Allowability of Costs — The Five Tests of FAR 31.201-2

At a Glance

Who it applies to

Any contractor whose price or payment is based on cost — cost-reimbursement, T&M/labor-hour, incentive, and any negotiated contract priced from cost data, plus most modifications and claims

What it obligates

Every billed or priced cost must satisfy five conditions simultaneously; failing any one makes the cost unallowable

Governing authority

FAR 31.201-2, within FAR Subpart 31.2 (Contracts With Commercial Organizations)

Burden of proof

On the contractor — FAR 31.201-2(d) requires records adequate to demonstrate the cost meets the criteria

The stakes

An unallowable cost is disallowed on the voucher, clawed back at rate settlement, and can carry a FAR 42.709 penalty

What It Is

FAR 31.201-2, Determining allowability, is the gate every dollar has to pass through before the government will pay it. It says a cost is allowable only if it satisfies five conditions at once: it must be reasonable (FAR 31.201-3); it must be allocable to the contract (FAR 31.201-4); it must comply with the Cost Accounting Standards if the contract is CAS-covered, and otherwise with generally accepted accounting principles and practices appropriate to the circumstances; it must be consistent with the terms of the contract; and it must not run into any limitation in FAR Subpart 31.2 — most importantly the 'selected costs' at FAR 31.205, which make dozens of specific categories expressly unallowable. All five are required. A cost can be perfectly reasonable in amount, properly allocated, and still be unallowable because FAR 31.205-14 says entertainment is unallowable, full stop. Two features of the rule catch contractors off guard. First, the burden is yours: FAR 31.201-2(d) says the contractor is responsible for accounting for costs appropriately and for maintaining records — including supporting documentation — adequate to demonstrate that costs claimed have been incurred, are allocable, and comply with the cost principles; if you can't support it, the contracting officer can disallow it, and you have no presumption in your favor. Second, 'unallowable' does not mean 'illegal' or 'you can't spend it.' It means the federal government won't reimburse it and you can't build it into a cost-based price. A firm can throw a holiday party; it just can't charge Uncle Sam for it. In plain terms: FAR Part 31 is the rulebook that decides which of your real, ordinary business expenses the government is willing to fund, and FAR 31.201-2 is its opening test.

When It Applies

• On every cost-reimbursement contract, where you invoice actual costs and each one must clear the allowability test.
• On time-and-materials and labor-hour contracts, for the materials and other direct costs billed at cost.
• When you price a negotiated proposal from cost buildups — proposed costs must be allowable to be a legitimate basis for the price.
• When you price a change order, a request for equitable adjustment, a termination settlement proposal, or a Contract Disputes Act claim.
• When you build the indirect rates you bill against — unallowable costs must be stripped from the pools before the rate is computed.

Key Features

The SDVOSB Angle

For an SDVOSB, allowability is where the transition from fixed-price to cost-type work either succeeds or quietly bleeds cash. On a firm-fixed-price job, the cost principles mostly matter for pricing; the moment you win a cost-reimbursement, T&M, or incentive contract, every dollar you bill is inspected against FAR Part 31 and the burden of proof is yours. Two habits protect a small firm. First, build the discipline before you need it: a chart of accounts with dedicated unallowable-cost accounts so entertainment, lobbying, alcohol, interest, and bad debts are segregated at the moment of entry rather than reconstructed during an audit two years later. Second, remember that unallowable costs in an indirect pool don't just hurt on one voucher — they inflate the overhead and G&A rates you bill on every federal contract, so a single sloppy pool becomes a systemic exposure at rate settlement. Small firms also under-appreciate the pricing side: unallowable costs are still real costs your business has to cover, so they belong in your profit target, not in your rate. Getting that right is exactly what separates a sustainable SDVOSB cost structure from one that wins awards and loses money.

How to Comply

1. Set up dedicated unallowable-cost accounts in your general ledger so unallowable items are segregated when they are booked, not at audit time.
2. Test every cost against all five FAR 31.201-2 conditions before it lands in a billing or a pricing buildup — not just against FAR 31.205.
3. Keep the supporting documentation FAR 31.201-2(d) requires: invoices, receipts, timesheets, contracts, and the business purpose of the cost.
4. Scrub unallowable costs out of your fringe, overhead, and G&A pools before you compute the rates you bill against.
5. Read the contract itself — a clause, a negotiated agreement, or an advance agreement under FAR 31.109 can make a cost allowable or unallowable regardless of the general rule.
6. When a cost is genuinely ambiguous, get an advance agreement with the contracting officer under FAR 31.109 rather than billing it and hoping.

Watch Out For

• Assuming 'unallowable' means you can't spend the money — it only means the government won't reimburse it or let you price it in.
• Treating FAR 31.205 as the whole test — a cost not mentioned in FAR 31.205 can still be unallowable for being unreasonable or unallocable.
• Leaving unallowable costs in an indirect pool, which inflates the rate you bill on every contract and multiplies the exposure.
• Forgetting FAR 31.201-6 directly associated costs — the travel and labor incurred solely to do an unallowable activity are themselves unallowable.
• Relying on your commercial accountant's instincts; GAAP allows plenty of costs that FAR Part 31 expressly disallows.
• Assuming a fixed-price contract makes the cost principles irrelevant — they still govern change-order pricing, REAs, claims, and terminations.

Run the Numbers

Frequently Asked

Primary Sources

• FAR 31.201-2 — Determining allowability
• FAR Subpart 31.2 — Contracts With Commercial Organizations
• FAR 31.201-6 — Accounting for unallowable costs
• FAR 31.109 — Advance agreements
• FAR Part 31 — Contract Cost Principles and Procedures

Plain-English reference, not legal, accounting, or tax advice. Cost allowability and accounting determinations are fact-specific, and the FAR, the Cost Accounting Standards, and the statutory dollar thresholds quoted here are amended and escalated for inflation over time. Always read the current FAR text and the cost and payment clauses in your specific contract, confirm the applicable thresholds and your accounting treatment with the contracting officer or cognizant administrative contracting officer, and consult a qualified government-contract accountant or counsel before relying on a cost position, signing a certificate, or submitting a claim.

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