(Editor’s Note. The difference between the limitation of cost and limitation of funds clauses are not well known. Lack of compliance with the two clauses can cause considerable problems for contractors such as not having funds available for more work or providing an excuse for the government to not fully reimburse all incurred costs. We thought it would be a good time to review these two clauses. In our research for this article we came across a classic feature article by Professor John Cibinic (now deceased) in the Government CPA publication (no longer published) which forms the basis of this article where we have added updated cases and commentaries.).

The unique features of cost reimbursable contracts are the contractor is reimbursed its costs and does not assume the risk of nonperformance. The Limitation of Cost (LOC) clause plays a key role in accomplishing these tasks for fully funded contracts and the Limitation of Funds (LOF) does the same for incrementally funded contracts. These clauses protect both parties when the estimated costs are not sufficient to complete performance. They allow, but do not obligate, the government to fund the contract in excess of original amounts and they allow, but do not require, the contractor to continue performance if the funding is not made. This way the government does not sign a blank check when it agrees to reimburse a contractor for its costs while the contractor is protected from the risk of having to complete performance when funding is insufficient.

Despite these straight forward concepts, the LOC and LOF clauses have been a source for many disputes where often both parties are at fault. Contractors do not accurately keep track of their costs or they do not timely notify the government of additional funding needs while the government does not take timely action when it is notified of funding. In this article, we will address notice requirements, circumstances when a CO may fund a cost overrun irrespective of whether there are appropriate notices and the impact of adequacy of contract accounting.

The LOC clause, found at FAR 52.232-20, is used when the contract is fully funded which means the cost type contract is funded for the amount of the estimate of cost plus profit or fee that is specified in the contract. When the government obligates an amount that is less than this estimate the contract is said to be incrementally funded and the LOF clause found at FAR 52.232-22 governs. Both clauses are similar in most respects where the basic differences is the LOF clause (1) applies to the fee also (2) specifically entitles the contractor to request a termination of the contract if additional funds are not provided and (3) expressly provides for an adjustment of fee if the funds run out.

Though the FAR seems to say either the LOC or LOF should be used some agencies will include both clauses in their contracts where the LOC clause supersedes the other when contracts are fully funded. The clauses do not apply to every conceivable liability of government. For example, the courts have ruled they do not apply to claims for damages from breach of contract or where a contract provides for indemnification of the contractor or if a contract provides for special termination costs.

Notice Requirements

The notice requirements of the LOC and LOF clauses are essential for the proper administration of funding for cost type contracts. Given timely notification of a contract’s funding status the government can take appropriate actions to adjust funding or to modify contract work to fit available funds. There are two types of notice requirements, one relating to incurred costs and one related to sufficiency of funds.

Incurred Costs

This type of notification is addressed in section (b)(1) of the LOC clause and (c) of the LOF clause. A contractor is required to notify the CO when the costs incurred and to be incurred within a stated period (e.g. the next 30, 60 or 90 days) will exceed a certain percentage of the costs or funds (e.g. 75% to 85%). This notice is required on all cost type contracts and is not dependent on an overrun or underrun of costs or funds. It simply advises the government that the contractor’s incurred costs are approaching the estimated costs or funds limitation. With this information the CO can assess the contractor’s progress with its incurred costs and take any necessary action. The CO is not required to take any particular action and the notification does not constitute notice of an approaching overrun even if the facts in the notice would indicate such an overrun is inevitable.

Sufficiency of Funds

This notice is the most important. Under (b)(2) of the LOC, the contractor is required to notify the CO at any time it has reason to believe the actual cost of completion will be greater than or substantially less than the earlier estimated cost. There is no timetable for this type of notice. It is required any time during performance when the facts indicate the incurred costs will vary. The courts have ruled notification of overruns for even minor amounts are required (e.g. notice was required for a 1.5% overrun amount). Though there is not a lot of incentive for the contractor to notify the government its incurred costs are expected to be significantly less such notification for the government is important since it allows funds to be used for other purposes.

What Constitutes Notice

No particular form is required for either type of notice other than they be in writing. A contractor’s duty to provide notice is not to be excused even if the government possesses information for which it could deduce an overrun is likely to occur. So, for example, cases have not excused notification requirements when an auditor’s tabulation of invoices would have shown the overrun or a detailed analysis by the CO would have shown it. In addition, mere notification of proposed overhead rate increases has been ruled to be insufficient notification under LOC and LOF clauses. Though it could be argued that when contractors are required to submit detailed progress reports identifying percentage of completion and funding status adequate information is available to the CO, contractors should play it safe and send in overrun notices in writing, directed to the CO and specifically referring to the appropriate LOC or LOF clause. Cases have ruled that notification to program managers, contract specialists or technical representatives are not sufficient where they must be addressed to the CO.

