Inflation Costs Present Both Barrier, Opportunity For Contractors In 2023

Coming into the new year with a full appropriation should bode well for federal contractors, though continuing inflation costs and a looming debt debate could portend a mix of challenges and opportunities, said Deltek’s Kevin Plexico.

In a Jan. 5 webinar outlining 2023 federal contracting trends, Plexico, senior vice president of information solutions for the Herndon firm, said that the certainty of the $1.7 trillion fiscal 2023 budget — coupled alongside previous funding from legislation like the Infrastructure Investment and Jobs Act and Inflation Reduction Act — should provide favorable circumstances for contractors.

“In the near term, the rollout of funds in recent legislation, such as the infrastructure legislation, the Inflation Reduction Act and unspent funds from COVID legislation, we expect a strong contracting environment for 2023,” said Plexico.

But it won’t be without its problems as well, namely from a mix of ongoing inflationary costs and the looming debt challenges set to take center stage in the 118th Congress. Following the contentious election of Rep. Kevin McCarthy (R-Calif.) as speaker, House Republicans are expected to seek to freeze federal spending at fiscal year 2022 levels. Stark divisions between House Republicans and Senate Democrats  lead many observers to expect protracted budget battles, and possibly a government shutdown or even a default on debt service payments, on the horizon

Plexico said that with the national debt at more than $31 trillion, or 129% of the nation’s gross domestic product, political debate over spending reductions will likely dominate the weeks and months ahead.

That is also coupled with ongoing inflation, which has raised the costs of wages, energy and goods and services for contractors and agencies. As result, Plexico said those ongoing pressures mean agencies are likely to add economic price adjustment clauses to critical fixed-price contracts, which could allow them to increase contract prices to help cover contractors’ increased expenses for labor and materials. 

“But that comes with risk to companies of pricing themselves out of critical bids,” he said. “So if you’re finding yourself challenged with increasing costs that are putting pressure on your margins, but still a strong need to be competitive in your pricing, you’re certainly not alone. That’s a problem that I think many companies are facing.”

But on the other side of the coin, those same inflation costs could present an opportunity for contractors, as low unemployment levels may lead agencies to turn to the companies to fill gaps in the federal workforce.

As the government continues to face more of its workforce reaching retirement age with less young talent coming in the door, the competition for talent has grown fiercer, thus driving wage growth and making it more expensive to recruit. 

“We expect rising employment costs to eat into the federal budget,” said Plexico. “So while federal agencies are certainly dealing with strong increases in budgets, you can think of a significant percentage of that largely being eaten up by wages. On the bright side for vendors, we think there’s going to be opportunities emerge around training and development of federal employees. We see some of these gaps in federal employment, there’s going to be an opportunity for contractors to step in to help fill some of those workforce gaps.”

One area that isn’t expected to cool off yet in government contracting is mergers & acquisition activity. 

Despite rising interest rates overall, Plexico said that the faster-than-market growth of federal spending has kept the M&A market for government contracting very active, backed by interest from private equity investors looking for opportunities among companies that have grown beyond their small business designations. 

“I think the M&A environment is going to continue to be vibrant as long as we see above-market growth and above-[gross domestic product] growth in federal budgets,” he said. “To the extent that reverses with potential looming belt-tightening that might show up in [upcoming] federal budgets, that could start to slow the M&A activity, but certainly for the foreseeable future and the years ahead, I think M&A is going to be a vibrant market.”