Contents

The Right to Terminate
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Contractor Entitlement
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Cost Limitations
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A Potpourri of Opportunity
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Settlement Methods
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Termination Costs
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Unabsorbed Overhead
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Profit
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Commercial Item Contracts
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Timing
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Audit
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Summary

Inquiries

To discuss a specific matter involving
• Complete terminations
• Partial terminations
• Undefinitized changes
• Termination costs
• Termination inventory
• Total Cost method
• Inventory method
• Preparing termination proposals
contact us and speak with one of our government contract consultants.

 

 

Terminations for Convenience of
Federal Government Contracts

by: Gregory L Fordham

(Last updated Jan 2013)

The ebb and flow of federal procurement is as routine as the changes in the tides and as predictable as the consequence of political elections or world events. Like the ending of the great World Wars, the end of the Cold War resulted in numerous cuts in defense budgets along with cancellations of many major weapons systems. In more recent times, the war on terrorism stimulated spending but as that effort ebbs so too will the spending which will result in both reduced spending and cessation of certain efforts. Thus, terminations are inevitable for every defense business.

The Right to Terminate

The government's right to terminate for convenience is provided in a required contract clause. The termination clause provides that the government may terminate performance of work under the contract in whole or in part.

Since the termination for convenience clause is required, the prime contract can be interpreted to contain the clause even if it is not actually present or referenced in the contract. For a subcontract to be terminated, however, the clause must actually be present or referenced in the subcontract; otherwise, the contract is breached when terminated. It is the contractor's responsibility to include the termination clause in all of its subcontracts or purchase orders.

Contractor Entitlement

Depending on the type of procurement, a contractor's entitlement can differ depending on the actual contract clause giving rise to the termation. The termination provisions in the contract clause under FAR Part 12 commercial items contracts is different than the termination provisions in the termination clause under FAR Part 49. So, the first step to understanding a contractor's entitlement is properly identifying the contract clause governing the termination.

The difference between the commercial item termination clause in FAR Part 12 and the more typical provisions in FAR Part 49 can be significant. For example, under FAR Part 49 the FAR 31 cost principles can apply, although there are limitations, while under FAR Part 12 they do not apply at all.

Under a termination for convenience issued under FAR Part 49 the contractor is entitled to the reasonable costs of terminating the work--cost of the terminated work, termination costs and settlement expenses--plus a reasonable profit. This differs from a contract breach where the contractor could be entitled to its costs, a reasonable profit, consequential damages and anticipatory profits.

Under a FAR Part 12 termination a contractor's entitlement is more simply described; yet, depending on the circumstances may not be any less complicated. (Termination of commeercial item contracts under FAR Part 12 are discussed separately below in their own section on commercial item contracts.)

In the current budgetary environment, the government may try to use many techniques to reduce its financial liabilities. For example, the government may try to terminate for default or to reduce quantities using the changes clause. In many if not most cases, neither of these techniques will be appropriate.

Normally, termination for default should not apply unless the contractor has failed to perform the contract in accordance with a material provision of the contract. Even then, default may not be appropriate in all cases. In some cases a termination for convenience will still be the government's most appropriate course of action and clearly a more preferable outcome for the contractor than a default.

The changes clause is frequently cited by both government and industry as the basis for negotiating contract adjustments arising from reductions in quantity. The changes clause, however, does not normally permit reductions in the quantity ordered by the government. As a result, reductions in quantity should generally be treated the same as a constructive partial termination.

For deductive changes there can also be important reasons for pricing the change as a partial termination. When separately priced items are deleted, they are frequently removed at their contract price without providing any adjustment in the price of the remaining contract items. Similarly, when work is simply deleted the cost of the deleted work plus applicable overheads are subtracted from the contract price. Again, there may be no adjustment in the price of the remaining work.

Clearly both of these approaches can have substantial adverse consequences. If termination pricing procedures were used the contractor could have many ways of increasing its cost recovery that are not otherwise available under the changes clause. Furthermore, under termination procedures the contractor's financial entitlements are clearly described which should facilitate settlement.

