B-126794, JANUARY 27, 1956, 35 COMP. GEN. 434

B-126794, JANUARY 27, 1956, 35 COMP. GEN. 434

COST CONTRACTS - OVERHEAD BASED ON FIXED PERCENTAGE OF COSTS - COST PLUS' PERCENTAGE-OF-COST PROHIBITION COST-TYPE CONTRACTS WHICH PROVIDE FOR OVERHEAD PAYMENTS BASED ON A FIXED PERCENTAGE RATE OF SOME ELEMENT OF DIRECT COST, BUT DO NOT PROVIDE FOR RETROACTIVE ADJUSTMENT TO ACTUAL COST, VIOLATE THE PROHIBITION IN SECTION 4 (B) OF THE ARMED SERVICES PROCUREMENT ACT OF 1947 AGAINST COST-PLUS-A- PERCENTAGE-OF-COST SYSTEM OF CONTRACTING.

TO THE SECRETARY OF DEFENSE, JANUARY 27, 1956:

WE HAVE GIVEN CONSIDERABLE STUDY TO THE MANNER IN WHICH THE MILITARY SERVICES HAVE BEEN CONTRACTING FOR THE PAYMENT OF INDIRECT COSTS UNDER COST-TYPE CONTRACTS WITH BOTH NONPROFIT AND COMMERCIAL ORGANIZATIONS. FOR INSTANCE, WE HAVE NOTED THAT THE MAJORITY OF RESEARCH CONTRACTS CONTAIN PROVISIONS FOR THE PAYMENT OF OVERHEAD BASED ON A STIPULATED PERCENTAGE OF DIRECT LABOR OR OTHER COSTS INCURRED UNDER THE CONTRACTS, IN LIEU OF REIMBURSEMENT OF THE ACTUAL COSTS OF OVERHEAD. IN OUR AUDIT SUMMARY REPORT ON SURVEY OF PROCUREMENT PRACTICES OF THE ARMY ORDNANCE CORPS, APRIL 1955, COPIES OF WHICH WERE TRANSMITTED TO YOU BY LETTER DATED APRIL 15, 1955, B-114814, AT PAGE 71, WE POINTED OUT THAT THIS METHOD OF PAYING OVERHEAD WAS UNDESIRABLE AND RECOMMENDED THAT THE USE OF FIXED OVERHEAD RATES BE DISCONTINUED UNLESS THEY WERE SUBJECT TO RETROACTIVE REVISION. ALSO IN OUR LETTER TO YOU, DATED MAY 20, 1955, B 114880, WE SUGGESTED THAT FIXED OVERHEAD RATES SHOULD NOT BE USED. SINCE THAT TIME, WE HAVE CONCLUDED THAT AN AGREEMENT TO PAY OVERHEAD IN THIS MANNER MAKES THE CONTRACT ONE FOR PAYMENT ON A COST-PLUS-A- PERCENTAGE-OF-COST BASIS AND, CONSEQUENTLY, WE FEEL THAT THE MATTER REQUIRES CORRECTIVE ACTION ON YOUR PART. EXAMPLES OF THIS TYPE OF CONTRACTING ARE LISTED BELOW.

ORDNANCE CONTRACT NO. DA-01-009-ORD-454, DATED SEPTEMBER 19, 1955, ENTERED INTO ON A COST BASIS WITH THE UNIVERSITY OF ALABAMA PROVIDES IN ARTICLE III (A) (3), FOR THE PAYMENT OF OVERHEAD AT THE FIXED PERCENTAGE RATE OF 36.1766 OF THE DIRECT SALARIES AND WAGES REIMBURSABLE UNDER THE CONTRACT.

AIR FORCE CONTRACT NO. AF33 (616/-2647, DATED AUGUST 20, 1954, ENTERED INTO ON A COST-PLUS-A-FIXED-FEE BASIS WITH THE MONROE CALCULATING MACHINE COMPANY PROVIDES IN PART V FOR THE PAYMENT OF OVERHEAD AT THE FIXED RATE OF 55 PERCENT OF THE DIRECT SALARIES AND WAGES PAID UNDER THE CONTRACT.

ORDNANCE CONTRACT NO. DA-04-495-ORD-721, DATED SEPTEMBER 12, 1955, ENTERED INTO WITH THE UNIVERSITY OF SOUTHERN CALIFORNIA ON A COST BASIS PROVIDES IN ARTICLE 4 (B) (10) FOR THE PAYMENT OF OVERHEAD IN AN AMOUNT EQUAL TO 38.51 PERCENT OF THE DIRECT COST OF SALARIES AND WAGES PAID UNDER THE CONTRACT. ARTICLE 4 (C) PROVIDES THAT THE OVERHEAD RATE SHALL BE REDETERMINED AS OF JANUARY 1 OF EACH YEAR FOR PROSPECTIVE APPLICATION.

AIR FORCE CONTRACT NO. AF33 (600/-28322, DATED SEPTEMBER 8, 1954, ENTERED INTO WITH THE HARVEY MACHINE CO., INC., ON A COST-PLUS-A-FIXED FEE BASIS PROVIDES IN PART VI FOR THE PAYMENT OF OVERHEAD AT THE RATE OF 115 PERCENT OF DIRECT SALARIES AND WAGES, INCLUDING OVERTIME PREMIUM ON DIRECT LABOR, EXPENDED IN THE PERFORMANCE OF THE CONTRACT. THIS RATE IS SUBJECT TO PERIODIC REVISION FOR PROSPECTIVE APPLICATION IN ACCORDANCE WITH CLAUSE 37 OF THE CONTRACT.

