CHAPTER 5
Principles—Selected Costs
Part 31 of the FAR states that costs shall be allowed to the extent that they are reasonable, allocable, and allowable under certain specific provisions. FAR Section 31.205 covers the allowability of 51 specific cost elements. This chapter focuses on those cost elements that involve complex ideas or are specific to government contracting, and are therefore most likely to need clarification.
GENERALLY UNALLOWABLE COSTS
The following categories of cost are generally unallowable under FAR 31.205.
Public Relations and Advertising Costs (31.205-1)
Generally, public relations and advertising costs relating to sales promotion are unallowable because the government procurement system generates sales through direct contacts and the solicitation of proposals.
Public relations activities consist of all undertakings designed to: (1) maintain, protect, and enhance the image of an organization or its products or services; or (2) maintain or promote reciprocal understandings and favorable relations with the general public or any segment thereof. Public relations activities include advertising and customer relations. Public relations costs include the costs of purchasing media time and space, engaging the services of outside organizations, and paying the salaries, travel, and fringe benefits of employees engaged in public relations.
The FAR enumerates a nonexclusive list of allowable public relations costs, including: costs specifically required by the contract; costs incurred in responding to inquiries regarding the contractor’s policies and activities; and costs associated with corresponding with the press, the public, customers, stockholders, and creditors. In addition, the list includes costs involved in conducting general liaison activities with the news media and government public relations officers that are necessary to inform the public on matters of public concern, such as notices of plant closings or openings, contract awards, financial information, and employee layoffs or rehirings. The list also includes: the costs of participation in such community service activities as blood banks, savings bond drives, charity drives, and disaster assistance; the costs of plant tours and open house functions; and the costs of ceremonies involving ship launchings, keel laying, commissioning, and rollout as provided specifically by the contract.
The provision generally prohibits public relations costs, not specifically allowed, that are incurred to promote the sale of products or services by stimulating interest, or by disseminating information calling favorable attention to the contractor for purposes of enhancing the company image to sell the company’s products or services. Unallowable public relations costs include the costs of: sponsoring meetings, symposia, and seminars; and developing promotional material such as brochures, videotapes, magazines, handouts, and other media designed to call favorable attention to the contractor and its activities. (Also see 31.205-13, Employee Morale, Health, Welfare, Food Service, and Dormitory Costs and Credits; 31.205-21, Labor Relations Costs; 31.205-43, Trade, Business, Technical, and Professional Activity Costs; and 31.205-44, Training and Educational Costs.) Other unallowable costs include souvenirs, models, imprinted clothing, buttons, other mementos, and membership in civic and community organizations.
Product advertising refers to the use of any media forum to promote the products or services of the contractor where the advertiser has control over the content, manner, and printing of the advertisement. As listed in the FAR, advertising media include radio, television, newspapers, magazines, trade papers, direct mail, dealer cards, free goods, conventions, exhibits, window displays, and outdoor advertising.
Allowable advertising costs are those costs used to recruit the personnel necessary to fulfill contract obligations, as limited by FAR 31.205-34 (Recruitment Costs), acquire the scarce items required for contract performance, and dispose of scrap or surplus materials acquired for contract performance. Such costs must be specifically required by the contract or must arise from the contract requirements.
In addition to the flat statement of unallowability for all advertising costs except the three previously mentioned, the FAR cites the following advertising costs as explicitly unallowable: the costs of air shows and other special events, such as conventions and trade shows; and the costs of ceremonies, such as new product announcements.
Special rules cover costs incurred to promote American aerospace exports at domestic and international exhibits; reasonable costs are allowable, including transportation of the aircraft, parts, and equipment, and associated costs. However, some costs remain specifically unallowable, such as those for entertainment, hospitality suites/chalets, and other activities not necessary to establish and operate the exhibit.
Bad Debts (31.205-3)
The FAR provides that “debts, including actual or estimated losses arising from uncollectible accounts receivable due from customers and other claims, and any directly associated costs such as collection costs, and legal costs are unallowable.” This provision is based on the premise that bad debt expenses are not allocable to government contracts because the government always pays its just debts. This provision has also been applied to situations such as when a terminated employee fails to reimburse the contractor for an outstanding cash advance.
Contributions or Donations (31.205-8)
Contributions and donations, which include cash, property, and service, are unallowable, regardless of the recipient. The stated rationale for this principle is that if contributions and donations were allowable, the government would be the actual maker of the gift to the recipient. This situation would permit contractors to make policy decisions regarding who received government support.
An exception is permitted in FAR 31.205-1(e)(1), Public Relations Costs, for costs pertaining to community service activities such as blood bank drives, charity drives, savings bond drives, and disaster assistance. For example, the time spent by employees in Red Cross blood drives either in-plant or recruiting vendors/subcontractors is allowable. However, membership in the Red Cross is not allowable.
Entertainment Costs (31.205-14)
Entertainment costs are unallowable. Unallowable entertainment costs are listed as the costs of amusement, diversion, and social activities as well as directly related costs, such as meals, lodging, gratuities, transportation, rentals, tickets to shows or sports events, and social club memberships.
In practice, most controversies involving entertainment costs arise because contractors classify an entertainment cost as proper. For example, a contractor may classify an entertainment cost as an employee morale cost or as a cost of professional meetings and conferences. The government will disagree, particularly if the cost relates to meals for employees not in travel status. Even when an activity is found to be calculated to improve employee morale for those in attendance, the ASBCA has found the cost to be unallowable when the event also had any aspects of amusement, diversion, and social activities.
Social club membership costs are specifically unallowable whether or not reported as taxable income by the employee enjoying membership privileges. Such costs include membership in social, dining, or country clubs or organizations having the same purpose.
Fines, Penalties, and Mischarging Costs (31.205-15)
Unless they are incurred to comply with specific contract terms and conditions or the written instructions of the contracting officer, fines and penalties are unallowable if they are the result of the contractor’s violations of, or failure to comply with, federal, state, local, or foreign laws and regulations.
Costs incurred in connection with or related to the mischarging of costs on government contracts are unallowable. Such costs include those incurred to identify, measure, or otherwise determine the magnitude of the improper charging, and costs incurred to remedy or correct the mischarging, such as costs to rescreen and reconstruct records.
Interest and Other Financial Costs (31.205-20)
The FAR provides that “Interest on borrowings (however represented), bond discounts, costs of financing and refinancing capital (net worth plus long-term liabilities), legal and professional fees paid in connection with preparing prospectuses, costs of preparing and issuing stock rights, and directly associated costs are unallowable except for interest assessed by State or local taxing authorities under the conditions specified in FAR 31.205-41.”
The government recognized interest expense as an unallowable cost as early as the 1940s. The government assumes that it is doing business with a properly capitalized organization—it does not wish to subsidize contractors who choose to use a high degree of leverage in their capital base. Since dividends are normally not allowable (because they are actually a distribution of profit rather than a cost), making interest expense reimbursable would encourage heavily leveraged firms.
Lobbying and Political Activity Costs (31.205-22)
Costs associated with the following activities are unallowable:
Attempts to influence the outcomes of any Federal, State or local election, referendum, initiative or similar procedure, through in kind or cash contributions, endorsements, publicity or similar activities;
Establishing, administering, contributing to or paying the expenses of a political party, campaign, political action committee, or other organization established for the purpose of influencing the outcomes of elections;
Any attempt to influence—(i) The introduction of Federal, state or local legislation, or (ii) The enactment or modification of any pending Federal, state or local legislation through communication with any member or employee of the Congress or state legislature (including efforts to influence state or local officials to engage in similar lobbying activity), or with any government official or employee in connection with a decision to sign or veto enrolled legislation;
Any attempt to influence—The introduction of Federal, state or local legislation, or the enactment or modification of any pending Federal, state or local legislation by preparing, distributing or using publicity or propaganda, or by urging members of the general public or any segment thereof to contribute to or participate in any mass demonstration, march, rally, fund raising drive, lobbying campaign or letter writing or telephone campaign,
Legislative liaison activities, including attendance at legislative sessions or committee hearings, gathering information regarding legislation, and analyzing the effect of legislation, when such activities are carried on in support of or in knowing preparation for an effort to engage in unallowable activities; or
Costs incurred in attempting to improperly influence (see 3.401), either directly or indirectly, an employee or officer of the Executive branch of the Federal Government to give consideration to or act regarding a regulatory or contract matter.
The following activities are excepted from the coverage:
Providing a technical and factual presentation of information on a topic directly related to the performance of a contract through hearing testimony, statements or letters to the Congress or a state legislature, or subdivision, member, or cognizant staff member thereof, in response to a documented request (including a Congressional Record notice requesting testimony or statements for the record at a regularly scheduled hearing) made by the recipient member, legislative body or subdivision, or a cognizant staff member thereof; provided such information is readily obtainable and can be readily put in deliverable form; and further provided that costs under this section for transportation, lodging or meals are unallowable unless incurred for the purpose of offering testimony at a regularly scheduled Congressional hearing pursuant to a written request for such presentation made by the Chairman or Ranking Minority Member of the Committee or Subcommittee conducting such hearing.
Any lobbying to influence state or local legislation in order to directly reduce contract cost, or to avoid material impairment of the contractor’s authority to perform the contract.
Any activity specifically authorized by statute to be undertaken with funds from the contract.
“When a contractor seeks reimbursement for indirect costs, total lobbying costs shall be separately identified in the indirect cost rate proposal, and thereafter treated as other unallowable activity costs. Contractors shall maintain adequate records to demonstrate that the certification of costs as being allowable or unallowable (see 421.703-2) pursuant to this subsection complies with the requirements of this subsection. Existing procedures should be utilized to resolve in advance any significant questions or disagreements concerning the interpretation or application of this subsection.”
Losses on Other Contracts (31.205-23)
The FAR provides that: “The excess of costs over income under any other contract (including the contractor’s contributed portion under cost-sharing contracts) is unallowable.” The concept behind this provision is that costs related to a specific contract should not be allocated to other work. Each contract should stand on its own in terms of profitability.
Improperly handled cost variances can lead government personnel to question costs on the grounds that the variances could be used as a way of recovering losses on unprofitable government contracts. Cost centers (e.g., wind tunnels, computer centers) are not considered to be contracts for purposes of this provision.
