FAR Allowable Vs. Unallowable Costs for Government Contracts


John Mahaffey

Author: John Mahaffey, Director of Audit and Accounting Services, Gorfine, Schiller & Gardyn

The Federal Acquisition Regulation (FAR) is the primary regulation used by all federal executive agencies in the acquisition of supplies and services with appropriated funds. It's jointly issued by the Department of Defense, the General Services Agency, and NASA. FAR is also used by state Department of Transportation and other agencies in determining allowable costs.

The details of the FAR are extensive, and often times, it can be overwhelming for firms as they prepare their indirect cost rates for 2020 as well as prepare for an audit of those rates.

Gorfine, Schiller &Gardyn’s Director of Audit and Accounting Services, John Mahaffey, provides an in-depth overview of FAR in a recent Q&A, including:

  • How to determine allowable versus unallowable costs
  • Allowable compensation costs under FAR
  • Complex areas when determining allowable costs

Q: How can organizations determine what are allowable and unallowable costs under FAR?

A: FAR Part 31 - Contract Cost Principles and Procedures, are the regulations for pricing contracts and determining allowable costs. Specifically, within Part 31, is Subpart 31.2 - Contracts with Commercial Organizations. This subpart covers all contract types, except for those with educational institutions, not-for-profit organizations, or state and local governments.

The FAR provides a significant level of detail on various specific costs, but there are several general rules to consider when deciding whether a cost is allowable and chargeable to a government contract.

The cost must be reasonable. Reasonableness is defined in the FAR as that which would not exceed what will be incurred by a prudent person in the conduct of a competitive business. In other words, what's “normal” in practice. The reasonableness of a particular cost can be challenged by auditors.

The cost must also be allocable. In other words, it must benefit, either directly or indirectly, a government contract. In order for the cost to be allocable, it must be assignable to a government contract on the basis of benefits received. If a firm incurs a cost specifically for a project, it is considered a direct cost and a direct benefit to that contract. An incurred cost allocated between projects on the basis of benefits received would be an indirect cost, chargeable to a government contract and allocable. A necessary cost for the overall operation of a business, such as general and administrative (G&A), are indirect costs, and allocable under the definition.

Overall, the cost must be reasonable, allocable to a contract, in accordance with generally accepted accounting procedures. If the cost meets those tests, the next step is to look to regulations for specific cost items.

Q: There is a significant amount of detail in FAR Part 31.205-6 - compensation for personal services. What should architectural and engineering (A/E) firms know about this section?

A:Compensation is typically one of the largest, if not the largest expense of an A/E firm. Part 31.205-6 is extensive, and it starts with describing allowable compensation in a general sense. To start, the compensation must be for work performed in the current year, with some exceptions.

Severance pay is allowable if it's required by law or an agreement, although abnormal severance is not allowed. Back pay is allowed only if a firm is correcting a prior error.

In addition, total compensation, which will include the base salary, bonus, company 401(k) contributions, and other fringe benefits, must be reasonable for the work performed. Firms should review industry compensation surveys to gauge what's reasonable for a particular position or a class of employees. It also needs to be based on an established compensation plan that's consistently followed. There is no presumption of allowability if a major unapproved change in compensation practices is made. If a firm plans to change the way compensation is structured, it would be wise to speak to the contracting officer for approval ahead of time.

It’s important for owners of the firm to note that distribution of profits is not an allowable cost charged to a government contract. It’s critical to have written plans, procedures, and policies around compensation, especially if elements of compensation are challenged.

Bonuses and incentive compensation is another challenging area. Is it a bonus paid for compensation, or is the firm simply distributing profits out of the business? This is an area that can be challenged by the government and auditors, making it critical to have a written bonus plan. Bonuses need to be paid either under a written bonus plan or an established policy that's so consistently applied that it is implied that there’s a firm policy in place. The basis for the bonus must be supported and based on established criteria, which should be defined in advance and based on merit or performance measures.

Company contributions to pension plans are a form of compensation. In order to be allowable, those contributions to the plan have to be funded by the same due date as the federal tax return, including extensions. It can be funded after year-end, but if it's not funded by that due date, it's not an allowable cost, so it’s important to make that date.

