On March 13, 2020, the President declared a national emergency due to the COVID-19 pandemic. Virtually overnight, many federal, state, and local government agencies, as well as broad sectors of the private sector, were shut down. Some governmental agencies such as the Department of Defense (“DOD”) and, importantly many DOD contractors, were deemed to be performing “essential” work and were required to stay in operation despite the pandemic. To protect the health and safety of their employees in the face of the pandemic and the widespread lack of personal protective equipment, or PPE, that would otherwise allow essential workers to return to the workplace, DOD and its contractors implemented remote and hybrid work practices, that is, allowing employees to work from home all or part of the time, or mixing remote work with a limited on-site work schedule.
Undoubtedly most federal agencies and their contractors assumed that remote and hybrid work practices would be temporary, and once the COVID emergency was over, governmental and private sector workplaces would return to pre-pandemic routines. That has not happened and, in fact, remote and telework practices have become permanent features of the American workplace. For example, in March 2022, two years after the national emergency began, the Deputy Secretary of Defense issued a Memorandum regarding “DoD Workplace Guidance for Final Reentry of DoD Civilian Personnel,” and stated that:
The Under Secretary of Defense for Personnel and Readiness is reviewing and incorporating flexibilities such as telework into the Department’s civilian employee human capital strategies and personnel policies. These actions will improve the DoD civilian employee experience and leverage innovation and productivity gained through flexible workplace policies. Continuation of flexibilities used during the COVID-19 pandemic increases the DoD’s efficiency and effectiveness, as well as allows the Department to better attract and retain those with the necessary skills and abilities needed to accomplish current and future missions.
According to the U.S. Bureau of Labor Statistics, private sector employers have also embraced flexible work practices, reporting that in August and September 2022, 27.5% of private-sector establishments had employees teleworking some or all of the time, and that 95.1% of establishments – including those that did and did not currently have telework – expected the amount of telework at their establishment to remain the same over the next six months. Experts in recruiting and employment have also observed that DOD contractors are “learning to accept” remote work practices in order to remain competitive in what has become a consistently tight labor market. Some contractors are also finding ways to accommodate remote and hybrid work on classified work, following DOD’s lead in separating classified and unclassified work so that employees can work on a hybrid remote/on-site schedule.
With an increased number of employees adopting remote and hybrid work schedules, workplaces have fewer people in them on a day-to-day basis. Some of the reductions in attendance in the workplace can be substantial. For example, the Government Accountability Office (“GAO”) recently reported on the reduced utilization of federal agency headquarters buildings in the Washington, D.C. area, with some surprising findings. GAO calculated that 17 of the 24 federal agencies in its review used an estimated average 25 percent or less of their headquarters’ building capacity in a three week sample period across January through March 2023. The agencies found to be making better use of their facilities used only an estimated 39 to 49 percent of the capacity of their headquarters on average. While GAO recognized that agencies have long had problems fully utilizing their headquarters facilities, it found that all 24 agencies reported that their in-office workforce has not returned to pre-pandemic levels due to the much more frequent and increased use of telework and remote work.
As of this writing, there is no published analysis like the GAO report that reveals contractors’ reduced utilization of their facilities due to the more frequent and increased use of telework, remote work, and hybrid schedules, but it is fair to assume that contractors have seen reductions in facilities utilization to some degree or another. It is also fair to assume that government auditors will begin questioning the costs incurred by contractors to maintain facilities that are, in the view of the auditors, underutilized. The good news for contractors is that under the Federal Acquisition Regulation (“FAR”) the costs of “idle capacity” in a facility are allowable and recoverable, subject to two conditions, as discussed in detail below.
As discussed below, FAR 31.205-17 states that the costs of “idle capacity” are allowable, given that “[c]osts of idle capacity are costs of doing business and are a factor in the normal fluctuations of usage or overhead rates from period to period.” These costs are allowable provided that the capacity is presently necessary, or was originally reasonable and is not subject to elimination in accordance with sound business, economics, or security practices. Idle capacity is the unused capacity of partially used facilities, so the post-COVID phenomenon of partially occupied facilities resulting from remote and telework practices may result in “idle capacity,” but not unallowable occupancy costs. At the same time, it is unlikely that these new workplace practices would result in “idle facilities,” which are “completely unused facilities that are excess to the contractor’s current needs.”