In a decision involving Unisys (ASBCA No. 41135), the contractor had incurred costs for technical efforts under a cost-reimbursement subcontract after all funds had been expended. The prime contractor was not required to make any payments beyond the amount in the subcontract. However, the subcontractor was also not required to perform beyond the efforts covered by the subcontract funding. The subcontract classified those costs that exceeded the fund limitation as IR&D costs. The government objected on the basis that the costs represented a loss on the subcontract and that costs in excess of the funding should have been charged to the subcontract. The ASBCA disagreed with the government based on the opinion that the additional work was not required by the contract and was thus IR&D.
Organization Costs (31.205-27)
Expenditures in connection with (1) planning or executing the organization or reorganization of the corporate structure of a business, including mergers and acquisitions, (2) resisting or planning to resist the reorganization of the corporate structure of a business or a change in the controlling interest in the ownership of a business, and (3) raising capital (net worth plus long-term liabilities), are unallowable. Such expenditures include but are not limited to incorporation fees and the costs of attorneys, accountants, brokers, promoters and organizers, management consultants, and investment counselors, whether or not they are employees of the contractor. Unallowable “reorganization” costs include the cost of any change in the contractor’s financial structure, excluding administrative costs for short-term borrowings for working capital, resulting in alterations in the rights and interests of security holders, whether or not additional capital is raised.
The costs of activities intended primarily to provide compensation are not considered organizational costs subject to this subsection, but are governed by 31.205-6. These activities include acquiring stock for executive bonuses, employee savings plans, and employee stock ownership plans.
The government formalized this cost principle in 1977 on the basis of considerations regarding allocability. The government is not concerned with the form of a con-trac-tor’s organization and thus does not believe that organization costs are necessary for, or allocable to, government contracts.
Costs Related to Legal and Other Proceedings (31.205-47)
Costs incurred in connection with any proceedings brought by a federal, state, local, or foreign government for violation of, or a failure to comply with, a law or regulation by the contractor (including its agents or employees), or costs incurred in connection with any proceeding brought by a third party in the name of the United States under the False Claims Act, 31 U.S.C. 3730, are unallowable if the result is:
“(1) In a criminal proceeding, a conviction;
(2) In a civil or administrative proceeding, either a finding of contractor liability where the proceeding involves an allegation of fraud or similar misconduct or imposition of a monetary penalty where the proceeding does not involve an allegation of fraud or similar misconduct;
(3) A final decision by an appropriate official of an executive agency to debar or suspend a contractor, rescind or void a contract, or terminate a contract for default by reason of a violation or a failure to comply with a law or regulation;
(4) Disposition of the matter by consent or compromise if the proceeding could have led to outcomes listed in (1) through (3) above; or
(5) Not covered by paragraphs (1) through (4) above, but where the underlying alleged contractor misconduct was the same as that which led to a different proceeding whose costs are unallowable by reason of subparagraphs 1 through 4 above.
To the extent that they are not otherwise unallowable, costs incurred in connection with any proceeding under paragraph (b) above, commenced by the United States that is resolved by consent or compromise pursuant to an agreement entered into between the contractor and the United States, and which are unallowable solely because of paragraph (b) above, may be allowed to the extent specifically provided in such agreement.
In the event of a settlement of any proceeding brought by a third party under the False Claims Act in which the United States did not intervene, reasonable costs incurred by the contractor in connection with such a proceeding that are not otherwise unallowable by regulation or by separate agreement with the United States, may be allowed if the contracting officer, in consultation with his or her legal advisor, determines that there was very little likelihood that the third party would have been successful on the merits.
To the extent that they are not otherwise unallowable, costs incurred in connection with any proceeding under paragraph (b) above, commenced by a state, local, or foreign government, may be allowable when the contracting officer (or other official specified in agency procedures) determines that the costs were incurred either as a direct result of a specific term or condition of a federal contract or as a result of compliance with specific written direction of the cognizant contracting officer.
Costs incurred in connection with proceedings described in paragraph (b) above, but which are not made unallowable by that paragraph, may be allowable to the extent that: (1) the costs are reasonable in relation to the activities required to deal with the proceeding and the underlying cause of action; (2) the costs are not otherwise recovered from the federal government or a third party, either directly as a result of the proceeding or otherwise; and (3) the percentage of costs allowed does not exceed the percentage determined to be appropriate considering the complexity of procurement litigation, generally accepted principles governing the award of legal fees in civil actions involving the United States as a party, and such other factors as may be appropriate. Such percentage shall not exceed 80 percent. Agreements shall be subject to this limitation. If, however, an agreement explicitly states the amount of otherwise allowable incurred legal fees and limits the allowable recovery to 80 percent or less of the stated legal fees, no additional limitation need be applied. The amount of reimbursement allowed for legal costs in connection with any proceeding, shall be determined by the cognizant contracting officer, but shall not exceed 80 percent of otherwise allowable legal costs incurred.
Costs not covered elsewhere in this subsection are unallowable if incurred in connection with:
Defense against federal government claims or appeals or the prosecution of claims or appeals against the federal government (see 33.201).
Organization, reorganization (including mergers and acquisitions) or resisting mergers and acquisitions (see also 31.205-27).
Defense of antitrust suits.
Defense of suits brought by employees or ex-employees of the contractor under section 2 of the Major Fraud Act of 1988 where the contractor was found liable or settled.
Costs of legal, accounting, and consultant services and directly associated costs incurred in connection with the defense or prosecution of lawsuits or appeals between contractors arising from either an agreement or contract concerning a teaming arrangement, a joint venture, or similar arrangement of shared interest or dual sourcing, coproduction, or similar programs, are unallowable, except when (i) incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the contracting officer, or (ii) when agreed to in writing by the contracting officer.
Patent infringement litigation, unless otherwise provided for in the contract.
Representation of, or assistance to, individuals, groups, or legal entities that the contractor is not legally bound to provide, arising from an action where the participant was convicted of violation of a law or regulation or was found liable in a civil or administrative proceeding.
Protests of federal government solicitations or contract awards, or the defense against protests of such solicitations or contract awards, unless the costs of defending against a protest are incurred pursuant to a written request from the cognizant contracting officer.”
Costs that may be unallowable under 31.205-47, including directly associated costs, are to be segregated and accounted for by the contractor separately. While any proceeding is pending, the contracting officer will generally withhold payment of such costs. However, if in the best interests of the government, the contracting officer may provide for conditional payment upon provision of adequate security, or other adequate assurance, and agreement by the contractor to repay all unallowable costs, plus interest, if the costs are subsequently determined to be unallowable.
Goodwill (31.205-49)
When the price paid for a business by the acquiring company exceeds the sum of the identifiable individual assets acquired less liabilities assumed, based upon fair market values, the excess is commonly referred to as “goodwill.” An intangible asset, goodwill may arise from the acquisition of a company as a whole or a portion thereof. Any costs for amortization, expensing, writeoff, or write-down of goodwill (however represented) are unallowable.
After losing a significant ASBCA decision over goodwill costs, the government formulated this principle to clearly establish goodwill as an unallowable cost. Purchased goodwill is the excess of the purchase price over the fair market value of the assets of an acquired business entity. The rationale for this cost principle is that the repeated sale of assets between contractors could increase contract costs to the government even though the same assets were used to provide goods or services to the government.
Costs of Alcoholic Beverages (31.205-51)
The costs of alcoholic beverages are unallowable. This provision was considered necessary to ensure that only reasonable and allocable costs are paid under government contracts.
Asset Valuations Resulting from Business Combinations (31.205-52)
For tangible capital assets, when the purchase method of accounting for a business combination is used, whether or not the contract or subcontract is subject to the CAS, the allowable depreciation and cost of money are based on the capitalized asset values measured and assigned in accordance with CAS 404, if allocable, reasonable, and not otherwise unallowable.
For intangible capital assets, when the purchase method of accounting for a business combination is used, allowable amortization and cost of money are limited to the total of the amounts that would have been allowed had the combination not taken place.
Excessive Pass-Through Costs (31.203(i))
A specific provision on allowability of costs is set forth in FAR 31.203(i): “Indirect costs that meet the definition of ‘excessive pass-through charge’ are unallowable.” The basic definition is an additive by an upper-tier contractor to a subcontractor’s costs when the upper-tier contractor adds no or negligible value to the subcontracted work. An additive by the upper-tier contractor is applicable indirect costs such as G&A or subcontract administration overhead and profit or fee. No percentage reflecting excessive costs is cited in the regulation. In practice, some agencies use 8 percent as a limit. The onerous aspect of this rule is that a contractor may allocate indirect costs in accordance with its approved accounting system and negotiate a fixed-price contract, yet have the government retroactively deem a pass-through charge excessive. Contract clauses require specific disclosure of pass-through charges when subcontracting efforts exceed certain thresholds.
COSTS RELATED TO HUMAN RESOURCES
The allowability of the following costs related to human resources is addressed in FAR 31.205.
Compensation for Personal Services (31.205-6)
Compensation for personal services includes all remuneration, whether paid immediately or deferred, for services rendered by employees to the contractor during the period of contract performance. It includes, but is not limited to: salaries; wages; directors’ and executive committee members’ fees; bonuses (including stock bonuses); incentive awards; employee stock options and stock appreciation rights; employee stock ownership plans; employee insurance; fringe benefits; contributions to pension funds, other postretirement benefits, and annuity and employee incentive compensation plans; and allowances for off-site pay, incentive pay, location allowances, hardship pay, severance pay, and cost of living differential. Compensation for personal services is allowable subject to the following general criteria and additional requirements contained in other parts of this cost principle.
Bonuses and incentive compensation are allowable provided the awards are paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered. They are also allowable pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such payment and that the basis for the award is supported.
Executive Compensation
Costs incurred after January 1, 1998, for compensation of a senior executive in excess of the benchmark compensation amount determined applicable for the calendar year by the Administrator of the Office of Federal Procurement Policy (OFPP) are unallowable. This limitation, which is generally not announced until May of the applicable year, is the sole statutory limitation on allowable senior executive compensation costs incurred after January 1, 1998, under new or previously existing contracts. This limitation applies whether or not the affected contracts were previously subject to a statutory limitation on such costs. The limit for the calendar year ending December 31, 2010, was $693,951. Since 1998 the average increase each year has been about 15 percent.
