How the Pentagon plans to manage inflation costs in contracts

Adm. Michael M. Gilday, chief of naval operations (left), testifies alongside Navy Secretary Carlos Del Torro and Marine Corps Commandant Gen. David H. Berger at a House hearing on May 18, 2022.

Adm. Michael M. Gilday, chief of naval operations (left), testifies alongside Navy Secretary Carlos Del Torro and Marine Corps Commandant Gen. David H. Berger at a House hearing on May 18, 2022. Tom Williams/CQ-Roll Call, Inc via Getty Images

The Defense Department urged contracting officers to "be mindful" of the varying impacts of inflation and "limit the scope" of equity pay adjustment clauses, according to new guidance.

The Defense Department knows cost increases due to inflation may begin to affect contracts. But, according to recent guidance, defense contracting officers are urged to "limit the scope" when using clauses for pay adjustments. 

"The current economic environment requires we understand the impacts of inflation to existing contracts and consider various approaches to manage risk of inflation to prospective Department of Defense (DOD) contracts," John Tenaglia, the principal director for Defense Pricing and Contracting, wrote in a memo dated May 25. 

"Against this backdrop, DOD contractors and contracting officers (COs) alike have expressed renewed interest in using economic price adjustment (EPA) clauses."

Handling cost increases for existing contracts depends on the contract type and contractors are responsible for notifying DOD when costs are approaching the limits laid out in those agreements, the memo states. But an EPA clause could be a solution, when approached with care, for developing contracts or those in negotiation.

"For contracts being developed or negotiated during this period of unusually high inflation, an EPA clause may be an appropriate tool to equitably balance the risk of inflation between the Government and contractor," Tenaglia wrote. "In crafting an EPA clause, COs must be mindful that the impacts of inflation vary widely, depending on the nature of costs…the CO should take care to use an index that is closely related to the cost components judged to be most unstable."

The document also stresses that "any clause addressing potential contract cost or price changes due to economic conditions, e.g. inflation, is effectively an EPA clause, whether or not the term EPA appears in the clause." Also, contracting officers should "limit the scope" of such clauses to "costs most likely to be impacted by economic fluctuations and should exclude costs that are not likely to be impacted by inflation from adjustment under the clause," such as depreciation, or labor costs where a union agreement exists. 

The memo comes as inflation costs hit everyday items and services, such as gasoline and food costs, and as defense officials and congressional leaders push for more funding in the budget for 2023 to offset higher costs.  

Adm. Michael Gilday, the chief of naval operations, told the House Armed Services Committee during a May budget hearing that inflation "adds another stressor to this budget." Gen. James McConville, the Army's chief of staff, also told the committee in a separate hearing that he was "very concerned about the impact of inflation on our soldiers and families" particularly regarding proposed pay increases that would be eclipsed by current inflation rates. 

"The budget was planned around about a 2% inflation rate," McConville said, "we wanted to give our soldiers and families, and our civilians, a 4.6% pay raise that was based on the employment cost index…And that number is a lot less than 8%."

DOD estimated cost growth from fiscal 2022 to 2023 based on the gross domestic product price index to be around 2.2%, the Pentagon noted in a letter to Republican leaders dated May 2. The letter also notes that the 2023 budget request added $20 billion per year to protect buying power and account for compensation increases, while also acknowledging that "adjustments may be needed as prices fluctuate." 

Ranking members on the defense committees, Sen. Jim Inhofe (R-Okla.) and Rep. Mike Rogers (R-Ala.), criticized the Pentagon for not taking precautions against potential effects of inflation and resurfaced calls for a budget increase above inflation rates. 

"Overall, we are concerned that the Department is not taking a proactive stance to mitigate the harmful effects of inflation," the ranking members wrote in a statement May 4 following the Pentagon's response to an inquiry. 

"Remember: At the end of the day, getting the inflation number right is important, but it's only part of the story. If we want to protect our country and meet national security needs, we need 3 to 5 percent real growth above inflation. We plan to accomplish this goal in this year's NDAA."

Democrats, in turn, have warned of the potential for wasteful spending as defense budgets increase and advocated for acquisition reform as an alternative.