The cost principle governs both “Idle Facilities” and “Idle Capacity” costs. The predecessor to this cost principle from the Armed Services Procurement Regulations, ASPR 15-205.12, did not draw a distinction between “idle facilities” and “idle capacity,” and therefore the older cases construing the ASPR regulation do not distinguish between the two. Prior to 1968, when the current provisions of the cost principle (as set forth in the Defense Acquisition Regulations (DAR) and FAR) were adopted, ASPR 15-205.12, “Excess Facility Costs,” stated only “[c]osts of maintaining, repairing, and housing idle and excess contractor-owned facilities, except those necessary for standby purposes, are unallowable.” After 1968, the successor DAR provision, DAR 15-205.12, “Cost of Idle Facilities and Idle Capacity,” largely adopted the definitions and standards of allowability (except for minor grammatical differences) that appear in FAR 31.205-17 today.
The definitions set forth in the current cost principle should be closely reviewed to avoid any confusion between the concepts of “idle capacity” and “idle facilities,” as well as the allowability factors applicable to each distinct category. FAR 31.205-17 states:
(a) Definitions. As used in this subsection— Costs of idle facilities or idle capacity means costs such as maintenance, repair, housing, rent, and other related costs; e.g., property taxes, insurance, and depreciation. Facilities means plant or any portion thereof (including land integral to the operation), equipment, individually or collectively, or any other tangible capital asset, wherever located, and whether owned or leased by the contractor.Idle capacity means the unused capacity of partially used facilities. It is the difference between that which a facility could achieve under 100 percent operating time on a one-shift basis, less operating interruptions resulting from time lost for repairs, setups, unsatisfactory materials, and other normal delays, and the extent to which the facility was actually used to meet demands during the accounting period. A multiple-shift basis may be used in the calculation instead of a one-shift basis if it can be shown that this amount of usage could normally be expected for the type of facility involved. Idle facilities means completely unused facilities that are excess to the contractor’s current needs.
The standards for the allowability of these two separate categories of costs are different, and therefore it is important to highlight specifically the standard of allowability for “idle capacity” costs. The cost principle further states:
(c) Costs of idle capacity are costs of doing business and are a factor in the normal fluctuations of usage or overhead rates from period to period. Such costs are allowable provided the capacity is necessary or was originally reasonable and is not subject to reduction or elimination by subletting, renting, or sale, in accordance with sound business, economics, or security practices. Widespread idle capacity throughout an entire plant or among a group of assets having substantially the same function may be idle facilities.
As discussed below, there are no reported cases that construe the definitions found in the current cost principle, but earlier decisions addressed the concepts of “necessary” and “originally reasonable” facilities—two key concepts included in the current regulation. Still, no reported cases have addressed the final sentence of subsection (c), which suggests that “[w]idespread idle capacity” may result in idle facilities.
The two justifications for the allowability of idle capacity costs – necessity and reasonableness – are stated as alternatives; therefore, establishing either justification should be sufficient to support the allowability of the costs if questioned. The first justification, that the capacity is presently necessary, puts the focus on the contractor’s current operations and facility utilization. Depending on the circumstances, it is conceivable that a contractor could demonstrate that a facility leased or built pre-COVID remains “necessary” even if post-COVID work practices have shifted, and employees do not utilize the facility the same way due to remote and hybrid work schedules. For example, an office facility that was previously configured with hallways, offices, and cubicles may now be reconfigured for more collaborative workspaces, such as more shared workstations and common rooms that support on-site and offsite workers. Other facilities that were previously dedicated to offices and cubicles might now be converted to additional warehouse or storage space, to address the need for more on-site inventories due to supply chain disruptions that resulted from the pandemic. Another possibility is that contractors may be scaling back remote and hybrid work schedules, anticipating that employee attendance in the workplace may return to pre-pandemic levels.
