Analysis: What is an REA and How Do I Price It?
By: Craig Stetson, Partner, Capital Edge Consulting
Background – What is an REA?
A request for equitable adjustment, commonly referred to as an REA, is a contractor’s request to the government for a unilateral adjustment to the contract price or schedule, or both, due to a change arising during contract performance that was not included in the initial contract scope of work nor contemplated at the time of price negotiation. The contractual authority used to execute an REA resides in Federal Acquisition Regulation (FAR) clauses 52.243-1 Changes-Fixed-Price, 52.243-2 Changes-Cost-Reimbursement or 52.243-3 Changes-Time-and-Materials or Labor-Hours. Other relevant FAR clauses exist and may be used in conjunction with the applicable Changes clause, depending on the nature of the circumstance(s) giving rise to the REA – examples include FAR 52.242-14 Suspension of Work and 52.242-15 Stop-Work Order.
Unanticipated, unknown or unknowable changes to or circumstances affecting the contract scope of work arising during contract performance and adversely affecting a contractor’s ability to carry on contract performance obligations, within negotiated pricing, performance and delivery assumptions and expectations, may entitle contractors to submit an REA as means of contractual relief for increased costs incurred or expected to be incurred, delays or accelerations to schedule obligations, or both. Common reasons or causes leading to an REA include:
- Contracting Officer’s formal request to perform additional or reduced tasks outside the scope of the contract
- Contracting Officer’s direction to stop or suspend work
- Defective specifications, drawings or work instructions relied upon and used as the basis of the scope of work
- Differing site conditions from those anticipated at contract award
- Delays or accelerations in work due to government actions or inactions
- Partial termination for convenience of a contract
An REA does not require the use of standard forms nor does a required format exist. Rather, REAs are typically prepared in a letter format including detailed narrative explaining the nature and reasons for the changes, events or circumstances giving rise to the contractor’s request. Detailed calculations with relevant assumptions, supporting bases of estimates and applicable accounting schedules are also included to clearly demonstrate the methods used to develop the corresponding cost impacts.
Government contract regulations do not identify or require the use of specific costing methods (discussed further below) for purposes of calculating the quantum elements of an REA. REAs do arise for various reasons and in different circumstances, therefore, a single (required) costing method to apply when calculating cost impacts generally is unrealistic and impractical. Contractors need the flexibility to select the proper costing method that best fits the circumstance(s) that will, in turn, produce the most accurate cost representations. General compliance requirements, however, do exist regardless of which specific costing method is utilized, including – use of fundamental estimating techniques and cost accounting practices that produce logical, fair and equitable results; exclusion of applicable unallowable costs and / or recognition of unique contractual provisions; and existence of sufficient evidential matter to support relevant assumptions and calculations.
Changes to a contract, i.e., contractual requirements, scope of work, or otherwise, come in two forms – directed or constructive. Both forms of a change are common and may be used, depending on specific circumstances, to form the basis or entitlement (discussed later) of an REA. A formal FAR definition does not exist for either type of change, however, a general working definition of each is as follows:
Directed Change – a unilateral, formal and written direction from the customer (i.e., government contracting officer) changing specific aspects of the general scope or requirements of a contract. The authority for the government contracting officer to unilaterally change the terms and conditions of a contract is the FAR Changes clause referenced above, resulting in a written change order to the contract via Standard Form 30.
Constructive Change – an informal change to the contract scope or requirements for which a contractor performed work that the government did not formally direct, however accepted, for purposes of successfully achieving the final scope of work objective. An example includes a contractor’s performance of work in accordance with government-provided drawings or specifications that were subsequently determined to be defective. The contract called for a defined end item or service that could not be accomplished without the contractor’s performance, and government’s acceptance, of the additional work required due to the defective contractual specifications. Constructive changes may also arise for reasons outside the government’s direction resulting in contractors performing additional out-of-scope work to achieve the final work objective, e.g., differing site conditions on a construction project.
Additionally, FAR clause 52.243-7 Notification of Changes may be incorporated in contracts, which requires the contractor to notify the government when the contractor believes the government’s conduct represents a change to the scope or terms and conditions of the contract.
Entitlement and Quantum
Effective and successful REAs require a thorough presentation, explanation and documentation of two critical elements – entitlement and quantum. These fundamental components clearly articulated and documented will form a legitimate foundation leading to the government’s consideration of the merits, amounts sought for recovery and succeeding negotiation. Alternatively, the government may dismiss early-on an REA simply due to lack of supporting documentation pertaining to either, or both, the entitlement and quantum aspects. A brief discussion of each is as follows:
Entitlement – explanation of the change, event or circumstance giving rise to the REA and the related contractual authority or remedy for which relief (usually money or time) is being sought. A well constructed entitlement argument is a critical first step as it will establish the merits and lay the foundation for creation and successful settlement of the REA. Entitlement arguments should i) be written clearly and concisely in an active voice, ii) establish a clear nexus between the relevant change, event or circumstance and the corresponding harm caused, iii) be supported with pertinent explanations, iv) reference relevant dates or key events, and v) cite the authoritative basis (e.g., contract clause) permitting the request for relief.
Quantum – calculation of the cost impacts, damages or amounts (money or time) being sought due to the related change or changes. After establishment of a solid entitlement argument, the second step is to calculate the corresponding monetary effect (generally an increase in cost). Quantum calculations should be i) logical with a clear ‘audit trail’ of the inputs and source data, ii) consistent with established or permitted cost accounting practices, and iii) compliant with applicable regulatory or contractual requirements.