Cost Limitations

The total amount payable to a contractor for a fixed price termination settlement proposal is limited by the total contract price less payments that have been made or are to be made under the contract. The limitation is considered prior to deducting disposal or other credits arising from the termination but it does not include the costs of termination settlement.

The total amount payable to the contractor under a termination for convenience of a fixed price contract may also be limited by the contract's loss ratio. Care should be taken in computing the loss ratio, however. It should be computed as if the terminated work was still going to be performed. The ratio from that computation is what should be applied to the termination costs. Since a termination decreases the allocation base the overhead rates subsequent to termination could be higher than those that would have otherwise been experienced. A higher loss ratio would result if the higher overhead rates were used.

Cost type contracts are not constrained by settlement limits or loss ratios. Cost type contracts, however, can be constrained by the limitation of cost or limitation of funds clauses.

A Potpourri of Opportunity

Since the termination settlement proposal represents only the costs of terminating the work, a termination may give rise to the preparation of numerous other proposals. For example, there may be unsettled changes and these should be resolved prior to settling the terminated work for several reasons. The most important is that unsettled changes from ordered or constructive changes can increase the cost ceiling to which the termination settlement of fixed price contracts could be subjected. If the unsettled changes are resolved first and increase the price ceiling then more of the termination costs may be recovered when they might otherwise be limited. (see Pricing Changes and Claims in Government Contracts for additional information on contract price adjustments.)

In the case of a partial termination, an adjustment in the price of the unterminated work is also in order. So, the termination proposal provides another vehicle for increasing a contractor's cost recovery when contract prices are reduced.

In essence, a termination can result in many proposals being submitted by the contractor. Utilizing these various opportunities is important for maximizing a contractor's cost recovery and increasing its current period revenue stream. Moreover, when the issues to be resolved are particularly contentious these various opportunities can provide contractors with multiple bites at the apple so that cost recovery is maximized and cash flow is expedited.

Settlement Methods

Prime contractor termination settlement proposals may be settled through negotiation, by vouchering in the case of the cost type contract or by unilateral determination. Under negotiation, there are two principle techniques for quantifying and settling the termination settlement proposal. These methods are the inventory basis and the total cost basis.

Under the inventory basis, only the uncompleted, undelivered goods/services are quantified using the termination cost principles and procedures. The value of completed and delivered goods/services are quantified using their contract unit price.

Under the total cost basis, the contract becomes in essence a cost reimbursement contract. Thus, under the total cost basis even completed and delivered goods/services are quantified in the termination settlement proposal using the termination cost principles and procedures.

In some cases like supply contracts the inventory basis is preferred. In other cases like construction contracts the total cost basis is required. In many cases where the inventory basis is preferred, however, the total cost basis may be used if approved by the contracting officer. When there are completed and delivered goods/services the two techniques can yield different outcomes. When there are no completed or delivered goods/services, however, both techniques yield identical results.

Terminated cost type contracts may continue vouchering their costs for six months after the termination date. The termination costs are vouchered in the same manner as normal interim billings.

Unilateral determination is the final method for settling prime contractor termination proposals. The Terminating Contracting Officer (TCO) may issue a unilateral determination when the contractor fails to submit its termination proposal within the prescribed time period or when the parties cannot mutually agree on the settlement amount.

Termination Costs

Termination costs under FAR Part 49 are guided by the cost principle at FAR §§31.205-42. The remainder of the FAR 31 Cost Principles and Procedures are simply guides, however. In fact, in the event of terminations, a ccontractor can even deviate from their normal cost accountig practices because terminations are not considered similar purpose and like circumstance of the contractor's normal cost accounting practice. See the article on Cost Accounting Standards for more details.

The primary guiding principle in FAR Part 49 terminations is fairness. Toward that end the termination cost principle at FAR 31.205-42 recognizes eight types of costs that may be included in the contractor's termination settlement proposal.

Common items The costs of items reasonably usable on the contractor's other work are not allowable costs of a termination. Thus, in order for the costs of common items to be allowable costs of a termination they must be in excess of the reasonable quantitative requirements of the contractor's other work. Furthermore, in order for them to be usable on other work they must be suitable for use in the contractor's normal course of business. Thus, even if they are items normally used in the contractor's industry they do not qualify as common items if they are not normally used in the contractor's normal course of business. Finally, even if the items were inventoried by the contractor prior to the receipt of the contract the items should not be considered common items if they are of no value to the contractor subsequent to the termination.