Compensation means the total amount of wages, salary, bonuses, deferred compensation, and employer contributions to defined contribution pension plans for the fiscal year, whether paid, earned, or otherwise accruing, as recorded in the contractor’s cost accounting records for the fiscal year. The definition of “senior executive” has been changed for compensation costs incurred after January 1, 1999. Prior to January 2, 1999, senior executive means: (1) the Chief Executive Officer (CEO) or any individual acting in a similar capacity at the contractor’s headquarters; (2) the four most highly compensated employees in management positions at the contractor’s headquarters, other than the CEO, and (3) if the contractor has intermediate home offices or segments that report directly to the corporate office, the five senior executives at each such intermediate home office or segment. Effective January 2, 1999, senior executive includes the five most highly compensated employees in management positions at each home office and each segment of the contractor, whether or not the home office or segment reports directly to the contractor’s headquarters.
Compensation Based on Changes in the Prices of Corporate Securities or Corporate Security Ownership
Any compensation that is calculated, or valued, based on changes in the price of corporate securities is unallowable. Any compensation represented by dividend payments or that is calculated based on dividend payments is unallowable. If a contractor pays an employee in lieu of the employee receiving or exercising a right, option, or benefit that would have been unallowable under this paragraph, such payments are also unallowable.
Pension Plans
The FAR defines pension plan as “a deferred compensation plan that is established and maintained by one or more employees to provide systematically for paying benefits to plan participants after their retirement, provided that the benefits are paid for life or are payable for life at the option of the employee.”
Also treated as pension costs are expenditures such as permanent and total disability and death payments; survivorship payments to beneficiaries of deceased employees may be treated as pension costs provided that the benefits are an integral part of the pension plan and meet all the criteria pertaining to pension costs.
Generally, pension costs are allowable, subject to the cost limitations, standards, and exceptions set forth in the cost principle that limits cost allowability to the lesser costs, or to the amount deductible for the year’s federal income tax. There are generally two types of pension plans: deferred benefit and defined-contribution benefit. Deferred benefit pension plan costs must be measured, allocated, and accounted for in accordance with CAS 412 (Composition and Measurement of Pension Costs) and CAS 413 (Adjustment and Allocation of Pension Costs). Defined-contribution benefit plan costs also must be measured, allocated, and accounted for in accordance with CAS 412 and CAS 413 provisions. Defined-contribution plans establish in advance, by the level of contributions, what benefits are to be paid, and contributions are made to provide the stated benefit.
One factor that might be used to determine whether pension costs are allowable is the IRS standards. In particular, Section 401 of the Internal Revenue Code requires that an employee’s pension plan must be in writing and communicated to the employees, the employer’s contributions must be irrevocably funded, and no discrimination may be made in favor of officers, supervisors, or highly compensated employees related to contributions or benefits. However, IRS approval of a pension plan does not mandate DCAA audit acceptance of the cost of the plan. Other considerations are the level of benefits under the plan and the time period for employment or membership before an employee’s interest is vested under the plan.
Other Compensation
Fringe benefits are allowances and services provided by the contractor to its employees as compensation in addition to regular wages and salaries. Fringe benefits include, but are not limited to, the cost of holidays, vacation and sick leave, employee insurance, military leave, and supplemental unemployment benefit plans. To the extent that the costs of fringe benefits are reasonable and are required by law, employer-employee agreements, or established contractor policy, they are allowable.
That portion of the cost of company-furnished automobiles that relates to personal use by employees (including transportation to and from work) is unallowable regardless of whether or not the cost is reported as taxable income to the employees.
Although a government contract may provide that the costs of an employee’s travel, relocation, wages, leave, and training are allowable, tuition costs at dependent schools abroad are not. While a contract may state that the government will provide access to schools on a space-available, tuition-paying basis to the contractor’s employees, it may not require the government to pay tuition costs.
The ASBCA has allowed a contractor to be reimbursed for overtime compensation to employees required to travel outside working hours, even though the travel policy could be construed as an attempt to thwart the government’s disallowance of first-class travel expenses.
Rebates and purchase discounts, regardless of form, granted to employees on products or services produced by the contractor or affiliates are unallowable. Both the Defense Acquisition Regulatory Council and the Civilian Agency Acquisition Council have indicated that such discounts and rebates are traditionally treated as reductions in profit margins or sales and, thus, are not costs and should not be allowable.
Compensation for severance pay, or dismissal wages, is allowable to the extent that it is: (1) required by law; (2) part of an employer-employee agreement; (3) established policy constituting, in effect, an implied agreement on the part of the contractor; or (4) the particular circumstances of the employment. Such compensation is made in addition to regular salaries and wages to terminated employees. Such compensation may be limited when paid in addition to early or normal retirement payments.
Backpay resulting from underpayment for work performed is allowable. Also, backpay to union employees for the difference in past and current wage rates for working during labor/management negotiations without a contract or labor agreement is allowable. For these costs to be allowable, management must have a formal agreement with the employees regarding such payments or the payments must be made pursuant to an established and consistently followed contractor policy or practice so as to allow the inference that the contractor agreed to make such payment.
Backpay awarded for violations of Federal Labor Laws or the Civil Rights Act of 1964 is unallowable. This latter category includes circumstances where backpay is not awarded as additional compensation for work that has been performed, such as where an employee was improperly discharged or discriminated against.
The compensation must be for work the employee provided in the current year; it may not constitute a retroactive adjustment of prior years’ salaries or wages. Remuneration must be consistent with the terms and conditions of the contractor’s established compensation plan or practices, thus implying an agreement to make the payments. Where the contractor makes major changes to the terms of existing or new compensation plans without informing the relevant contracting officer either before implementation of the revisions or within a reasonable time thereafter, and without allowing the government reasonable time to review the changes, the FAR directs that contracting officers will “normally challenge” the resultant increased costs.
Reasonableness of Compensation
The compensation in total must be reasonable. By the former standards, compensation was reasonable if the total paid to an employee was reasonable. Under the current FAR cost principle, compensation is reasonable if each of the allowable elements comprising the employee’s compensation package is reasonable. The total reasonableness may still be challenged, however.
Factors used to determine reasonableness are general conformity with the compensation practices of similar-sized firms in the same industry, in the same geographic locale, and engaged in predominantly private sector work, and the cost of obtaining comparable services from other sources. The relative importance of these factors in determining reasonableness will vary according to the type of services generating the compensation.
Those elements of remuneration for which offsets will be considered are wages and salaries, incentive bonuses, deferred compensation, health insurance benefits, compensated personal absence benefits, pension and savings plan benefits, life insurance benefits, and compensated personal absence benefits. If any one element or the sum of all the elements comprising the compensation paid to an employee or class of employees is challenged by a contracting officer, the contractor must then demonstrate that the compensation was reasonable, and can show any circumstances surrounding the challenged item or that other compensation elements were lower than would be reasonable but for the challenged item. The contractor can only apply such an offset to allowable elements of compensation packages of employees in jobs within the same job grade or level.
Certain compensation costs are closely scrutinized. In instances of compensation to owners of closely held corporations, partnerships, sole proprietors, or members of their immediate family or persons contractually committed to acquiring a substantial financial interest in the contractor’s enterprise, compensation costs are examined to determine whether the remuneration is reasonable for personal services rendered or whether the payment was a distribution of profits. Major revisions in existing compensation plans and new plans will be challenged by the contracting officer, particularly when insufficient or untimely notice is given to the government. If a contractor’s business is not subject to normal competitive restraints on its compensation levels or if incurred compensation is above the amounts allowed as deductions by the Internal Revenue Code, these compensation costs will be scrutinized.
Deferred Compensation
Deferred compensation is payment made by an employer to compensate employees in the future for services rendered before receipt of the compensation. Deferred compensation is allowable when it is based on current or future services, but is not for work performed before the payment. It does not include payments of year-end accruals for salaries, wages, or bonuses paid within a reasonable time after the end of the cost accounting period.
Other Considerations
Two types of compensation associated with business acquisitions are unallowable. The first type is “golden parachutes,” which are payments to employees under agreements in which they receive special compensation if their employment terminates following a change in the management or ownership of the business.
Likewise unallowable are “golden handcuffs.” These are payments under plans introduced in connection with a change (whether actual or prospective) in management control of ownership; the employees receive special compensation payment for remaining with the contractor for a specified period of time.
The provision pertaining to labor/management agreements was not affected by the revisions to the FAR. Costs of compensation arising from labor/management agreements are not allowable if applied to government contracts, to the extent they are unreasonable, discriminatory against the government, or unwarranted by the character and circumstances involved.
A provision will be found to be discriminatory against the government where employee compensation is greater than amounts paid for comparable private sector work under similar circumstances. The application of special provisions of labor/management agreements (such as hazardous duty pay) is unwarranted if the provision is designed to apply to a specific set of circumstances that is significantly different from that arising under the government contract.
When personal services are performed in a foreign country, compensation may also include a differential that may properly consider all expenses associated with foreign employment, such as housing, cost of living adjustments, transportation, bonuses, additional federal, state, local, or foreign income taxes resulting from foreign assignment, and other related expenses.
Postretirement benefits (PRBs) cover all benefits, other than cash benefits and life insurance benefits paid by pension plans, provided to employees, their beneficiaries, and covered dependents during the period following the employee’s retirement. Benefits encompassed include, but are not limited to, postretirement health care; life insurance provided outside a pension plan; and other welfare benefits such as tuition assistance, day care, legal services, and housing subsidies provided after retirement. To be allowable, PRB costs must be reasonable and incurred pursuant to law, employer-employee agreement, or an established policy of the contractor. In addition, to be allowable, PRB costs must also be calculated in accordance with the following:
Cost recognized as benefits when they are actually provided must be paid to an insurer, provider, or other recipient for current year benefits or premiums.
If a contractor elects a terminal-funded plan, it does not accrue PRB costs during the working lives of employees. Instead, it accrues and pays the entire PRB liability to an insurer or trustee in a lump sum upon the termination of employees (or upon conversion to such a terminal-funded plan) to establish and maintain a fund or reserve for the sole purpose of providing PRB to retirees. The lump sum is allowable if amortized over a period of 15 years.
Accrual costing other than terminal funding must be measured and assigned according to generally accepted accounting principles and be paid to an insurer or trustee to establish and maintain a fund or reserve for the sole purpose of providing PRB to retirees. The accrual must also be calculated in accordance with generally accepted actuarial principles and practices as promulgated by the Actuarial Standards Board.