The second justification for allowability asks whether the idle capacity (if demonstrated to be idle capacity) was “originally reasonable” and is now not subject to reduction or elimination by subletting, renting, or sale, in accordance with sound business, economics, or security practices. The first part of this test is a retroactive inquiry and may require that the contractor reconstruct the decision-making process that led to the leasing or construction of a facility many years before. Because major real estate transactions are often out of the ordinary for most companies and thus require senior management (if not board of directors) approvals, documentation should be available that supported those senior level approvals. In smaller companies, however, that degree of formality may not have been followed, and reconstructing the business decision could be a challenge due to the passage of time, changes in management, and missing or incomplete records.
The second part of this test is a contemporaneous inquiry, namely, that the idle capacity is not subject to reduction due to “sound” business, economic, or security practices. One can imagine a wide range of circumstances that could prevent elimination of idle capacity, especially with the widely reported collapse of commercial office space rentals due to remote and telework practices. For government contractors, business, economic, and security factors may weigh more heavily, given that many contractors operate out of secured facilities and subletting or selling a portion of such facilities to a third party can involve significant costs to reestablish secure boundaries. If contractors have idle capacity in leased facilities, subletting may be restricted by the terms of the master lease between the landlord and the contractor, or limited lease terms might make subletting for a short term impractical for a prospective sublessee.
Even though there are no contemporaneous cases that interpret the current language of FAR 31.205-17, there are several older cases construing the earlier version of the regulation that are instructive as to the kinds of facts and circumstances a contractor should present, and the likely evaluation of those facts and circumstances by a court or board of contract appeals, on both factors supporting the allowability of idle capacity and idle facility costs.
The most recent reported case that discusses the “Idle Facilities and Idle Capacity Costs” cost principle dates to 1987, suggesting that the law and regulations governing idle capacity and idle facility costs are well understood and well settled. Still, the older cases construing the prior versions of the cost principle provide valid and controlling precedent as to the standards for “necessity” of facilities and “originally reasonable” facilities.
As discussed in greater detail below, these older cases establish important precedent in applying the cost principle, including:
In two cases from the 1960s involving contractors performing government contracts for research, development, prototyping, and manufacturing of advanced technology products, the Armed Services Board of Contract Appeals (the “Board”) rejected the government’s attempts to disallow idle facilities and idle capacity costs because the Board found the facilities in question to be necessary for the contractor’s R&D business.
In Cook Electric Company¸ the government sought to disallow the costs of five of six company-owned buildings at a plant that had suffered declining business over a period of years. The resident Air Force auditor, who had been assigned to the plant for several years, proposed the cost disallowances in the five buildings not based on any precise measurements in the various buildings, but instead his “judgment” as to the percentage of idleness based on “observed occupancy and usage of the space throughout the year in question.” In reviewing the auditor’s recommendations, the Contracting Officer (“CO”) decided to cut in half the auditor’s estimated idleness for two buildings, based on the CO’s own judgment as to the idleness of the facilities and the contractor’s acknowledgment that some space was idle, although neither party provided detailed measurements to support their position. The Board held that the CO’s decision to cut the auditor’s estimate in half for those two buildings was reasonable, affirming those disallowances.
With respect to the remaining three buildings, the Board entirely rejected the auditor’s estimated idleness factor given the nature of the facilities in each building and the nature of the contractor’s business. The auditor deemed 20% of Building 2 to be idle because it housed a model shop that was intermittently used. The Board found the facilities were necessary to the contractor’s business:
This usage of space and equipment is ancillary to appellant’s principal operations. It is not continuous, but the facilities must be maintained ready for use in order to allow the uninterrupted operation of the plant. We find that they were reasonably required, and that there was no idle and excess space in building no. 2.
Likewise, the auditor estimated 15% of Building 5 to be idle based only on the decline in business volume, even though the entire building was devoted to large chambers used as test laboratories by the contractor. The Board again found that the facilities were necessary for the contractor’s operations, and rejected any disallowance:
This is another instance where facilities must be maintained, even though they are not continuously used. In research and development work, and the manufacture of prototypes, a certain amount of test work is required. We are unable to find on this record that there was any idle and excess space in building no. 5.
