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This paper updates earlier estimates of savings associated with aircraft and engine procurement contracts resulting from economic price adjustment (EPA) clauses which link contract costs to the inflation rate. It was prepared at the request the Chairman of the Subcommittee on Defense, Committee on Appropriations, U.S. House of Representatives. In accordance with the Congressional Budget Office (CBO) mandate to provide objective analysis, this paper contains no recommendations.

R. William Thomas of the National Security Division prepared the paper under the general supervision of Robert F. Hale and John D. Mayer, Jr. Barbara Hollinshead of CBO's Budget Analysis Division was responsible for inflation projections used to project EPA adjustments. Frances Lussier provided valuable assistance. Patricia H. Johnston provided editorial assistance, and G. William Darr prepared the report.
 

Rudolph G. Penner
Director
August 1986
 
 

BACKGROUND AND SUMMARY

The U.S. Air Force is currently procuring a number of aircraft and engines under contracts that incorporate an economic price adjustment (EPA) clause. These clauses provide for upward or downward adjustments in the total contract costs based on the rates of inflation in labor and materials used in the production programs. In 1985 the Congressional Budget Office (CBO) prepared an analysis of Air Force contracts that used EPA clauses to determine the final contract costs and prices for many aircraft.¹ This report updates that analysis.

Inclusion of an EPA clause transfers the risk associated with predicting inflation from the contractor to the government. During the 1970s, inflation at higher than expected rates led to large increases in certain Air Force contracts that used the EPA mechanism. More recently, the fact that inflation has been at lower rates than projected has led to substantial savings in contracts that include EPAs.

Inflation is measured using national price data compiled by the Bureau of Labor Statistics (BLS), which may not be the same as the prices paid by the contractors. Normally, EPAs adjust for "abnormal" escalation--that is, for deviations from the rates of inflation projected at the time the contract was negotiated. No adjustment is typically made for the first two years of the contract or if the deviations are small (less than 1 percent to 2 percent). The adjustment clauses are used only with firm fixed-price or fixed-price-incentive contracts.²

The EPA clauses are not often included in contracts, since according to Air Force policy, the use of an EPA must be of demonstrated potential benefit to the government. Only 42 contract actions in 1984 (out of more than 16,000) included an EPA clause. This represented 6 percent of the value of all contracts let by the Air Force that year. The Air Force often will propose using an EPA clause if the contractor will agree to reduce his price. Actual benefits or costs of the EPA will, of course, depend on the rate of inflation.

The CBO projects that, for the four aircraft and three engine contracts analyzed in this update, total contract savings from the application of provisions of EPA clauses will be $977 million (see Table 1). Of this amount, some $211 million is associated with actual inflation rates through 1985, and thus may be considered firm. The remaining $766 million is estimated, based on CBO's February 1986 projections for inflation from 1986 through 1989, and is, thus, subject to change as actual data become available.³ It is highly unlikely, however, that inflation could accelerate so quickly as to eliminate the majority of these savings.

Savings of $567 million, or more than half of the $977 million total, will come from the C-5B contract alone. This contract was rewritten in 1984 to lower the estimated rate of inflation, resulting in a decrease of some $440 million in the baseline contract value. The current savings estimate includes $105.5 million in fiscal year 1985 funds that became surplus as a result of this action.

The Air Force has adjusted funding in a number of programs in anticipation of future EPA savings. In considering the fiscal year 1986 Department of Defense (DoD) Appropriation Bill, the Congress also incorporated reductions for EPA savings from the 1986 request and prior-year appropriations for affected programs. Finally, the Balanced Budget and Emergency Deficit Control Act of 1985 required further cuts in funds available for fiscal year 1986 and from previous years' appropriations.⁴ The CBO calculates that these adjustments account for some $654 million of the estimated total savings of $977 million, leaving net savings of about $324 million from prior-year funding and the fiscal year 1987 budget request (see Table 1).

These findings are similar to those in CBO's 1985 report, which identified $1.1 billion in savings over the lives of the contracts examined in that report. But three changed circumstances underlie the need for an updated report:

• Inflation in the second half of 1985 and the first half of 1986 was less than projected;
  
  
• Several programs' funds were altered by the Congress, in part as a result of the former analysis; and
  
  
• Other changes in funding for these programs were made by the Air Force in its 1987 budget, in anticipation of substantial EPA savings.

This document is available in its entirety in PDF.

1. Congressional Budget Office, "Inflation Savings in U.S. Air Force Aircraft Programs Generated by Economic Price Adjustment Clauses," Staff Working Paper (August 1985).

2. In a fixed-price-incentive contract, the contractor's profit depends on his success in meeting a target cost. Increases in cost above this target are shared between the government and the contractor, up to a ceiling on the government's liability. Economic price adjustments change both the target cost and ceiling cost upward or downward, but do not affect the profit-sharing formula.

3. See Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1987-1991 (February 1986), p. 7.

4. Sequestrations of budget authority reduce net program funds. The CBO assumed that all funds sequestered in 1986 from EPA contracts, or $148.3 million, offset potential savings. The CBO recognizes that the reduction in costs mandated by the sequestration order may be met through other program adjustments.