Federal contractors are often told that a cost is “unallowable” and left to wonder what that means. The answer lives in FAR Part 31, the cost principles, which decide what costs the government will pay under cost-reimbursement contracts, what belongs in the indirect rates used to price other contracts and what an auditor will question. Three words organize the whole framework: allowable, allocable and reasonable.
Why the cost principles exist
When the government reimburses costs or negotiates prices based on cost data, it needs a common definition of which costs count. The cost principles provide that definition. They apply directly to cost-reimbursement contracts, to the pricing of contract modifications and terminations and to the negotiation of indirect rates. They also shape fixed-price work indirectly, because the indirect rates a firm uses in its pricing must exclude unallowable costs if those rates are ever to survive a government review.
Allowable: the overall test
A cost is allowable only if it meets all of several conditions. It must be reasonable. It must be allocable to the contract. It must comply with any applicable Cost Accounting Standards or, for most small firms, with generally accepted accounting principles and practices appropriate to the circumstances. It must comply with the terms of the contract. And it must not be made unallowable by one of the specific limitations the regulation sets out.
Reasonable and allocable
A cost is reasonable if, in its nature and amount, it does not exceed what a prudent person in the conduct of competitive business would incur. The test considers whether the cost is generally recognized as necessary, whether it follows sound business practice and arm’s-length bargaining, whether the contractor acted responsibly toward the government, the public and its own employees, and whether there was any significant deviation from the contractor’s established practices. A legitimate cost can still be questioned if the amount is extravagant.
A cost is allocable to a contract if it is incurred specifically for that contract, benefits both that contract and other work and can be distributed in reasonable proportion to the benefits, or is necessary to the overall operation of the business even though a direct relationship to any particular contract cannot be shown. Allocability is why indirect cost pools and bases matter: they are the mechanism for distributing shared costs fairly.
The specific limitations
The regulation then walks through dozens of cost categories, declaring some allowable with conditions and others unallowable outright. Examples that surprise new contractors include:
- Entertainment, including meals and events for morale or client relations, is unallowable
- Alcoholic beverages are unallowable
- Most advertising and public relations costs are unallowable, with narrow exceptions such as recruiting and required notices
- Lobbying and most political activity costs are unallowable
- Interest on borrowings is unallowable, even though it is a real cost of doing business
- Bad debts, fines, penalties and the costs of defending certain legal proceedings are unallowable
- Contributions and donations are unallowable
- Compensation is allowable but subject to reasonableness and, for certain employees, statutory caps
Other categories, such as travel, training, bid and proposal costs, and professional services, are allowable within limits that the regulation describes.
What contractors must do
Unallowable costs must be identified and excluded from any billing, claim or proposal to the government. That means the accounting system needs a way to segregate them, typically by separate accounts, and that staff coding expenses need to understand the rules. Including expressly unallowable costs in a submission can lead to penalties, not just disallowance. An accountant experienced in government contracting can help set up the structure. The full text of the cost principles is at acquisition.gov, and reading the sections that touch your business is time well spent before your first cost-type contract or audit.