Cost continuing after termination Costs that cannot be discontinued immediately after the effective date of termination are generally allowable costs of a termination as long as they are not attributable to the negligent or willful failure of the contractor to discontinue those costs. These costs can include idled facilities costs; the costs of deactivating, reassigning, returning or relocating employees; severance payments required by law, agreement or established company policy; the costs of early retirement; the costs of completing parts in order to avoid loss; costs incurred while the contractor determines how to terminate the contract; and plant reconversion costs if their exclusion would be inequitable.

Initial costs Initial costs include various types of non-recurring costs such as excessive spoilage, idle time, reduced productivity and increased training costs encountered in the early period of performance. They also include various preparatory costs, such as plant rearrangement and alterations; management and plant organization; and manufacturing and production engineering. A contractor's bid and proposal costs can even be claimed if proper adjustments are made, although since the mid to late 1990's case precedent has not been as favorable as in years prior.

Loss of useful value The costs associated with the loss of useful value for special tooling, special test equipment and special machinery are also allowable costs of the termination. The definitions provided in FAR §45.101 should be used in determining whether these items exist under the contract. The treatment of these items as either a direct or indirect cost is not a determinant factor to their existence.

Rental under unexpired leases Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when it can be shown that they have been reasonably necessary for the performance of the terminated contract provided that the amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable and that the contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such leases.

Alterations of leased property The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for the performance of the contract.

Settlement expenses Accounting, legal clerical and similar expenses necessary for the preparation and presentation of the proposal to the contracting officer are allowable as are the costs of terminating and settling any subcontracts. In addition, the costs of inventorying, storing, transporting, protecting and disposing of any termination property are also allowable. The indirect costs associated with the salary and wages incurred as settlement expenses are also allowable. Frequently, these indirect costs are limited to payroll taxes, fringe benefits, occupancy costs and the costs of immediate supervision; however, the allowable indirect costs are not absolutely limited to those areas.

Even the costs of outside consultants are recoverable as settlement expenses. As a result of their recoverability sometimes it makes more sense to utilize outsiders instead of pulling employees from their normal duties and risk upsetting day-to-day activities. On the other hand, if the termination is substantial, settlement efforts are a way to keep employees active and get them paid while waiting for the next project to come through. In fact, there are provisions for partial payment while preparing the termination settlement proposal.

Subcontractor claims The prime contractor and each subcontractor are responsible for prompt settlement of their respective subcontractors. Contractors are required to settle with subcontractors in general conformity with the policies and principles relating to settlement of prime contracts. Thus, subcontractor settlements are generally allowable provided that the settlement is not more favorable than what the subcontractor would have been able to obtain had it contracted directly with the government. This requirement includes a prohibition against permitting the prime contractor to recover anticipatory profits or consequential damages that were included in a subcontractor's settlement proposal.

If the subcontractor obtains a final judgment against the prime contractor, however, the judgment should be treated by the Government's TCO as a cost of settling the terminated subcontract. In this case, the final judgment amount can include consequential damages and anticipatory profits provided that the prime contractor had made reasonable efforts to include a termination clause or similar language prohibiting the recovery of consequential damages or anticipatory profits in the subcontract.

Generally, the Government's TCO must approve or ratify any prime contractor settlements with subcontractors. The TCO, however, may, after written request from the prime contractor, give written authorization to the prime contractor to settle terminated subcontract proposals of $100,000 or less without approval or ratification. For contracts awarded prior to January 22, 1991 the threshold is $25,000.

While the government reserves the right to approve or ratify first tier subcontractor termination settlement proposals, no such requirement exists for lower-tier subcontracts. Instead, each level of subcontractors and the prime contractor must submit certifications that there is no known information about lower-tier sub contract settlements that would serve to cast doubt on the reasonableness or allocability of the settlements to the terminated portion of the prime contract.

