Resources

Federal Acquisition Regulation (FAR) 31.205 is a crucial set of rules for government contractors. It defines which costs can be billed to the government and which can’t. Understanding it is essential for any company doing business with the federal government, as it directly impacts both profitability and compliance. 

Broadly, FAR 31.205 helps ensure taxpayer money is spent wisely and that contractors are fairly paid for their work. However, its rules can be complex, especially for new government contractors who are used to private sector practices.

What Is FAR 31.205?

FAR 31.205 is a section of the Federal Acquisition Regulation that outlines specific cost principles for commercial organizations. It provides a comprehensive guide for determining which costs are allowable on government contracts and which are not. It covers 46 different cost categories and offers detailed guidance on each. 

But what are allowable and unallowable costs? Allowable costs are ones that can be billed to the government and included in a contractor’s indirect cost rates, while unallowable costs cannot. This differentiation significantly impacts a contractor’s pricing strategy and overall profitability on government projects. 

FAR 31.205 is based on four main principles:

1. Reasonableness: Costs must be generally recognized as ordinary and necessary for the conduct of the contractor’s business.
2. Allocability: Costs must be assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship.
3. Compliance with Generally Accepted Accounting Principles (GAAP) and FAR: Costs must be accounted for consistently and in accordance with GAAP and FAR requirements.
4. Specific treatment in FAR: Some costs are explicitly defined as allowable or unallowable in FAR 31.205.

A thorough understanding of these principles is essential for contractors to navigate government contract cost accounting and stay compliant with regulations.

Categories of Costs Under FAR 31.205

FAR 31.205 categorizes costs into three main groups: generally allowable costs, expressly unallowable costs, and conditionally allowable costs. 

Let’s explore each category in detail:

Group 1: Generally Allowable Costs

Generally allowable costs are typically accepted as necessary for business operations. They can be reimbursed under government contracts, provided they meet the criteria for allowability. 

Some examples include:

• Direct labor costs: Wages and salaries for employees directly working on government contracts. For instance, an engineer’s time spent designing a component for a specific contract would be allowable. Contractors must maintain accurate timekeeping records to support these costs and be mindful of the rates agreed in time and material contracts.
• Materials and supplies: Costs for materials and supplies used directly in contract performance are generally allowable. This could include raw materials, components, or even office supplies if they’re specifically used for the work of fulfilling the contract. Contractors should implement a system to track and allocate these costs accurately.
• Indirect costs: Expenses that benefit multiple contracts or the entire business, such as rent, utilities, and administrative salaries, are typically allowable as indirect costs. These costs are allocated using a predetermined rate or formula.
• Depreciation: The cost of equipment and facilities used in contract performance can be recovered through depreciation. Contractors must use accepted accounting methods to calculate depreciation and ensure it’s allocated appropriately.
• Training and education: Costs for employee training directly related to contract performance or maintaining necessary certifications are generally allowable. For instance, cybersecurity training for employees working on a government IT contract would likely be an allowable expense.

Even if a cost is typically allowable, it must still meet the criteria of being reasonable, allocable, and compliant with Cost Accounting Standards (CAS) where applicable. As such, maintaining detailed documentation and having a robust cost accounting system are essential for substantiating these costs during audits.

Group 2: Expressly Unallowable Costs

Expressly unallowable costs are those explicitly prohibited by the regulation. They are never permissible, regardless of circumstances. Here are some key examples:

• Alcohol and entertainment: The U.S. government takes a strict stance on these expenses to prevent misuse of taxpayer funds. This includes not only the cost of alcoholic beverages but also related entertainment expenses. For example, a business dinner where alcohol is served would require careful separation of the meal cost (potentially allowable) from the alcohol cost (always unallowable).
• Contributions and donations: While charitable acts may benefit a company’s public image, charitable contributions of any kind—whether cash, property, or services—are expressly unallowable. Contractors must be careful to separate these activities from allowable community involvement efforts that directly benefit the contract or company operations.
• Fines and penalties: This category extends beyond obvious legal infractions to include items like late fees on credit cards or tax payments. It underscores the importance of robust compliance and financial management systems for government contractors.
• Interest and other financial costs: Most interest expenses, including those related to capital leases, are unallowable. This can significantly impact how contractors finance their operations and assets.
• Lobbying costs: Any expenses related to influencing legislation, elections, or contract matters are unallowable. This includes both direct lobbying efforts and indirect support of lobbying activities.
• Losses on other contracts: Contractors cannot use profits from one government contract to offset losses on another. Each contract must stand on its own financially.