Finally, the auditor found 25% of Building 6 to be idle because it housed a carpenter shop, chemical laboratories, residual inventory, an “ancient” wind tunnel, and various pieces of equipment such as a centrifuge and a crane that were used from time to time. The Board found that all these facilities were used by the contractor and were necessary for the business; importantly, the Board found no reason to question the contractor’s business judgment in maintaining these facilities:
We are, furthermore, not convinced that there was any idle and excess space and equipment in building no. 6. A plant of this size requires space for storage of maintenance equipment and other currently unused large machinery, whether it is mobile or permanently set up. The chemical laboratory was an integral part of the plant. The old wind tunnel may have outlived its usefulness, but it does not appear to have been a material item in relation to plant space and equipment, and we see no reason to disturb the judgment of the company management as to when to dispose of it.
The Board’s rejection of speculative estimates of idleness based on an auditor’s personal observations that fail to consider the nature of the contractor’s business is directly on point. The government simply cannot rely on opinion and speculation in attempting to disallow allegedly idle facility costs, especially where the contractor demonstrates in detail the need for such facilities.
The Board reached a similar result in Vare Industries, Inc. Like the contractor in Cook, Vare was performing a series of research and development and prototype testing and production contracts in a single leased building that housed all its operations and equipment – a machine shop, a monorail for transporting heavy equipment, a loading dock, administrative offices, a library, a laboratory, test facilities, and a large government-owned tank used for testing. Based on its operations and expected business growth, the contractor renewed its lease for another three-year term, but within a year saw a “precipitous drop” in its government contracts business. A government industrial engineer who “examined” the facility recommended that 60% of the facility costs be disallowed because the balance of the facility was “unnecessary.” In addition, government auditors who had been resident at the facility for four or five months examining records sought to disallow entirely the costs of the offices that they themselves occupied, and used reduced headcount ratios to recommend disallowing 73% of the costs for the machine shop that was still otherwise in use. The CO, who had not visited the plant at all during the fiscal year in question, decided to disallow 50% of the facilities costs. The CO admitted that his disallowance factor was “not empirical,” but was in the interest of settling the contracts.
The Board rejected the government’s disallowance of facilities costs in its entirety. The Board found that the 50% disallowance was “concededly arbitrary,” and that based on testimony from the contractor, some work of a production nature was going on in the plant during the period in question. The Board noted that there was “no showing either way” of the approximate minimum space required to carry on that work, and that “something more than is present” in the record before the Board was necessary to justify any disallowance:
The lease apparently had been renewed in 1964 for a three-year period. The government does not assert that this renewal was then unreasonable in view of then present and anticipated workload or that the facilities were not then necessary. (See ASPR 15- 205.12(b)(ii).) There is no indication that government auditors had disallowed charges to the overhead pool of full rental payments in prior years. The abrupt fall in Vare’s sales and workload gave rise to this disallowance. The reduction of fifty percent is concededly arbitrary, though, the contracting officer believes, arbitrary in favor of the contractor. The United States is not obliged to pay a contractor to maintain excess plant facilities. However, in view of the language and intent of the cited ASPR paragraph and the time period here involved in relation to Vare’s previous operations, sales, and workload, something more than is present in this record is necessary to support the reduction for purposes of their inclusion in an overhead pool for allocation on an otherwise proper basis to government contracts of rent payments actually made.
The most recent decision from the 1980s finding that idle capacity was necessary for contract performance is Fiesta Leasing and Sales, Inc.In Fiesta, the contractor was required to provide five large passenger buses to the Air Force for use at an Air Force base. The contract was terminated for convenience, and the contractor sought with varying degrees of success to rent or re-lease the buses to other customers. As part of its termination claim, the contractor sought “idle facility” costs for the days when the buses could not be otherwise rented or leased, and the Board found that ‘[s]ince the buses were only partially unused, they are appropriately treated as idle capacity,” and awarded the contractor depreciation costs associated with that idle capacity.
