Allowable, Allocable and Reasonable: Three Separate Tests
A cost billed to the government has to survive five separate conditions, and contractors habitually argue only one of them. Reasonableness and allocability are distinct questions with different evidence, and neither one produces allowability on its own.
The rule in short
A cost is allowable only if it is reasonable, allocable, consistent with applicable accounting standards or generally accepted principles, consistent with the terms of the contract, and not limited by the cost principles themselves. Reasonableness asks what a prudent person in competitive business would incur, and no presumption favors the contractor. Allocability asks whether the cost is assignable by benefits received. Named costs fail regardless of both tests.
Allowability is not a test. It is the conclusion reached when five separate conditions are all satisfied: the cost is reasonable; it is allocable; it complies with applicable cost accounting standards, or otherwise with generally accepted accounting principles; it accords with the terms of the contract; and it survives any limitation in the cost principles themselves. Failing any one makes the cost unallowable regardless of how well it passes the others.
What a prudent person would have spent
A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business. The standard is objective and it is applied to both the decision to incur the cost and the amount incurred. A necessary expense purchased at an unnecessary price fails on the second half.
Two features of the rule matter more than the standard itself. No presumption of reasonableness attaches to the incurrence of a cost merely because the contractor incurred it. And where an initial review of the facts results in a challenge, the burden of proof is on the contractor to establish reasonableness. That allocation explains why contemporaneous documentation of the decision is worth more than any later analysis.
The considerations named in the rule are the vocabulary an auditor will use: whether the cost is of a type generally recognized as ordinary and necessary; the restraints imposed by arm's-length bargaining, laws and regulations, and sound business practices; the contractor's responsibilities to the government, its employees, its owners and the public; and any significant deviation from the contractor's established practices.
Assigning a cost to the work that benefited
A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or another equitable relationship. Three routes qualify. The cost was incurred specifically for the contract. It benefits both the contract and other work and can be distributed to them in reasonable proportion to the benefits received. Or it is necessary to the overall operation of the business even though a direct relationship to any particular cost objective cannot be shown.
Allocability disputes are about method rather than merit. Nobody argues that a facilities cost should not exist; they argue about the base over which it is spread. The contractor's disclosed and consistently applied allocation practice is the anchor, and a change in that practice made mid-performance invites a challenge even where the new method is defensible in isolation.
Many unallowable costs are ordinary business expenses that any company would incur. Interest on borrowing, entertainment, donations and certain organization costs are all legitimate expenditures that the government has simply declined to pay for. The obligation is not to stop incurring them; it is to identify them, exclude them from any billing, claim or proposal, and account for them separately along with their directly associated costs. Failing at the accounting stage is what turns an ordinary expense into an enforcement problem.
| Condition | Question asked | Evidence that answers it | Who bears the burden | Typical failure |
|---|---|---|---|---|
| Reasonableness | Would a prudent person in competitive business have incurred this, at this amount? | Contemporaneous justification, competition, market data | The contractor, once questioned | Compensation or a purchase without support at the time |
| Allocability | Does the cost benefit this work, and in what proportion? | The allocation base and the disclosed practice | The contractor | A base changed without adjusting for impact |
| Accounting standards or principles | Was it measured and assigned consistently? | The disclosure statement and prior treatment | The contractor | An unreported change in practice |
| Contract terms | Does anything in this contract limit or exclude it? | The schedule, the clauses and any advance agreement | Whoever asserts the limit | A ceiling or an exclusion overlooked at billing |
| Named limitations | Is the cost in an expressly unallowable category? | The selected cost provisions | Neither; it is a rule | Claiming an item the rule names outright |
Costs the rules exclude by name
The selected cost provisions name categories that are unallowable in whole or in part regardless of how reasonable or allocable they are. Among them are most advertising and public relations, bad debts, contributions and donations, entertainment, fines and penalties, interest and other financial costs, lobbying and political activity, alcoholic beverages, goodwill, losses on other contracts, and costs of organization such as mergers and reorganizations.