IT WILL BE OBSERVED THAT ALL OF THE CITED CONTRACTS WERE NEGOTIATED UNDER THE AUTHORITY OF THE ARMED SERVICES PROCUREMENT ACT OF 1947, 41 U.S.C. 153, 62 STAT. 21, AND THAT THEY HAVE THE COMMON CHARACTERISTIC OF PROVIDING FOR OVERHEAD PAYMENTS BY MEANS OF PREDETERMINED OVERHEAD RATES TO BE APPLIED TO SOME ELEMENT OF DIRECT COST WHICH IS UNDETERMINED AT THE TIME THE RATE IS SET, WITH NO PROVISION FOR RETROACTIVE ADJUSTMENT TO THE ACTUAL COST.

SECTION 4 (B) OF THE ARMED SERVICES PROCUREMENT ACT OF 1947, PROVIDES THAT THE COST-PLUS-A-PERCENTAGE-OF-COST SYSTEM OF CONTRACTING SHALL NOT BE USED. IN CONSTRUING A SIMILAR STATUTORY PROHIBITION THE SUPREME COURT OF THE UNITED STATES IN THE CASE OF MUSCHANY V. UNITED STATES, 324 U.S. 49, STATED:

THE PURPOSE OF CONGRESS WAS TO PROTECT THE GOVERNMENT AGAINST THE SORT OF EXPLOITATION SO EASILY ACCOMPLISHED UNDER COST-PLUS-A- PERCENTAGE-OF-COST CONTRACTS UNDER WHICH THE GOVERNMENT CONTRACTS AND IS BOUND TO PAY COSTS, UNDETERMINED AT THE TIME THE CONTRACT IS MADE AND TO BE INCURRED IN THE FUTURE, PLUS A COMMISSION BASED ON A PERCENTAGE OF THESE FUTURE COSTS.

THE EVILS ATTRIBUTED TO THIS SYSTEM OF CONTRACTING HAVE BEEN ELABORATED ON MANY TIMES. THEY CONSIST, ESSENTIALLY, IN ABETTING THE TEMPTATION AND POSSIBILITY THAT A CONTRACTOR MAY INCREASE HIS PROFIT BY CARELESSLY OR DELIBERATELY INCREASING HIS COST AT THE EXPENSE OF THE GOVERNMENT UNDER A REIMBURSABLE CONTRACT.

THE FIXED PERCENTAGE RATES SPECIFIED IN THE SUBJECT CONTRACTS WERE INTENDED TO REPRESENT PAYMENT FOR REIMBURSABLE INDIRECT COSTS AND WERE NOT INTENDED TO ENHANCE THE NET RETURN TO THE CONTRACTOR. NEVERTHELESS, INASMUCH AS THE AMOUNT PAID AS REIMBURSEMENT FOR OVERHEAD WILL DIMINISH OR INCREASE IN PROPORTION TO THE DIRECT COSTS INCURRED RATHER THAN THE OVERHEAD INCURRED BY THE CONTRACTOR, WE ARE OF THE OPINION THAT THE CONTRACTS VIOLATE THE EXPRESS PROHIBITION AGAINST THE COST-PLUS-A- PERCENTAGE-OF-COST SYSTEM OF CONTRACTING AND, THEREFORE, ARE ILLEGAL. FURTHERMORE, THE USE OF FIXED RATES FOR OVERHEAD MAY BE UNFAIR TO EITHER THE GOVERNMENT OR THE CONTRACTORS. SUCH FIXED RATES ARE INCONSISTENT WITH THE BASIC PRINCIPLES OF A COST-TYPE CONTRACT IN THAT THEY WILL NOT NORMALLY RESULT IN REIMBURSEMENT OF THE ACTUAL COST. ACCORDINGLY, THE PRACTICE OF PAYING OVERHEAD ON THE BASIS OF FIXED PERCENTAGE RATES, AS DISCUSSED ABOVE, SHOULD BE DISCONTINUED.

ON THE OTHER HAND, WE SEE NO OBJECTION TO THE USE OF PROVISIONAL PERCENTAGE RATES SUBJECT TO RETROACTIVE ADJUSTMENT OF THE CHARGES TO ACTUAL COSTS. THUS, SOME OF THE FEATURES WHICH HAVE BEEN URGED AS MAKING THE USE OF FIXED RATES DESIRABLE WOULD BE RETAINED. THIS WOULD NOT NECESSARILY REQUIRE THAT AN AUDIT OR THE CONTRACTOR'S OVERHEAD CHARGES BE MADE IN EVERY INSTANCE. THE DECISION TO AUDIT OR NOT TO AUDIT, AND THE EXTENT OF AN AUDIT, WOULD INVOLVE THE EXERCISE OF JUDGMENT BASED UPON A NUMBER OF CONSIDERATIONS SUCH AS THE SIGNIFICANCE OF THE AMOUNT INVOLVED, THE DOLLAR VOLUME OF GOVERNMENT CONTRACTS HELD BY THE CONTRACTOR, PREVIOUS EXPERIENCE, AND THE PATENT REASONABLENESS OF OVERHEAD DATA FURNISHED BY THE CONTRACTOR.

PROVISIONS FOR THE PAYMENT OF OVERHEAD IN FUTURE COST-TYPE CONTRACTS, OR IN MODIFICATIONS OF THE RATES STIPULATED IN SUCH EXISTING CONTRACTS, MUST BE CONSISTENT WITH THE DECISION HEREIN.