To be allowable, costs must be funded by the time set for filing the federal income tax return or any extension thereof. PRB costs assigned to the current year, but not funded or otherwise liquidated by the tax return time, will not be allowable in any subsequent year. Increased PRB costs caused by delay in funding beyond 30 days after each quarter of the year to which they are assignable are unallowable. Costs of post-retirement benefits attributable to past service (“transition obligation”) as defined in Financial Accounting Standards Board Statement 106, paragraph 110, are allowable subject to the following limitation: “The allowable amount of such costs assignable to a contractor fiscal year cannot exceed the amount of such costs which would be assigned to that contractor fiscal year under the delayed recognition methodology described in paragraphs 112 and 113 of Statement 106.”
The government is to receive an equitable share of any amount of previously funded PRB costs that revert or inure to the contractor. Such equitable share is to reflect the government’s previous participation in PRB costs through those contracts for which certified cost or pricing data were required or that were subject to subpart 31.2.
Employee Stock Ownership Plans (ESOPs) (31.205-6(q))
Costs of ESOPs are allowable as deferred compensation under Cost Accounting Standard 415. For example, a contractor’s contributions in any one year may not exceed the deductibility limits of the Internal Revenue Code for that year. Also, when the contribution is in the form of stock, the value of the stock contribution is limited to the fair market value of the stock on the date that title is effectively transferred to the trust. When the contribution is in the form of cash, stock purchases by the ESOP in excess of fair market value are unallowable. When the fair market value of unissued stock or stock of a closely held corporation is not readily determinable, the valuation will be made on a case-by-case basis taking into consideration the guidelines for valuation used by the IRS.
Employee Morale, Health, Welfare, Food Service, and Dormitory Costs and Credits (31.205-13)
Aggregate costs incurred on activities designed to improve working conditions, employer-employee relations, employee morale, and employee performance (less income generated by these activities) are allowable except as specifically limited. Some examples of allowable activities are house publications, health clinics, wellness/fitness centers, employee counseling services, and food and dormitory services, which include operating or furnishing facilities for dining rooms, cafeterias, canteens, vending machines, lunch wagons, living accommodations, and similar types of services for the contractor’s employees at or near the contractor’s facilities.
The cost of gifts is unallowable. Gifts do not include awards for performance or awards made in recognition of employee achievements pursuant to an established contractor plan or policy. Costs of recreation are unallowable, except for the costs of employees’ participation in company-sponsored sports teams or employee organizations designed to improve company loyalty, teamwork, or physical fitness.
Losses from operating food and dormitory services may be included as costs only if the contractor’s objective is to operate such services on a break-even basis. Losses sustained because food services or lodging accommodations are furnished without charge or at prices or rates that obviously would not be conducive to the accomplishment of such an objective are not allowable. A loss may be allowed however, if the contractor can demonstrate that unusual circumstances exist (e.g., the contractor must provide food or dormitory services at remote locations where adequate commercial facilities are not reasonably available; or charged but unproductive labor costs would be excessive but for the services provided or where cessation or reduction of food or dormitory operations will not otherwise yield cost savings) such that even with efficient management, operating the services on a break-even basis would require charging inordinately high prices, or prices or rates higher than those charged by commercial establishments offering the same services in the same geographical areas. Costs of food and dormitory services are to include an allocable share of indirect expenses pertaining to these activities.
When the contractor has an arrangement authorizing an employee association to provide or operate a service, such as vending machines in the contractor’s plant, and retain the profits, such profits are to be treated in the same manner as if the contractor were providing the service. Contributions by the contractor to an employee organization, including funds from vending machine receipts or similar sources, may be included as costs incurred only to the extent that the contractor demonstrates that an equivalent amount of the costs incurred by the employee organization would be allowable if directly incurred by the contractor.
Professional and Consulting Costs (31.205-33)
Professional and consulting services are services rendered by persons who are members of a particular profession or possess a special skill and who are not officers or employees of the contractor. Examples include services acquired by contractors or subcontractors to enhance their legal, economic, financial, or technical positions. Professional and consultant services are generally acquired to obtain information, advice, opinions, alternatives, conclusions, recommendations, training or direct services such as studies, analyses, evaluations, liaison with government officials, or other forms of representation.
The costs of professional and consultant services are allowable when reasonable in relation to the services rendered and when not contingent upon recovery of the costs from the government. The costs of professional and consultant services performed under any of the following circumstances are unallowable:
Services to improperly obtain, distribute, or use information or data protected by law or regulation
Services that are intended to improperly influence the contents of solicitations, the evaluation of proposals or quotations, or the selection of sources for contract award, whether award is by the government or by a prime contractor or subcontractor
Any other services obtained, performed, or otherwise resulting in violation of any statute or regulation prohibiting improper business practices or conflicts of interest
Services performed that are not consistent with the purpose and scope of the services contracted for or otherwise agreed to.
In determining the allowability of costs (including retainer fees) in a particular case, no single factor or any special combination of factors is necessarily determinative. However, the contracting officer will consider the following factors, among others:
The nature and scope of the service rendered in relation to the service required
The necessity of contracting for the service, considering the contractor’s capability in the particular area
The past pattern of acquiring such services and their costs, particularly in the years prior to the award of government contracts
The impact of government contracts on the contractor’s business
Whether the proportion of government work to the contractor’s total business is such as to influence the contractor in favor of incurring the cost, particularly when the services rendered are not of a continuing nature and have little relationship to work under government contracts
Whether the service can be performed more economically by employment rather than by contracting
The qualifications of the individual or concern rendering the service and the customary fee charged, especially on nongovernment contracts
The adequacy of the contractual agreement for the service (e.g., description of the service, estimate of time required, rate of compensation, termination provisions).
Retainer fees, to be allowable, must be supported by evidence that: (1) the services covered by the retainer agreement are necessary and customary; (2) the level of past services justifies the amount of the retainer fees (if no services were rendered, fees are not automatically unallowable); (3) the retainer fee is reasonable in comparison with maintaining an in-house capability to perform the covered services, when factors such as cost and level of expertise are considered; and (4) the actual services performed are documented.
Fees for services rendered are allowable only when supported by evidence of the nature and scope of the service furnished. However, retainer agreements generally are not based on specific statements of work. Evidence necessary to determine that work performed is proper and does not violate law or regulation is to include:
Details of all agreements (e.g., work requirements, rate of compensation, nature and amount of other expenses, if any) with the individuals or organizations providing the services and details of actual services performed
Invoices or billings submitted by consultants, including sufficient detail as to the time expended and the nature of the actual services provided
Consultants’ work products and related documents, such as trip reports indicating persons visited and subjects discussed, minutes of meetings, and collateral memoranda and reports.
Not all items listed must be available. However, sufficient evidence must exist to determine that the cost is allowable.
Recruitment Costs (31.205-34)
The following recruitment costs are allowable: (1) costs of help-wanted advertising; (2) costs of operating an employment office needed to secure and maintain an adequate labor force; (3) costs of operating an aptitude and educational testing program; (4) travel costs of employees engaged in recruiting personnel; (5) travel costs of applicants for interviews; and (6) costs for employment agencies, not in excess of standard commercial rates.
Help-wanted advertising costs are unallowable if the advertising does not describe specific positions or classes of positions, or includes material that is not relevant for recruitment purposes, such as extensive illustrations or descriptions of the company’s products or capabilities.
Relocation Costs (31.205-35)
The costs of the permanent relocation of new or existing employees are generally allowable subject to FAR ceilings based on time, percentages, and absolute dollar amounts. Relocation costs are the expenses incurred by an existing employee with a permanent change of duty assignment for at least 12 months or an indefinite period, or resulting from the recruitment of a new-employee.
Allowable relocation costs include: travel costs of the employee and members of his or her immediate family; the costs of transporting household furnishings and personal effects to the new location; the costs of finding a new home, such as advance trips to locate living quarters and temporary lodging; closing costs incident to disposition of the employee’s actual residence; and other necessary and reasonable expenses associated with relocation. Allowable costs now include payments for employees’ Social Security or income taxes that increased due to reimbursement of relocation costs.
For these costs to be allowable, they must also meet the following criteria: (1) the move must be for the benefit of the employer; (2) reimbursement must be in accordance with an established policy or practice that is consistently followed by the employer and is designed to motivate employees to relocate promptly and economically; (3) the costs must not otherwise be unallowable under Subpart 31.2; and (4) amounts to be reimbursed cannot exceed the em-ploy-ee’s actual expenses, except that, for miscellaneous costs of the type discussed above, a flat amount, not to exceed $5,000, may be allowed in lieu of actual costs.
Specific types of relocation costs are unallowable, such as a loss on the sale of a home; costs incident to acquiring the new home, such as real estate brokers’ fees, property taxes, and property and mortgage life insurance; cost of litigation; and continuing payments of the mortgage principal on the residence being sold.
Trade, Business, Technical and Professional Activity Costs (31.205-43)
FAR 31.20S-43 provides that three types of trade, business, technical, and professional activities are allowable: (1) memberships in trade, business, technical, and professional organizations; (2) subscriptions to trade, business, professional, or other technical periodicals; and (3) meetings and conferences, which includes the costs of meals, transportation, rental of meeting facilities, and other incidentals (provided that the primary purpose of incurring such costs is the dissemination of trade, business, technical, or professional information or the stimulation of production or improved productivity).
Training and Educational Costs (31.205-44)
Training and educational costs include the costs of training materials, textbooks, tuition, fees, compensation paid to employees while they are in training, and similar costs. The allowability of such costs depends on the type of training provided. Contractor expenses for maintenance, depreciation, and rental of training facilities are allowable to the extent that such costs are otherwise allowable under the contract.
Vocational training costs include costs for such programs below the college level as on-the-job, classroom, and apprentice programs designed to increase the vocational effectiveness of employees. These costs include compensation for trainees (but not overtime), the salaries of the training staff, training materials and textbooks, and tuition and fees for outside courses.
Allowable education costs for part-time instruction at the college level are limited to: (1) tuition and fees charged by the educational institution (or a special session), the institution’s salaries, and related costs (which, however, cannot exceed the normal tuition payment); (2) salaries and related costs of instructors who are employees of the contractor; (3) training materials and textbooks; and (4) straight-time compensation for employees for time spent attending classes during working hours not in excess of 156 classroom hours per year where circumstances do not permit class attendance after normal working hours. This requirement may be modified by negotiation of an advance agreement.
