Government Contracting: Questioned Costs & Allowability

BRENDAN HALLORAN: Welcome to Cherry Bekaert's GovCon podcast, where we discuss current government contracting trends, compliance matters, and best practices to guide federal contractors forward.

BRENDAN HALLORAN: I'm Brendan Halloran, a senior manager in Cherry Bekaert's Government Contractor Services Group. With me today is Kurt Smith, also a member of Cherry Bekaert's Government Contractor Services Group.

BRENDAN HALLORAN: Today we're looking at allowability and questioned costs, a pertinent topic for government contractors who've had audit questioned costs or need to determine allowability and treatment of costs in their systems.

KURT SMITH: Thank you, Brendan. As practitioners in the GovCon space, this topic is important to us. Let me discuss what makes a cost allowable.

KURT SMITH: The parameters are in the cost principles at FAR 31.2. FAR 31 generally covers cost principles; Subpart 31.2 concerns commercial entities, which covers most contractors we work with. An allowable cost is defined in FAR 31.201-2 and has five parts: reasonableness, allocability, compliance with Cost Accounting Standards for CAS-covered contracts, terms of the contract, and any limitations in the cost principles themselves.

KURT SMITH: Reasonableness is a basic test often described as the prudent person test. FAR 31.2 states a cost is reasonable if, in its nature and amount, it does not exceed what would be incurred by a prudent person in competitive business. Sometimes reasonableness is obvious—for example, paying $200 for a two-by-four would not be reasonable. You can check market prices or your own records to support reasonableness.

KURT SMITH: Allocability addresses whether a cost should be allocated to a contract or a final or intermediate cost objective based on a cost-beneficial relationship. A direct cost benefits a particular contract requirement and is allocable to that contract. Indirect costs are allocated based on the benefit to multiple cost objectives.

KURT SMITH: For example, fringe benefits are allocable to labor based on benefit packages for personnel who work on contracts. Those benefits accompany the labor to a contract or an indirect cost pool. Misallocating indirect costs can occur, for instance, when facilities could be treated as direct or indirect depending on circumstances.

KURT SMITH: I will skip CAS for now, as it has significant depth. Regarding contract terms, contractors should read and comply with all contract terms. Many compliance issues arise because contractors do not fully review contract requirements.

KURT SMITH: Limitations in Subpart 31.2 address specific areas of cost discussed in FAR 31.205. Allocability issues can include mischarging direct costs—such as an employee charging time to a contract where they did not perform effort—which is typically resolvable by reviewing time records.

BRENDAN HALLORAN: The distinction between direct and indirect costs is clearly stated in the cost principles. A direct cost benefits one final cost objective, i.e., a contract. An indirect cost benefits two or more final cost objectives or intermediate cost objectives.

BRENDAN HALLORAN: Supervisory labor that benefits multiple contracts is indirect, while labor exclusively working on a single contract is direct. A useful test is the "but-for" test: would we incur the cost but for the requirements of the contract? Costs must be treated consistently—direct costs are always direct in like circumstances, and indirect costs are always indirect in like circumstances.

BRENDAN HALLORAN: Kurt, can we return to the facility issue we discussed earlier?

KURT SMITH: Yes. Facilities can be direct or indirect depending on whether they specifically benefit one contract or multiple contracts. A common example is facilities used for contracts with security or facility clearance requirements. If certain contracts require unique space or security measures, contractors can develop special allocations to allocate those facility costs to the benefiting contracts.

KURT SMITH: Those allocations should be clearly defined and traceable to statements of work or contract requirements. These situations often require additional evaluation but can be handled properly with defined processes.

BRENDAN HALLORAN: That example—facilities used for classified contract performance—can indeed raise interesting issues.

KURT SMITH: Another critical point for those new to government contracting is support and documentation. From my experience as a DCAA auditor for about 12 years, the prevailing culture is that if it's not documented, it didn't happen. Smaller contractors often fail to document costs or processes and then cannot support them during audits.

KURT SMITH: If DCAA cannot find evidence supporting a cost, it will be questioned as unsupported. Proper documentation is essential.

BRENDAN HALLORAN: Thanks. That covers many considerations for cost allowability. On the other side, what costs do we expect to be treated as unallowable or to fall into problematic circumstances?

BRENDAN HALLORAN: Contractors must know all contract details because contract terms may make a cost or portion of a cost unallowable for that contract. Early awareness, even during negotiations, is critical. For example, some contracts limit application of certain overheads or prohibit applying overhead to particular cost elements, and some contracts include rate caps.