The leading case on assessing the reasonableness of the contractor’s decision to acquire and maintain specific facilities is Aerojet-General Corp.before the Armed Services Board of Contract Appeals. In Aerojet, the contractor had acquired land and constructed an entirely new facility in Dade County, Florida, to construct a completely new type of solid rocket motor for potential use in the Apollo program and possibly other programs. The motor was to be 260 inches in diameter, or 21 feet, 8 inches wide, and 60 feet long, which the Board described as “gigantic proportions.” Neither Aerojet, based in Sacramento, California, nor any other contractor had facilities available to manufacture and test such a rocket motor, and in any event if the 260-inch motor was manufactured in Sacramento, its transportation to Cape Canaveral would have been essentially impossible. The Board found that due to the size and hazardous nature of the completed motor, it would have to be tested in a remote location such as the Dade County facility on the edge of the Everglades, and then transported by water to National Aeronautics and Space Administration (“NASA”) facilities at Cape Canaveral. After two successful tests of the motor, NASA decided to terminate its interest in the program, and shortly thereafter the Air Force did as well, rendering the Dade County facility completely idle.
Although Aerojet sought to find alternative uses for the facility, it was unsuccessful but sought to recover the costs of maintaining the idle facility pending its final disposition. The government objected and sought to disallow the idle facilities costs on the grounds that because Aerojet had a rocket motor production facility in Sacramento, California, it was unnecessary for Aerojet to build an entirely new facility in Dade County, Florida for the 260-inch rocket motor. The Board rejected the government’s after-the-fact rationale, and instead looked to the reasonableness of the decision to acquire and build the Dade County facility at the outset of the program:
From what has been said we conclude that new manufacturing and test facilities were required if Aerojet was to participate in the large rocket motor program. We have already noted that isolation and access to water transport likewise were necessary, and that a Pacific Coast location would be unsuitable. Thus, on the basis of our record we hold that the Aerojet management decision that the Dade County plant was necessary to the corporation’s business was a reasonable decision at the time it was made based on all of the information then available. Actually, at that time management had two choices. Aerojet could either: (1) participate in the large rocket program; or (2) not participate. Being in the rocket motor business, and in fact the leading developer and producer of rocket motors, the decision to participate was well justified. Acquisition of the Dade County site was a next logical step.
The Board also held that the same conclusions supported a finding that the Dade County facility was “necessary” when acquired within the meaning of ASPR 15- 205.12, as discussed above.
The Board easily reached the opposite conclusion, however, in the matter of Hercules, Incorporated. Hercules, another solid rocket motor producer, had invested in a new, highly automated plant to produce tactical rocket motors using a “composite” propellant formulation called HERCOPEL. The Board found that at the time Hercules built the plant, however, its two principal competitors already had a lead over Hercules in the composite propellant technology, and Hercules believed that it might be competitive on emerging tactical rocket motor programs because its new mechanized plant would reduce labor costs. Despite Hercules’ hopes, it did not win any production contracts for the new facility and subsequently shut down the facility and sought to recover accelerated depreciation costs under its other government contracts. As an alternative theory of recovery, Hercules argued that the plant costs were allowable idle facilities and idle capacity costs. In support of its claim, Hercules cited Aerojet as justification for recovering idle facilities costs on a novel, but ultimately unneeded, rocket motor production plant.
The Board disposed of Hercules’ argument based on its findings regarding the business decision made to enter the composite rocket motor competition squarely in third place:
In Aerojet, we recognized that absolute necessity to a point of mathematical certainty is not in every case required. However, the evidence in the instant appeal merely shows that the automated HERCOPEL plant would give Hercules the potential for entering a market in which its two competitors had a substantial lead. … Moreover, it is not clear that the rocket motors could not have been built in appellant’s other plants. Nor is there adequate proof of the validity of market projections upon which the Hercules decision was made. It is difficult to second guess a management decision this many years later, but on the evidence before us we conclude that the decision to build the HERCOPEL facility was a calculated risk, but not a necessity.
The application of the Aerojet test to assessing the “originally reasonable” decision to acquire facilities later alleged to have been unnecessary at the time of acquisition by the contractor was applied once again in General Dynamics Corporation. In General Dynamics, the Board again looked to the contractor’s contemporaneous business judgment in acquiring the facilities in question rather than the government’s after-the-fact arguments to reject the disallowance of idle facilities and idle capacity costs. General Dynamics had acquired a facility in Rochester, New York, in the mid-1950s and used the facility for the design and manufacturing of defense electronics. Through the 1960s, the plant was involved in manufacturing electronic systems for the F-111 aircraft, but demand exceeded the capacity of the Rochester plant and its workforce and some work was off-loaded to other company facilities to meet demand. Beginning in 1970, there was a drastic reduction in the F-111 program and other defense electronics programs, and the business General Dynamics hoped to keep in Rochester did not materialize. The contractor therefore shut down the facility, transferred remaining work to other company facilities, and sought to recover its costs for idle facilities and idle capacity in Rochester.