The cost of full-time education at the postgraduate level is covered to the extent of tuition and fees. Costs are allowable if the course or degree pursued is related to the employee’s field of work or expected work and the course or degree pursued is for a period of not longer than two school years or the length of the degree program, whichever is less. Subsistence and salaries and any other payments are unallowable.
Advance agreements may be negotiated to extend the limit of 156 hours per year per employee for part-time training at the college level or the two-year limit on full-time postgraduate study. Subsistence, salaries, or any other payments may also be allowed to the extent set forth in an advance agreement. The contractor must demonstrate that the costs are consistently incurred under an established program and that the course of study is related to the employee’s current or reasonably foreseeable work.
Specialized training programs are those designed to enhance the effectiveness of managers or to prepare employees for management positions; they exclude courses that are part of a degree program. Costs of specialized training include enrollment fees and employee salaries, subsistence pay, training materials, and travel costs. Costs of attendance at such programs are allowable for up to 16 weeks per employee per year.
Certain training and educational costs are expressly unallowable. Grants made in any form to educational or training institutions are considered contributions and are, thus, unallowable.
Generally, educational costs are allowable only for employees. However, pay differentials may be provided for the education (at the primary and secondary levels only) of dependents of an employee who is working in a foreign country. To qualify, suitable education in the foreign country must be inordinately expensive, and these costs may be included in an overseas differential.
Travel Costs (31.205-46)
Travel costs incurred by employees in travel status while on company business are generally allowable. Travel costs include transportation, lodging, subsistence, and incidental expenses. Calculation of these costs may be based on the actual cost incurred, per diem or mileage costs, or a combination of these two methods to determine a reasonable charge.
Both direct and indirect travel costs are allowable under this cost principle. Travel costs directly attributable to a specific contract’s performance are treated as direct costs under FAR 31.202. The costs incurred in the normal course of the overall administration of the business are treated as indirect costs.
The criteria for allowing corporate aircraft costs require that a flight manifest be maintained and made available for all such flights. The flight manifest, or log, must at a minimum contain the dates, times, and points of departure and arrival; the name of each passenger and his or her relationship to the contractor; the purpose of the trip; and authorization for the trip. Costs include those of charter, lease, operation, personnel, maintenance, depreciation, and insurance.
When the use of corporate aircraft is not required for contract performance, the allow-ability of flight costs is limited to the standard commercial fare unless the contracting officer specifically approves the extra cost. Under special circumstances, the contracting officer may agree to reimbursement greater than the standard airfare costs for the costs of corporate aircraft.
Costs related to personal use of company-owned or -leased automobiles are dealt with in the section dealing with compensation. These costs, including those of leasing, operating, maintaining, depreciating, and insuring the vehicles, are allowable, if reasonable, to the extent the automobiles are used for company business.
According to the DCAA Contract Audit Manual, advanced planning of travel should be an integral part of the contractor’s internal travel policy. Such planning to combine visits to the same geographical area into a single trip would minimize the use of above-standard fares and accommodations and minimize the number of trips to the same location by multiple segments of the company.
In 1985, legislation revised the cost allow-ability criteria from reasonable meals and lodging to use of government employee per diem rates. The act creates parity between the allowable transportation, relocation, and travel expenses for contractor’s employees and government reimbursement rates. The result is that contractor costs for travel, including lodging, other subsistence, and incidentals will only be allowable if reasonable and to the extent permitted for federal employees. This act authorizes the General Services Administration to establish reimbursement allowances for each locality for federal employees.
This principle was established to equalize the travel cost reimbursements of government and contractor employees. These per diem rates limit daily reimbursement on a location-by-location basis.
The rules in the government’s Joint Travel Regulation (JTR), Federal Travel Regulation (FTR), and the Standardized Regulations are extensive. However, only three provisions apply to contractors. First, the definition of what constitutes meals, lodging, and incidental expenses contained in the per diem reimbursement also applies to contractor payments. Second, the daily limits for lodging and per diem also apply to contractor payments. However, contractor payment limitations are based on combined lodging and per diem each day whereas government employee limitations are based on individual lodging and per diem each day. Third, the unusual circumstances that permit reimbursement greater than the established limits also apply to contractor payments.
The FAR permits a deviation from this provision in special and unusual circumstances. Generally, it allows travel costs for lodging, meals, and incidental expenses up to a ceiling of 300 percent of the maximum per diem rates if certain conditions are met. Some of these conditions are: (1) the employee attends a meeting, conference, or training session where the lodging and meals must be incurred at a prearranged place and the lodging costs absorb all or practically all of the applicable maximum per diem rate; (2) the employee travels to a location where a special event or function has caused subsistence costs to increase temporarily during the period of the event or function; or (3) the employee incurs unusually high expenses because of special duties connected with the assignment, such as procuring a suite or other extraordinary accommodations.
The travel reimbursement regulations have removed taxes from being included in the published per diem lodging rates. This has the effect of lowering the amount allowable for per diem lodging. In late May 1999, a proposed rule was issued to remove the limitations on lodging and per diem costs levied by the Joint Travel Regulations (JTR) for contractors. Congress removed the JTR requirement for contractors in 1995. The proposed rule is unlikely to be put into effect because some rule writers believe that this action is not appropriate.
The costs of first-class air travel above the standard commercial fare are unallowable unless traveling by the lowest customary standard, coach, or equivalent airfare would necessitate circuitous routing, require travel during unreasonable hours, result in excessively long travel, cause increased overall travel costs, not adequately meet the physical or medical needs of the person traveling, or not be reasonably available to satisfy mission requirements. For airfare in excess of the normal standard commercial fare to be allowable, the contractor must document and justify these conditions supporting the use of the higher fares. The cost of these types of airfare tickets could be lowered if the contractor could use an advance ticket purchase system, which most airlines offer, if an itinerary is known a certain number of days in advance.
The ASBCA has disallowed the costs of first-class airfare where the company’s policy was to permit first-class air accommodations when its employees scheduled their travel outside of normal working hours to the fullest extent possible. The contractor argued that the government benefited from such a policy because the employees traveled on their own time in order to fly first class. Additionally, the contractor asserted that these costs were necessary to provide its executives better and more secure working conditions and, alternatively, that they were allowable as additional compensation to corporate officers. However, the ASBCA rejected these arguments as not among the exceptions to the general rule disallowing airfare costs greater than the standard commercial rate. Additionally, the ASBCA noted that the employees receiving the benefit did not report the first-class differential as income in their individual income tax returns, and the contractor did not enter the amount as additional compensation.
COSTS RELATED TO PHYSICAL RESOURCES
The allowability of costs related to physical resources is addressed in FAR 31.205.
Cost of Money (31.205-10)
The cost of capital committed to facilities is an imputed cost calculated by applying a cost-of-money rate to the facilities capital employed in contract performance. The cost-of-money rate is the rate established by the Treasury Department for this purpose. The assets can be funded by either equity or debt, but since facilities capital includes all assets—not just assets purchased by issuing debt—the facilities capital cost is not considered a form of interest. CAS 414, Cost of Money as an Element of the Cost of Facilities Capital, establishes the basic ground rules for calculating the cost of facilities capital.
The cost-of-money factors should be computed to the fifth decimal place. They are to be applied in the same manner as indirect cost rates to recover the cost of money committed to facilities. They should be included on all contract proposals, public vouchers, and progress payment requests, as applicable. Regardless of the applicability of CAS 414, facilities capital costs are allowable if: (1) capital investment is measured, allocated, and costed in accordance with CAS 414; (2) adequate records are maintained to demonstrate compliance with CAS 414; (3) the cost is specifically identified in cost proposals for contracts on which it is claimed; and (4) requirements of 31.205-52 on asset write-ups are observed.
Inclusion of contract clause 52.215-30, Facilities Capital Cost of Money, specifically establishes the allowability of the cost of facilities capital for a specific contract (if the contractor computes such costs). If the cost is not proposed or if the contractor elects not to claim the cost, contract clause 52.215-31, Waiver of Facilities Capital Cost of Money, is included in the contract. Although the costs of facilities capital need not be recorded in the contractor’s books and records, memorandum records kept in sufficient detail to be verified do have to be maintained. When allowable, the costs are considered “incurred” for purposes of reimbursements and progress payments.
The cost of capital assets under construction is a cost imputed by applying a cost-of-money rate to the costs incurred for capital assets under construction. As with the cost of capital committed to facilities, the cost-of-money rate is established by the Treasury Department and the resulting cost is not considered a form of interest. CAS 417, Cost of Money as an Element of the Cost of Capital Assets Under Construction, establishes criteria for measuring and allocating this cost.
Regardless of the applicability of CAS 417, fabrication or development is allowable if: (1) the cost of money is calculated and allocated in accordance with CAS 417; (2) adequate records demonstrate compliance with CAS 417; and (3) the costs are included in the capitalized costs that form the basis for depreciation or amortization.
Actual interest costs cannot be used in lieu of the facilities cost of capital assets under construction. The imputed cost need not be recorded in the books and records, although memorandum entries have to be maintained to permit verification of relevant supporting data. If the imputed cost is allowable, it is considered incurred for purposes of reimbursements and progress payments. Specifically, the cost-of-money factor, which is expressed in terms of a rate per unit of allocation base, is applied to payment requests as the applicable allocation base is incurred and billed.
Depreciation (31.205-11)
If a contractor shows that depreciation is reasonable and allocable as normal depreciation on a contractor’s plant, equipment, and other capital facilities, it is an allowable contract cost. According to FAR 31.205-11, depreciation is “a charge to current operations which distributes the cost of a tangible capital asset, less estimated residual value, over the estimated useful life of the asset in a systematic and logical manner.” Useful life relates to the economic usefulness, as opposed to the physical life of an asset in the contractor’s operations. Economic usefulness is determined by the contractor’s retirement and replacement practices.
Depreciation will be considered reasonable if the contractor’s method of depreciation is: (1) consistent with the policies and procedures followed in the same cost center for private sector business; (2) reflected in the contractor’s financial statements and books of account; and (3) both used and acceptable for federal income tax purposes. While depreciation costs are calculated differently for financial statements and tax purposes, allowable depreciation is limited to the amounts acceptable for federal income tax purposes and consistent with the depreciation procedures used on nongovernment business.