Clearly, the settlement of subcontracts can be extensive and expensive. Consequently, it is only appropriate that indirect costs may be allocated to the amount of settlements with subcontractors. Contractors should be careful, however, to avoid any double counting of costs arising from both subcontractor settlements and its own termination settlement costs.

Unabsorbed Overhead

Unabsorbed overhead is the misallocation of indirect costs to final cost objectives other than those for which the costs were incurred. This can occur when indirect costs are allocated using a cost base that is unexpectedly reduced because of a change. The change that is most often associated with unabsorbed overhead is a performance delay but a termination may also yield similar results.

Unabsorbed overhead is not an allowable termination cost because, whether correctly or incorrectly, it is not considered to be a cost of terminating the work. Unabsorbed overhead would be an allowable cost of any unsettled change proposals, however. Particularly if the termination was preceded by a stop-work-order--as is often the case.

While unabsorbed overhead is not an allowable termination cost many of the costs that otherwise comprise unabsorbed overhead can be recovered through other means. The termination cost principle recognizes that terminations represent an unusual circumstance that can warrant special treatment. This language, in essence, opens the door for contractors to change their cost allocation procedures on-the-fly.

Similar opportunities to modify cost structures exists even on terminated contracts that are covered by Cost Accounting Standards. Thus, contractors may successfully recover the costs comprising unabsorbed overhead by designing methods for allocating as a direct cost of the terminated contract as much as possible of the otherwise indirect costs.

Profit

Under a FAR 49 termination or whenever a cost element based settlement is being followed, the contractor is entitled to a reasonable profit on its termination costs. The profit calculation is not a simple mark-up, however. In other words, it is not just cost incurred plus a percentage.

Indeed, the difference between the contract price less completed work, work in process and an an estimate to complete is used to determine whether the contract would have been a profitable contract. If so, the contractor can claim an amount for the profit earned on its terminated work. When performing the calculation it is important to develop indirect costs for the rate purposes using the activity volumes that would have existed had the contract not been terminated. After all, when the contract is terminated the allocation base is likely reduced and the indirect rates increased. Using these higher rates would reduce a contractor's profit position and associated profit recovery and even potentially put the contractor into a loss position

If the contractor would have earned a profit, the government may want to simply prorate the amount actually earned through the termination date even though the higher risk items, like first article approval, were performed early in the contract. Nonetheless, there are no hard and fast rules about how to calculate the amount actually earned, although one can certainly use the recognized purposes of profit and match those to actual contract performance to justify a weighted profit request commensurate with the work actually achieved.

If the contract would have been particularly lucrative the government may even want to limit the contractor's earnings to the percentage that the government typically allows during negotiation like five or ten percent. Yet, there is no requirement for this approach either. In fact, it is arguably contrary to the goal of change quantification principles to alter the contractor's profit position as a result of the change.

Consequently, when the contract is in an highly lucrative profit position the contractor may want to use several techniques to retain the benefits that it would have enjoyed had the contract not been terminated. First, it should try to employ the inventory basis where possible, particularly when some line items are more profitable than others. Second, it should componentize its profit request and allocate higher earned profit values to those components having higher risk.

On the other hand, if the profit calculation reveals that the contract would have been in a loss position then the contractor must also recognize some portion of the loss. After all, as with other forms of contract changes, a termination may not improve a contractor's profit position. Avoiding the loss position is another reason that undefinitized changes need to be settled first in order to make sure that the contract price properly reflects the level of work actually performed.

When the contract is in a loss position, there can be some unpleasant consequences. For example, it could result in the contractor having to pay money as a result of the government's termination. Of course, even in a profit position such a result is possible if government finance payments substantially exceed the percentage of completion. In this latter case it is not a consequence of profit. Rather, it is just the consequence of reconciling cash position relative to performance.

Commercial Item Contracts

Although commercial items can appear in contracts issued under a variety of acquisition procedures, the termination of commercial item contracts under FAR Part 12 are governed by a different termination clause than that contained in FAR Part 49 and described above. As one would expect, the commercial item version is much simpler and essentially provides two elements for compensating the contractor when terminating commercial items contracts.

