Accounting 101 for Government Contractors: Allowable vs. Unallowable Costs

In government contracting, not all costs are treated the same. When your organization enters into a contract with the government, you will work with a specific set of accounting rules as outlined by the Federal Acquisition Regulations (FAR). These principally deal with the allocation of direct or indirect costs, as well as overhead and general and administrative costs. And because the federal government will not reimburse all incurred costs, your organization must become astute at determining allowable versus unallowable costs.

Allowable costs

An allowable cost is one that can be included on your invoice to the government for reimbursement. Under FAR 31.201-2, a cost is allowable only when it meets all of the following three requirements.

1. It is allowable under the terms of the contract. The terms of the contract may include costs that are specifically unallowable. Contractors are encouraged to review their prime and subcontracts up front to identify what costs are allowable and what costs are not on a specific contract.
2. It is allowable under the limitations set forth in FAR 31-205 and by the Cost Accounting Standards (CAS) Board.
3. The cost is reasonable and allocable. A cost is considered reasonable if the amount and nature are what a prudent person dealing in a competitive business would pay. A cost is considered allocable if it is incurred specially for the contract, benefits the contract, and is necessary to the business operations.

Unallowable costs

An unallowable cost will not be reimbursed by the federal government and should not appear on a bill to a government agency. Some are expressly unallowable under the FAR, including:

• Entertainment
• Donations
• Interest
• Bad debt
• Fines and penalties

Excessive or unreasonable costs are also unallowable. These tend to be related to compensation and travel. Many such costs are permissible, but if they exceed the limits set by the Federal Travel Regulations, then excess portions are considered unallowable.

Best practices for avoiding unallowable costs

Your organization certainly doesn’t want to run up contract costs that won’t be reimbursed. There are a number of things you can do to avoid incurring them.

• Implement an adequate and comprehensive FAR-compliant accounting system that has the ability to track allowable and unallowable costs as they are entered into the system.
• Develop formal written policies and procedures for your entire company that describe and differentiate allowable and unallowable costs.
• Invest the time and money that it takes to train key personnel on these policies and procedures, and make sure employees know what to look for when identifying unallowable costs.
• Review all costs as part of your month-end closing procedures to ensure they are properly classified for FAR 31-205.
• Test the policies and procedures periodically to ensure they are operating effectively. This can be done via internal audits and reviews or a voluntary external audit.
• Review and revise your policies and procedures as needed to make sure they are in compliance with any changes that occur to the FAR.

How we can help

Success in government contracting hinges on compliance with federal regulations. Defining your cost pools, evaluating the allowability of costs, and being aware of cost ceilings can help ensure such compliance and make your bids more attractive and competitive. CLA’s government contracting team can assist you in developing and implementing best practices and reviewing and testing policies and procedures.