If no additional funds are available, the contracting officer has no option but to direct the contractor to stop work and turn over what it has accomplished to date. Advance notice by the contractor serves to protect the government from the over-expenditure of appropriated funds, and the LOC clause also protects the contractor by allowing the contractor to cease performance once the estimated cost has been expended. The basic purpose for the LOC clause is to provide the government an option for the action to be taken when notified by the contractor that additional funds will be required to complete the work. Although the government is not obligated to reimburse a contractor s overrun costs absent timely notice under the LOC clause, it is ultimately within the discretion of the contracting officer to retroactively fund an overrun despite the contractor s failure to provide notice. For example, in General Electric Company v. United States, 3 the court stated: The language of the Limitation of Cost clause and a long line of board decisions indicate that the government is not obligated to reimburse a contractor for overrun costs of which it has no timely notice. Yet, although the government is not compelled to fund an overrun in the absence of proper notice, it is within the discretionary authority of the contracting officer to allow the additional costs. If the government increases the cost estimate retroactively, overruns incurred before the increase are reimbursable on the same basis as those incurred after the increase, up to the new limit. However, retroactive funding of overruns does not waive notice requirements or obligate the government to fund later overruns. Therefore, even if the government repeatedly increases a contract s estimated costs retroactively, it is unreasonable for the contractor to assume that the government will continue to do so in the future. Failure to Notify In general, the government is not obligated to reimburse overrun costs in excess of the contract estimated cost if a contractor fails to give timely notice of reasonably foreseeable overruns during contract performance. This is because a contractor s failure to give the required notice deprives the government of its option to provide additional funds or stop the work. Therefore, a contractor s claim for reimbursement of an overrun will be denied absent discretionary action by the contracting officer. Per the LOC clause, a contractor exceeds the contract estimated cost at its own risk. This general rule was enunciated in the early case of Acme Precision Products, 4 where it was found that in the absence of prior authorization, a contractor is not entitled to be reimbursed for costs in excess of the limitation specified in the LOC clause. The board stated: This clause is designed to give the government unilaterally an effective tool to prevent the over expenditure of appropriated funds. The clause is designed to give government officials charged with such responsibilities an opportunity to determine before the exhaustion of funds whether there are additional funds which can and should be made available for the continuation of the project and, where the answer is in the affirmative, to make such additional funds available in ample time to prevent the cessation of work under the contract. A contractor cannot create an obligation against public funds by neglecting to inform the contracting officer that the allotment of funds has been exhausted in violation of the terms of the contract and continuing to incur costs in excess of the contract ceiling. The alleged shortcomings of appellant s own personnel and accounting system are no excuse for appellant s failure to comply with the obligations which it assumed when it entered into the contract. Following a long line of similar cases, in Arbiter Systems, Inc., 5 the government was not obligated to reimburse a contractor for indirect costs incurred in excess of funding limitations because the contractor did not notify the government of potential cost overruns sufficiently in advance to enable the government to decide whether to Contract Management May

5 Cost limitations in government contracts example, in Bionetics Corp., 13 a change in the accounting system was found to be the contractor s responsibility. 14 increase the funds or permit the contractor to stop work. This rule also applies to time-and-materials (T&M) contracts. For example, in Software Research Associates, 6 a contractor was not entitled to compensation beyond the ceiling price limitation of a T&M contract because it did not give formal notice of a possible cost overrun as required by the contract s Payments clause. Another example would be Corbett Technology Co., 7 where the government was not obligated to reimburse a contractor for work in excess of the cost ceiling on a T&M contract because the contractor exceeded the contract price without the contracting officer s knowledge, authorization, or approval. Thus, the cost limitations in government contracts will be rigidly enforced. For example: To be sufficient, the required LOC notice must be in writing and addressed to the contracting officer. For example, in Manpower Program Analysis Consultation and Training, Inc., 8 notice to administrative personnel was deemed not equal to the required notice to the contracting officer. 9 The contractor must also notify the government of anticipated overruns and provide a revised estimate of the total cost of performance. Thus, in Advanced Materials, Inc. v. William J. Perry, Secretary of Defense, 10 a contractor s three written notices stating only that it had reached 75 percent of the contract s estimated cost were inadequate because they failed to state that the estimated cost would be exceeded. No revised estimate of the total cost of completion was given. 