FAR Part 31: Contract Cost Principles
FAR Part 31 establishes the cost principles and procedures that determine which costs are allowable, allocable, and reasonable for government contract purposes. It is the foundation of government contract accounting and the basis for every DCAA audit.
This guide covers the core concepts of contract cost principles — allowable vs unallowable costs, direct and indirect cost allocation, key cost principles for specific expense categories, CAS applicability, and the audit findings that trip up contractors most often.
100M+ government records · 300+ gov/news sources · Updated hourly
Allowable vs Unallowable Costs
The distinction between allowable and unallowable costs is the most fundamental concept in government contract accounting. Every cost charged to or reimbursed under a government contract must pass through a four-part test established in FAR 31.201-2.
To be allowable, a cost must be:
- Reasonable: A cost is reasonable if a prudent person in the same circumstances would incur it. The nature and amount of the cost must be consistent with sound business practices, arm's-length transactions, and the contractor's responsibilities to the government.
- Allocable: A cost is allocable to a contract if it is incurred specifically for the contract, benefits both the contract and other work, or is necessary for the overall operation of the business and is assignable to the contract based on the relative benefits received.
- CAS/GAAP compliant: The cost must be measured, assigned, and allocated in accordance with applicable Cost Accounting Standards (CAS) or Generally Accepted Accounting Principles (GAAP) if CAS does not apply.
- Not specifically unallowable: The cost must not be expressly listed as unallowable under the specific cost principles in FAR 31.205.
Always Unallowable
- Entertainment costs (FAR 31.205-14)
- Alcoholic beverages (FAR 31.205-51)
- Lobbying and political activity costs (FAR 31.205-22)
- Fines and penalties (FAR 31.205-15)
- Donations and contributions (FAR 31.205-8)
- Bad debts (FAR 31.205-3)
- Interest and financing costs (generally, FAR 31.205-20)
- Goodwill (FAR 31.205-49)
- Organization costs (ongoing, FAR 31.205-27)
- First-class airfare (FAR 31.205-46)
Generally Allowable
- Compensation for personal services (within limits, FAR 31.205-6)
- Employee morale and welfare costs (FAR 31.205-13)
- Insurance and indemnification (FAR 31.205-19)
- Material costs (FAR 31.205-26)
- Professional and consultant services (FAR 31.205-33)
- Recruiting costs (FAR 31.205-34)
- Rental costs (FAR 31.205-36)
- Training and education costs (FAR 31.205-44)
- Travel costs at economy rate (FAR 31.205-46)
- Depreciation (FAR 31.205-11)
Direct vs Indirect Cost Allocation
Government contract accounting requires contractors to classify costs as either direct or indirect. This classification determines how costs are charged to contracts and is one of the most scrutinized aspects of a contractor's accounting system.
Direct costs are costs that can be specifically identified with a particular contract or final cost objective. The most common direct costs include labor hours worked on a specific contract, materials and supplies purchased for a contract, subcontractor costs, and travel directly related to contract performance. Direct costs are charged to contracts based on actual usage, measured through timekeeping systems, purchase orders, and other source documents.
Indirect costs are costs that benefit multiple contracts or the business as a whole and cannot be readily identified with a single contract. They are allocated to contracts through indirect cost rates, which express the ratio of indirect costs to a direct cost base. The most common indirect cost pools include:
- Fringe benefits: Health insurance, retirement contributions, payroll taxes, paid time off, and other employee benefits. Typically allocated as a percentage of direct labor dollars.
- Overhead: Costs associated with the productive functions of the business, including supervision, facilities, IT infrastructure, and project support. Allocated based on direct labor dollars or hours.
- General and Administrative (G&A): Costs of managing the business as a whole, including executive management, finance, HR, legal, business development, and corporate functions. Allocated as a percentage of total cost input or value-added cost input.
Consistency in cost allocation is critical. Once a contractor classifies a cost as direct or indirect, that treatment must remain consistent across all contracts and accounting periods. Shifting costs between direct and indirect pools to improve a billing rate or to move costs from an unallowable category to an allowable one is a common audit finding and can constitute a False Claims Act violation.
Key Cost Principles by Category
FAR 31.205 contains over 50 specific cost principles covering individual expense categories. Each principle specifies whether a cost type is allowable, unallowable, or conditionally allowable (with limitations). The following are the cost principles that most frequently affect government contractors.
Compensation (FAR 31.205-6)
Employee compensation is allowable provided it is reasonable for the work performed and the contractor's industry. The benchmark test compares compensation to the Bureau of Labor Statistics (BLS) data and industry surveys. Executive compensation is capped — the allowable amount for senior executives cannot exceed the benchmark compensation amount published annually by OFPP. Bonuses are allowable if part of an established compensation plan, applied consistently, and reasonable in amount.
Travel (FAR 31.205-46)
Travel costs are allowable at the lesser of actual cost or the government per diem rates (published by GSA for CONUS, DoD for OCONUS). Airfare is limited to coach class unless the flight exceeds 14 hours or specific exceptions apply. Lodging and meals follow GSA per diem rates. Mileage for personal vehicles follows the IRS standard mileage rate. First-class airfare is always unallowable. Business-class airfare is allowable only when the flight exceeds 14 hours nonstop.
Entertainment (FAR 31.205-14)
Entertainment costs are always unallowable, regardless of their business purpose. This includes amusement, diversion, social activities, and any costs directly associated with entertainment (such as tickets, meals at entertainment events, and hospitality suites). The distinction between entertainment and legitimate business meals can be subtle — a working lunch at the office is generally allowable, while dinner at a restaurant with a client may be classified as entertainment.
