Understanding Allowable Costs Speeds Reimbursement: 6 Best Practices for Avoiding Unallowable Costs

Understanding which costs may be allocated to a direct or indirect project, and billed to the government as an allowable cost speeds reimbursement of expenses, and helps avoid potential government penalties. The Federal Acquisition Regulations  (FAR) provides official guidance and numerous examples of allowable and unallowable costs.

Here we will discuss what is and is not allowable and some best practices to segregate unallowable costs in order to help avoid mistakenly billing these costs to the government.  It’s common and acceptable for contractors to incur unallowable costs, as long as these costs are excluded from billings to the government.  Additionally, some costs are unallowable for government contracting purposes, yet deductible for tax purposes.  Hence, a keen understanding of the treatment of these costs is important.

What Costs are Allowable?

To meet federal standards of allowability, costs must be reasonable, allocable, necessary to the project, and in compliance with funding statutes and agency requirements.

To evaluate allowability of an expense, first determine what costs are allowable according to the terms of the contract. Review contract terms to prevent payment delays and other potential penalties. Determine which accounting standards and practices apply: Cost Accounting Standards Board (CASB) or Generally Accepted Accounting Principles (GAAP)? Certain contractors are required to follow established written cost accounting practices.

To determine if the cost is reasonable, assess if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of a competitive business. A few questions to test reasonableness:

• Are the expenses generally recognized as ordinary and necessary for the conduct of 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 expenses be consistent with procedures that apply to both federal awards and other activities of the recipient?
• Have costs deviated significantly from any established practices?

The cost is allocable if the cost is incurred solely to perform the work under the contract, or the cost benefits both the contract and contractor’s other work in reasonable proportion to the benefits received, or the cost is necessary to the overall operation of the business.

Allowable expenses are:

• Necessary and reasonable for proper and efficient performance and administration of the agreement.
• Treated consistently as either a direct or indirect cost.
• Determined in accordance with the Generally Accepted Accounting Principles, except as otherwise stipulated by the contract.
• Net of all applicable credits.
• Not to be included as cost or used to meet the cost-sharing or matching requirements of any other federal award, unless specifically permitted by federal law or regulation, or by the contract.
• Adequately documented.
• Authorized or not prohibited under state or local laws and regulations.
• In compliance with all applicable limits or exclusions on types or amounts of costs.

Unallowable Costs

Unallowable costs will not be reimbursed, and if submitted for reimbursement, could trigger government penalties. If a cost cannot meet the above criteria of reasonableness, allowability, allocability, and consistency, it is unallowable.

Unallowable costs are also any charges to a federal award that the federal awarding agency or pass-through entity determines to be unallowable, in accordance with the applicable federal statutes, regulations, or the terms and conditions of the federal award. Non-federal entities must not use awards or match funding for unallowable costs. FAR 31.205 provides guidance to federal contractors regarding allowable and unallowable costs.  Standard unallowable costs for non-federal entities are identified here. 

Examples of Allowable and Unallowable Costs

Best Practices for Avoiding Unallowable Costs

1. Implement an adequate and comprehensive compliant accounting system that has the ability to segregate and track allowable and unallowable costs as they are entered into the system.
2. Develop formal written policies and procedures for your entire organization that describe and differentiate allowable and unallowable costs.
3. Invest in training key personnel on these policies and procedures, and make sure employees know what to look for when identifying unallowable costs.
4. 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.
5. Review and revise your policies and procedures, as needed, to make sure they remain in compliance with any changes that occur in the regulations.
6. Review your costs periodically to ensure they remain properly identified as allowable or unallowable.

If you have questions, or need expertise and help with understanding what costs are allowable, please contact us.