Unallowable costs are defined by FAR 31.2. Costs can also be deemed unallowable by contracting officer decision. This regulation, FAR 31.2, defines costs as unallowable in two broad categories. One is expressly unallowable costs. This one is manageable it includes those costs that are unallowable 100% under all circumstances. This is a relatively short list. The second is what is called circumstantial unallowable costs. In other words, it depends on the specific circumstances. It depends on a number of criteria. As they say, for every rule there are exceptions and limitations. This is definitely the case in government contracting. The circumstantial unallowable costs fit this criteria quite well. The majority of FAR 31.2 focuses on this latter category defining rules, exceptions and criteria for allowability. However most small businesses do not incur costs often falling into this latter category. In circumstances where the contractor incurs a circumstantial unallowable cost it is advisable to do the research and possibly get an opinion from an expert.
The typical expressly unallowable costs for small businesses in most situations include the following:
Promotional Advertising (FAR 31.205-1)
Promotional activities of any kind (FAR 31.205-1)
Bad debt expense (FAR 31.205-3)
Federal income tax (FAR 31.205-41)
Contingencies (FAR 31.205-7)
Interest expense, other financing costs and professional services related to financial costs. (FAR 31.205-20)
Recreation, entertainment, and amusement (FAR 31.205-14)
Fines and penalties (FAR 31.205-15)
Organizational and re-organizational costs (FAR 31.205-27)
Charitable contributions and political contributions (FAR 31.205-8)
Certain types of travel costs such as first class air fare, hotels and meals over the Federal Per Diem Rates. There are exceptions to this rule of course. (FAR 31.205-46)
Expenses representing a distribution of profits (FAR 31.205-6 and others)
Alcoholic beverages (FAR 31.205-51)
Good will (FAR 31.205-49)
Losses on contracts (FAR 31.205-48)
Personal use of anything, as compared to allowable documented business use (FAR 31.205-46/31.205-6)
Asset write-ups from business combinations, contractors are prohibited from charging depreciation for the write-up. This item rarely effects small businesses (FAR 31.205-52).
There are certain circumstantial unallowable costs that small business contractors commonly incur that DCAA likes to target and question. Some of these include:
Compensation, if considered unreasonable it will be questioned. This is especially a focus area of DCAA for the compensation paid to owners and executives of closely held small contractors. (FAR 31.205-6)
Bonuses and incentive compensation. Bonuses and incentive compensation must be based on a written plan or policy implying an agreement with the employee. These plans should be performance based to the extent possible. DCAA frowns upon profit sharing. (FAR 31.205-6)
Legal costs: Certain legal costs are unallowable. Some of these include legal costs associated with organization and re-organizations, costs associated with patents not required by a government contract, patent infringement, legal costs to defend against allegations of fraud or noncompliance, etc. (FAR 31.025-47)
Consultant costs: This is a DCAA cherry picking target. The substantiation now required for allowable consultant costs is significant. DCAA is very much focused on this item in audits of small contractors. Need a well-documented agreement that spells out scope of work, contractor need, rates, period of performance, detailed accounting on invoices, work product, etc. Failure to provide this documentation will put the allowability of these costs in jeopardy. (FAR 31.205-33)
Related Party Rental Costs: This is another cherry pick target for DCAA. If the contactor and its landlord or lessor are under common management, ownership or control in most cases the allowable rent costs are limited to ownership costs. Ownership costs include depreciation, property taxes, insurance, other facility costs and cost of money. Small business owners that purchase a building with the intent to lease it back to the owner’s government contracting business is not a good idea if the owner has more than 50% ownership of both the lessor and lease or executes common control. The costs will be limited to ownership costs in most cases. (FAR 31.205-36). Businesses, however, whether governmental or non-governmental, are now required to follow ASC 842, a lease accounting standard published by the Financial Accounting Standards Board (FASB). Almost all leases must be represented on the balance sheet with liability and an ROU asset under ASC 842. That is why small businesses could be seen much more interested in including lease accounting software that can assist them in stripping away some burden from their shoulders.
Travel Costs: Allowable costs limited to lowest available coach air fare. In some situations business class is appropriate and provided for in the regulation. Hotel and meals are limited to the Federal Travel Regulation Per Diem Rates. The lodging rate is a not to exceed, receipt required, the meals/incidental per diem is a fixed rate. (FAR 31.205-46)
Auto Expense: If the contractor does not keep a mileage log it is likely DCAA will question the cost on lack of business purpose grounds. Need to document business mileage to win on this one. (FAR 31.205-46 and FAR 31.205-6).
Of course the government can make a case for unallowable cost for any cost that it perceives to be unreasonable. Burden of proof for reasonableness rests with the contractor (FAR 31.201-3).
This document is not intended as a complete discussion on the subject. The subject of unallowable costs is a large and complex one. The intent of this document is to identify those costs that a small business contractor is likely to incur and to point out the DCAA cost challenges a small business contractor is likely to encounter.