FAR Cost Principles and Cost

What Costs are Expressly Unallowable

(Editor’s Note. DCAA has recently issued two Memorandums for Regional Directors (MRDs) addressing which costs determined to be unallowable are “expressly unallowable” and hence subject to imposition of penalties. The December 18th MRD lists what DCAA believes are the FAR and DFARS “cost principles that identify expressly unallowable costs.” DCAA issued a second January 7 MRD that is a follow-up guidance that seeks to provide further clarification on its views of why certain unallowable costs are subject to penalties (a summary of this MRD is in the last issue of the GCA REPORT). Industry representative comments on the fi rst MRD were highly critical stating DCAA is “overreaching” and its definition of expressly unallowable costs are “contrary” to case law. We believe such negative reactions are the reason the second MRD was issued where it is too soon to see what reactions that MRD is generating. We decided to summarize below the first MRD because (1) it provides an excellent review of selected FAR cost allowability rules which even we found enlightening and (2) those unallowable costs that are considered to be expressly unallowable costs and hence subject to penalties should be identified since a decision to include or exclude these costs from government submittals like incurred cost proposals, forward pricing proposals or forward pricing rate proposals should strongly consider whether inclusion of such costs will mean that penalties will be sought.)

The Dec. MRD includes a 32 page set of quotations from the FAR and DFARS cost principles where 110 unallowable costs are considered to be “expressly unallowable.” As if that were not enough, the guidance states the listing is not “comprehensive” and that “there could be situations where the costs questioned could be expressly unallowable based on the facts and circumstances of that particular situation” where then the audit team may perform additional analysis to determines whether the costs in question are expressly unallowable.

Though we will spare the reader an extensive listing of each unallowable cost DCAA believes is expressly unallowable, we will summarize the more common costs incurred where we identify the relevant FAR or DFARS section.

