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Allowable Costs

The Federal Government has very clearly defined rules concerning what costs are allowable and what cost are not allowable. For instance, in the simple calculation of the Eichleay Formula which is used for Unabsorbed Home Office Overhead some of the costs which a contractor may normally report in accordance with generally accepted accounting practices in terms of home office overhead may not be allowable by the Federal Government.

Allowable costs are defined in the FAR as costs that are reasonable and chargeable to the contract. (See FAR 31.201-2). Although this is a broad definition, FAR Section 31 specifically addresses many types of costs a contractor may incur. It is important to note that these cost principles apply not only to cost-reimbursable contracts, but also to fixed- price contracts. When applied to fixed-price contracts, these principles govern primarily extended overhead calculation and negotiation of changes over $100,000.00 in value.

One of the elements of allowability is reasonableness. To be reasonable, the cost must:

* be generally recognized as an ordinary or necessary part of the business;
*follow sound business practices;
*comply with federal, state, and local laws; and
*be consistent with the contractor's established practices.

The determination of reasonableness of a particular cost depends on all of the circumstances and facts concerning the cost.

The other element of allowability is allocability of the cost to the contract. Allocability involves a determination as to whether the cost can be charged to the contract. To be allocable to the contract, the cost must:

*be specifically incurred for the contract;
*benefit the contract and other work; and
*be necessary for the overall operation of the business.

If a cost is reasonable and allocable (chargeable) to the contract, then it will be allowable, unless specifically prohibited by the cost regulations.

Probably the best way to define unallowable costs is to list the ones specifically determined by the government in the FAR to be unallowable. The following costs are considered unallowable as noted in FAR Section 31:

* bad debts
* interest
* entertainment
* contributions or donations
* fines and penalties
* lobbying
* losses on other contracts
* alcoholic beverages
* business organization costs (incorporation, reorganization, merger)

There are a number of other costs which may or may not be allowable depending upon the facts and circumstances concerning the cost. Examples of these costs, which are described in FAR Section 31, include:

* training
* depreciation
* insurance
* employee morale, health, welfare (generally allowable)

This is an area which requires guidance from a professional familiar with the cost principles, the FAR, and judicial rulings on allowability. If an auditor raises questions about a specific cost, you should give as much background and explanation as to the reasonableness of the cost and the reason it is charged to this contract. For those costs that are unallowable, by regulation, the government will not consider any argument to include them.

The cost principles in FAR Section 31 apply to construction contracts whenever the contarctor submits cost or pricing data in support of a proposal, modification, or change order which will be negotiated under the contract. For contract modifications, these principles will be utilized by the government on any proposal over $100,000.00. All proposals over $500,000.00 require an audit to be performed and the government's auditors also will use these cost principles in evaluating your costs.

(Also See Claim Preparation Costs)