Unallowable Costs in Government Contracts

Government Capitol Building with trees around it.The federal government will not reimburse contractors for certain expenses, known as unallowable costs. Common unallowable expenses include entertainment, alcohol, company parties and certain travel expenses.  These are defined in FAR 31. Your contract also may exclude certain other expenses. In many cases, these represent legitimate business expenses. You may deduct them for tax purposes, but you cannot bill them to the government.

Cost Allowability

According to FAR 31.201-2 (a): “A cost is allowable only when the cost complies with all of the following requirements:

  1. Reasonableness.
  2. Allocability.
  3. Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances.
  4. Terms of the contract.
  5. Any limitations set forth in this subpart.”

Reasonableness

According to FAR 31.201-3(a): “A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business.”


Allocability

According to FAR 31.201-4: “A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it-

  1. Is incurred specifically for the contract; (Direct)
  2. Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; (Overhead) or
  3. Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.” (G&A)

CAS and GAAP

Costs must comply with the Cost Accounting Standards (CAS), when applicable, and Generally Accepted Accounting Principles (GAAP). In other words, you must have acceptable treatment of a cost for financial reporting purposes.


Terms of the Contract

Individual contracts may dictate the treatment of certain costs. Your contract may:

  1. Clearly enumerate specifically unallowable costs. Note these are subject to the 2X penalty discussed below.
  2. Simply may not include costs (unallowable by omission) such as travel. These often result in unbillable direct costs.
  3. Call for a cost to be treated as direct that is normally treated as indirect by a contractor.

Burden of Proof

Note the burden of proof when auditors question a cost.

  • Proving a cost is unallowable: Government
  • Proving a cost is reasonable: Contractor
  • Proving a cost is allocable: Contractor

FAR 31.205

FAR 31.205 lists 52 costs with prescribed treatment. Start your research here to determine if the cost in question matches one of the enumerated items. Be sure to read any referenced FAR clauses as they provide additional guidance.

If a cost here is deemed unallowable, then it is treated as “expressly unallowable” and subject to the 1X penalty discussed below.

Best Practices

Separate G/L accounts

  • Industries prefer the 9xxx series of accounts
  • Put “UN” or “Unallowable” in the description

Users needs the ability to identify unallowable costs on expense reports, requisitions, and purchase orders. Document, document, document…

  • Travel – take screenshots of airfare, hotel and rental car rates
  • Write-up any instance where you claim higher than FTR/JTR/per diem such as location, availability of rooms, etc.

Penalties

Penalties for the improper treatment of costs are outlined in FAR 42.709.

  • Claimed expressly unallowable costs on ICP and billings results in 1x penalty plus interest.
  • Claimed unallowable costs when identified at time of proposal for a contractor is 2x penalty plus interest.
  • Note that costs determined to be disallowed due to insufficient documentation should not incur additional penalty unless the nature of the cost in question was expressly unallowable.

Unallowable Costs & Indirect RatesCalculating Money

Unallowable costs are excluded from the cost pools (not billable), but included in the bases as appropriate.

CAS 405

CAS 405 reads, in part (emphasis added):

“The cost accounting treatment to be accorded such identified unallowable costs in order to promote the consistent application of sound cost accounting principles covering all incurred costs.

The Standard is predicated on the proposition that costs incurred in carrying on the activities of an enterprise—regardless of the allowability of such costs under Government contracts—are allocable to the cost objectives with which they are identified on the basis of their beneficial or causal relationships.

All unallowable costs covered by paragraphs (a) through (d) of this subsection shall be subject to the same cost accounting principles governing cost allocability as allowable costs. In circumstances where these unallowable costs normally would be part of a regular indirect-cost allocation base or bases, they shall remain in such base or bases. Where a directly associated cost is part of a category of costs normally included in an indirect-cost pool that will be allocated over a base containing the unallowable cost with which it is associated, such a directly associated cost shall be retained in the indirect-cost pool and be allocated through the regular allocation process.”

If an unallowable cost is otherwise direct in nature, it’s included in the base of Fringe, OH, and G&A as appropriate. See the example of Unallowable Direct Labor below.


Unrecovered Costs

Because of the inclusion in the allocation bases as appropriate, unallowable costs lead to unrecoverable fringe, overhead, and G&A.

Unrecovered Fringe

Since all W-2 labor is in the base of fringe, then unallowable (or unbillable) direct labor bears its fair share of fringe which is now unrecoverable.

Unrecovered Overhead

Note that we have two separate overhead pools. Similar to fringe, direct labor (allowable and unallowable) are in the base of overhead, so we have a portion of each overhead is now unrecoverable.

        

Unrecovered G&A

Direct labor plus fringe and overhead are in the base of G&A, so we have a portion of G&A that is unrecoverable.

Total Unrecovered Costs

In the example above, $18,232 of unallowable costs resulted in a total of $36,902 of unrecovered costs.

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