It’s important to note that even if some of these expenses are deductible for tax purposes, they still cannot be included in the costs billed to the government or used to calculate indirect cost rates. Contractors should implement robust systems to identify and segregate these costs to maintain compliance and avoid potential audit issues.

Group 3: Conditionally Allowable Costs

Conditionally allowable costs may be allowable under certain circumstances, but they require careful consideration and documentation in order to substantiate them.

Here are some key examples:

• Recruiting costs: Generally allowable when related to specific positions or contracts, but unallowable for general company advertising. For example, posting a job listing for a software engineer needed for a specific government contract would likely be allowable. However, a general recruitment campaign to boost the company’s workforce wouldn’t be.
• Marketing and selling costs: This is an area where many contractors struggle to draw the line between allowable and unallowable expenses. Direct selling efforts, including technical explanations of products or services, are generally allowable. However, costs associated with promotional materials, trade shows, or corporate image enhancement are typically unallowable. For instance, the cost of preparing a technical presentation for a potential government client would likely be allowable, but the cost of branded giveaways at a trade show wouldn’t be.
• Travel costs: Travel expenses are often allowable but must adhere to federal travel regulation limits. Costs exceeding these limits are unallowable. For example, if the federal per diem rate for a particular location is $150 per day, and an employee expenses $200, only $150 would be allowable. The excess $50 would need to be classified as an unallowable cost.

Contractors should establish clear policies and procedures for handling these conditionally allowable costs. Proper documentation and justification are crucial for demonstrating the allowability of these expenses during audits. When in doubt, seeking expert guidance can help navigate the complexities of these cost categories.

Allowable and Unallowable Cost Matrix

Looking for a more detailed breakdown of which costs are allowable and unallowable? In our allowable and unallowable cost matrix, we break down over 35 different categories of expense, outlining whether they are mostly allowable or mostly unallowable and specifying the applicable FAR clause. 

If you’d like us to send you a copy of this matrix, contact us here. 

Proper Cost Accounting for Government Contractors

Government contractors need to ensure that their accounting systems are compliant with all relevant regulations. This system should:

1. Accurately segregate allowable and unallowable costs
2. Track direct and indirect costs separately
3. Support the calculation of accurate indirect cost rates

Proper cost accounting not only  helps you stay compliant, but also impacts your ability to price contracts competitively and maintain profitability. Many contractors find that investing in specialized accounting software and expertise can significantly streamline this process and reduce compliance risks. 

Government Oversight and Audits

Government agencies, primarily the Defense Contract Audit Agency (DCAA) and Defense Contract Management Agency (DCMA), oversee contractor compliance with FAR 31.205. These agencies conduct various audits, including incurred cost audits, to ensure that contractors are properly classifying and billing costs. 

During the audit process, the agencies may scrutinize any expense that occurred during the timeframe they’re examining. They often focus heavily on accounts that could be either allowable or unallowable, such as travel expenses or taxes, to ensure that everything is classified properly. 

Misclassifying costs can lead to serious consequences, including:

• Reduced reimbursement
• Contract penalties
• Damage to the contractor’s reputation
• Potential legal action in cases of willful misrepresentation

To mitigate these risks, contractors should maintain thorough documentation and be prepared to justify their cost classifications during audits. Many find that working with experienced professionals during audit preparation can significantly improve outcomes and reduce stress.

Manage Costs and Avoid Compliance Issues

If government contractors want to stay profitable and avoid compliance issues, they must stay aligned with FAR 31.205. While the regulations may seem daunting, especially for those new to government contracting, with the right approach, contractors can turn their understanding of FAR 31.205 into a competitive advantage in the government marketplace. 

When in doubt about cost classification or any aspect of FAR compliance, it’s always best to seek professional guidance. MillerMusmar can help you stay compliant with FAR, CAS, and DFARS standards, prepare for government audits and more. The best way to stay compliant is to be proactive, so contact us today to begin shoring up your cost accounting.