Several categories are conditional rather than absolute, which is where the analysis gets real. Legal costs of defending a proceeding are treated differently depending on how the proceeding ended. Compensation is allowable within limits tested for reasonableness. Travel is allowable subject to stated ceilings. Reading a category heading and stopping is the most common error in this part of the regulation.
The exposure for including an unallowable cost
Beyond disallowance, a contractor that includes an expressly unallowable cost in a proposal for settlement or in a final indirect cost rate proposal can be assessed a penalty equal to the disallowed cost, and a doubled penalty where the cost had already been determined unallowable for that contractor before the proposal was submitted. Interest runs on the improperly claimed amounts.
That structure rewards a screening process performed before submission rather than after audit. The screening has to reach directly associated costs, since a cost incurred solely because an unallowable cost was incurred is itself unallowable and travels with it. Disputes over disallowance are resolved through the process described in claims, certification and the disputes process.
The moments when cost principles decide the money
Three situations bring the principles into contracts that otherwise seem untouched by them. Pricing a modification where cost analysis is used, which is the subject of changes clauses and the request for equitable adjustment. Settling costs after a contract is ended early, addressed in the settlement proposal after an early ending. And establishing final indirect rates on any cost-reimbursement work.
In each case the contractor is presenting costs rather than a price, and the principles apply to what is presented. A firm that has priced competitively for years under the methods described in the comparison of procurement methods can find its accounting examined for the first time when it submits an adjustment request, which is a poor moment to discover that unallowable costs were never segregated.
Points to carry away
- Allowability is a conclusion reached only after five separate conditions are satisfied.
- No presumption of reasonableness attaches to a cost merely because it was incurred.
- Once reasonableness is questioned, the burden of proof rests on the contractor.
- Allocability turns on relative benefit received, not on the contract that can afford the cost.
- Directly associated costs of an unallowable cost are themselves unallowable.
- Claiming an expressly unallowable cost can carry a penalty in addition to disallowance.
Questions readers ask
Do the cost principles apply to a firm-fixed-price contract?
Not to the payment of the price, but frequently to the pricing of it. The principles govern the determination of allowable costs under cost-reimbursement contracts, and they also apply where cost analysis is used to price a negotiated contract or modification, and to the settlement of costs after a contract ends early. A fixed-price contractor that never sees an audit during performance can find the same principles applied to a request for equitable adjustment or a termination settlement proposal.
What are directly associated costs?
A cost incurred solely as a result of incurring another cost that is unallowable. If the underlying cost is unallowable, the directly associated cost is unallowable too. The classic example is travel and meeting expense incurred solely to conduct an unallowable activity, or the salary of an employee for the time spent on it where that time is material. The rule is why the accounting treatment of an unallowable activity has to reach the activity's whole footprint rather than the invoice that named it.
How is a cost accounting standards question different from an allowability question?
Allowability asks whether the government will pay for a cost. The accounting standards ask whether the contractor measured, assigned and allocated it consistently with the practices it disclosed and applied to its other work. A cost can be entirely allowable and still produce a liability if the contractor changed its accounting practice without adjusting for the impact. Coverage depends on the value of the awards and on exemptions, and the triggering figures move with inflation adjustments.
Sources
- Acquisition.gov — FAR Part 31, Contract Cost Principles and ProceduresThe applicability rules, the general conditions and the selected cost provisions.
- Acquisition.gov — FAR 31.201-2, Determining AllowabilityThe five conditions that must all be satisfied for a cost to be allowable.
- Acquisition.gov — FAR 31.201-3, Determining ReasonablenessThe prudent person standard, the absence of a presumption and the burden of proof.
- Acquisition.gov — FAR 31.201-4, Determining AllocabilityThe three routes by which a cost may be assigned to a cost objective.
- Acquisition.gov — FAR Subpart 31.2, Contracts With Commercial OrganizationsThe selected costs, including every expressly unallowable category.
- Acquisition.gov — FAR 42.709, ScopeThe penalties available where an unallowable cost is included in a proposal.
- eCFR — 48 CFR Part 9903, Contract CoverageWhen cost accounting standards coverage attaches and what exemptions apply.
Lawwise is a publication, not a law firm. This article states general rules and cites its sources; it is not advice about any particular case, and the law differs by state and changes over time.
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