11 Giving timely notice of an impending overrun does not by itself authorize the contractor to exceed the estimated cost because the contracting officer is not obligated to respond to the notice. For example, in Connell-Beach Associates International, Inc., 12 reimbursement of a contractor s overrun was denied because, while notice provided the contracting officer the opportunity to have the work continued without interruption by increasing the funding, it did not obligate the contracting officer to do so. It is the contractor s responsibility to maintain an adequate accounting and financial reporting system to alert it to the possibility of an overrun before the overrun is incurred. An inadequate accounting system is no excuse for lack of notice under the LOC clause. For Failure to foresee subcontractor overruns due to program management inadequacies is no excuse from notice requirements. In Varigas Research, Inc., 15 for example, a contractor s failure to foresee a subcontractor s cost overrun did not excuse the contractor from giving the government notice of its own resulting overrun. The contractor s failure to foresee the subcontractor overrun was due to its own management shortcomings. The requirement for determination of final indirect rates per audit does not excuse failure to provide earlier notice during contract performance. For example, in General Time Corporation, 16 it was found that the notice requirement of the LOC clause operates independently of the determination of final overhead rates, which necessarily occurs after completion of the contract. Notice must be given during contract performance to enable the government to exercise its option to either stop work or incur additional costs. A contractor s hope or expectation of new business is not an excuse for lack of notice under the LOC clause. For example, in Inter-National Research Institute, 17 a contractor s hope of securing more business did not excuse notice of an imminent overrun. 18 A change order modification is subject to the cost limits of the LOC clause unless the modification contains a statement increasing the estimated cost. In Titan Corporation, 19 a contractor was not entitled to reimbursement for the excess costs because costs incurred for performing changed work were not an exception from the LOC clause. The LOC clause stated that its provisions were binding unless specifically overcome by other contract provisions Contract Management May 2010

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7 Cost limitations in government contracts Exemptions to Notice Requirements A survey of approximately 50 years of dispute cases indicates that contractors have amassed an extremely low batting average of winning appeals when they fail to give proper advance notice of overruns under the LOC clause. However, there are special circumstances that, if successfully proven before the boards and courts, may relieve the contractor of providing timely notice under the LOC clause, and overrun costs will be appropriately granted. These special circumstances, although relatively rare, are outlined below. As an exception to the general rule, a contractor s failure to comply with the notice provisions of the LOC clause will be excused if the contractor, through no fault of its own, could not reasonably foresee that an overrun would occur. This principle was explained in Arbiter Systems, Inc., 21 where the board stated: It is well established that the contracting officer has the discretionary authority to fund and pay costs a contractor incurs above a contract s cost ceiling. General Electric Co. v. United States [13 CCF 82,881], 188 Ct. Cl. 620, 412 F.2d 1216 (1969). It is an abuse of that discretion not to fund an overrun when it was impossible for the contractor to determine that an overrun would occur and the sole reason for the refusal is the lack of contractor notice of the potential overrun. General Electric Co. v. United States [16 CCF 80,284], 194 Ct. Cl. 678, 440 F.2d 420 (1971). However, the contractor bears the burden of proof that a cost overrun was unforeseeable and that it was impossible to obtain advance approval and funding from the contracting officer before exceeding the contract s cost limitation. 22 The most frequent instances of unforeseeable overruns arise when unexpected cost increases are incurred after the completion of contract performance, thus rendering timely notice impossible. For example, in General Electric Co. v. United States, 23 a contractor was entitled to recover a cost overrun despite its failure to give notice Contractors have amassed an extremely low batting average of winning appeals when they fail to give proper advance notice of overruns under the LOC clause. that an overrun might occur. The contractor had no reason to believe that an overrun was imminent because the increase in indirect costs that caused the overrun occurred well after contract performance was completed. Therefore, under the terms of the LOC clause the contractor was relieved of the notice requirement and it was found that the contracting officer had abused his discretion by refusing to fund the overrun. In its opinion, the court stated: [T]he contracting officer abused his discretion under the [LOC clause] in refusing to fund the overrun. The board found that General Electric could not have known of the overrun in time to notify the contracting officer and receive the latter s approval for an increase in funding. Moreover, there is no claim that General Electric was in any way to blame for its lack of timely knowledge of the overrun or that its accounting procedures were inadequate. Under these circumstances we hold that the contracting officer did not have discretion to refuse additional funding. Similarly, in Johnson Controls World Services, Inc. v. United States, 24 insurance cost overruns were not subject to the limitation of the contract s LOC clause because the overruns were not reasonably foreseeable during the time of performance. The contract required the contractor to obtain certain insurance through the National Defense Projects Rating Program. That program used a formula to approximate insurance costs on an annual basis, but provided that a final settlement