Government Contracting Database
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 allocable to the contract, per the terms of the contract at issue, Cost Accounting Standards and the FAR. (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 calculations, determination of costs following termination, and negotiation of contract modifications.
One of the elements of allowability is reasonableness. To be reasonable, the cost must:
- Be the type of cost generally recognized as ordinary and necessary for the conduct of the contractor’s business or the contract performance;
- Be generally accepted under sound business practices, arms-length bargaining, and federal and state laws and regulations;
- Be consistent with the contractor’s responsibilities to the government, other customers, the owners of the business, employees, and the public at large; and
- Not include any significant deviations from 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 incurred specifically for the contract;
- Benefit both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or
- 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
- Contributions or donations
- Fines and penalties
- 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:
- Pension costs
- Relocation Costs
- Employee morale, health, welfare (generally allowable)
- Professional fees (including attorneys’ fees)
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.
Updated: May 24, 2018