ASBCA Curbs Attempted Decrement of T&M Contract Based on Indirect Cost Rate Issues

The U.S. government’s audit and contract adjustment rights are not without limits; they are governed by contractual and regulatory authorities. Applying this legal principle, the Armed Services Board of Contract Appeals (ASBCA) recently agreed with a contractor that the government lacked the authority to reduce fixed-rate labor hour charges under a time-and-materials (T&M) contract based on indirect cost rate issues. This case, as well as a recent Civilian Board of Contract Appeals case discussed in our Sept. 18 advisory,¹ illustrate that contractors should understand the scope of audit and adjustment provisions in their contracts (and in the Federal Acquisition Regulation (FAR) generally – the Boards will read in applicable clauses as a matter of law regardless of whether they appear in the contract) and be prepared to challenge government actions that surpass their bounds.

The appeal of Allard Nazarian Group, Inc. dba Granite State Manufacturing (ASBCA Nos. 62413, 62414)² involved two contracting officer final decisions and demands for payment arising from the contractor’s alleged failure to submit final indirect cost rate proposals for fiscal years 2009 to 2014. The contracting officer applied either a 16% or a 20% decrement to all invoices the contractor submitted during that period, including the contractor’s direct, fixed-price labor costs under four T&M contracts. The contractor appealed the government’s claim for reimbursement to the ASBCA and, in a motion for partial summary judgment, argued that the contracting officer’s application of the decrement to direct labor hour charges under a T&M contract had no regulatory basis. The ASBCA agreed.

All four contracts included FAR 52.232-7, Payment under Time-and-Material and Labor-Hour Contracts, which requires payment of the hourly rate specified in the contract multiplied by the direct labor hours performed, and reimbursement for material costs that includes certain allocable indirect costs. Although only one of the four contracts included FAR 52.216-7, Allowable Cost and Payment, which governs the process for reimbursing costs and setting final indirect cost rates, the ASBCA held that all four contracts contained the clause under the Christian doctrine,³ because FAR 16.307(a) requires the clause be included in T&M contracts.

This ruling reminds contractors of the importance of understanding the regulatory structure of the FAR, which mandates the inclusion and operation of certain clauses for certain types of contracts and can have large implications for the balance of government and contractor rights under a particular contract. Even if a T&M contract omits FAR 52.232-7 or FAR 52.216-7, tribunals will read them in by operation of law under the mandates of FAR 16.307.

On the merits of the motion for partial summary judgment, the government contended its decrement to direct labor hour charges was permitted under FAR 52.216-7(g), which gives the government the authority to “have the Contractor’s invoices or vouchers and statements of cost audited” and to “adjust” any payment “for prior overpayments.” The ASBCA disagreed, finding the language of FAR 16.307(a) limited the application of FAR 52.216-7 only to material costs in T&M contracts:

The contracting officer shall insert the clause at 52.216–7, Allowable Cost and Payment, in solicitations and contracts when a cost-reimbursement contract or a time-and-materials contract… If the contract is a time-and-materials contract, the clause at 52.216–7 applies in conjunction with the clause at 52.232–7, but only to the portion of the contract that provides for reimbursement of materials (as defined in the clause at 52.232–7) at actual cost.

Consequently, FAR 52.216-7 only authorized adjustment of the material costs in the T&M contracts and not the contractor’s direct labor hour billings. The ASBCA explained: “the government applied a decrement to appellant's direct labor rate costs based upon appellant's alleged failure to submit auditable indirect cost rate proposals. FAR 52.216-7(g) does not provide a proper justification, or regulatory authority, for the government's actions taken here.”

The government’s power to audit and establish indirect rates also does not include any authority to adjust billings that have no connection to indirect rates or cost reimbursement contract elements. The ASBCA held that FAR 42.703-2(c), which authorizes the government unilaterally to establish final indirect cost rates when the contractor provides no indirect cost rate proposal, also “does not grant the contracting officer authority to apply the unilaterally-established final indirect cost rates as a decrement to a contractor’s direct labor costs,” which “are determined by contractually mandated and agreed upon hourly labor rates.” The Board concluded:

The government has not cited any other authority that specifically allows it to assess a decrement upon direct labor on a time and materials contract where the contractor has failed to submit an auditable final indirect cost rate proposal. The government's imposition of an indirect cost rate decrement upon appellant's fixed labor costs is unreasonable as not supported by the regulatory authorities cited by the government and contrary to the traditional demarcation between direct and indirect costs and the separate treatment of those costs.

The ASBCA made “no determination about the propriety of the government's decrement as applied to appellant's indirect costs, as that issue [wa]s not before the Board for consideration as part of appellant's motion for partial summary judgment.”

The ASBCA explained that the government does have the power to audit and, if appropriate, adjust direct labor hour billings on T&M contracts, but under FAR 52.232-7 and not under any authority or procedure the government invoked in this case. For this reason, the ASBCA found unpersuasive the government’s complaint that it was unable to “validate, through audit, the number of hours and categories of labor claimed and paid,” which it claimed on its own justified the decrement to the direct labor hour billings. The Board reasoned that FAR 52.232-7 grants the government the right to request at any time before final payment on a T&M contract an “audit of the invoices or vouchers and substantiating material,” and, if appropriate, to reduce previously paid amounts. The board found this provision “squarely protect[s] the government’s interest regarding previous payment of fixed hourly labor rate charges pursuant to time and material contracts.” If the government wished to audit the contractor’s direct labor costs, it had the power to do so under FAR 52.232-7(f) by requesting “vouchers and supporting documentation.” If that audit revealed direct labor overpayments, the government had the power to adjust prior payments for direct labor. What the government did not have the power to do is to adjust prior direct labor payments for supposed issues with indirect cost rate support where those indirect rates were never applied to the invoiced fixed rate direct labor.

This case, and the CBCA case discussed in our Sept. 18 advisory, prove that the extent of the government’s audit and adjustment powers come down to the language in the FAR, which differs based on contract type. For cost reimbursement contracts or even hybrid contracts with cost reimbursement elements, the government’s audit and adjustment powers are broad and can even extend to fixed price elements of the contract.⁴ By contrast, the FAR does not grant the government such broad powers for fixed-rate direct labor portions of T&M contracts. When a contractor allegedly fails to support its incurred indirect costs, the FAR only gives the government the ability to audit and adjust the “materials” portion of a T&M contract and not a firm fixed price labor hour portion (which under FAR 52.232-7(f) is only subject to adjustment based on an audit of the vouchers and other support for those precise direct labor hours).

These cases highlight the importance of carefully evaluating the government’s authority to take the broad audit and adjustment actions it so often claims to have (along with following our list of best practices in responding to government audit requests). While the government’s audit and adjustment powers are certainly expansive, they are not limitless.

© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.