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

Updated November 2024

To successfully operate as a government contractor, it’s essential to understand which costs are deemed allowable and which are unallowable under government contracts. Failure to recognize this distinction can lead to compliance issues and potential complications for your business.

The Federal Acquisition Regulation (FAR) establishes the primary policies and procedures governing government procurement, with FAR Part 31 specifically outlining contract cost principles and procedures for government contracts.

This post is Part I in our two-part series on allowable and unallowable costs in government contracting. Let’s start by exploring what qualifies as an allowable cost.

Understanding allowability 

Under FAR 31.201-2, allowable costs for government contracts are defined based on five key criteria:

• Reasonableness (FAR 31.201-3): Costs must pass the "prudent person" test, meaning they are reasonable in nature and amount. 
• Allocability (FAR 31.201-4): Costs should be assignable to a particular contract or cost objective. 
• Standards: Costs must adhere to standards set by the Cost Accounting Standards (CAS) Board when applicable, or otherwise follow generally accepted accounting practices appropriate to the situation.
• Terms of the Contract: The specific terms of each government contract may influence cost allowability.
• Limitations: Any limitations established in FAR 31.201-2 must be observed.

Reasonableness: The Prudent Person Test 

For a cost to be considered allowable under government contracts, it must pass the "prudent person" test. This means that the cost should not exceed what a reasonable person would incur in terms of nature and amount during contract performance. 

Unsure About a Specific Expense?
Consider the following questions to assess if a cost meets the reasonableness standard:

• Is the expense ordinary and necessary for the business purpose?
• Does the expense deviate from established practices?
• Does it comply with federal and state laws?
• Is it aligned with sound business practices?

Example:
Suppose you’re traveling for business and decide to rent a large vehicle, like a Chevy Suburban. Is this reasonable? The answer depends on the circumstances. For a single traveler, a large car may seem excessive. However, if there are seven people on the trip, renting one large vehicle could be more cost-effective than renting two smaller ones.

To justify the expense, document the reasoning behind renting the larger vehicle and retain this analysis with the trip’s expense records.

Allocable Costs: Single or Multiple Contracts

Determining where to assign costs can be challenging. Consider whether an expense is allocable to a single contract or should be distributed across multiple contracts. The criteria below help determine allocability: 

• Costs incurred specifically for a contract are allocable to that contract.
• Costs that benefit multiple contracts (directly or indirectly) can be allocated across those contracts based on the benefits received.
• Costs necessary for the overall business, such as general administrative expenses, may be allocated as indirect costs.

Remember, each cost should be allocated only once to any contract, project, or other cost objective.

Unallowable Costs: Defined

Unallowable costs are expenses that fail to meet the criteria for allowability. According to FAR 2.101, these are costs that “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 classified as unallowable under the following conditions:

• Expressly Unallowable: Some costs, such as alcohol, are clearly defined as unallowable by regulation, leaving little room for interpretation.
• Contractually Unallowable: Certain costs may be deemed unallowable per the specific terms of your government contract. For instance, while travel or overtime costs might typically be allowable, they could be unallowable if restricted by contract terms.
• Failure to Meet Allowability Criteria: Costs that lack reasonableness, allocability, sufficient documentation, or are inconsistently applied can be classified as unallowable.
• Directly Associated Costs: These costs are “guilty by association.” If a typically allowable cost is incurred in connection with an unallowable cost or purpose, it will also be deemed unallowable.

Knowledge is Key for Government Contractor Employees

A clear understanding of allowable versus unallowable costs is essential for maintaining compliance with federal and state regulations, helping to safeguard your company’s standing in government contracting. 

Training on allowable and unallowable costs shouldn’t be limited to accounting staff. All employees—from project support teams to contract administrators and executive management—should be well-versed in identifying allowable and unallowable costs.

In part II of our series on allowable and unallowable costs, we’ll explore adequacy, consistency, and segregation to help prevent penalties.

For more information, please contact Christine Williamson or Theresa Gonzalez from CohnReznick.