  1. Major repair and overhaul of rented equipment (31.105).
  2. Indirect costs that meet the definition of “excessive pass through charges” referenced in FAR 52.215-23.
  3. All unallowable advertising and public relations costs (31.205-1). The guidance recognizes that some advertising costs are allowable (e.g. required by contract, needed to acquire scarce resources, promote sales of products overseas that are normally sold to the US government, help wanted ads). Unallowable public relations and advertising costs that are expressly unallowable are those found in section (d) and (e) such as whose primary purpose is to promote the sale of products or services or to call favorable attention to the company to sell those products or services. Other examples of unallowable costs subject to penalties include (a) trade shows unless they promote export sales (b) sponsoring meetings, conventions, symposia, seminars and other special events when the primary purpose is other than disseminating technical information or stimulation of production (c) ceremonies such as corporate celebrations or new product announcements (d) promotional material such as brochures, handouts, magazines, tapes and other media (e) costs of souvenirs, models, imprinted clothing or other mementos provided to customers or the public (f) memberships in civic or community organizations or (g) donations of excess food to nonprofi t organizations.
  4. By far, the greatest types of unallowable costs are those related to compensation for personal services found in 31.205-6. Examples of compensation costs believed to be expressly unallowable are:
    • Compensation for certain individuals needing special considerations such as owners of closely held companies, partners, sole proprietors, members of immediate family or those committed to acquire a financial interest in the company. Examples of unallowable costs for these individuals are a distribution of profit disguised as compensation or amounts in excess of what the IRS considers to be deductible.
    • Payments made to employees who move to a replacement contractor (g)(3) where there is continuity of employment with credit for prior length of service
    • Abnormal or mass severance (g) that is payment on a conjectural basis. Only specific payments will be considered on a case-by-case basis. Also severance paid to foreign nationals in excess of what is typically paid to employees in the same industry in the US
    • Backpay (h) as a retroactive adjustment of prior years’ salaries. Exceptions to unallowable costs are when the payments are a result of (1) underpaid work (2) the difference in past and current wages for union employees working without a contract and (3) payments to nonunion employees based upon results of a union agreement.
    • Compensation calculated based on changes in the price of corporate securities (i)(1)
    • Compensation represented by dividend payments or calculated based on such payments (i)(2)
    • Payments to an employee in lieu of them receiving or exercising an option (i)(3)
    • Except for nonqualified, pay-as-you go pension plans, pension costs assigned to the current year but not funded by the time set for filing of the federal income tax return, including extensions (j)(1)(i).
    • Cost of changes to pension plans that are discriminatory to the government or not intended to be applied to all employees under similar circumstances in the future (j)(1)(ii)
    • Deferred compensation if awards are made in periods subsequent to the period when the work being remunerated was performed (k)
    • Costs for a business acquisition if they are (1) payments for special compensation in excess of the normal severance pay practices if their employment terminated following a change in management control or (2) special compensation that is contingent on the employee remaining with the contractor for a specified period of time (l)
    • Portion of company-funded automobile that relates to personal use by employees regardless of whether the cost is reported as taxable income to the employee (m)
    • Employee rebates or discounts of products or services of contractor (n)
    • Post retirement benefits must be funded by the time set for filing federal income taxes, including extensions and any increased costs caused by delay in funding beyond 30 days (o)
    • Excess compensation for senior executives (p)(1) or all employees (p)(2) for either contracts awarded before June 24, 2014 or any employee for contracts awarded after June 24, 2014 (p)(3)
  5. Contributions or donations including cash, property and services regardless of recipient (31.205-8)
  6. Actual interest cost in lieu of imputed cost of money (31.205-10)
  7. Certain depreciation costs (31.2015-11) including those that (a) would significantly reduce the book value of a tangible capital asset below its residual value (b) depreciation, rental or use charges on property acquired from the government by a division or affiliate (c) lease costs under a sale and leaseback arrangement that exceeds the amount that would be allowed if the contractor retained title (d) capital leases between related parties exceeding those that would exist had the parties not been related and (e) no depreciation or rental allowed on property fully depreciated by the contractor. (Editor’s Note. Though not mentioned in the guidance, negotiated use charges on fully depreciated assets are allowable so be sure there is an advance agreement.)
  8. Gifts that are not in recognition of employee achievements or not included in 31.205-6(f). (31.20513). Also costs or recreation except for those costs of employee participation in company sponsored sports teams or employee organizations designed to improve company loyalty, team work or physical fi tness.
  9. Costs of amusement, diversions, social activities and directly associated costs such as tickets to shows or sports events, meals, lodging, rental transportation or gratuities (31.205-14). Also costs of membership in social, dining or country clubs or other organization having similar purposes regardless of whether the costs is reported as taxable income to the employee.
  10. Costs of fines and penalties resulting from violations or failure to comply with federal, state, local or foreign laws or regulations except when they are incurred as a result of compliance with specific terms and conditions of a contract or written instructions from the CO (31.205-15).
  11. Costs of idle facilities unless they are needed to meet fluctuations in workload or necessary when acquired and are now idle due to changes in requirements, economies, reorganizations, terminations or other causes not reasonably foreseen. These costs are allowable for only a reasonable period, ordinarily not to exceed one year, depending on initiatives taken to dispose of the facilities (31.205-17).
  12. IR&D costs incurred in a previous accounting period except for deferred IR&D costs provided the following four conditions are met: (a) the total IR&D costs applicable to the product can be identifi ed (b) the proration of such costs to sales of the product is reasonable (c) the contractor had no government business during the time the costs were incurred or did not allocate IR&D cost to government contracts except to prorate the cost of developing a specific product to the sales of that product and (d) no costs of current IR&D costs are allocated (31.205-18).
  13. Insurance costs are also a significant area identified in the guidance (31.205-19). Here are some unallowable insurance costs that are considered to be expressly unallowable:
    • If purchased insurance is available, the self-insurance costs plus administrative expenses cannot exceed the costs of comparable purchased insurance
    • Self insurance charges for risks of catastrophic losses
    • Actual losses unless expressly provided in a contract except for losses under nominal deductible insurance or minor losses of small hand tools occurring under ordinary course of business that are not insured
    • Costs allowed for business interruption insurance shall exclude coverage for profit
