Managing unallowable costs in flexibly priced government contracts is an ongoing challenge for contractors. Despite the long-standing guidelines, many businesses still struggle with effectively identifying, segregating, and tracking unallowable expenses. Mismanagement can lead to financial penalties, additional audits, or possibly contract terminations, making establishing robust systems and processes essential.

The five classifications of unallowable costs 

Unallowable costs are grouped into five categories, and understanding them is vital to avoiding compliance issues:

1. Expressly unallowable costs: These are explicitly prohibited by federal regulations or contract terms (e.g., disallowed overtime charges).

2. Costs denied by contracting officers: Costs denied by a contracting officer's written decision, such as unapproved legal fees, are only possible if approved.

3. Costs resolved through dispute resolution: Any costs deemed unallowable via dispute resolution processes.

4. Costs related to unauthorized work: Costs incurred for work not formally added to the contract.

5. Exceeding the contract ceiling: Costs that exceed funding limits or contract ceilings without proper modification or approval.

Key factors to allowable costs

The allowability of a cost depends on factors outlined in FAR 31.205 and other agency-specific regulations:

1. Reasonableness: The cost must be reasonable; something a prudent businessperson would incur in similar circumstances.

2. CAS compliance: Certain larger contractors must comply with Cost Accounting Standards (CAS), as non-compliance can result in unallowable costs.

3. Contract-specific terms: Each contract may include unique cost restrictions, such as limits on overtime or G&A charges on travel.

Costs must be treated consistently across similar situations, and supporting documentation must be maintained for at least six years.

Make sure all claimed travel costs are allowable

Travel costs are among the most scrutinized expenses in audits. Auditors review:

• The necessity and purpose of the trip
• The duration and number of travelers
• Receipts for lodging, airfare, and rental cars

To avoid unallowable expenses, contractors must comply with internal travel policies and FAR requirements. All travel costs must align with per diem rates set by the GSA, DoD, or Department of State, depending on the location. Any expenses exceeding these rates must be justified with documentation. Segregating unallowable travel costs is critical to ensuring they are not claimed in any invoices or indirect cost claims.

Allowable employee morale costs vs. unallowable entertainment expenses

Distinguishing between employee morale and entertainment costs can be tricky. Potential unallowable entertainment costs include:

• Tickets to shows or sporting events
• Memberships to social clubs
• Golf outings or holiday parties

However, employee morale costs may be allowable if they directly improve performance, loyalty, or fitness. For example, company-sponsored sports teams may be allowable, but purely social golf outings would not. Contractors should evaluate each expense by asking:

• Does this cost benefit the business or employee productivity?
• Is it a common practice in the industry?

Make sure professional consultant and legal costs are allowable

Professional consultant and legal costs must meet specific documentation requirements to be allowable:

1. Consultant costs: The nature of the service must be documented through a written agreement, detailed invoices, and, potentially, proof of the consultant's work product.

2. Legal costs: Legal expenses tied to lawsuits (such as patent infringement) are generally unallowable unless directed by a contracting officer. Even allowable legal costs must meet reasonableness standards and cannot be recoverable from another source.

The consequences of claiming unallowable costs

The consequences of claiming unallowable costs vary depending on the frequency and severity of the errors. Potential consequences include:

• Penalties under FAR 42.709 for expressly unallowable costs.
• Audits, if unallowable, costs are charged to government contracts.
• Civil or criminal penalties in cases of intentional misconduct.

To avoid these risks, contractors need strong policies on executive compensation, bonuses, and allowable expenses. Regular ledger reconciliations and internal audits or management reviews can catch issues early.

Best practices for configuring ERP systems to meet DCAA compliance

A properly configured ERP system is crucial for managing unallowable costs. Here are the essential best practices:

1. GL account segregation: Separate allowable and unallowable costs within the system to avoid errors.

2. Automated segregation of per diem rates: Implement ERP functionality to automate per diem rate applications, reducing manual entry errors.

3. Accurate record keeping: Maintain detailed records and documentation to ensure audit compliance.

4. Internal controls: Enforce controls within the ERP system to prevent unauthorized changes and ensure timekeeping and expense reports are submitted in a timely manner.

5. Regular reconciliation: Tie project ledgers to the general ledger to prevent discrepancies during audits on at least a monthly basis.

Addressing unallowable costs is critical

Effectively managing unallowable costs is about building trust and compliance in your government contracting operations. With the proper internal controls and proactive measures, you can protect your business from potential penalties and position it for long-term success in a highly regulated environment. In federal contracting, even minor errors can lead to significant consequences. Addressing unallowable costs with the right tools and strategies is essential for growth and continued success.