of insurance costs would occur after the contract s termination. At the final settlement, a significant overrun was realized. The contractor successfully argued that it could not have reasonably foreseen the losses attributable to new workers compensation and liability claims. The government, by its actions or inactions, may waive its rights under the LOC clause, or it may be estopped from asserting its right to refuse funding of cost overruns not approved by the contracting officer in advance. Accordingly, four elements must be present in order for the government to be estopped from asserting its LOC clause rights: The government must know of the overrun; The government must intend that the alleged conduct will be acted on, or the contractor must have a right to believe that the conduct in question was intended to induce continued performance; The contractor must not be aware that no implied funding of the overrun was intended; and The contractor must rely on the government s conduct to its detriment. However, the burden of proving these elements falls on the contractor. Thus, in American Electronic Laboratories, Inc. v. United States, 25 a board decision denying a contractor s claim for reimbursement of cost overruns was reversed because the record established that by its conduct the government was estopped from enforcing the LOF clause. The board erred in holding that the facts failed to establish the elements necessary for an equitable estoppel against the government s invocation of the LOF clause. The contracting officer knew of the overrun, the government expected the contractor s continued performance, the contractor was reassured repeatedly that additional funds were available, and 38 Contract Management May 2010

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9 cost limitations in government contracts Apart from a conscious management decision to absorb overrun costs, the importance of monitoring costs incurred and complying with the notification requirements of the LOC clause is obvious: failure to comply can result in the non-recovery of cost. To ensure compliance and avoid the risk of financial loss, a contractor needs a cost accounting system that monitors actual costs incurred and tracks obligated commitments to suppliers and subcontractors. The burden is on the contractor not only to track its actual costs incurred on a regular and periodic basis, but to reasonably project the total cost of performance on an ongoing basis. As we have seen, some LOC clause disputes involve an increase in indirect costs as the cause of an overrun, and whether that overrun was reasonably foreseeable during contract performance. Therefore, the accounting system must be able to keep management abreast of actual and projected indirect rate fluctuations at all times during contract performance. The burden is on the contractor to track the variance between provisional indirect billing rates and actual indirect rates, and to notify the government if an overrun is expected. A contractor cannot wait until indirect rates are settled via final audit to claim an overrun. the contractor relied on the government s conduct to its detriment by continuing performance with its own funds. Finally, a contractor may be relieved of notice requirements if the LOC clause is overcome by other contract provisions. For example, in Scherr and McDermott, Inc. v. United States, 26 a clause which provided that the contractor s overhead was subject to revision at the end of the fiscal year and was to be paid on the basis of such annual or other audits as the government may make imposed a contractual obligation upon the government to conduct at least one audit per year. Hence, when the government did not conduct an audit until more than one year after performance, it violated its duty. The excess costs resulting from the government s failure to make the required annual audit were reimbursable. How to Administer the Clause Fortunately, contractors have their overruns funded retroactively in many cases because the government needs the work. However, there is no guarantee that the government will continue to do so in the future. In addition, the exceptions to the LOC clause notice requirements previously discussed are rare and the contractor bears a high burden of proof in order to obtain relief when the government refuses to fund the overrun. In any event, a management decision is required as to whether the contractor should continue to incur costs to complete the project or exercise its contractual rights to cease performance when the estimated cost has been expended. In addition to an adequate accounting system, contractors must establish a procedure whereby a letter of notification is submitted to the contracting officer immediately upon incurrence of the applicable percentage of the estimated cost being expended, and whether there are any potential overrun events. The letter must state that formal notice is being given under the LOC clause, whether additional funds will be required to complete the work, and that work will be stopped by a specific date unless further authorization is received from the contracting officer to exceed the total estimated cost. With this in mind, let us use an example to illustrate an ideal LOC clause notice situation. Assume a contractor received a cost-plus-fixedfee completion contract to perform a scientific study with a final report as the end-item deliverable. The contract estimated cost is $12 million and the period of performance is 12 months commencing on January 1, A large subcontract to a testing laboratory is included in the contract estimated cost. As the project begins, the contractor starts to monitor its actual incurred costs and subcontractor funding obligations from the accounting system, as well as performing provisional versus actual indirect rate variance analyses on a monthly basis. The contractor s financial procedures also require that a monthly estimate at completion (EAC) analysis be prepared. 40 Contract Management May 2010

