Under FAR 31.201, the federal government reimburses a contractor cost only when it is reasonable, allocable to the contract, consistent with applicable accounting standards, permitted by the contract’s own terms, and not restricted by FAR Subpart 31.2. Costs that flunk any of those five tests, or that fall into categories the regulation flatly bars (alcohol, entertainment, lobbying, goodwill amortization, most fines and penalties, and others), are unallowable and cannot be billed. The rules apply whenever a contracting officer performs cost analysis, and they bite hardest on cost-reimbursement contracts and on any fixed-price work where a price adjustment or termination settlement forces the parties to examine actual costs.
The Five Allowability Tests
FAR 31.201-2 lays out the screen every claimed cost has to pass. Fail one and the cost is out.
- Reasonableness. The amount cannot exceed what a careful businessperson would pay in similar circumstances.
- Allocability. The cost must have a clear connection to the contract being charged.
- Accounting standards. The cost must conform to Cost Accounting Standards Board rules where those apply, and to generally accepted accounting principles where they do not.
- Contract terms. The specific contract can impose tighter restrictions than the regulation itself.
- Limitations in Subpart 31.2. Certain costs are capped or barred outright, whatever else might be said for them.
The contractor carries the entire burden of proof. A contracting officer can disallow anything that lacks adequate supporting documentation, and “adequate” means records that trace from the invoice back through to the source documents showing the cost was incurred, is allocable, and satisfies the cost principles.
What “Reasonable” Actually Means
A reasonable cost, under FAR 31.201-3, is one that does not exceed what a prudent person would spend running a competitive business. When the answer isn’t obvious, contracting officers weigh four factors: whether the cost is ordinary and necessary for the business or the contract; whether the transaction reflects arm’s-length bargaining and complies with federal and state law; whether the contractor considered its obligations to the government, other customers, owners, employees, and the public; and whether the contractor departed significantly from its own established practices for the same type of cost.
One point trips people up repeatedly. FAR 31.201-3 states outright that no presumption of reasonableness attaches to any cost a contractor incurs. Following your own commercial practices is a factor, not a shield. If a contracting officer challenges an expense, you have to affirmatively prove the amount was justified. Fall short, and the government can limit reimbursement to whatever figure it considers appropriate.
How Allocability Works
FAR 31.201-4 defines when a cost properly attaches to a government contract. A cost is allocable if it fits one of three descriptions: it was incurred specifically for that contract; it benefits both the contract and other work, in which case it gets distributed in reasonable proportion to the benefits received; or it is necessary to overall business operations even without a direct link to any single contract, as with general corporate overhead.
The organizing concept is relative benefit. A contractor cannot load disproportionate overhead onto a government cost-reimbursement contract while keeping commercial jobs lean. Auditors look specifically for cost-shifting between commercial and government accounts, and it remains one of the quickest ways to draw an investigation.
Costs That Are Never Allowable
FAR Subpart 31.205 bars or limits dozens of specific cost categories. Several catch contractors off guard:
- Alcoholic beverages. Always unallowable, no exceptions.
- Entertainment. Amusement, recreation, and social activities are out.
- Goodwill. Any amortization, write-off, or write-down is barred.
- Lobbying and political activity. Costs aimed at influencing legislation or elections cannot be charged.
- Certain legal costs. Defending federal fraud claims, antitrust suits, and patent infringement litigation are unallowable, unless the contract provides otherwise for the patent category.
- Promotional advertising. Advertising whose primary purpose is selling products or services is unallowable, though advertising for recruiting or to meet contract requirements may be allowed.
- Fines and penalties. Anything resulting from violations of law or regulation is unallowable.
Executive compensation has a ceiling too. The government caps the compensation of any individual employee that can be charged to covered contracts. For fiscal year 2025 the cap was $671,000. It moves periodically, so verify the current benchmark before proposing.
Credits Must Reduce the Bill
FAR 31.201-5 requires that any income, rebate, allowance, or other credit related to an allowable cost flow back to the government. Buy materials, bill the government, then collect a volume discount or refund from the supplier, and the applicable share of that benefit reduces the contract cost or comes back as a cash refund. The rule stops contractors from recovering the full price of something that ultimately cost them less.
Penalties for Claiming Unallowable Costs
FAR 31.201-6 requires contractors to identify and exclude unallowable costs from every billing, claim, and proposal. Getting this wrong has real consequences under FAR 42.709.
The penalty runs on two tiers. Include an expressly unallowable indirect cost in a proposal and the penalty equals the full amount of the disallowed costs allocated to covered contracts, plus interest on any amount the government already paid. If that same cost had already been determined unallowable for that contractor before the proposal went in, the penalty doubles to twice the disallowed amount.
Accounting systems need to flag and segregate unallowable costs before invoices leave the building. The Defense Contract Audit Agency samples indirect cost pools and traces entries back to source documentation. When an auditor finds an unallowable cost in a sampled transaction, the projected amount across the entire pool is subject to the same penalty provisions. A single misclassified expense, projected across a large pool, becomes a significant financial hit.
Advance Agreements for Gray-Area Costs
FAR 31.109 encourages contractors and contracting officers to settle the treatment of unusual or hard-to-categorize costs in writing before the money is spent. Resolving allowability after the fact creates friction and delays payment; nailing it down up front is cheaper for everyone.
Advance agreements must be in writing, signed by both parties, and incorporated into current and future contracts, with their applicability and duration spelled out. They can cover a single contract, a group of contracts, or every contract a contractor holds across one or multiple agencies. The regulation flags them as particularly useful for compensation practices, travel and relocation, use charges on fully depreciated assets, professional service fees, precontract costs, idle facilities and capacity, independent research and development, and general and administrative costs on construction, architect-engineer, and government-owned contractor-operated work.
One boundary matters. A contracting officer cannot use an advance agreement to approve a cost treatment that conflicts with Part 31. If the cost principles bar interest, an advance agreement cannot make interest allowable. The agreement clarifies how the rules apply to your situation; it does not rewrite them.
If the Contracting Officer Disallows a Cost
When a contracting officer disallows a cost and you disagree, the dispute follows the Contract Disputes Act. Submit a written claim to the contracting officer requesting a specific dollar amount. For claims exceeding $100,000, you must certify that the claim is made in good faith, the supporting data is accurate and complete, and the amount reflects what you believe the government owes.
The contracting officer then issues a final decision. Two appeal paths follow. A notice of appeal to the appropriate Board of Contract Appeals (the Armed Services Board for defense contracts, the Civilian Board for most civilian agency contracts) must be filed within 90 days of receiving the decision. A complaint at the U.S. Court of Federal Claims must be filed within 12 months. Choosing one forum generally closes the door to the other.
You must keep performing while the dispute runs. Walking off is not an option. A six-year statute of limitations applies to claims, so sitting on a disputed cost too long can forfeit the right to recover it.