What Are Allowable and Unallowable Costs in Government Contracts?

If you have come across the terms “allowable” and “unallowable” costs in relation to your GSA Schedule contract but you have no idea what they mean, you have come to the right place. As consultants at Winvale, we don’t expect all of our clients to be savvy accountants when it comes to costs incurred on their GSA Multiple Award Schedule (MAS) contract, and we don’t expect you to know either. 

Not all incurred costs are created equal in government contracts. The Federal Acquisition Regulation (FAR), the rulebook for federal government contracting, outlines two types of costs related to your contract—allowable and unallowable. Understanding which line item you may allocate and bill as allowable is important to avoid potential government penalties down the road. 

FAR 31 provides numerous examples of allowable and unallowable costs, so let’s break down these cost types and the rules the U.S. government has put in place to interpret the differences.

What Are Unallowable Costs?

Expenses acquired by the contractor that do not meet the authorized criteria under the current contract terms in FAR 31 are identified as unallowable by the government and excluded from any billing, claim, or proposal applicable to the contract.

Some common examples of unallowable costs (under Office of Management and Budget guidelines) include but are not limited to:

• Donations/contributions (FAR 31.205-8)
• Fines and penalties (FAR 31.205-15)
• Advertisements and media
• Entertainment (FAR 31.205-14)
• Tax expenses 

What Are Allowable Costs?

The government has a strict set of accounting principles and federal regulations in place for allowable costs. Under FAR 31.201-2, determining allowability of expenses is framed around four key factors: 

1. Is the Cost Predetermined as Allowable According to the Terms of the Contract?

At the initiation of a government contract, contractors should review the contract terms for allowable costs to have a clear understanding of what that contract deems allocable up front. That way, contractors can prevent payment delays and other potential penalties from the government. 

2. Is the Cost Allocated Applicable to Accounting Standards and Practices?

You’ll want to determine whether the cost is applicable to Cost Accounting Standards (CASB) or U.S. Generally Accepted Accounting Principles (GAAP) and if the accounting practices are appropriate to the circumstances. Certain contractors and subcontractors are required to have written cost accounting practices and are expected to consistently comply with their established accounting practices when performing on the contract. 

3. Reasonableness 

FAR 31.201-3 defines cost reasonableness as dependent on all the circumstances and facts concerning the cost. Because a contractor pays for a cost, it does not constitute the expense as reasonable. Ask yourself a couple of questions to examine the reasonableness of your costs before invoicing the government for reimbursement.

• Are my expenses generally recognized as ordinary and necessary for the conduct of my business or in the performance of the contract?
• Are these costs generally accepted under sound business practices, arms-length bargaining, and federal and state laws and regulations?
• Will the expense be consistent with our responsibilities to the government, customers, the owners of the business, employees, and the public at large? 
• Have costs deviated significantly from your established practices?

As an example, if a GSA Schedule contractor declared a yacht as necessary in running her business, the costs related to the yacht would most likely be deemed unallowable, including lease payments, maintenance and repair, gas, and insurance because the expenses would not be consistent with other contractors, and would clearly deviate from past established practices. 

However, if a contractor declared a car as necessary to running the business, the costs may be considered allowable if the car was used as a necessary vehicle to conduct business. 

4. Allocability 

FAR (31.201-4) Determining Allocability decides whether a cost can be charged to the contract and is based on the following requirements:

• The cost it is incurred solely to advance the work under the contract.
• The cost benefits both the contract and other work of the institution, in proportions. that can be approximated through use of reasonable methods.
• The cost is necessary to the overall operation of the organization.

Best Practices for Avoiding Unallowable Costs

Your organization certainly does not want to fund contract costs that won’t be reimbursed. Here are a few tips to help you steer clear of incurring unallowable expenses.

• Make sure you have a FAR-compliant accounting system in place that accurately tracks allowable and unallowable costs as they are incurred. Contractors are likely to lose out when competing with other firms that have a known ability to track costs properly.
• Make sure your employees know the difference between allowable and unallowable costs. It would help if you create a formal policy about it so these procedures can be consistently practiced throughout your organization.
• You’ll want to invest in the time and money it takes to train key personnel on the written policy you create. A contractor is responsible for accounting for costs appropriately and for maintaining records, including any supporting documentation adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements. 
• Review all your costs every month to ensure they are compliant with FAR 31-205. Keep in mind your Contracting Officer (CO) may disallow all or part of a claimed cost that is inadequately supported. 
• Make sure to regularly review and revise your policies and procedures so they reflect any updates to the FAR.

Do You Need Help Understanding Contract Costs?

Since contract type is primarily based on the contract payment method, it is very important that contractors review each new government contract for pricing information and cost regulations. The terms of the contract may include costs that are specifically unallowable and costs that are allocable. Reviewing your contract terms, defining your cost pools, evaluating the allowability of costs, and being aware of cost ceilings are steps that can be taken to help your organization mitigate risks associated with improperly classifying costs.

Before claiming reimbursement costs, ask yourself, “Have I allocated all direct or indirect costs in accordance with the terms of this contract?” And “Are these costs in compliance with federally established cost allocation standards and contract cost principles?”

If you need more information on allowable or unallowable costs, please contact one of our experts at Winvale. For more government contracting resources, check out our monthly newsletters and our Winvale blog. We keep the government contractor community up to speed on the latest updates with GSA.