Notwithstanding the lack of a regulatory compliance requirement regarding the use of any particular REA costing method, there are, however, ‘preferred’ costing methods that are consistently used by contractors and accepted by the government or Boards and Courts. Four common and ‘preferred’ costing methods are noted and discussed further below:
- Discrete Item Basis
- Modified Total Cost Basis
- Measured Mile Analysis
- Eichleay Method
It is important to note that within the costing methods noted above, excluding Eichleay, specific assumptions or cost estimating techniques may be required and appropriate considering the specific circumstances pertinent to the REA and overall existence and completeness of corresponding accounting and other records. Use of any of the estimating techniques noted below should be adequately documented with a complete basis of estimate.
Typical estimating techniques that may be required and used include the following:
- Parametric – use of historical data to estimate a particular unit of measure, e.g., cost per foot or pound, hours per a defined task, etc.
- Analogous – use of historical data and expert judgment to form an analogy to the current situation.
- Cost Estimating Relationship (CER) – use of historical data to form patterns or relationships between two variables (independent and dependent), e.g., material scrap is 2% of total material purchases, sustaining engineering hours are 20% of total engineering hours, etc.
- Expert Judgment – subject matter experts analyze the situation and form an estimate based on their collective experience and professional judgment.
Discrete Item Basis – The widely preferred method of costing an REA is the discrete item (bottom up) approach. Discrete item means the specific event, direction, action / inaction, etc., that directly gives rise to the REA. Examples include – identification of defective contract specifications, notification to stop work, differing site conditions, delays or acceleration in schedule, excessive customer inspection and acceptance procedures, and many others.
Under the discrete item basis method, the cost impact of each item is calculated separately and includes the incremental or marginal costs incurred or to be incurred that would not have been incurred but for the occurrence of the discrete item. All relevant cost elements are included in the cost impact calculation, including, e.g., direct labor and material, indirect expenses, ODCs and reasonable profit. Contractors are encouraged, and perhaps required under specific contractual provisions, to maintain an accounting system capable of capturing costs, on a discrete basis, attributable to change orders (see for example, FAR 52.243-6 Change Order Accounting).
Modified Total Cost Basis – When calculation of discrete or specific cost impacts is not practical, a modified total cost approach may be appropriate and is generally used and applicable to contracts experiencing multiple and intertwined changes occurring on a concurrent basis and with fault or responsibility shared between the parties. The shear amount, complexity and interrelationships of the changes make the development of the entitlement and quantum elements of the REA highly impracticable as well as calculation of cost impacts with a reasonable degree of accuracy. The modified total cost approach is common in the manufacturing and construction industries.
The calculation of cost impacts under this approach generally is performed at contract completion or at milestones achieved with discrete funding and is simply derived as total costs incurred, less the contract price, less an estimate of the costs incurred attributable to events for which the contractor is responsible.
Measured Mile Analysis – Another appropriate and accepted costing method, commonly used in construction contracts, is a measured mile analysis. This costing approach compares actual labor effort expended and corresponding productivity realized during periods of performance when delays, disruptions, etc., were not present (baseline period) to differing periods of performance when delays, disruptions, etc., were present. The differences in the actual labor effort expended (increased) and productivity realized (decreased) is then ascribed to the delays, disruptions, etc., occurring during the period, all other things equal.
The calculation of cost impacts under this approach is the difference in actual costs based on the comparison the baseline performance period to the disrupted performance period. Contractors are encouraged to maintain detailed and accurate daily reports to document on a contemporaneous basis the work activities performed and challenges encountered.
Eichleay Method – The predominantly accepted method used to calculate cost impacts associated with under absorbed indirect expenses caused during periods of contract delay is the Eichleay method (named after Eichleay Corporation, ASBCA No. 5183). This costing method is a prescribed formula that utilizes revenue and indirect expense amounts to calculate the daily indirect expenses that should be allocated or distributed to specific contracts. The calculated daily overhead amount is then multiplied by the number of delay days incurred under the contract to determine the total cost impact.
Use of this method requires contractors to demonstrate i) the government caused the delay, ii) the government required the contractor to remain able to resume work on short notice (standby status), and iii) the contractor could not take additional or new work during its standby status.
REAs submitted with an absolute value equal to or exceeding $2,000,000 require certification of cost or pricing data pursuant to Truthful Cost or Pricing Data Act requirements, unless otherwise exempt. The absolute value is required to be used for certification purposes and means the values of deleted and added work are combined as positive amounts, rather than the deleted work as an offset to the added work.
Additionally, REAs submitted under Department of Defense contracts exceeding the simplified acquisition threshold, currently and generally $250,000, require certification regarding the request is made in good faith and supporting data are accurate and complete.
Changes – for various reasons and in several forms – occur and are very common in government contracts. An REA provides a contractual mechanism for contractors to seek adjustments to contract price, schedule or both due to changes arising during contract performance. The REA preparation and submission process may be complex or simplified depending on the nature and number of changes relevant to the situation. Clear communication and documentation are key to supporting an REA and achieving a successful resolution and settlement.
Various costing methods exist and are commonly used and accepted as the basis for calculating the quantum element of an REA. Contractors may elect a costing method discussed above or other method that best fits the specific circumstances and causes pertinent to the REA. Whichever costing method is selected, the general and overarching expectations and requirements regarding a clear explanation of the facts, assumptions and bases of estimate or calculations relevant to the REA remain. That is, if the numbers (quantum) are not clearly documented and a solid nexus demonstrated between the cause and corresponding cost impact, the probability of a successful settlement may be diminished.