If a contractor has contracts subject to CAS 409, Depreciation of Tangible Capital Assets, the contractor must adhere to these standards for the CAS-covered contracts and may elect to use that provision for non-CAS contracts. If such an election is made, the contractor must apply all the requirements of CAS 409, ignoring any conflicting language in the FAR depreciation cost principle.
The FAR makes special provision for assets acquired before the effective date of CAS 409. Where the undepreciated asset amount of an asset (as a result of depreciation policies and procedures used previously for government contracts and subcontracts) is different from the undepreciated balance on the books of accounts and financial statements, for contract cost purposes, the allowable depreciated balance will be depreciated over the remaining life of the asset using the methods and useful lives followed for book purposes.
When property is acquired at no cost from the government, no depreciation is allowed. If an asset has been fully depreciated by the contractor or any division, subsidiary, or affiliate of the contractor under common control, no depreciation is allowed. However, if agreed upon, a reasonable charge for the use of such property is permitted. In calculating such a charge, consideration is given to costs, total estimated useful life at the time of negotiations, the effect of any increase in maintenance costs or decreased efficiency caused by age, and the amount of depreciation previously charged to government contracts or subcontracts.
The FAR applies the provision of CAS 404, Capitalization of Tangible Assets, to items acquired by users of a capital lease. Under Statement of Financial Accounting Standard No. 13, a lease must be classified as a capital lease for financial reporting purposes if any one of four stated criteria is present: (1) an automatic transfer of title; (2) a bargain purchase option; (3) lease terms that equal or exceed 75 percent of the total estimated economic life of the leased property; and (4) a situation in which the present value of the minimum lease payments is equal to or more than 90 percent of the excess of the fair value of the property over any related investment tax credit retained by the lessor.
In the case of a sale and leaseback arrangement, rental costs are limited to the amount the contractor would have been allowed had it retained title to the property. In the event of a write-down from carrying value to fair value as a result of impairments caused by events or changes in circumstances, allowable depreciation of the impaired assets is limited to the amounts that would have been allowed had the assets not been written down. However, this does not preclude a change in depreciation resulting from other causes, such as permissible changes in estimates of service life, consumption of services, or residual value.
Gains and Losses on Disposition of Depreciable Property or Other Assets (31.205-16)
Gains and losses on the disposition of depreciable assets are generally recognized in the year they occur and are charged or credited to the cost pool that received the related depreciation amortization charges. Gains or losses are considered adjustments of prior depreciation or amortization charges. Thus, the amount of a gain or loss is the difference between the net proceeds (including insurance proceeds) and the book value of the asset. Gains are generally limited to the difference between the original cost capitalized and the undepreciated or unamortized value, except in the special case of involuntary conversions.
For example, assume that an asset was purchased for $1,100, the current unde-preciated value is $400, and the asset is sold for $1,500. The book gain is $1,100 ($1,500-$400), but the gain for government contracts purposes is limited to $700 ($1,100-$400). No gains or losses are recognized on the disposition of nondepreciable property. In one case, the ASBCA determined that the government was not entitled to share in the gain on sale of an asset when the original depreciation charges were not charged to government contracts.
Involuntary conversions occur as a result of events beyond the owner’s control (e.g., fires, windstorms, floods, accidents, theft). When a cash insurance award is received and the asset is not replaced, the gain or loss is recognized in the period when the conversion takes place, and the gain is limited to the difference between the original cost and the book value of the asset at the time of the conversion. If the asset is replaced, however, the depreciable basis of the new asset can be adjusted by the amount of the gain or loss.
For example, assume that an asset had an original cost of $1,000 and a book value of $200, and was insured for $300. Assume that $3,000 is the cost of replacing the asset. Assume that the asset is destroyed by a hurricane. The contractor can elect to recognize a gain of $800 ($1,000-$200) and capitalize the asset at $3000 (therefore, the gain for government contract purposes is limited to the difference between the book value and the original cost). Alternatively, the contractor can elect simply to capitalize the difference between the replacement cost and the gain, $2,200 ($3,000-$800).
Idle Facilities and Idle Capacity Costs (31.205-17)
Costs arising from idle facilities are unallowable unless they meet one of the two following criteria: (1) the facilities are necessary to meet fluctuations in workload; or (2) the facilities were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes that could not reasonably have been foreseen.
Idle facilities are normally allowable for a reasonable period of time (usually one year), depending on the actions taken to avoid the costs. In one case, the ASBCA held that idle facilities costs were allowable for a period of more than one year because: (1) the decrease in business had not been foreseeable; and (2) the contractor had made efforts to reduce the costs.
Another issue in the same case was allocating the costs. Idle facilities, obviously, had no “total business” activity, the basis often used for making such allocations. The ASBCA, therefore, determined that the G&A costs of the division level that included the idle plant were the appropriate basis for making such an allocation. The ASBCA reached a similar conclusion in another case. Although the one-year limit was not strictly applied, the allocation base was not limited to the G&A pool of the idle plant. In general, the appropriate pool for allocation of such costs is the G&A pool that most closely relates to the overall business pertinent to the idled plant.
Maintenance and Repair Costs
This cost principle has been removed from the FAR (31.205-24); however, the concepts are still applicable and were not overcome by removal of the provision.
Maintenance and repair costs are incurred to keep property in efficient operating condition and are expensed in the year they are incurred. Normal maintenance and repair costs are allowable. Extraordinary maintenance and repair costs are allowable provided that those costs are allocated to the applicable periods for purposes of determining contract costs. Costs that are incurred to add permanent value to property or to prolong property’s life appreciably, on the other hand, are classified as capital costs and cannot be expensed in the period incurred, but must instead be capitalized and allocated over the periods benefiting from the costs.
Manufacturing and Production Engineering Costs (31.205-25)
Manufacturing and production engineering costs are allowable. They include the costs of developing new or improved materials, systems, processes, methods, equipment, tools, and techniques to be used in the production process; deploying pilot production lines; improving current production facilities; and analyzing material and manufacturing producibility. These costs do not include basic and applied research, development effort created for sale, and costs subject to capitalization and amortization.
Plant Reconversion Costs (31.205-31)
Plant reconversion costs are incurred to restore or rehabilitate the contractor’s facilities to approximately the condition they were in before the start of a government contract. These costs are unallowable except when incident to the removal of government-furnished property. Contracting officers are authorized to allow such additional contract costs when dictated by considerations of equity and when agreed to in advance.
Rental Costs (31.205-36)
Rental and lease costs of real and personal property are allowable to the extent reasonable, subject to two caveats: (1) rental cost under a sale and leaseback arrangement is limited to amounts that would have been allowable if title to the property had been retained; and (2) rental costs under leases between entities under common control are limited generally to normal ownership costs.
An additional caveat within this cost principle restricts the application of the principle to operating leases. Assets acquired under capital leases, defined in FAS-13, are leases that: (1) transfer ownership; (2) grant bargain purchase options; (3) cover the majority of the assets’ remaining useful life; or (4) cover the difference between the value of the asset and the lessor’s investment tax credit for the asset. These leases are treated as if purchased, and the costs are capitalized and depreciated over their useful lives.
The FAR provides that the reasonableness of rental costs of property acquired under operating leases will be determined by reference to rental costs of comparable property, if any; market conditions in the area; the type, life expectancy, condition, and value of the property; alternatives available; and other terms of the agreement.
The ASBCA has considered the subject of what constitutes a “sale and leaseback” under this FAR cost principle on several occasions. These decisions establish that a sale and leaseback of property that: (1) has never been the subject of depreciation charges; and (2) was not made for the purpose of raising capital, is not a “sale and leaseback” within the meaning of the cost principle.
Similarly, the ASBCA has considered the subject of “common control” of business entities for the purpose of this cost principle. The decisions hold that the contractor can rebut the potential for common control based upon interlocking officers and ownership interest—which would otherwise limit allowability of rental costs to the costs of ownership—by submitting evidence that common control was in fact exercised. Thus, if the contractor can establish that, despite appearances, separate management exists for the lessor and lessee and no one person or group actually controls both entities, rental costs payable under the lease, if reasonable, are allowable.
Special Tooling and Special Test Equipment Costs (31.205-40)
The costs of special tooling and test equipment are allowable and, usually, are clearly allocable to specific contracts. They are not allocable, however, if the tooling or equipment was acquired before the effective contract date (whether or not the tooling or equipment is subsequently altered or adapted for use in performance of the contract). Also, if the contract specifically excludes the tooling or equipment costs in question, the costs must be amortized or depreciated.
Some costs for special tooling or equipment are disallowed because the contractor could, with relatively minimal expense, make the tooling or equipment suitable for general use. The costs of adapting tooling or equipment for use on a government contract—and the costs of returning them to their prior configuration or condition after use—are allowable.
NEW BUSINESS-RELATED COSTS
The allowability of the following costs is addressed in FAR 31.205.
Independent Research and Development and Bid and Proposal Costs (31.205-18)
IR&D costs are the costs of a contractor’s technical efforts sponsored by, or required in, performance of a contract or grant. Such activity is directed toward the conduct of basic or applied research, development, or systems and other concept simulation studies.
The goal of basic research is increasing knowledge of science and gaining a deeper understanding of the subject under study. Applied research is the practical application following basic research, although it may not be severable from the related basic research. Applied research also includes attempts to advance the state of the art and to determine and exploit the potential scientific discoveries or improvements in technology, materials, processes, methods, devices, or techniques.
Development consists of the systematic use of scientific and technical knowledge for the design, development, testing, or evaluation of a potential new product or service, or improvement of an existing product or service, to accomplish specific performance requirements or objectives. It specifically excludes subcontracted technical efforts undertaken solely to develop additional services for existing products and efforts to develop manufacturing, production materials, systems, processes, methods, equipment, tools, and techniques not intended for sale.
Systems and other concept formulations are analyses to study efforts concerning particular IR&D efforts or aimed at identifying new or modifying and improving existing systems, equipment, or components. IR&D costs do not include technical efforts used to develop and prepare data specifically to support a bid and proposal submission.
Many issues arise over whether IR&D costs are proper indirect costs or the direct costs of a particular cost objective. The government prefers such costs to be direct under most circumstances. However, court and board decisions make it clear that unless the work is specifically required for contract performance, the costs are allowable IR&D costs.
