Allowability Allocability And Reasonableness
When dealing with government contracts, understanding the concepts of allowability, allocability, and reasonableness is essential. These three principles are fundamental to the cost accounting standards that govern how contractors charge expenses to government-funded projects. Whether it’s a federal defense contract or a grant awarded for research, every cost submitted for reimbursement must pass the test of being allowable, allocable, and reasonable. Failing to comply with these standards can lead to disallowed costs, audits, financial penalties, or even contract termination. Hence, organizations need to build a strong compliance framework around these key concepts.
Understanding Allowability
Definition of Allowable Costs
Allowability refers to whether a particular cost is permitted under the terms of the government contract and applicable regulations. For U.S. federal contracts, allowability is typically governed by the Federal Acquisition Regulation (FAR), especially FAR Part 31. A cost is considered allowable when it meets certain criteria and is not explicitly unallowable.
Key Criteria for Allowable Costs
To be considered allowable, a cost must:
- Be reasonable in nature and amount
- Be allocable to the contract or project
- Comply with the terms of the contract
- Follow applicable cost principles (such as those outlined in FAR Part 31 or the Uniform Guidance for grants)
- Not be prohibited by law or regulation
Examples of Allowable and Unallowable Costs
- Allowable: Salaries for employees working on a project, cost of materials used, travel necessary for contract performance
- Unallowable: Alcoholic beverages, entertainment expenses, lobbying costs, fines and penalties
Exploring Allocability
What Is Allocability?
Allocability determines whether a cost is directly related to and can be assigned to a specific contract or project. It ensures that the government pays only its fair share of the total cost incurred by a contractor. A cost is allocable if it is incurred specifically for the project, benefits both the project and other work proportionally, or is necessary for the overall operation of the business and can be distributed reasonably.
Tests of Allocability
There are several ways to assess whether a cost is allocable:
- The cost is incurred solely to support a specific contract
- The cost benefits multiple projects and can be reasonably distributed among them
- The cost is necessary to the overall function of the business, such as rent or administrative salaries, and is allocated using a consistent methodology
Direct vs. Indirect Costs
Allocability is also closely related to how costs are categorized:
- Direct Costs: These can be specifically identified with a particular final cost objective, such as labor for a specific job or raw materials used for a certain product.
- Indirect Costs: These support multiple projects and must be allocated using a defined formula or allocation base. Examples include office rent, IT support, or executive management salaries.
Defining Reasonableness
Reasonable Cost Principle
Reasonableness refers to whether a cost would be considered prudent and fair under the circumstances. The cost must reflect what a prudent person would pay in the conduct of competitive business. The determination of reasonableness is based on facts and circumstances at the time the cost is incurred.
Factors to Consider
To determine whether a cost is reasonable, several factors must be evaluated:
- Whether the cost is generally recognized as ordinary and necessary
- The restraints imposed by industry practices or governmental regulations
- Whether the contractor followed sound business practices and arms-length bargaining
- Significant deviations from established practices or policies
Examples of Reasonableness in Practice
Suppose a contractor purchases laptops for project staff. If the chosen models are moderately priced and align with company policies, the cost is likely reasonable. However, if the laptops are high-end luxury models, the cost may be deemed unreasonable, even if the expenditure is otherwise allowable and allocable.
Interrelationship of the Three Principles
Integrated Application
Allowability, allocability, and reasonableness are not stand-alone rules; they are interdependent. A cost must satisfy all three criteria to be charged to a federal award or contract. For example, a cost that is allowable under FAR but not allocable to the contract cannot be billed. Similarly, a cost that is allocable and allowable but unreasonable in amount may also be rejected during an audit.
Compliance and Documentation
Government contractors must maintain sufficient documentation to demonstrate that costs meet all three standards. This includes:
- Timekeeping records for labor costs
- Invoices and receipts for materials and services
- Cost allocation plans for indirect expenses
- Internal policies and procedures that reflect consistent and compliant practices
Importance for Government Contractors and Grantees
Audit Readiness
Government agencies such as the Defense Contract Audit Agency (DCAA) regularly audit contracts to ensure cost compliance. Failure to comply with allowability, allocability, and reasonableness standards can result in disallowed costs and penalties. Contractors that maintain good accounting systems, documentation, and training are better prepared to defend their cost claims.
Risk Mitigation
By applying these principles consistently, contractors can mitigate legal and financial risk. This is especially important for firms heavily reliant on government business or those entering into cost-reimbursement type contracts.
Performance and Reputation
Beyond compliance, ensuring all costs are allowable, allocable, and reasonable contributes to transparency, integrity, and efficient project execution. These qualities enhance a company’s reputation and increase its chances of winning future government awards.
Best Practices for Compliance
Establish Clear Internal Policies
Develop comprehensive written policies that align with FAR, Uniform Guidance, or other applicable regulations. These should cover cost classification, procurement standards, and expense reporting.
Train Staff Regularly
Educate employees involved in budgeting, accounting, and project management on how to determine whether a cost meets the three key criteria. Training should be updated regularly to reflect changes in regulations.
Use Consistent Cost Allocation Methods
Ensure that indirect costs are allocated using a fair and consistent basis, such as labor hours, square footage, or headcount. Any changes in methodology must be documented and justified.
Conduct Periodic Internal Audits
Regular self-assessments can help identify potential issues before a government audit. Review cost reports, test samples, and verify supporting documentation to maintain readiness.
In the world of government contracting and grant management, mastering the principles of allowability, allocability, and reasonableness is critical for success. These concepts form the backbone of cost compliance and financial integrity. Organizations that understand and apply these standards not only ensure regulatory compliance but also build trust with stakeholders, reduce risk, and enhance long-term business performance. A proactive approach with proper systems, documentation, and training ensures that every cost submitted is defensible, justified, and in full alignment with legal and contractual obligations.