How to Determine Whether a Cost is Reasonable

One of the overarching criteria for deciding on whether to charge a particular cost to a government contract, either directly or indirectly, is whether it is reasonable in amount. We often mention "reasonableness" in this blog when discussing cost allowability criteria. A couple of days ago, we discussed reasonableness as it relates to bonuses and incentive compensation. Since then, we've been asked how one goes about determining whether a cost is reasonable.

As everyone soon learns, there are no hard and fast standards for determining "reasonableness". It is a highly subjective area and one in which reasonable persons can and do disagree. Contractors, of course will make a broad argument while the Government will take a more limited or restrictive view. Some contractors like to use the New York Times test; how would this look in the news? If the public disclosure of the cost would embarrass the company, they may choose not to claim it. Some situations are obvious. You wouldn't pay executive level salaries to clerical employees and you wouldn't charter a private jet to go to a negotiation conference with the Government. Most disagreements about reasonableness however are in those grey areas where neither side has the compelling argument. Publically held, heavily commercial or fixed price oriented contractors are less risky from the Government's perspective than are contractors with mostly cost-type contracts. The "market place" adds a level of restraint on how a company expends its funds. Closely held companies with mostly cost-reimbursable contracts are higher risk for incurring unreasonable costs because the market forces are not in play. So, what does FAR have to say about "reasonableness"?

FAR 31.201-3 states that a cost is reasonable if in its nature and amount, it does not exceeds that which would be incurred by a prudent person in the conduct of a competitive business. From the Government's perspective, it is the contractor's responsibility to establish that each cost is reasonable. There is never a presumption that a cost is reasonable.

As general guidance, we recommend that contractors consider four questions when deciding whether a cost is reasonable.

1. Is the type of cost generally recognized as necessary in conducting business? The purchase and up-keep of an ocean-going yacht for exclusive use of the company president is not a necessary cost of doing business.
2. Is the cost consistent with sound business practice, law, and regulation, and are purchases conducted on an "arms-length" basis? To pay a premium price for materials on a Government contract while receiving a bargain price for the same materials on a commercial job may not be consistent with sound business practices.
3. Do your actions reflect a responsible attitude toward the Government, other customers, owners, employees, and public at large? Excessive salaries to executives and unconscionable retainers for retired executives as consultants are not acting responsibly toward owners and employees.
4. Are your actions consistent with established practices? If your established practice has always been to perform design work in-house but for some reason you decide to out-source it at a higher cost (and you had available capacity), it would be unreasonable to out-source it.

As you consider these matters, it would also be a good practice to prepare documentation to support your decision making process. If challenged, contemporaneous documentation prepared before the incurrence of the cost will carry much more credibility than documentation prepared at a later date.