Quick Guide: Unallowable Costs In Government Contracts

If you’re struggling to understand the difference between “allowable” and “unallowable” costs related to your government contracts, you are not alone. Even the most experienced government contractors struggle from time to time when it comes to identifying which costs can be allocated directly, indirectly or not at all to a government contract.

While FAR Sub Part 31 (FAR 31) provides numerous examples of allowable and unallowable costs, it does not cover all potential costs that may be incurred by a government contractor in the normal course of business or in performance of a contract that might be outside of their normal course of business.

FAR 31.201-2 provides a framework for determining the allowability of a particular cost using the following guidelines:

1. Reasonableness
2. Allocability
3. Standards promulgated by the Cost Accounting Standards Board (CASB), if applicable, otherwise United States Generally Accepted Accounting Principles (GAAP) and practices appropriate to the circumstances
4. Terms of the contract
5. Limitations noted in FAR 31.201-2

Let’s take a closer look at each component of these guidelines.

What Are “Reasonable” Costs?

Reasonableness is defined under FAR 31.201-3 as a cost that does not exceed that which would be incurred by a prudent person in the conduct of competitive business. There is no presumption of reasonableness just because a contractor paid the cost. Instead, reasonableness is determined through consideration of a variety of facts and circumstances, including:

1. The cost is ordinary and necessary to the conduct of the contractor’s business or the contract performance;
2. The expense meets generally accepted business practices, arm’s length bargaining, and federal and state laws and regulations;
3. The contractor meets his or her responsibility to the government, other customers, the owner of the business, employees, and the public at large and;
4. There are no significant deviations from the contractor’s established practices.

For example, if a contractor declared three Ferrari’s and an SUV as necessary to running his business, it would raise some eyebrows at the Defense Contract Audit Agency (DCAA). The costs related to the sports cars would almost certainly be deemed unallowable, including lease payments, maintenance and repair, gas and insurance. The SUV and its related costs, however, may be deemed allowable, depending on the circumstances of the car’s use.

How Is Allocability Determined?

The determination for allocability is based on the following:

1. Cost must be incurred specifically for the contract;
2. Cost must benefit both the contract and other work, and the cost can be distributed to the work in reasonable proportion to the benefits received, or;
3. Cost must be necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.

For example, the question of allocability often comes up when dealing with business development costs. Consistent business development activities (excluding those defined as expressly unallowable) are vital to an organization and can be allocated over all the contracts of the organization, both commercial and government. However, if an allowable cost only benefits some of the contracts and not the organization as a whole, only the contracts obtaining the benefit would be allocated the costs in question.

How Do the Terms of the Contract Impact the Allowability or Unallowability of a Cost?

The terms of the contract may include costs that are specifically unallowable. All contractors must thoroughly review their prime and subcontracts to ensure that they know what costs are unallowable on a specific contract.

For example, a contract might require a contractor’s staff to perform work at a government site. However, the contract might assume that the staff are local, and therefore no travel costs would be allowable under the terms of the contract. Another example is a limitation on the number of hours individuals work on a contract to avoid overtime costs.

What Happens to Unallowable Costs?

Costs that are expressly unallowable or mutually agreed upon to be unallowable, including mutually agreed to be unallowable directly associated costs, must be identified and excluded from any billing, claim or proposal applicable to a government contract. A directly associated cost is any cost that is generated solely as a result of incurring another cost. When an unallowable cost is incurred, its directly associated costs are also unallowable.

For example, let’s say a government contractor holds a party for its employees. As part of the costs of the party, the firm reimburses travel to the event and pays for overnight accommodations. The party itself is unallowable, which means the travel and lodging costs are also unallowable as they are directly associated with the party.

Another good example is the purchase of alcohol as part of a business meal. The business meal is deemed allowable; however, the cost of the alcohol, an expressly unallowable cost and any sales tax or tips allocated to that cost must be separately recorded as unallowable costs.

The practices for accounting for and presentation of unallowable costs must be those described in 48 CFR 9904.405, Accounting for Unallowable Costs.

How Does the Allowability or Unallowability of Costs Affect Certain Types of Contracts?

Firm Fixed Price Contracts

If the contractor is required to provide cost and pricing information as part of the contract negotiation, the contracting officer is responsible with ensuring the pricing takes unallowable costs into account. The officer must be certain these costs are not included in the indirect rate calculations as it will impact the proposed cost of the contract.

If a contracting officer questions the contractor’s ability to account for allowable and unallowable direct and indirect costs, the contractor is likely to lose out when competing with other firms that have a known ability to track costs properly.

Time and Materials Contracts

If time and/or certain materials are mutually agreed to be unallowable, the contractor cannot bill for those costs. In addition, if the contractor is permitted to bill and mark up other direct costs (ODCs), the markup will reflect the indirect rate of the contractor. The costs used to calculate the indirect rate can be audited and disallowed, which can result in a contractor having to repay the government for certain claimed costs. Penalties may also apply. In addition, criminal charges can be brought under the False Claims Act.

Cost Plus Fixed Fee Contracts

All mutually agreed to be unallowable costs, expressly unallowable costs and unallowable directly associated costs cannot be billed to the contracts, either directly or indirectly. These contracts require certification of the indirect cost rates proposed for final payment purposes. If unallowable costs are included in final indirect cost settlement proposals, penalties may be assessed and the company will have to repay the government for any discovered unallowable costs. As noted above, criminal charges can be brought under the False Claims Act.

How Can a Contractor Avoid Improperly Classifying an Unallowable Cost?

No system is 100% perfect, but contractors can take steps to mitigate the risk of improperly classifying costs:

1. Implement an adequate accounting system that has the capacity to track allowable and unallowable costs.
2. Develop and implement formal written policies and procedures for your company and within the accounting department to note what types of costs are allowable or unallowable and procedures for determining the allocation of such costs.
3. Train and periodically retrain all employees on company policies and procedures. Consider more routine training for accounting personnel in policies and procedures, and how to properly report and record allowable and unallowable costs.
4. Ensure that accounting personnel have appropriate oversight provided by experienced internal staff or external government contracting specialists.
5. Review costs as part of month-end close processes to ensure proper classification.
6. Test policies and procedures periodically to ensure understanding and compliance with established governmental policies and procedures. Remediate when required.
7. Routinely review established policies and procedures to ensure that they meet current standards, guidelines and are applicable to current and projected contract types.

Need Help?

To make sure your I’s are dotted and T’s are crossed when it comes to allowable and unallowable costs, contact us online or call 800.899.4623.