Lobbying (FAR 31.205-22)
Costs of lobbying, political contributions, and attempts to influence legislation are unallowable. This includes costs of lobbying legislators, executive branch officials, or agency personnel about pending legislation or regulations. However, costs of providing technical or factual information to legislators in response to a direct request are allowable. The distinction between unallowable lobbying and allowable communication with the government requires careful documentation.
Cost Accounting Standards (CAS) Applicability
The Cost Accounting Standards (CAS) are a set of 19 standards that govern how costs are measured, assigned, and allocated to government contracts. CAS requirements are separate from but closely related to FAR Part 31, and the two work together to regulate government contract accounting.
CAS applicability is tiered based on the volume of CAS-covered contracts a contractor holds:
Full CAS Coverage
Applies to contractors receiving $50 million or more in net CAS-covered awards in the prior cost accounting period. All 19 standards apply, and a CAS Disclosure Statement is required.
Modified CAS Coverage
Applies to contractors with CAS-covered contracts totaling $7.5 million to $50 million. Only CAS 401 (consistency), CAS 402 (cost objectives), CAS 405 (unallowable costs), and CAS 406 (cost accounting periods) apply.
CAS Exempt
Contracts under $7.5 million, firm-fixed-price contracts awarded through sealed bidding, small business set-asides, and contracts with educational institutions are exempt from CAS.
The CAS Disclosure Statement is a critical document that describes a contractor's cost accounting practices. It must be submitted before contract award and updated whenever accounting practices change. Failure to follow disclosed practices or failure to disclose changes is a contract violation that can result in cost adjustments and potential penalties.
Cost Accounting Period and Rate Development
CAS 406 requires contractors to use their fiscal year as the cost accounting period for accumulating indirect costs and developing indirect cost rates. At the beginning of each fiscal year, contractors establish provisional (estimated) billing rates based on budgeted costs. These provisional rates are used to bill the government throughout the year.
After the fiscal year ends, contractors submit an incurred cost proposal to DCAA, which includes the actual costs incurred during the year and the actual indirect cost rates. DCAA audits the incurred cost proposal and recommends final rates to the contracting officer. The contracting officer then negotiates and establishes final rates.
The difference between provisional billing rates and final actual rates results in either overpayments (which the contractor must refund) or underpayments (which the government must pay). Incurred cost submissions are due within 6 months of the fiscal year end, and DCAA has a significant backlog of audits, meaning final rates may not be established for several years after the fiscal year closes.
Common DCAA Audit Findings
Inadequate Timekeeping
Employees not recording actual hours worked in real time, supervisory approvals missing, or systems allowing retroactive changes without audit trails. DCAA expects daily time recording with contemporaneous entries.
Labor Mischarging
Charging labor to the wrong contract or shifting labor between direct and indirect cost pools to balance budgets. Even unintentional mischarging can trigger fraud investigations.
Unallowable Costs Not Excluded
Failing to identify and exclude expressly unallowable costs (entertainment, lobbying, alcohol) from indirect rate calculations and billings. Contractors must have systems to flag these costs.
Inconsistent Accounting Practices
Changing how costs are classified (direct vs indirect) between periods without proper disclosure. CAS requires consistency in cost treatment across all contracts and periods.
Unsupported Costs
Costs without adequate documentation — missing receipts, unclear business purpose, or insufficient detail to demonstrate allowability, allocability, and reasonableness.
Incorrect Rate Calculations
Errors in the indirect rate computation, including wrong allocation bases, incorrect pool compositions, or failure to exclude unallowable costs from the rate numerator.
Frequently Asked Questions
What is the difference between allowable and unallowable costs?
Allowable costs are expenses that can be charged to or reimbursed under a government contract. To be allowable, a cost must meet four tests: reasonableness, allocability, compliance with CAS or GAAP, and compliance with the specific cost principles in FAR 31.205. Unallowable costs are expenses expressly prohibited from reimbursement, such as entertainment, alcoholic beverages, lobbying, fines and penalties, and certain advertising costs. Unallowable costs must be identified and excluded from any billing or claim submitted to the government.
What are direct costs vs indirect costs in government contracting?
Direct costs are expenses that can be specifically identified with a particular contract, project, or final cost objective. Examples include labor hours charged to a specific contract, materials purchased for a contract, and travel directly related to contract performance. Indirect costs are expenses that benefit multiple contracts or cost objectives and cannot be readily identified with a single contract. They are allocated across contracts using indirect cost rates, typically categorized as overhead, general and administrative (G&A), and fringe benefits.
What is CAS and when does it apply?
Cost Accounting Standards (CAS) are a set of 19 standards issued by the CAS Board that govern how costs are measured, assigned, and allocated to government contracts. Full CAS coverage applies to contractors receiving $50 million or more in CAS-covered contracts in the prior year. Modified CAS coverage applies to contractors with CAS-covered contracts totaling $7.5 million to $50 million. CAS-exempt contracts include small business set-asides, firm-fixed-price contracts awarded through sealed bidding, and contracts under $7.5 million.
What are the most common DCAA audit findings?
Common DCAA audit findings include: inadequate timekeeping systems (employees not recording actual hours worked), mischarging labor between direct and indirect cost pools, failing to identify and exclude unallowable costs, inconsistent cost accounting practices between periods, unsupported or inadequately documented costs, incorrect indirect rate calculations, commingling of allowable and unallowable costs, and failure to disclose cost accounting practice changes. These findings can result in contract payment suspensions, rate adjustments, and potential fraud referrals.
Track Your Contract Costs with Bureauify
Bureauify helps government contractors manage their pipeline, track opportunities, and understand the cost structures of contracts they are pursuing. Start with a free account.