Unallowable costs and how to segregate them
Unallowable costs are ordinary business expenses the government will not reimburse. Nothing about incurring them is improper. Including them in a rate or a billing is.
The allowability test
FAR 31.201-2 sets out what makes a cost allowable. All of these have to hold:
- The cost is reasonable — what a prudent person in a competitive business would have incurred.
- It is allocable to the contract.
- It conforms to Cost Accounting Standards where they apply, or to generally accepted accounting principles where they do not.
- It conforms to the terms of the contract.
- It is not excluded by the limitations in FAR 31.205.
Fail any one and the cost is unallowable, whether or not it appears on a list.
Selected costs that come up most
| Cost | Treatment |
|---|---|
| Entertainment (31.205-14) | Unallowable. Includes amusement, social activities, tickets, club memberships, and the associated costs. |
| Alcoholic beverages (31.205-51) | Unallowable in all cases. Split it off the restaurant receipt. |
| Advertising and public relations (31.205-1) | Largely unallowable. Recruitment advertising and certain trade-show costs directed at acquisition are the main exceptions. |
| Lobbying and political activity (31.205-22) | Unallowable. Includes the labor of employees engaged in it. |
| Fines, penalties, mischarging (31.205-15) | Unallowable, including those resulting from violations of law. |
| Interest (31.205-20) | Unallowable, on any borrowing, however represented. |
| Bad debts (31.205-3) | Unallowable, including collection costs and related legal cost. |
| Contributions and donations (31.205-8) | Unallowable. |
| Goodwill (31.205-49) | Unallowable — a real issue for contractors that have made acquisitions. |
| Compensation (31.205-6) | Allowable to the extent reasonable, and subject to a statutory cap on the allowable portion of compensation. The cap changes; check the current figure. |
This is not the whole of FAR 31.205, which runs to more than fifty selected cost items. It is the set that catches small contractors.
Directly associated costs
When a cost is unallowable, costs generated solely as a result of it are unallowable too. If an executive travels to a lobbying event, the airfare, hotel, and their labor for that time follow the lobbying into the unallowable account. This is the part contractors most often miss, because the underlying expense categories — travel, labor — look allowable on their face.
Screening during the year
Screening once, in the spring, while preparing the incurred cost submission, is how contractors end up restating rates. Build it into the routine instead:
- Mirror unallowable accounts against the allowable accounts they correspond to, so coding is a choice at entry rather than a reclassification later.
- Give AP a written screening list with the categories that come up in your business, and require the itemized receipt where a single transaction can contain both — meals with alcohol being the standard case.
- Review the unallowable accounts at every monthly close, and review a sample of the allowable accounts that most often hide unallowable items — travel, meals, professional fees, dues and subscriptions, marketing.
- Keep unallowable cost out of the indirect pools and in the G&A allocation base.
- Handle directly associated costs at the same time as the underlying item, not separately.
FAR 42.709 provides for penalties where expressly unallowable costs are included in a final indirect cost rate proposal. Screening in real time is cheaper than the alternative.
Frequently asked
Are unallowable costs illegal?
No. They are ordinary business expenses the government has decided not to reimburse. Incurring them is fine. Including them in a rate, a billing, or a final indirect cost rate proposal is the problem.
Do unallowable costs stay in the G&A base?
Yes. Unallowable costs are removed from the indirect cost pools but remain in the allocation base. Leaving them out of the base overstates the rate. This is a routine audit finding.
What is a directly associated cost?
A cost generated solely as a result of incurring an unallowable cost — the travel and labor tied to a lobbying trip, for instance. It becomes unallowable too, even though the category itself is normally allowable.
Are penalties assessed for including unallowable costs?
FAR 42.709 provides for penalties where expressly unallowable costs appear in a final indirect cost rate proposal. Expressly unallowable — named in the regulation — carries more exposure than a judgment call about reasonableness.
Related
Direct vs. indirect costs in a GovCon business
How to decide whether a cost is direct, indirect, or unallowable — and why consistency matters more than the individual call.
Read →Building a GovCon chart of accounts
A chart of accounts that segregates direct, indirect, and unallowable costs by construction — so compliance is a byproduct of posting, not a cleanup project.
Read →The incurred cost submission
Who has to file, the six-month deadline under FAR 52.216-7, the ICE model schedules, and the deficiencies that get submissions returned.
Read →