B&P costs consist of the expenditures to prepare, submit, and support solicited or unsolicited bids and proposals for potential government or nongovernment contracts. These costs exclude the costs arising from grant or cooperative agreement special efforts or contract performance requirements.
The FAR incorporates CAS 420, Accounting for Independent Research and Development Costs and Bid and Proposal Costs. This provision establishes the requirements for the measurement, assignment, and allocation of IR&D and B&P costs. CAS 420 requires that IR&D and B&P costs be segregated and allocated on the same basis used for allocating G&A expenses.
Selling Costs (31.205-38)
This principle identifies the elements of selling that are covered by other cost principles, such as advertising costs. The cost elements are governed by the more specific principles.
“Selling” is defined by the regulation to encompass all efforts to market the contractor’s products or services. It includes activities such as advertising, corporate image enhancement, market planning, direct selling, and bid and proposal expense. The costs of advertising and corporate image enhancement are covered more specifically in FAR 31.205-1, Public Relations and Advertising Costs. Corporate image enhancement also is covered by FAR 31.205-14, Entertainment Costs. Long-range market planning costs are controlled by FAR 31.205-12, Economic Planning Costs. Other market planning costs defined by this principle, such as market research and analysis and generalized management planning related to the development of the contractor’s business, are allowable to the extent that they are reasonable.
Costs associated with direct selling efforts are allowable if they are reasonable in amount. Direct selling efforts consist of activities undertaken to convince particular prospective customers to purchase particular goods or services. These efforts are conducted by means of person-to-person contact and involve familiarization of potential customers with the offered products or services, terms of sale, and service conditions. Other forms of direct selling include individual demonstrations, consultations, provision of technical advice, and discussion of the adaptation of the contractor’s products or services to meet the needs of the particular customer. Selling costs not specifically provided for are unallowable.
Brokerage or retainer fees, commissions, percentages, sellers’ or agents’ compensation, and similar payments are allowable only when paid to employees or established commercial or selling organizations maintained by the contractor for the purpose of securing business.
MISCELLANEOUS COSTS
The allowability of the following costs is addressed in FAR 31.205.
Contingencies (31.205-7)
A contingency is a possible future event or condition arising from presently known or unknown causes, the outcome of which is indeterminable at the present time. According to the FAR, the costs of contingencies are generally unallowable for historical costing purposes (i.e., for costs already incurred and recorded on the contractor’s books). In some rare cases, a contingency may be recognized when it is applicable to a past period to give recognition to unsettled factors in the interest of expediting settlement.
For purposes of developing cost estimates, contingencies fall into two categories. The first category consists of contingencies that arise from presently known and existing conditions whose effects are reasonably foreseeable (e.g., anticipated costs of rejects and scrap). The costs of these contingencies are included as part of the cost estimate (e.g., as part of the cost of rejects or of rework material in the total estimated contract price). Historical data are usually relied on to establish the fact that rejects have occurred on a consistent basis and are used as a basis for estimating the cost of rejects in the current contract. Such data are necessary to support cost estimates because nomenclature reviews of contingent costs in price proposals usually lead the government to view such costs as contingent and, thus, unallowable.
The second category consists of contingencies that arise from conditions either known or unknown, but whose effect cannot be sufficiently measured to provide equitable results to either the contractor or the government (e.g., lawsuits). These contingencies are excluded from routine cost estimates, but may be estimated separately (if the basis upon which the cost is computed is also disclosed) to facilitate the negotiation of appropriate contractual coverage of the costs. In practice, however, these costs are difficult to support.
Economic Planning Costs (31.205-12)
Costs of corporate planning efforts, including long-range business activity, are generally allowable. This activity may include future changes in the contractor’s markets, which may cause a possible reduction or increase of the products or services offered. This market change could have a significant effect on the contractor’s operation, to the extent that plant expansion or relocation may ensue. It also may lead to an expansion in the form of a merger or acquisition of another business. This latter category of planning costs is allowable up to the point of acceptance by a board of directors. After acceptance, the costs fall under Part 27, Organization Costs.
Conversely, the long-range plan may envision a need to downsize or compress company operations. The planning cost for this size reduction is still an allowable cost under this part. The government is currently taking steps to address the allowability of the cost of downsizing or compression of operations and the resulting benefits.
Research and development and engineering costs designed to lead to new products for sale to the general public are not allowable under this principle.
Insurance and Indemnification (31.205-19)
The costs of insurance coverage that is maintained in connection with the general conduct of the contractor’s business or is required or approved pursuant to contract terms are generally allowable.
To establish a program of self-insurance, contractors subject to CAS 416, Accounting for Insurance Cost, must follow the stated insurance requirements of that standard and Part 28 of the FAR. Also, the contractor must provide the contracting officer with such information as current financial statements, loss history, and formulas for establishing reserves.
If purchased insurance is available, the charge for any self-insurance coverage plus insurance administration expenses may not exceed the cost of comparable purchased insurance plus associated insurance administration expenses. Also, self-insurance charges for risk of loss from catastrophic losses are unallowable.
Insurance provided by captive insurers (i.e., insurers owned by or under the control of the contractor) is considered self-insurance, and charges for it must comply with the self-insurance provisions of CAS 416. However, if the captive insurer also sells insurance to the general public in substantial quantities and it can be demonstrated that the charge to the contractor is based on competitive market forces, the insurance will be considered purchased insurance.
CAS 416 requires that the allocation of insurance costs to cost objectives must be based on the beneficial or causal relationship between insurance costs and the cost objectives. The amount of insurance cost that may be assigned to a cost accounting period consists of the projected average loss for the period plus insurance administration expenses incurred during the same period.
Material Costs (31.205-26)
Generally, material costs are allowable. These include such items as raw materials, parts, subassemblies, components, and manufacturing supplies. Material costs must be adjusted for income or credits, including trade discounts, refunds, rebates, and returned materials. A contractor must establish that any failure to take cash discounts was reasonable.
Cost transfers between organizations under common control must be at a cost basis unless the contractor’s established practice is to transfer at other-than-cost for nongovernment products and services and either an established catalog price or a price set by adequate price competition exists. Even then, the government may reject the other-than-cost price if that price is unreasonable.
Other Business Expenses (31.205-28)
When allocated on an equitable basis, the following other business expenses are allowable: (1) registry and transfer charges resulting from changes in the ownership of securities issued by the contractor; (2) the costs of shareholder meetings; (3) the costs of normal proxy solicitations; (4) the costs of preparing and publishing reports to shareholders; (5) the costs of preparing and submitting required reports and forms to taxing and other regulatory bodies; (6) incidental costs of directors’ meetings; and (7) other similar costs.
Patent Costs (31.205-30)
Patent costs are incurred to protect rights to an invention and include the costs of preparing, filing, and prosecuting an application for a U.S. patent (when title or royalty-free license is to be conveyed to the government). These costs are often incurred by contractors who develop products or processes that they want to protect from uncompensated public use. The costs of general counseling services (including the fees of attorneys, engineers, and architects) on patents are allowable provided that the costs meet the requirements for professional and consulting costs.
Other patent costs are allowable only if incurred because of a specific contractual requirement. Such a requirement might exist if the government acknowledges that an item it needs cannot be produced without the contractor obtaining patent rights. In this case, however, the government must obtain the title or royalty for use of the patent before the costs are allowable. No costs related to foreign patents are allowable.
Precontract Costs (31.205-32)
Precontract costs are costs that are incurred before the effective date of a contract. These costs may include labor and special material costs incurred in contemplation of contract signing. The costs must result directly from contract negotiations, and they must be determined necessary to meet proposed delivery schedules. Precontract costs are allowable to the same extent, and on the same basis, as if they had been incurred after contract award.
The ASBCA has permitted precontract costs upon finding that the activity giving rise to those costs was necessary to meet delivery schedules several years in advance. Precontract costs can be addressed in an advance agreement.
Royalties and Other Costs for Use of Patents (31.205-37)
Royalties on a patent or amortization of the purchase price of a patent are allowable if necessary for contract performance unless: (1) the government has a license for the patent; or (2) the right to free use of the patent exists or the patent is invalid, unenforceable, or expired. If a patent was formerly owned by the contractor (i.e., owned, sold, and subsequently repurchased), costs are limited to the cost that would have been allowed had the contractor never sold the patent.
Government contracting personnel closely review the reasonableness of royalty costs when the recipient of royalty payments is affiliated with the contractor, the agreement was made in contemplation of award of the contract, or the agreement was made after the contract was awarded. If a contractor’s capitalized value for a patent is low, for example (consisting, perhaps, of minor costs of researching and obtaining the patent), the contractor might decide to sell the patent to another party (sometimes related) and later either pay royalties on the patent or repurchase it and then amortize the costs. However, the mere fact that royalties are being paid to an affiliated party does not preclude the allowability of the payments, according to the ASBCA.
Some contemplated royalty payments are never actually paid because the government is successful in an antitrust suit or because the contractor is able to discontinue payments by mutual agreement. Government concern in such situations arises when a fixed-price contract has been negotiated on the basis of expected royalty payments and the costs are not subsequently incurred. The government may allege that the contractor has received a windfall profit and could lodge a defective pricing allegation if the contractor knew the royalty payments would never be made.
Taxes (31.205-41)
Taxes not declared unallowable by the FAR are allowable if recorded in accordance with GAAP. If otherwise allowable taxes are disputed by a contractor as being illegal or erroneous, the contractor must request and follow instructions from the contracting officer before paying the taxes. Any interest or penalty costs incurred as a result of following the contracting officer’s instructions or incurred for lack of prompt response from the contracting officer are allowable.
Sometimes disputes arise over the applicability of state or local taxes levied on inventory in the contractor’s possession to which the government has legal title because state and local taxes cannot be levied on the federal government. However, the government’s title to property that is obviously in the possession of the contractor may be disputed by the local taxing authorities. In such cases, the contractor should not pay the tax before asking the contracting officer’s advice.
Refunds of allowable taxes, fines, or penalties have to be credited ratably to the government (as directed by the contracting officer) to the extent that the government participated in the original cost. Refunds are carefully reviewed to ensure that adequate credit is given to the government. Normally, refunds such as for any carryback loss provision can be credited in the year the refund is received. On the other hand, if the mix of contractor business has changed from the time when the tax was charged, the government may seek an alternative allocation of the credit.
