The Government Contractors’ Guide to Allowable Costs vs. Unallowable Costs – Part I

To do business as a government contractor, you’ll need to be aware of what kind of costs the government considers allowable versus unallowable. Failure to understand this distinction can cause complications for your company and may leave you struggling to maintain regulatory compliance.

The Federal Acquisition Regulation (FAR) codifies policies and procedures and is the principal set of rules regarding government procurement. FAR 31 sets regulations around the contract cost principles and procedures.

This post is part I in our two-part blog series on allowable versus unallowable costs. First, let’s dive into what qualifies as an allowable cost.

Understanding allowability

According to FAR 31.201-2, the government defines allowable costs via the following five criteria:

• Reasonableness (FAR 31.201-3)
• Allocability (FAR 31.201-4)
• Standards promulgated by the Cost Accounting Standards (CAS) Board, if applicable; otherwise, generally accepted accounting practices and practices appropriate to the circumstances can apply
• Terms of the contract
• Any limitations set forth in FAR 31.201-2

Reasonable to pass the prudent person test

Costs that don’t exceed (in either nature or amount) what would be incurred by a “prudent person” during your contract performance are considered allowable by the government.

On the fence about a specific expense? Here are a few questions you can ask yourself to help you determine if a cost is reasonable:

• Is this expense ordinary and necessary for the business purpose?
• Does this expense represent a departure from our normal, established practices?
• Do these expenses violate any federal and/or state laws?
• Are these expenses accepted under sound business practices?

Here’s an example. If you’re traveling for business and rent a large car, such as a Chevy Suburban, does that sound reasonable? The answer could be yes or no and depends on the situation. If it’s for one person, that may seem excessive. However, if there are seven people on the trip, renting one large car for everyone may be more cost-effective than renting two.

Documentation and analysis as to why the individual or group decided to rent the larger car should be completed and saved alongside the expense documentation for the trip.

Allocable to all contracts or not

You may also find yourself asking where you should assign costs for an expense, and whether those costs are allocable to one contract or to multiple contracts. The following criteria determine whether costs are allocable:

• If the costs have been incurred for a specific contract, they are allocable to that contract
• If the costs benefit more than one specific contract (both direct and indirect), they can be distributed across the contracts based on the benefits received
• If the costs are necessary to the overall business, such as general administrative expenses

You should only allocate costs one time to any contract, project, or other cost objective.

Unallowable costs for different reasons

Unallowable costs are those costs that do not meet the definition of allowability. FAR 2.101 defines unallowable costs as costs “under the provisions of any pertinent law, regulation, or contract [that] cannot be included in prices, cost-reimbursements, or settlements under a Government contract to which it is allocable.”

Costs can be treated as unallowable if:

• Expressly unallowable. These are costs that, in direct terms, are defined as unallowable and leave little room for interpretation as to whether they would be considered allowable or not. Alcohol is an example of an expressly unallowable cost.
• Contractually unallowable. Some unallowable costs are determined to be unallowable in accordance with the terms of your contract. Travel or overtime – which might normally be determined to be allowable – could be ruled as unallowable if stated as such in the contract.
• Does not meet the criteria of allowability. Costs that are not reasonable, not allocable, do not have adequate support, or are inconsistently applied can be deemed unallowable.
• Directly associated costs. Think of costs that are “guilty by association.” A cost that is normally allowable is incurred with a cost or purpose that is unallowable, the allowable cost will be deemed unallowable because of the association.

Knowledge is key for employees working for a government contractor

Having a clear understanding of the differences between allowable and unallowable costs is important because it helps keep your company compliant with all federal and state regulations.

You’ll want to train more than just your accounting staff on how to identify when a cost may be considered allowable or unallowable.  However, remember: all employees – from those supporting direct to project, to contract administrators, to executive management – should understand what costs are allowable and unallowable.

In part II of our series on allowable and unallowable costs, we’ll tackle the concepts of adequacy, consistency, and segregation to avoid penalties.