Unallowable Cost

An unallowable cost in government contracting is a cost that the government will not reimburse on a cost-type contract, either because it is specifically identified as unallowable in FAR Part 31.205, because it fails to meet the general reasonableness and allocability tests of FAR 31.201-2, or because it is prohibited by specific contract terms.

What is an Unallowable Cost?

FAR 31.205 enumerates specific cost categories that are either entirely unallowable, conditionally allowable, or allowable subject to limits. Understanding which cost categories are unallowable is the foundation of cost-type contract compliance. The most significant unallowable cost categories include: interest and financing costs (FAR 31.205-20, with limited exceptions for facilities capital); entertainment (31.205-14, including most meals, sports events, and social activities); advertising and public relations that are not directly related to government contract performance (31.205-1); fines, penalties, and copyright infringement costs (31.205-15); bad debts (31.205-3); charitable contributions (31.205-8); lobbying and political activity (31.205-22); executive compensation above the OFPP benchmark (31.205-6); and costs incurred for the acquisition of facilities or equipment not approved through the proper channels.

"Expressly unallowable" costs are a specific subset identified by FAR 31.001, costs that are clearly unallowable based on established legal precedent or specific FAR language, such that a contractor billing them constitutes a knowing violation. The penalty for billing expressly unallowable costs (even inadvertently, under FAR 42.709) is twice the amount of the unallowable cost, distinguishing them from merely "questionable" costs that DCAA may question but that represent ambiguous situations.

Contractors must identify and segregate unallowable costs from their indirect cost pools throughout the accounting year. Unallowable costs must be excluded from the cost base used to calculate indirect rates, they cannot be recovered even indirectly through pool allocation. The ICS must separately identify unallowable costs in each pool and demonstrate their exclusion from billed amounts.

Why Unallowable Costs Matter for Government Contractors

Misclassification of unallowable costs as allowable is one of the most common and costly DCAA audit findings. Even well-intentioned contractors regularly bill entertainment costs as business meals, include charitable donations in the G&A pool, or inadvertently allow lobbying costs to flow into billed indirect rates. Building a cost screening process, routine review of G&A and overhead pool transactions against FAR 31.205 categories, prevents inadvertent billing before it reaches the ICS and DCAA scrutiny. The worst-case scenario is a referral to the Inspector General for costs that appear to have been knowingly billed.

Example

A defense analytics firm's year-end review of its G&A pool identifies four cost categories requiring unallowability analysis: a $35,000 annual sponsorship of an industry conference (likely advertising/PR under FAR 31.205-1, allowable if directly promoting government capabilities; unallowable if general brand advertising); $8,200 in charitable golf tournament entries and hole sponsorships (unallowable under FAR 31.205-8 and 31.205-14); $12,500 in interest on a line of credit used for payroll timing (unallowable under FAR 31.205-20); and $4,100 in penalty payments from a late tax filing (unallowable under FAR 31.205-15). Total excluded: $24,800 from the G&A pool, reducing the billable G&A by approximately $24,800 before the rate is applied to direct costs.

Frequently Asked Questions

Can a contractor include unallowable costs in its indirect rate pools if it labels them as unallowable?

No. Unallowable costs must be excluded from indirect rate pools entirely, they cannot be included in the pool even with an offsetting exclusion line item when calculating rates. Including unallowable costs in the pool base (even if excluded in the rate calculation) can inflate the pool in ways that affect how other costs are allocated, creating accounting distortions. FAR 31.201-6 requires that unallowable costs be identified and segregated in the accounting system, not just noted in rate calculations.

What is the difference between an "unallowable" cost and a "questionable" cost?

An unallowable cost is one that clearly fails FAR Part 31, it should not be billed regardless of circumstances. A questionable cost is one where the facts and circumstances create ambiguity about allowability, for example, a business meal where the documentation of business purpose is incomplete. DCAA questions costs in audits when the auditor believes the allowability determination is uncertain based on available evidence. Contractors can respond to questioned costs with additional documentation that resolves the ambiguity. Expressly unallowable costs, by contrast, cannot be made allowable with additional documentation.

Are executive bonuses always unallowable above a certain amount?

Executive compensation is allowable up to the OFPP benchmark (currently set by the Office of Federal Procurement Policy annually, most recently approximately $600,000-$700,000 per covered executive on CAS-covered contracts). Compensation above this benchmark is unallowable for CAS-covered contracts. For non-CAS-covered contracts, the general reasonableness standard applies, total compensation that is unreasonable compared to market rates for the services performed is unallowable. Incentive bonuses are allowable if they are part of a documented compensation plan established before the bonus period begins; discretionary bonuses paid after-the-fact without a prior plan are subject to more scrutiny.

How does DCAA treat pre-contract costs?

Costs incurred before a contract is awarded are generally not allowable unless the contract contains a specific clause authorizing pre-contract costs (FAR 31.205-32) and the contract is eventually awarded. If the government decides not to award the contract, pre-contract costs already incurred cannot be recovered. Contractors who commence work before award do so at their own financial risk. Pre-proposal costs (costs of preparing proposals and bids) are a different category, they are B&P costs included in G&A and are allowable under FAR 31.205-18 as a normal cost of doing business.