BRENDAN HALLORAN: Contractors should be consistent, but particular contract requirements or agreements must be applied consistently where they exist.

KURT SMITH: Practical examples that commonly generate questioned costs include employee morale, advertising, executive compensation, interest, alcohol, and travel. Executive compensation caps change periodically, and long-term compensation tied to stock valuation is often audited.

KURT SMITH: These areas are covered under FAR 31.205, which contains numerous specific cost items. In some cases an item in FAR 31.205 is allowable; in other cases it is unallowable. For example, FAR 31.205-14 addresses employee morale, health, welfare, food service, and dormitory costs. Costs of recreation are generally unallowable except for employee participation in company-sponsored sports teams or employee organizations designed to improve company loyalty, teamwork, or physical fitness.

KURT SMITH: I observed a contractor whose apprentice school had athletic teams; the government allowed costs that promoted morale and physical fitness when reasonable. However, activities involving family members or purely recreational enjoyment are typically unallowable and require caution.

KURT SMITH: Expressly unallowable costs must be removed from claims and can be subject to penalties and interest. These issues can become contentious because of the additional financial exposure.

BRENDAN HALLORAN: Another common compliance issue is period of benefit. Costs out of period—costs that benefited another fiscal period—can cause disputes and require administrative resolution.

BRENDAN HALLORAN: Overall, Kurt has detailed key issues around allowability and typical areas of concern. Where do contractors most often see questioned costs arise?

KURT SMITH: The bulk of questioned costs occur in audits of incurred cost submissions. An incurred cost submission is a series of schedules contractors must submit to report indirect costs for the fiscal year, typically six months after fiscal year end. It is required by the Allowable Cost and Payment clause inserted into cost-type contracts.

KURT SMITH: If you perform cost-type contracts or time-and-material contracts with a cost element, you generally must submit an incurred cost submission. These submissions are extensive and time-consuming.

KURT SMITH: If your annual costs exceed a certain threshold, currently $100 million, you will likely undergo audit. If your costs are below that threshold, your submission may be placed in a low-risk pool and subject to statistical sampling. The contracting officer (ACO) can also specifically request audit of a submission, which DCAA will typically perform.

BRENDAN HALLORAN: Prior-year findings and question costs are typically part of the government's risk assessment. Maintaining clean submissions year to year can reduce perceived risk and the likelihood of audit.

KURT SMITH: I recall auditors always reviewing previous audit findings. Another area where contractors encounter questioned costs is in proposals. Under FAR 15.4, the government may request cost or pricing data during negotiation. Cost data are detailed elements of cost, while pricing information is the price only. When cost data are submitted, the government can audit and question rates, material estimates, and labor estimates.

KURT SMITH: For large proposals, auditors may question proposed rates and cost elements. Be careful preparing submissions and proposals.

BRENDAN HALLORAN: What can contractors do to avoid questioned costs?

KURT SMITH: Document and support everything. When auditors request support for your G&A pool or any cost pool in your incurred cost submission, have the supporting documentation readily available.

KURT SMITH: Use consistent accounting practices and align with the cost principles. Identify and segregate unallowable costs on entry to the accounting system. We recommend creating separate general ledger accounts for unallowable costs so they are clearly segregated.

KURT SMITH: Scrub your incurred cost submission for unallowable items. For example, ensure travel claims adhere to per diem limits for lodging and meals and only claim allowable amounts in the submission.

BRENDAN HALLORAN: In travel and other focus areas, maintain consistent routines and document how you determined costs such as airfares.

BRENDAN HALLORAN: If a contractor receives questioned costs in an audit, respond actively during the audit and provide supporting documentation. If there are findings, contractors should have the opportunity to respond and present additional support.

KURT SMITH: Incurred cost audits are often recent-year records rather than archival documents, which helps in gathering support. If you receive findings, document your position and attempt to negotiate with the contracting officer. Contracting officers vary in how much they will negotiate, but a well-supported case is worth presenting.

BRENDAN HALLORAN: If a cost is found expressly unallowable, determine whether it was a one-time error. There is a penalty waiver provision that may apply in some circumstances; contractors should evaluate and use available regulatory provisions to maximize recovery opportunities.

BRENDAN HALLORAN: If negotiations reach an impasse, know your rights regarding appeals or other remedies. Develop and document your position thoroughly before attempting negotiation.

KURT SMITH: These are practical considerations and recurring issues we see in the field.

BRENDAN HALLORAN: We will revisit this topic in the future to discuss other audit hot topics and focus areas.