In denying the recovery of idle facility and capacity costs, the government first argued that the Rochester facility was not necessary when it was acquired, or in the alternative, the overall decline of the F-111 program and other defense electronics programs were “foreseeable” and the costs of resulting idle facilities and capacity were therefore unallowable. But the Board rejected both arguments, finding in favor of General Dynamics:
Appellant only needs to show that it made a reasonable business decision at the time of purchase based upon an anticipated increase in its overall business activity, commercial and/or military. There is no requirement, as the government contends, that the facility must be purchased for use in connection with government needs. Since the government did not contest the necessity or reasonableness of appellant’s decision to purchase the Rochester facility based upon an anticipated increase in its overall business activity, we find no cause based on the record … to doubt that the Rochester plant was necessary when acquired. The subsequent use of the plant … confirms appellant’s reasons for purchasing the plant. * * * The government further interjects an argument that, since appellant could foresee the decline of the F-111 Program and a general decline in military electronics business prior to such decline, idle facilities costs are not allowable. The government, in arriving at this unrealistic position, has attempted to substitute foreseeability of an event for necessity of the acquisition. While foreseeability may in certain circumstances be a factor in determining necessity, it has not been shown to be applicable in this situation since the decline in the program relied upon occurred no earlier than the late 1960’s and the facility was purchased in the mid 1950’s.
The Aerojet line of cases establishes that to determine the original reasonableness of the contractor’s decision to acquire facilities that might later become completely idle facilities, or partly utilized idle capacity, the government must demonstrate that the contractor’s decision to acquire those facilities was unreasonable when they were first acquired. In Aerojet and General Dynamics, the government failed to prove that the contractor’s original decision was unreasonable or unjustified, especially when the contractor presented detailed proof as to its contemporaneous business plans, needs, and projections. In Hercules, the Board agreed with the government that the contractor’s decision to enter a new market in third place and to build a new facility with no current contract and no solid business projections was a “calculated risk” that simply did not pan out.
It is well established that in litigation “the government has the burden of proof for demonstrating that a cost is unallowable.”The cases discussed above in detail demonstrate the specific and focused factual showing the government must make in seeking to disallow the costs of alleged idle capacity, and such a showing cannot be made based on speculation, uninformed judgments by auditors and COs, or after-the-fact reinterpretations of the contractor’s business judgment.
Changes in workplace practices resulting from the COVID-19 pandemic were unforeseeable when the pandemic started in 2020, and certainly unforeseeable when contractors entered into leases or constructed facilities before the pandemic based on then-known business needs and operational practices. The possibility that contractors may now be experiencing idle capacity in those facilities due to post-pandemic changes in workplace practices does not necessarily result in the disallowance of facility and occupancy costs due to underutilization of facilities. The FAR expressly recognizes the costs of idle capacity as allowable costs subject to two conditions, and to support the allowability of idle capacity costs, contractors must be prepared to demonstrate that they satisfy the requirements of the cost principle.
If the allowability of such costs becomes contested, contractors should keep in mind that the government bears the burden of proving that idle capacity costs are unallowable because the requirements of the cost principle have not been met. As most of the relevant cases show, that can be a difficult – but not impossible – burden for the government to meet. As a result, if a contractor becomes involved in a dispute, it should be prepared to present a thorough, well-documented case that the requirements of the cost principle have been satisfied, including testimony that supports the contractor’s prior decision-making (business judgment) and contemporary operational needs.
So, should contractors be worried that idle capacity costs might become a significant audit issue soon, if not already? Yes. Therefore, contractors should begin now to prepare to defend the issue by collecting the historical record that will be needed to demonstrate that idle capacity costs are allowable in accordance with the cost principle, and consistent with existing precedent.