The following taxes are unallowable contract costs: (1) federal income and excess profits taxes; (2) taxes related to financing, refinancing, or refunding operations or reorganizations; (3) taxes for which exemptions are directly or indirectly available (see below); (4) special tax assessments on land that represents capital improvements; (5) taxes on real and personal property not used in connection with government contracts; (6) taxes related to funding deficiencies and related transactions under deferred compensation plans; and (7) tax accruals to recognize the difference between taxable income and pretax income as recognized in the financial statements.
The indirect tax exemptions are available not to the contractor but to the federal government. For example, a contractor might claim an indirect tax exemption from property owned by the government but actually in the contractor’s possession. Because the federal government is exempt from state and local taxes, it considers inventory on government contracts—even when still in the contractor’s possession—to be exempt from state and local taxes. If the contracting officer determines that obtaining such an exemption is too great an administrative burden, however, the tax is allowable. Any partial tax exemption attributable to the government renders any remaining portion of the tax unallowable.
Because tax exemptions might exist for government-owned inventory held by the contractor, special rules on the allocation of taxes have been developed. Taxes on property used solely for government work must be allocated only to government contracts, and taxes on property used solely for nongovernment work must be allocated only to nongovernment contracts. If property taxes are insignificant, however, separate allocations are not necessary. Similarly, if separate allocations do not differ significantly from a combined allocation, separate allocations are not required. If property is used for both government and nongovernment work, taxes should be allocated to all work based on the relative use of the property.
Tax accruals arising from differences between state and local taxable income and the income reported for financial purposes are not allowable. The government, in other words, accepts only the taxes reflected on the tax return (i.e., taxes actually paid).
After considerable governmental review and discussion covering a period of years, the environmental tax found at section 59A of the Internal Revenue Code, also called the “Superfund Tax,” has been included as an allowable tax cost.
Termination Costs (31.205-42)
The termination of a contract creates different circumstances and permits deviation from many of the cost principles and the CAS. Upon notification of a termination, the contractor should segregate costs related to the termination settlement. Generally, costs that cannot be avoided, costs that would have been amortized in future periods, and settlement expenses are allowed as part of the claim under a terminated contract.
The costs of common items reasonably usable on the contractor’s other work are not allowable unless the contractor submits evidence that the items could not be retained at cost without sustaining a loss. (For example, a common item such as welding rod cannot be included in termination costs because it can be used elsewhere. However, if the contract required purchasing more welding rod than the company could use in 50 years on other work, the costs may still be claimed on the termination.)
Costs that cannot be discontinued immediately after the effective date of termination, despite all reasonable efforts by the contractor, are generally allowable. However, any costs continuing after the effective date of the termination due to the negligent or willful failure of the contractor to discontinue the costs are unallowable.
Initial costs, which include the following, are allowable: starting load and preparatory costs; excessive spoilage due to inexperienced labor; idle time and subnormal production due to testing and changing production methods; training; and lack of familiarity or experience with the product or process.
Loss of useful value of special tooling, and special machinery and equipment, are generally allowable, as are rental costs under unexpired leases, less the residual value of such leases, if shown to have been reasonably necessary for the performance of the terminated contract.
Settlement expenses, which include accounting, legal, and clerical expenses necessary for preparing, assembling, and presenting the claim, are generally allowable. These costs, usually considered indirect, are charged direct to a termination claim, and are not included in their usual indirect cost pools.
Subcontractor claims are treated with the same type of review and scrutiny as the contractor’s claims. These costs, including the allocable portion of the claims common to the contract, are generally allowable. A prime concern should be a review to ensure no duplication of costs claimed.
Environmental Cleanup Costs
No cost principle has been published on environmental costs. However, the decision not to promulgate such a regulation did not come easily. A draft cost principle on environmental costs was prepared to address the allowability of environmental cleanup costs. The first version would have rendered most of those costs unallowable except for contractors operating government-owned facilities. The next version has been opposed by certain government agencies, because it would make most of those costs allowable. The Department of Defense (DOD) opinion was that perhaps no specific coverage is necessary, because the principles of allocability could resolve any disputes.
Allocability cannot satisfactorily resolve all potential issues, however. If costs are incurred now (i.e., when the contractor has all government business) based on a liability that arose years ago (i.e., when the contractor had substantially all commercial business), the costs would be considered unallocable, because the costs should be allocated to commercial business. On the other hand, if costs are incurred now (i.e., when the contractor has all commercial business) based on a liability that arose years ago (i.e., when the contractor had substantially all government business), the costs may be allocable to government contracts, but no government contracts exist. In any event, the costs could not be recovered.
From 1992 to 1997, a draft cost principle was coordinated within the government, but publication has been delayed. However, the DOD contract auditors and contract administrators are applying the concepts through an audit guidance document. Although the guidance states that environmental costs are normal costs of doing business and are generally allowable if reasonable and allowable, the detailed discussions behind this statement disclose numerous conditions in which the government might consider the costs to be unallowable. For example, for these costs to be allowable, a contractor must have taken prompt and prudent actions to minimize damages. Some costs may have to be capitalized as an improvement to land and thus become unallowable as a cost related to nondepreciable assets.
Another implementation guide suggests that contractors should not be reimbursed for costs if contamination could have been avoided. Increased costs resulting from the contractor not taking immediate action after a contamination is discovered are unallowable under this guidance. Any recoveries through insurance and other sources must be credited to the government. If the contamination is at a closed segment, the costs should be assigned to the segment that assumed the work of the closed segment. If no segment presently has that work, the guidance states that this cost is not directly allocable to any other segment. In the case of a closed segment in which the property has been sold, the auditors are advised to consider whether the sales price of the land was higher due to the contractor’s agreement to clean up the facility. Therefore, the costs are considered part of the gain or loss on the sale of the land and not an allowable contract cost. Finally, under most conditions, each contaminator is legally responsible for the entire cost of a cleanup. According to the audit guidance, if the contractor is required to pay for any portion of another firm’s liability, those costs are unallowable as bad debt expense unless the firm is no longer in existence.
In subsequent clarification of this guidance, the determination of “environmental wrongdoing” was specifically stated to include incidents regardless of whether any formal charges were made against the contractor. If no other reasonable means of allocating cleanup costs can be established, the period of time that the facilities were occupied should be used according to this guidance. Cost allocations should be included as part of a G&A cost pool rather than an overhead pool.
During 1993, DOD began collecting data on about two dozen contractors who had incurred significant environmental cleanup costs. The data will be analyzed to develop policies that ensure consistent treatment of the costs. The draft cost principle will then be revised for further consideration.
In 1991, DOD and Lockheed entered into an agreement whereby DOD would reimburse most of the cost of environmental cleanup activities at a location that had been used predominantly for defense contracts for many years. Advance agreements are desirable in this area in view of the amount of dollars involved and the concern that, for lack of specific coverage in the FAR, an agency may allege the costs to be unallowable.
The American Institute of Certified Public Accountants issued Statement of Position 96-1 on “Environmental Remediation Liabilities” in 1996. This pronouncement provides for accrual of costs, including legal fees, at the point in time that a liability is known to exist.
Restructuring Costs (DFARS 231.205.70)
The increasing significance of downsizing and restructuring, particularly in the defense and aerospace industries, requires that special attention be paid to cost allowability. DOD has established a policy to accommodate downsizing efforts that reduce costs or maintain unique capabilities needed by the government. This policy relates to novation agreements that permit a contract to be transferred to a new party. Such agreements are needed when a business combination occurs. The government will generally not agree to a transfer unless the new parties agree that the contract price will be no greater than the price that would have been charged had the transfer not occurred. DOD policy is to accept novations without restrictions on price increases as long as costs will be lower in the long term or a capability vital to the government will be retained because of the business combination.
The implementation of this policy requires that an advance agreement be negotiated before any restructuring costs are allowable. A contractor must submit a detailed proposal of estimated costs and savings resulting from the restructuring. The auditor may recommend that certain costs be amortized over a period of up to five years. Any capitalized costs will be excluded from the cost-of-money calculation according to DOD policy; however, the basis for this is not likely to be supported by a Board of Contracts Appeals or the courts. Any accounting for restructuring costs is not likely to be considered an accounting change because restructuring is a new cost.
A restructuring cost is considered external if it involves two or more separate entities. A restructuring cost is internal if it involves only one entity. External costs are allowable based on the considerations noted. Costs that are specifically unallowable (e.g., incorporation fees, depreciation on the basis of asset valuations) will not be allowable under restructuring cost provisions. The comparison of savings and costs will be made using present value techniques. In 1995, the Cost Accounting Standards Board issued a retroactive interpretation of numerous standards that echoed the DOD guidance on external restructuring.
In 1995 and 1996, Congress enacted legislation that resulted in cost principle revisions to the DOD FAR Supplement. External restructuring costs are the nonroutine, nonrecurring costs after a business combination that affect the operations of entities not previously under common control. Normally these costs are considered to be incurred within three years of the business combination. Restructuring costs of $2.5 million or less are considered immaterial and not subject to the cost limitations related to restructuring costs.
Restructuring costs related to business combinations that occurred on or before September 30, 1996, or not using FY 1997 funds, are allowable if the audited savings meet or exceed the amount of the restructuring costs. For business combinations after September 30, 1996, and if FY 1997 funds were used, the restructuring costs are allowable if: (1) the savings exceed the restructuring costs by a ratio of at least 2 to 1; or (2) the savings exceed the costs by a ratio of less than 2 to 1 but the Secretary of Defense determines that the business combination resulted in the preservation of a critical defense capability.
Cost of Government Shutdowns
The federal budget process caused several agencies to shut down operations during late 1995 and early 1996. Under some circumstances, contractor costs associated with these shutdowns may be allowable. Some agencies, particularly the Environmental Protection Agency, have expressed a policy of denying most claims, especially those for direct labor costs.
If a contracting officer issued a stop work order, the contractor will have an excellent chance of cost recovery. The contractor should have taken reasonable steps to limit the cost impact. If employees can be furloughed based on company policies, this should be done. If no stop order was issued, the chances of recovery are less, but must be evaluated on a case-by-case basis. For stop work orders and resulting delay periods, for years, contractors have been able to recover unabsorbed overhead based on formulas accepted in previous court and Board of Contract Appeals decisions.