As to the content of the notices, both the LOC and LOF clauses state revised estimates of the costs at completion should be submitted. Nonetheless, contractors should be aware that specific departments with their own FAR supplements may have more detailed requirements. For example, the Department of Education has detailed requirements for notices. Contractors are not required to have knowledge of the precise amount of the overrun but they must include an estimate of all costs they believe will be incurred. As estimates of additional costs become available contractors should update their notice since the original notice will be valid for the costs included in it.

Keeping Track of Funding

Contractors must keep records and make estimates that will enable them to comply with the LOC and LOF clauses and to estimate overruns. Estimates will be the primary means of determining funding status during the early stages of contract performance but as it continues, estimates and incurred cost need to be used. Contractors cannot rely only on incurred cost reports but information on potential liabilities to vendors, subcontractors, employees or other third parties should be maintained. In addition, estimates to complete must remain current. Finally, the contractor must estimate the costs of shutting down the products or services in case the government does not provide new funding. For example, incurred costs reports of $800,000 on a funded contract may not reflect $150,000 of liabilities due to vendors, additional cost to complete of $100,000 and $50,000 to close down the contract and protect property.

Funding Overruns

The CO has the discretion to decide whether it will fund the overrun and for what amount. If the government wishes the work to continue but the contractor refuses to work without additional funding then the CO must fund the additional estimated costs. The CO also has several other options such as terminating the contract, letting the funds run out or reduce the scope of the work to fit available funds.

Mere compliance with the LOC and LOF clauses does not guarantee overrun approval. The clauses provide only that a written notice from the CO specifying an increase in estimated costs will suffice to provide additional funding. Absent this written approval, the contractor must show the CO has taken definite action to indicate additional funds have been provided. Some cases have found for the contractor where overrun funds were found to have been approved without written notification when the CO in an internal memo recommended funding, or a letter from the CO advising the contractor to submit its claim, or the CO ordered the contractor to perform additional tasks under the contract after being informed the contract funds were exhausted. However a CO’s continued performance of contract administration functions will not necessarily be sufficient to constitute funding. For example, approval of vouchers “subject to audit” even though the vouchers reflected overrun amounts did not constitute approval to fund overruns. The clauses also state that issuance of change orders or terminations do not necessarily constitute approval for overrun funding. The only exceptions have been when the government issues changes or terminations when there has been notice that funds have been exhausted.

Recovery Absent Notice

The government may not refuse to fund an overrun if the contractor had no basis to know “through no fault or inadequacy on its part” an overrun had occurred. The courts have used different theories to make rulings when these conditions occur – “abuse of discretion”, “impossibility to comply” where many commentators have stated the contractor can invoke this rule if it can show the overrun was not “reasonably foreseeable.”

Adequacy of Accounting & Financial Reporting

Before a contractor may be excused from failing to give notice under the LOC and LOF clauses it must show it maintained an accounting reporting system “adequate to apprise it of the possibility of a cost overrun before the overrun occurred.” In other words, lack of an adequate accounting system does not excuse the contractor where some cases ruled the contractor was not excused when it operated without a bookkeeper and failed to obtain an audit. Some have argued that the risk of an inadequate accounting system should fall on the government since FAR 31.301-3(a) permits award of a cost reimbursable contract only when the contractor has an adequate accounting system for determining contract costs but that argument has not had much success in court cases.

Reasonable Forseeability

Cases dealing with reasonable forseeability have hinged on what the contractor knows and what it should have known. It is not sufficient for a contractor to simply rely on its costs recorded in its accounting system but rather must include costs incurred but not yet recorded and costs in the future must also be taken into account where the contractor is required to make reasonable estimates of these costs. However, one case ruled the contractor did not reasonably foresee an overrun even though its projections indicated it might occur. The board ruled since the contractor had a record of sometimes being high and sometimes low the contractor did not have reason to believe an overrun would occur prior to contract completion and hence it was not required to provide notice to the government.

Increased overhead rates are the most frequent case of overruns. Even when the contract performance is completed before the end of its fiscal year the contractor is expected to make reasonably accurate business projections of its final overhead rate. However other cases have ruled the contractor is not required “to have a crystal ball” and other circumstances were considered excusable for not projecting accurate overhead rates such as when an expected follow-on contract was not awarded, whether a business decline was much more severe than expected or where a contract was cancelled due to a protest. Other circumstances of excusing the need to notify the government of higher overhead rates occurred when costs in dispute for allowability or allocability is finally settled, resulting in higher overhead rates or methods for allocating indirect costs are challenged but then finally allowed.

Despite some circumstances where inadequate accounting records have been excused contractors should not depend on these unusual situations where they need to have adequate accounting and estimating systems in place before taking on cost type work and also need to keep accurate estimates to complete. Contractors should also notify the government as soon as possible of estimated overruns where though yes there is a risk of unhappy government customers and possible cancellations these risks usually pail when faced with a nonrecoverable cost overrun.Reference the following website: https://govcontractassoc.com/limitation-of-cost-and-funds-clauses/