Under FAR 31.205, allowable and unallowable costs are sorted by a mix of general tests and category-specific rules: every cost a contractor bills to the federal government must first pass a five-part allowability test in FAR 31.201, and then survive the specific principle in Subpart 31.2 that governs its category. Some categories are flatly banned (entertainment, alcohol, lobbying, most fines, federal income taxes, bad debts). Others are allowable but capped or conditional (executive compensation, travel, consultants, selling costs). If a cost fails either layer, the contractor absorbs it.1Acquisition.GOV. Part 31 – Contract Cost Principles and Procedures
The Five-Part Test Every Cost Must Pass
Before any category rule applies, a cost has to clear five requirements. Miss one and the cost is disallowed.2Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
- Reasonableness. The cost cannot exceed what a careful businessperson would pay in similar circumstances. There is no presumption of reasonableness just because the contractor spent the money.3Acquisition.GOV. 48 CFR 31.201-3 – Determining Reasonableness
- Allocability. The expense must connect to the contract, either directly, as a proportional share across multiple contracts, or as general support for the business.4Acquisition.GOV. 48 CFR 31.201-4 – Determining Allocability
- Accounting standards. The contractor must follow Cost Accounting Standards where they apply, or otherwise generally accepted accounting principles.
- Contract terms. The individual contract can narrow what is otherwise allowable.
- Subpart 31.2 limitations. Even a reasonable, allocable cost is out if a specific cost principle says so.5Acquisition.GOV. FAR Subpart 31.2 – Contracts With Commercial Organizations
When a contracting officer challenges a cost, the burden sits entirely with the contractor to prove all five are met.3Acquisition.GOV. 48 CFR 31.201-3 – Determining Reasonableness
Costs You Cannot Bill to the Government
Some expenses are prohibited outright. Reasonableness and allocability do not save them, and claiming them can trigger penalties on top of the disallowance.
Advertising and Public Relations
General brand advertising, promotional brochures, souvenirs, and image-enhancement material are unallowable. What the government will pay for is narrow: advertising the contract itself requires, recruitment ads for contract work, ads needed to acquire scarce materials for performance, and trade-show costs tied to promoting U.S. exports. Routine public communications about company operations (plant closings, layoffs, contract awards) are allowable if kept to basic informational purposes.6Acquisition.GOV. 48 CFR 31.205-1 – Public Relations and Advertising Costs
Entertainment, Alcohol, and Bad Debts
Entertainment is unallowable in every form: event tickets, social outings, meals tied to amusement, club memberships. Building a business relationship with a government client does not change the answer. And a cost that is unallowable as entertainment cannot be reclassified under a different principle to make it allowable.7Acquisition.GOV. 48 CFR 31.205-14 – Entertainment Costs Alcohol is banned separately and absolutely.8Acquisition.GOV. 48 CFR 31.205-51 – Costs of Alcoholic Beverages Uncollectible customer debts, plus any collection or legal costs chasing them, are also out.9Acquisition.GOV. 48 CFR 31.205-3 – Bad Debts
Fines, Penalties, and Lobbying
Fines and penalties from violating any law (federal, state, local, or foreign) are unallowable. The only exception is a penalty incurred because the contractor followed the specific written instructions of a contracting officer.10Acquisition.GOV. 48 CFR 31.205-15 – Fines, Penalties, and Mischarging Costs Lobbying and political activity costs are equally off-limits, including campaign contributions, PAC expenses, efforts to influence legislation at any level, and attempts to improperly influence executive branch officials on regulatory or contract matters.11Acquisition.GOV. FAR 31.205-22 Lobbying and Political Activity Costs
Federal Income Taxes and Related Items
Federal income taxes and excess profits taxes are expressly unallowable. So are taxes tied to corporate financing or reorganization, special assessments representing capital improvements to land, and excise taxes tied to pension or deferred compensation plan violations. If a tax exemption is available to the contractor, whether directly or through the government’s exempt status, the contractor generally cannot claim the tax as reimbursable.12Acquisition.GOV. Taxes State and local taxes actually incurred and properly allocable to the contract are usually allowable. The rule is not “all taxes are unallowable”; specific categories are banned while others pass through normally.
Legal Costs After an Adverse Outcome
Legal defense costs depend on how the proceeding ends. If a government-initiated proceeding produces a criminal conviction, a civil finding of liability involving fraud, or another adverse outcome like debarment or termination for default, the contractor’s legal costs for that proceeding become unallowable. The same rule applies to settlements or compromises if the underlying case could have led to one of those outcomes. There is one useful wrinkle: when a third party brings a False Claims Act suit and the government declines to intervene, the contracting officer has discretion to allow reasonable defense costs if the third party had very little chance of prevailing on the merits.13Acquisition.GOV. Costs Related to Legal and Other Proceedings
Costs Allowable Within Limits
Most cost categories sit between “banned” and “freely reimbursable.” The government will pay, but only up to a point and only with the right paper trail. This is where audits produce the most disputes.