Fringe benefits(paid time off, company-paid insurance, etc.) need to be reasonable, required by law, or pursuant to an agreement or established policy. Many firms allow employees to use company autos for personal use, and this is not an allowable cost, even if that personal use is recorded as compensation. This includes commuting to and from the workplace. Firms should keep mileage logs so that the costs can be allocated between the business use and the personal use.

Finally, there are compensation caps for federal contracts. For 2020, it’s $555,000. State DOTs also have caps for executive compensation, which are based on a sliding scale that's determined based on revenue.

Q: What are other areas of costs under FAR that firms might encounter as they prepare incurred cost proposals?

A: There are several obvious unallowable costs such as bad debts and collection costs, charitable contributions, fines, penalties, losses on other contracts, lobbying and political activity, alcoholic beverages, entertainment, and federal income taxes.

Entertainment is unallowable, and if there are any directly associated costs, they also become unallowable. For example, tickets to a baseball game is an unallowable cost and transportation, such as a cab ride to the event, is a related cost and unallowable.

Another area that would seem to be an obvious unallowable cost is interest. However, there is an allowable cost called facilities capital cost of money. It’s an imputed interest rate using a government-determined rate that's the same for everyone, applied to the fixed assets in a business, so, if the contract allows, everyone would get some form of interest that way.

Marketing is another confusing area and can be broken down into three main areas: public relations, direct selling, and bid and proposal costs. Public relations or advertising is generally unallowable. This includes a firm’s image enhancement or promoting the business. Trade shows are considered unallowable, but if employees attend for training, a portion of the trade show cost would be allowable. Direct selling is allowable. This is different from advertising and public relations in that there’s person-to-person contact with a particular potential customer. Bid and proposal costs are the costs of preparing and submitting bids and proposals on potential contracts. It’s a normal business activity and allowable.

Depreciation is allowable. Although, bonus depreciation or Section 179 where the entire cost of the asset is expensed in the first year is unallowable. Depreciation should be computed on a straight line basis over the estimated useful life of the asset.

Employee morale is another area with some complexities. Many different costs are considered employee morale, but it’s important to remember, no entertainment. Entertainment, such as holiday parties, is an unallowable cost no matter where it occurs, even if it's allowable by another section. Gifts are allowable, but they must be to recognize employee achievement. Recreation is only allowable if it's for employee participation such as a company-sponsored sports team or teambuilding event.

Insurance is another area of cost with a few exceptions. Officer life insurance is not allowable unless it's recorded as compensation to the employee and the company is not the beneficiary. Errors and Omissions insurance is an allowable cost, but the cost incurred to correct defective work, settle claims, or lawsuits regarding defective work are not an allowable cost.

Professional fees should be supported by agreements and detailed invoices with hours and rates. Legal fees for lawsuits against the government, in which the contractor loses the suit, are not allowable. Organization and reorganization costs, such as conducting a merger or acquisition are not allowable.

Employee relocation costs are allowable if the moving is for 12 months or more, for the benefit of the employer, and the cost cannot exceed what was actually incurred by the employee.

Rent is allowable, unless renting to yourself or related parties. For instance, if you own one company, then you own another LLC that owns the building that you're in and you rent to yourself, those costs are allowable. However, they're only allowable up to the actual cost of your ownership. Therefore, you would look to the costs of the LLC that owns the building, the depreciation, taxes, insurance, repairs, and maintenance. If those costs are $50,000 for the year and you paid $100,000 in rent, $50,000 would be disallowed as an allowable cost.

Meals while traveling are allowable and subject to the Federal Travel Regulations per diem amount. Meals during business meetings are allowable too if the purpose of the meeting is dissemination of trade, business, technical, or professional information. Documentation on the receipt such as who attended, information discussed, is recommended to support the cost. Other travel costs cannot exceed Federal Travel Regulations per diem rates, and the business purpose of the trip must be documented.

Q: What are Gorfine, Schiller & Gardyn’s services in this arena?

A: Gorfine, Schiller & Gardyn performs audits of indirect cost rates for state DOT contractors and also provides assistance in preparing indirect cost rate submissions for federal government contractors as well as general business and tax consulting and government contracting consulting.

For more information, click here.

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