The first is, "The percentage of the contract price reflecting the percentage of the work performed prior to the notice of the termination for fixed-price or fixed-price with economic price adjustment contracts or an amount for direct labor hours (as defined in the Schedule of the contract) determined by multiplying the number of direct labor hours expended before the effective date of termination by the hourly rate(s) in the Schedule."

The second is, "Any charges the contractor can demonstrate directly resulted from the termination." The contractor may demonstrate such charges using its standard record keeping system and is not required to comply with the cost accounting standards or the contract cost principles in Part 31.

At least one judicial interpretation of the commercial item contract termination provisions has taken these provisions quite literally, however, and allowed only a percentage of the work performed without regard to unamortized costs, startup costs, etc. As for the actual costs directly resulting from the termination the court interpreted those to be settlement expenses such as proposal preparation costs.

Since the number of decisions for commercial item contract terminations are few, the entire process may still be unsettled, particularly since other decisions have been more reasonable.

The commercial item clauses were intended to bring commercial contracting practices to the procurement of commercial items instead of the normal FAR requirements. So, while a simple percentage based on units of production may be a good approach when commercial item contractors have inadequate accounting records, it seems foolish to ignore those records when they exist, if the goal is to compensate the contractor fairly.

Since commercial item contracts were generally intended to adopt commercial item contracting practices, it seems natural that common law concepts like expectation interest, savings, offsets, equity and mitigation would only follow when compensating a contractor for a contract termination. If so, many of the normal FAR 49 concepts involving terminations costs would also follow. Not because FAR 49 applies but because a termination clause should not be a means for the buyer to claim, "Heads I win and tales you lose" irrespective of the volume assumptions on which the pricing was developed or the extent of preparations needed in order to perform the contract.

For example, when non-commercial item contracts have been terminated after first article, the costs of a contractor's excess inventory beyond the first article have been compensable when the production item delivery schedule was shorter than the lead time for long-lead items. Would commercial item contractors under similar circumstances not be entitled to the same equity? Similarly, although the changes clause for commercial item contracts contemplates bilateral acceptance, would the concept of constructive change be prohibited where there was no agreement; yet, the contractor was required to continue performance pending resolution under the contract's disputes clause?

The few judicial decisions that have applied a narrow interpretation to the percentage of the work performed may simply be an example of an outcome based opinion. In other words, parties always have a duty to mitigate damages which in the case of a termination can include proceeds from the disposal of termination inventory or special use equipment. In these few anomalous cases it is not clear to what extent the contractor attempted to mitigate its damages from the termination or whether the government offered helpful instruction for disposition of termination inventory or special use equipment.

Instead, the decision depicts a situation where the contractor claimed full value without consideration for residual value, remaining useful life or amounts that could be realized from disposition from the termination inventory. On the other hand, the government claimed that their was no contractor entitlement beyond what was actually contemplated in the line item pricing.

So, neither party proffered a very thoughtful application of the commercial termination requirement that the contractor receive, "a percentage of the contract price reflecting the percentage of the work performed prior to the notice of termination" even though there are a number of disciplines like accounting for long term contracts and earned value project management where percentage of completion concepts are well reasoned and long standing. Consequently, the court's decision could simply have been its best justification for an equitable result based on the facts in evidence.

If the result turns out to be something more one sided, the government may once again find itself with a failed foray into the commercial market and cutoff from the goods and services it desired but could not obtain prior to the passage of the Federal Acquisition Streamlining Act (FASA) and Federal Acquisition Reform Act (FARA) of the mid 1990s.

Timing

Prime contractors should submit their termination settlement proposals within one year of the termination date. Extensions in time to submit the termination settlement proposal may be requested by the contractor and may be granted by the terminating contracting officer.

Within the one year time period the prime contractor should have also received subcontractor termination settlement proposals. Therefore, when including a termination clause in subcontracts and purchase orders, the prime contractor should have imposed a shorter period of time for receiving termination settlement proposals than it has for submitting its own proposal.

Audit

Under a FAR Part 49 termination, the government has the authority to audit the prime contractor's termination settlement proposal under several contract clauses. Principally these clauses are the Audit-Negotiation or Audit-Sealed Bidding clauses. Although contractors are required to include these clauses in their subcontracts, the government may not have subcontract audit privileges if these clauses or similar language are omitted from the subcontract.

