The Five Requirements of Allowability

We often toss around the term "allowability" with little thought to its precise meaning in the Federal Acquisition Regulations (FAR) and in ways that assume everyone understands the parlance of Government contracting. Often when we use the term we are reflexively referring to the cost principles in FAR Part 31.205. But that is only one of the five requirements a cost must meet before it can be charged or billed to the Government. Now that a lot of contractors are in the midst of preparing their incurred cost proposals, it seems like a good time to review what it takes for a cost to be "allowable" on a Government contract.

The five requirements (or tests) for allowability are listed in FAR 31.201-2.

1. The cost must be reasonable. Several years ago, we wrote an article on "reasonableness" (see How to Determine Whether a Cost is Reasonable). The essential question is whether if in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of a competitive business (FAR 31.201-3). Some of the more contentious areas in recent years has been related to compensation.

2. The cost must be allocable.  We also covered cost allocability in a previous posting (see Cost Allocability). To be allocable, the cost must meet one of  three tests; (i) incurred specifically for the contract, (ii) benefit the contract and other work and can be distributed to them in reasonable proportion to the benefits received, or (iii) is necessary to the overall operation of the business, although a direct relationship to a particular cost objective cannot be shown (FAR 31.201-4). Examples of the latter include many G&A costs.

3. The cost must comply with Cost Accounting Standards (CAS), if applicable, otherwise GAAP (Generally Accepted Accounting Standards) and practices appropriate to the circumstances. For more information on CAS, see our CAS Index. This is requirement is where, for example, contractors are not allowed to base depreciation expense on accelerated methods under the Income Tax Code.

4. The cost must comply with the terms of the contract. Many contractors overlook cost limitations set forth in their contracts. For example, almost no one pays attention to FAR 52.222-2 which limits the cost of overtime usage. Keep in mind that while a contracting officer cannot make allowable costs that are specifically unallowable, they can place limitations on costs that are specifically allowable.

5. The cost must comply with the limitations set forth in FAR Subpart 31.2. This would include the cost principles set forth in FAR 31.205-1 through 52. It would also include additional cost principles found in Agency FAR Supplements like DFARS (DoD FAR Supplement), DEAR (Energy FAR Supplement), NFS (NASA FAR Supplement), and others.

Cost Allocability

Under the Federal Acquisition Regulations (FAR), the only costs that a contractor can charge to a Government contract are those that are allocable and allowable under FAR Part 31 cost principles, agency supplements, and contract terms. A cost is allocable to a Government contract if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. To be allocable, costs must meet one of three tests:

• It must be incurred specifically for the contract (i.e. a direct costs), or
• It must benefit contracts and other work and can be distributed to them in reasonable proportion to the benefits received, or
• Is necessary to the overall operation of the business, although a direct relationship to a particular cost objective cannot be shown.

There are rarely any disputes involving the first of the three tests - must be incurred specifically for a contract. However, the second and third tests require contractors to show a sufficient nexus between the cost and a Government contract. A recent opinion by the U.S. Court of Federal Claims (Teknowledge Corp. v. U.S., 2009 WL 57014) illustrates this point.

Teknowledge is an internet transaction company that provides secure transactions over the internet. In 1999, Teknowledge began developing a program for the finance services industry. In 2001, Teknowledge charged (amortized) about $285 thousand of development costs to its Government overhead pool. Teknowledge maintained that the costs were allocable because it benefited the Government through a potential increase in business, potential reduction of indirect costs charged to Government contracts, and continued viability of the company.

The court ruled that these benefits were remote and insubstantial and do not meet the requirement of the FAR standard. The court stated that there needs to exist a sufficient nexus between a given cost and a government contract. The word "benefit" as defined in the allocability test requires some showing that the cost relates to a government contract, not merely that it promotes the Government's public policy interests.