The Budget Control Act of 2011 not only provided a mechanism for Congress to raise the overall debt ceiling, it also imposed measures meant to reduce the national debt. These debt reduction measures will either come in the form of specified budget cuts or, if Congress does not achieve consensus, in the form of mandatory sequestration (across-the-board spending reductions). If history is any indication as to whether Congress can agree to large scale specified budget cuts (HA!), the possibility of sequestration being imposed after January 1, 2013, looms quite large. This article will discuss the possible impact that sequestration may have on your contracting company and some practical ideas as to what you can do to prepare.

The uncertainty that such a process creates can wreak havoc on current programs and contracts, anticipated efforts and awards, as well as the strategic planning process that most contractors’ follow. Will certain programs/contracts be scaled back or even terminated? Will the government ask us to “do more with less” or perform work “at risk” while they search for funding? Will the new contracts we anticipated pursuing and winning this year be delayed or even canceled?

Based on my experience with past periods of such uncertainty, there are certain strategies that the government and contract officers utilize to handle this uncertainty. These include:

1. Termination of specific programs and contracts. While this seems to make logical sense—Program/Contract terminations = cost savings—unfortunately, this is not always the case. Terminations for convenience can create substantial unanticipated costs for the government. It is very important for contractors to understand their rights and ability to recover costs in a T for C, especially if they have never been through such a situation before.

2. Not exercising option years for service-type contracts. This is actually the cheapest and most effective way for the government to terminate contracts and achieve actual cost savings. This strategy, however, leaves the contractor with little means of recourse or ability to recover additional funds.

3. Reduce the quantity of items being ordered. Unless provided for in the contract, this action can significantly impact the contractor who invested heavily in the ability to produce the higher quantities or in the resultant reduction in utilization of the plant.

4. Increase the utilization of cost reimbursable contracts. Despite the rhetoric of the Obama administration, cost reimbursable contracts can be a way of reducing the costs of certain efforts. The government could chose this contract type while also imposing indirect rate ceilings, utilizing “best efforts” for contract performance and tightening up award fee criteria as a means of achieving cost savings.

“...now is not a good time to be making large infrastructure, facility or other fixed expense investments...”

5. Utilize fixed price contracts where the deliverables are not clearly defined. This situation requires the contractor to be as diligent as possible when determining whether something is “out of scope” or not.

6. Do not enter into new awards. This will certainly adversely impact contractors who are expecting certain revenue streams to occur.

As you can see, there are many tools available to the government in order to reduce spending. So with all this uncertainty as to what may happen with current and future contracts, what should a contractor be doing today to prepare? I would recommend considering the following:

1. Prepare your accounting and reporting system for possible terminations for convenience. Once a T for C is implemented, the contract effectively converts to a cost reimbursable contract. Your system’s ability to identify and quantify actual costs incurred under the contract, as well as the needed backup documentation, will help maximize your cost recovery in this situation.

2. Know when to negotiate for change orders/modifications. In fixed price contracts, the government may ask the contractor for more work effort or to perform out of scope work. The effective contractor will have discussions with the Contract Officer about modifying the contract or initiating a change order before performing such work, which is when the contractor’s leverage is the highest.

3. Adhere to the Limitation of Costs/Funds clause requirements. Providing the government with the proper notifications when the 75% level of costs/funds has been reached can significantly increase the chances of the contractor recovering overrun funds. Once again, this places an emphasis on having an effective accounting and reporting system.

4. Minimize large fixed expense investments. With such uncertainty looming on the horizon, now is not a good time to be making large infrastructure, facility or other fixed expense investments. The ability to variabilize costs to adjust to possible decreasing revenue streams can help to ensure continued profitability.

It is possible that Congress may pass a bill to delay the implementation of sequestration. However, the best advice I can provide in these uncertain times is to “Prepare for the worst…..but hope for the best.” Cuts are coming regardless, so are you prepared?

Michael Smigocki, CPA, CVA, ABV is the Founder and Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony services to the government contracting and technology industries. He can be reached via email at MikeS@FedStrat.com.