    • Costs of insurance on the lives of offi cers, partners, proprietors or employees unless the insurance represents additional compensation
    • Insurance costs to protect contractors against costs of correcting its own defects in material and workmanship unless it is a normal business expense to cover fortuitous or casualty losses resulting from defects in materials or workmanship
    • Late payment charges related to paying deferred compensation or pension plan costs
  14. Interest on borrowings however represented. In addition, bond discounts, costs of financing or refi nancing capital (net worth plus long term liabilities), legal and professional fees paid in connection with preparing prospectuses, costs of preparing and issuing stock. The exception is interest assessed by State and local taxing authorities when connected to actions taken by instructions given by the contracting offi cer (FAR 31.205-20).
  15. Costs related to activities to prevent employees from exercising their rights to bargain collectively (31.205-21).
  16. Lobbying costs (31.205-.22). Many examples of unallowable lobbying costs are provided (e.g. any attempts to influence federal, state or local legislation, outcomes of elections, and contributions to any political organizations). There are also examples of actions that are not unallowable such as providing technical and factual information related to a contract to a political body or their representative.
  17. Excess of costs over income from any other contract (31.205-23).
  18. Organization or restructuring of the corporate structure (31.205-27). These costs include those related to mergers and acquisitions, resisting reorganization attempts, raising costs where all related costs such as fees, attorneys, consultants, etc, whether they are employees or not. (See our article below on restructuring costs.)
  19. Reconversion costs – e.g. restoring or rehabilitating to the same condition as before the contract - are unallowable (31.205-31). Fair wear and tear are excepted as well as costs related to removing government property and the restoring or rehabilitating facilities related to this removal.
  20. Costs of professional and consulting services (31.205-33). These costs are identified in section (c). (Editor’s note. We have covered this area is several prior articles – conduct a word search at our website for access to them.)
  21. Relocation costs (31.205-35). The guidance provides details on costs that are unallowable and those that are allowable. (Editor’s Note. Again, we invite the interested reader to several prior articles we have written on this issue which can be accessed at our website.)
  22. Rental costs (31.205-37). The guidance states rental costs for property owned by affiliates or related parties are unallowable to the extent they exceed normal costs of ownership such as depreciation, taxes, insurance, and facilities cost of capital (in lieu of interest) and maintenance.
  23. Royalties on patents or amortized costs of purchasing a patent necessary for performing a contract are allowable. (31.205-37). However, these costs are unallowable if the government has a license or right of free use to the patent, the patent has been adjudicated or administratively determined to be invalid or unenforceable or has expired.
  24. The guidance recognizes that selling costs is a “generic term” that includes many meanings, some of which are covered in other sections of the FAR such as advertising, corporate image enhancement, B&P, market planning and direct selling (FAR 31.20538). The guidance does not identify specifi c “selling” activities considered to be unallowable and subject to penalties but it is probably safe to assume if auditors deem selling costs to be unallowable they will also be considered expressly unallowable. (Editor’s note. See our articles on selling expenses.)
  25. Certain taxes are unallowable (31.205-41) and when they are, they are subject to penalties. Common taxes that are unallowable include federal income and excess profits taxes, taxes in connection with financing or reorganization, special assessments on land representing capital improvements, taxes on real or personal property used solely in connection with other work other than government contracts, excise tax in Subtitle D of IRS code, income tax accruals to account for differences between income and pretax income as reflected in books of accounts and financial statements and taxes that are exempt or given “preferential treatment” that are available to contractors unless the CO rules the effort to obtain the exemption outweighs the benefit.
  26. Employee training and education (31.205-44). Unallowable training and education costs include (a) overtime payments (b) costs of salaries to attend undergraduate level or part time graduate level unless unusual circumstances do not allow for attendance outside regular work hours (c) costs of tuition, fees, books, salaries, etc for full time graduate level education exceeding two years or length of program (d) grants to educational institutions (they are considered “gifts”) (e) training and education for other than bona fide employees where an exception is for dependents who are overseas and suitable education is not available and (f) contractor contributions to college savings plans for dependents.
  27. Travel costs (31.205-46). Reasonable and allowable lodging, meal and incidental travel costs are considered to be those set forth in the Federal Travel Regulations. The guidance does provide for exceptions for actual costs exceeding FTRs as long as the higher amounts do not exceed those costs provided in (a)(2)(i), (ii), or (iii) or air travel exceeding lowest price airfare is justifi ed (e.g. circuitous routing, prolonged delays, physical or medical reasons).
  28. Legal proceedings (31.205-47). The guidance references section (f) as well as (b) that identifi es legal and settlement costs that are unallowable. (Editor’s note. We invite the interested reader to our article accessible at our website using the key word search.)
  29. Additional FAR related costs are referenced including costs that are in excess of contract or grant price (31.205-48), costs of amortizing, expensing or writing off goodwill (31.205-49) and costs of alcoholic beverages (31.205-51).
    A few costs referenced in the DFARS include:
  30. Monies paid to the government for leasing of government equipment including payments for leases and support are considered to be unallowable advertising and public relations costs (DFARS 231-205-1(f). This provision does not apply to foreign military sales.
  31. Restructuring bonus costs (DFARS 231.205-6). Bonus or other related costs exceeding normal salary for restructuring costs associated with a business combination are unallowable on defense contracts. This limitation does not apply to severance payments or retirement incentive programs.
  32. Fringe benefit costs (DFARS 231-205-6) that are contrary to law, employer-employee agreement or an established policy are unallowable.
  33. Major contractors (all business segments allocating more than $11 million of IR&D/B&P costs) must report IR&D projects generating IR&D costs to the Defense Technical Information Center (DFARS 231205-18) with inputs and updates provided to the ACO and DCAA. Failure to follow these report requirements will make the costs expressly unallowable.
  34. Restructuring costs will be explicitly unallowable unless certain actions are taken (DFARS 231-205-70(c). In addition to provisions in FAR 31.205-27, contracts to prepare projections of restructuring costs and savings to be performed which are to be audited where the projected audited savings, on a present value basis, must exceed the costs by a factor of two to one and the business combination will result in preserving critical capabilities. .
  35. Costs of counterfeit electronic parts or suspect parts and the cost of rework or corrective action are unallowable unless (a) the contractor has a system to detect and avoid such parts (b) the parts are government furnished property and (c) the contractor provides timely notice to the government (DFARS 231-205-71).

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