The TCO must refer each prime contract termination settlement proposal of $100,000 or more and each subcontract termination settlement proposal submitted for ratification or approval to the appropriate audit agency for audit. For contract or subcontract termination settlement proposals of less than this value the TCO may still request audit review if desired.

Each contractor at any tier is the primary party responsible for auditing and reviewing their subcontractor settlement proposals. Even when the TCO requests an audit of a subcontract settlement proposals, he is discouraged from having the government duplicate the contractor's audit efforts. Rather, if the contractor is auditing its subcontractor settlement proposals, the government review should focus on the adequacy of the contractor's procedures and the extent to which they can be relied on by the TCO.

The termination clause under FAR Part 12 does not grant any audit rights to the government, although any expectation that the government is just going to cut a check for any amount claimed based on anything other than units of production without conducting some kind of review and assessment is probably unrealistic. So, for contractors with a complex commercial item termination settlement some accommodation should likely be expected. Consequently, it might not necessitate the intrusiveness of an audit but some support or validation, such as submission of supporting documents or a desk review, should be expected. After all, Since the neither the FAR 31 cost pinciples or the Cost Accounting Standards should apply to a FAR Part 12 termination, there likely is not any real sense to the audit except for validation of the costs claimed.

Summary

Terminating contracts is no simple matter. Contractors should expect to expend considerable effort in settling their terminated contracts. Understanding the consequences of the termination with respect to their own organizations and then maximizing the cost recovery for those consequences will prove substantial. Satisfying their responsibilities relative to subcontract settlement will also be expensive and time consuming.

Fortunately, all of these costs are recoverable including the costs of outside consultants and experts experienced in navigating the complex rules and maximizing a contractor's revenue stream. In fact, using experts can be essential since successfully negotiating a settlement can often require the contractor to know the government's job as well as his own in order to overcome objections and reach final settlement.

Fortunately, interim proposals may be submitted and partial payments requested. Thus, government financing is available for as much as 90 percent of the allowable costs incurred prior to final settlement.

Although a Contracting Officer may use his discretion in determining the amount of partial payments, that discretion must be reasonably exercised and directed at simply protecting the government's financial interest. Since the government will almost always have some amount of financial liability to the contractor, a Contracting Officer that denies the requests for partial payments will most likely abuse his authority and entitle the contractor to recover interest on the unpaid partial payment.

Naturally, if the contractor's settlement proposal exceeds applicable thresholds, the negotiation of final price will be subject to the Truth-in-Negotiations Act, at least with respect to FAR Part 49 based terminations. (There is no similar requirement for FAR Part 12) Care should be taken, therefore, to ensure that all appropriate disclosures are made.

In a quickly dwindling defense market, a termination settlement proposal may represent a company's last best opportunity to maximize its current period revenue stream and to recover whatever investments may have been made. To that end, contractors are fortunate that there are no cookie-cutter formulas for settling terminated contracts.

The primary objective for contract terminations is to compensate the contractor fairly and negotiate a settlement by agreement. Toward that end, the FAR Part 31 cost principles are simply guides and a contractor need not have extensive accounting data to prove the settlement amount. Estimates, standards, and negotiated amounts are all suitable means of arriving at the settlement amount.

When confronted with a government contract terminated for convenience, the Atlanta Georgia office of Celestial Defense provides three important consulting services to government contractors in general, defense contractors in particular and even the government, if desired. Those services involve expert knowledge of:

  • The actual regulatory requirements applicable to terminated contracts and their settlement including preparation of a termination settlement proposal and associated equitable adjustments, settlement with subcontractors including review of their settlement proposals and associated equitable adjustments;
  • Assessment of DCAA or other outside audit findings related to settlement proposals or associated equitable adjustments; and
  • Negotiation of final settlement amounts.

To discuss a specific matter involving
• Complete terminations
• Partial terminations
• Undefinitized changes
• Termination costs
• Termination inventory
• Total Cost method
• Inventory method
• Preparing termination proposals
contact us and speak with one of our government contract consultants.