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

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Segregating unallowables from allowables is no easy task. In part I of our two-part blog series, we touched on the definition of allowable and unallowable costs. Now, we are back to give you more food for thought in the unallowable category. 

In this post, we’ll cover three areas that are used to qualify unallowable costs: consistency, adequacy, and segregation. We’ll also look at what happens if you do claim unallowable costs on a federal contract.

Consistency and adequacy

There is a concept that consistency applies when costs incurred for the same purposes and in similar circumstances are consistently treated either as a direct or indirect cost.

According to FAR 31.201-2(d), “[t]he contractor is responsible for accounting for costs appropriately while maintaining records which include supporting documentation that adequately demonstrates that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles and agency supplements” such as Defense Federal Acquisition Regulation Supplement (DFARS).

Adequacy refers to costs that may be disallowed if adequate support for the cost incurred is not documented.

Segregation of costs

All unallowable costs should be identified and segregated. Most organizations new to government contracting do not have a chart of accounts set up to specifically identify unallowable costs.

You should properly segregate your costs, whether by account or other means, to avoid inclusion in any proposal, claim, or billing to the government.

There are different options contractors can use for segregating unallowable costs. These are explained by industry best practices. A standard approach for the contractor is creating accounts, departments, or cost centers that identify unallowable costs. For a new account created in your account chart, these can be identified by including “unallowable” in the name, using a digit such as ‘9’ at the beginning or middle of the account number, or doing both. Depending on the accounting system that is used, a department, cost center, or class can be created where unallowable costs would be applied and segregated. This allows for easy identification of unallowable costs to be appropriately excluded in proposals, billings, or claims to the government.

Some approaches include:

• A unique approach for the contractor is maintaining their current account structure without creating unallowable accounts. The segregation of unallowable costs is performed through a statistical sampling of accounts which is discussed in FAR 31.201-6(2).  If a contractor decides they want to use statistical sampling, it is a best practice to first receive approval via an advanced agreement with the Administrative Contracting Officer (ACO). Normally a contractor would then credit a certain factor to the various pools to be voluntarily removed from the claimed cost.
• An uncommon approach is to maintain the current account structure and subsequently segregate unallowable costs in a separate process after the costs are posted to the general ledger. If your organization chooses this option, you should then outline the proper processes for how they would perform this process. This results in a higher risk of unallowable costs still making their way into proposals, claims, or billings to the government. From the government’s perspective, this is also the least acceptable method and would draw higher scrutiny during an audit.

Potential penalties

Penalties can be assessed if unallowable costs are included in claimed cost, bid price, or invoices to the government. FAR 42.709 describes the penalties that can be assessed.

If any indirect unallowable costs are identified as expressly unallowable, they are subject to a penalty equal to the amount of the disallowed costs that have been allocated to the contract(s) for which an incurred cost proposal was submitted, plus interest on any paid portion of the amount that was disallowed.

If the cost was unallowable before the incurred cost proposal was submitted, the penalty is two times the amount of disallowed cost-plus interest. The government may assess other civil, administrative, or criminal penalties depending on the nature and reason for the unallowable costs identified.

It is the responsibility of government contractors to ensure all costs are allowable

Government contractors are ultimately custodians of taxpayer dollars. They have a duty to keep costs allowable, allocable, and reasonable. As a taxpayer, we all want to be assured that the government is watching the contractors’ costs and that we aren’t paying for improper expenses such as alcohol or contributions.