Employee Compensation
Total pay for any employee or job class must be reasonable for the work performed. That covers wages, salaries, bonuses, and benefits.14Acquisition.GOV. FAR 31.205-6 – Compensation for Personal Services For senior executives, a statutory annual cap limits how much compensation can be charged to contracts, adjusted periodically. Anything above the cap comes out of the contractor’s pocket. Paying well above market for comparable positions creates a double risk: hitting the ceiling, and having auditors question reasonableness even below it.
Travel
Travel on official company business for the contract is reimbursable, but lodging, meals, and incidental expenses are capped at the government’s per diem rates. Travel within the contiguous United States uses the Federal Travel Regulation published by the General Services Administration.15Acquisition.GOV. 48 CFR 31.205-46 – Travel Costs Alaska, Hawaii, and overseas travel follow separate schedules from the Department of Defense and the Department of State.16General Services Administration. Per Diem Rates Book a hotel above per diem and the contractor can only claim the maximum allowed; the difference is unallowable. The regulation does permit exceptions when the contractor can document that higher costs were unavoidable, but “the conference was at an expensive hotel” rarely qualifies.
Professional and Consultant Services
Hiring outside professionals is allowable, but with heavier documentation than most other categories. The contractor must maintain three types of evidence: details of the agreement including scope of work and compensation terms, invoices showing time spent and services actually delivered, and work products or related documents such as trip reports and meeting minutes.17Acquisition.GOV. FAR 31.205-33 – Professional and Consultant Service Costs Retainer fees add a fourth layer: the contractor must show the services covered are customary, past service levels justify the retainer amount, and the retainer is cheaper or more practical than building the capability in-house. Auditors do not demand a specific set of documents, but they need enough evidence to see what work was performed and confirm it was proper.18Defense Contract Audit Agency. Chapter 58 – Professional and Consultant Service
Selling Costs
Direct selling (person-to-person contact to pitch specific products or services, including technical demonstrations, negotiations, and liaison work) is allowable. Sellers’ commissions and agents’ fees are allowable when paid to actual employees or established selling agencies the contractor maintains for securing business.19Acquisition.GOV. Selling Costs Broadly targeted sales efforts that function as corporate image building get reclassified as public relations and fall under the stricter advertising rules. The boundary between direct selling and image enhancement is where marketing materials that serve both purposes get contested.
Settling Gray Areas With Advance Agreements
Before incurring an unusual or potentially disputed cost, a contractor can negotiate an advance agreement with the contracting officer that resolves allowability up front. The agreement must be executed before the cost is incurred, in writing, signed by both parties, and incorporated into the applicable contracts.20Acquisition.GOV. Advance Agreements
The regulation specifically encourages advance agreements for cost categories that generate disputes after the fact: executive compensation components like incentive pay and hardship pay, use of fully depreciated assets, precontract costs, independent research and development expenses, royalties, relocation costs, idle facility costs, severance pay, and professional service fees.20Acquisition.GOV. Advance Agreements One important limit: a contracting officer cannot agree to treat a cost as allowable if the cost principles say it is not. An advance agreement resolves ambiguity. It does not override the rules.
Documentation and Where Contractors Lose Money
The contractor bears full responsibility for proving that every claimed cost was actually incurred, is properly allocable, and complies with the cost principles. The contracting officer can disallow anything inadequately supported.2Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability In practice that means original invoices, timecards, receipts, subcontractor agreements, and documentation that connects the expense to the contract. Vague expense-report descriptions are a reliable way to lose money during an audit.
A few patterns show up over and over in disallowance findings. Inadequate documentation for consultant costs is the most common: contractors hire an expert, pay the invoices, file them away, and cannot produce work products or trip reports when the auditor asks two years later. Collecting deliverables and documenting meetings in real time is the fix.
The second is failing to segregate unallowable costs in the accounting system. Expenses like entertainment and alcohol should be coded to separate accounts from the moment they are incurred. Mixed into general overhead pools, they inflate the indirect rates applied across all government contracts, and untangling the problem during an audit is expensive.
The third is travel above per diem without proper justification. Contractors who build the government’s per diem rates into their internal travel policies and train employees accordingly avoid most of these disputes before they start.
The last is treating reasonableness as a formality. When a contracting officer challenges a cost, the burden shifts entirely to the contractor to prove the expense was what a careful business would have paid in similar circumstances.3Acquisition.GOV. 48 CFR 31.201-3 – Determining Reasonableness Having a competitive bid or market comparison ready before the question is asked makes that conversation much shorter.