10 cost limitations in government contracts Five months into the project, and after analyzing contract costs from inception to date, it becomes apparent that direct labor costs are higher than originally estimated and the subcontractor reports that it cannot complete its task within the original budget. Overall, the monthly expenditure rate is higher than budgeted. It is also noted that there is a significant year-to-date variance between the overhead provisional billing rate compared to the actual incurred overhead rate, indicating further cost growth. Using these facts, the contractor s financial analyst works with the project manager to prepare a revised EAC that projects the total cost of performance to be $14.4 million versus the original estimate of $12 million. At the current rate of expenditure, it is projected that the estimated cost of $12 million will be fully expended by October 31, 2011, but the work will only be 83 percent complete. Based on this analysis, it appears that the contractor will require an additional $2.4 million to complete the job within the original 12-month schedule. The finance department immediately communicates this information to the responsible contracts manager so that he or she can notify the contracting officer of the projected overrun. Based on the foregoing facts, the LOC clause notification should look something like this: June 15, 2011 Dear [Contracting Officer]: In accordance with FAR , Limitation of Cost, of the subject contract: 1) the costs XYZ Company expects to incur under this contract in the next 60 days, when added to all costs previously incurred (through August 15, 2011), will exceed 75 percent ($9,000,000) of the estimated cost ($12,000,000) specified in the Schedule; and 2) the total cost of this contract will be greater than had been previously estimated. Accordingly, the revised estimated cost of performance is $14,400,000 to complete the Final Report specified under the contract. As a result, we request that the contract estimated cost be increased by $2,400,000 in order to complete this project within the original 12-month schedule. At the current expenditure rate, it is projected that the estimated cost will be fully expended by October 31, 2011, and XYZ Company will stop work on the contract by that date unless and until the contracting officer increases the estimated cost accordingly. Sincerely, XYZ Company Guidance on how contracting officers should respond to such notices, and any additional information to be requested from the contractor, varies by agency. 27 In conclusion, the LOC clause notice must be formally addressed to the contracting officer in writing with a revised estimate of the total cost of performance. In the absence of the contracting officer s approval of additional funds, the contractor s remedy is to stop work under the LOC Contract Management May

11 cost limitations in government contracts clause. Therefore, to avoid unnecessary financial losses, contractors must strictly comply with the requirements of the clause. Contractor policy and procedures should strive to integrate program, financial, and contract management systems and organizations to reduce the risk of unreimbursed overruns in the performance of their government cost-type contracts. CM About the Author CHRISTOPHER WOLF is a senior contracts manager in the Federal Consulting practice of Deloitte, LLP, a premier U.S. audit, tax, consulting, and advisory services firm. He has over 30 years of contract management experience in the professional services industry, including work with commercial clients and federal, state, and local government clients. Mr. Wolf is a member of the Tysons Corner Chapter of NCMA. Send comments about this article to cm@ncmahq.org. To discuss this article with your peers online, go to and click on Join Discussion. Endnotes 1. FAR FAR Ct. Cl. 620, 412 F. 2d 1215 (1969). 4. ASBCA No. 6824, 61-1 BCA ASBCA Nos , 47404; 97-2 BCA 29, ASBCA No , 88-3 BCA 21, ASBCA No , 00-1 BCA 30, LBCA No. 80-BCA-113, 81-2 BCA See also Optimal Data Corporation v. United States, 35 CCF 75,708, 17 Cl. Ct. 72 (1989); aff g (ICBA 1985) 85-3 BCA 18, CCF 77,060 (1997). 11. See also Falcon Research and Development Co., ASBCA No , 87-1 BCA 19, ASBCA No , 97-1 BCA 28, NASA BCA No , 85-1 BCA 17, See also Samuel Ewer Eastman Associates, Economic Sciences Corp, Inc., DOT CAB No. 75-9, 76-2 BCA 12, ASBCA No , 84-1 BCA 17, ASBCA No , 75-2 BCA 11, ASBCA No , 80-1 BCA 14, See also Planar Corp., ASBCA No , 68-2 BCA 12, ASBCA No , 97-1 BCA 28, See also Breed Corporation v. United States, 27 CCF 80,333, 223 Ct. Cl. 702 (1981), aff g in part ASBCA Nos , 15163; 72-1 BCA ASBCA Nos , 47404; 97-2 BCA 29, See RMI, Inc. v. United States, 33 CCF 74,556 (1986); and Stanwick Corp., ASBCA No , 71-2 BCA 9115; reaff g 71-2 BCA CCF 80,284, 194 Ct. Cl. 678 (1971) CCF 77,722, 48 Fed. Cl. 479 (2001) CCF 73,973 (1985) CCF 80,439 (1966). 27. For example, see Health and Human Services Acquisition Regulation (HHSAR) Subpart , Administrative Actions for Cost Overruns. Beat The Increase! Extend your membership by a year or more at the current 2009 dues rate from now until June 30, 2010! Effective July 1, 2010, individual membership dues will increase from $110 to $125 annually. You have the opportunity to renew your membership at the current 2009 dues rate from now until June 30, Take advantage of this opportunity to beat the increase and save on your next renewal today! Or, enjoy the luxury of never paying dues again by purchasing a Pro Vita membership (membership for life) for $1,000. Membership dues contribute directly to the value of services that NCMA provides. Membership benefits that have been added over the past year include members-only Web site content, advocacy resources, Webinars on Demand, and Communities of Practice Virtual Conferences. Full details of the upcoming changes to membership rates are available at or you may contact us at Contract Management May 2010

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