What Is FAR Part 31?
FAR Part 31, codified at 48 CFR Part 31, establishes the cost principles and procedures for determining costs applicable to government contracts. It answers one question: when a contractor incurs a cost, can that cost be charged (directly or indirectly) to a government contract?
FAR Part 31 applies primarily to cost-reimbursement contracts, but its principles also govern indirect cost rates on time-and-materials (T&M) contracts, labor-hour contracts, and the pricing of fixed-price proposals when cost or pricing data is required.
FAR 31.201 through 31.205 contain the core rules. Subpart 31.2 applies to commercial organizations. Subpart 31.3 covers educational institutions. Subpart 31.7 covers state, local, and Indian tribal governments.
The Four Tests for Cost Allowability
Every cost charged to a government contract must pass all four tests. Failing any single test makes the cost unallowable.
Reasonableness
FAR 31.201-3 -- A cost is reasonable if a prudent business person would incur it in the conduct of competitive business. Consider the nature of the cost, the restraint exercised, arm's-length bargaining, and consistency with established practices.
Key question: would a reasonable person running a business with their own money spend this amount on this item?
Allocability
FAR 31.201-4 -- A cost is allocable to a contract if it is incurred specifically for the contract, benefits both the contract and other work and can be distributed in reasonable proportion, or is necessary to the overall operation of the business (even if not directly tied to any single contract).
Key question: does this cost have a clear, defensible connection to the contract being charged?
CAS Compliance
FAR 31.201-5 -- If a cost is defined as unallowable by FAR 31.205, a contract clause, or mutual agreement, it is unallowable regardless of the other tests. Contractors must also comply with applicable Cost Accounting Standards (CAS), which require consistency in how costs are estimated, accumulated, and reported.
Key question: does the FAR or your contract specifically prohibit this type of cost?
Accounting Standards
FAR 31.201-6 -- Costs must conform to generally accepted accounting principles (GAAP) and be consistent with the contractor's established accounting practices. A cost treated as direct on one contract cannot be treated as indirect on a similar contract without justification.
Key question: are you applying the same accounting treatment consistently across contracts?
Allowable vs Unallowable Costs: Quick Reference Table
This table covers the most commonly encountered cost categories under FAR 31.205. "Conditional" means the cost is allowable only if it meets specific criteria described in the cited FAR section.
| Cost Type | Status | FAR Cite | Notes |
|---|---|---|---|
| Advertising (recruiting, required notices) | Conditional | 31.205-1 | Allowable for help-wanted ads, legally required notices, and trade show costs. Promotional advertising to sell products is unallowable. |
| Advertising (promotional) | Unallowable | 31.205-1(d) | Advertising designed to promote the sale of products or services is unallowable. |
| Alcoholic beverages | Unallowable | 31.205-51 | Always unallowable. No exceptions. |
| Bad debts | Unallowable | 31.205-3 | Losses from uncollectible accounts are unallowable. |
| Bonuses and incentive compensation | Conditional | 31.205-6(f) | Allowable if based on individual performance, agreed-upon criteria, and overall compensation is reasonable. Must meet the reasonableness test. |
| Compensation (base salary) | Conditional | 31.205-6(a)-(b) | Allowable if reasonable for the work performed, conforms to the contractor's established practices, and does not exceed benchmarks for the industry and geography. |
| Contributions and donations | Unallowable | 31.205-8 | Charitable contributions and donations are unallowable. |
| Depreciation | Conditional | 31.205-11 | Allowable based on acquisition cost, not replacement value. Must use consistent methods conforming to GAAP. Assets revalued upward are limited to historical cost. |
| Entertainment | Unallowable | 31.205-14 | Costs of amusement, diversion, social activities, and directly associated costs (meals, lodging, transportation, gratuities) are unallowable. |
| Fines and penalties | Unallowable | 31.205-15 | Fines, penalties, and mischarging costs resulting from violations of law or regulation are unallowable. |
| Idle facilities and idle capacity | Conditional | 31.205-17 | Costs of idle facilities are unallowable unless the idleness is necessary to meet fluctuating workloads. Idle capacity costs are allowable if the capacity is reasonably anticipated to be needed. |
| Insurance | Conditional | 31.205-19 | Generally allowable if the type, extent, and cost of coverage are reasonable and customary. Self-insurance is allowable under specific conditions. |
| Interest and financing costs | Conditional | 31.205-20 | Generally unallowable except for interest on debt incurred for facilities capital under specific CAS 414 conditions. |
| Lobbying and political activity | Unallowable | 31.205-22 | Costs of lobbying, political contributions, and activities intended to influence legislation are unallowable. |
| Memberships and subscriptions | Conditional | 31.205-43 | Allowable for professional and technical organizations. Unallowable for clubs organized for entertainment, social purposes, or lobbying. |
| Moving/relocation costs | Conditional | 31.205-35 | Allowable if the move is for the contractor's benefit, relocation is to a new official station, and costs are reasonable. Specific limits apply to house-hunting trips and temporary living. |
| Professional and consultant services | Conditional | 31.205-33 | Allowable when reasonable in nature, extent, and amount. Retainer fees require evidence that services are necessary and the fee is reasonable. |
| Rent | Conditional | 31.205-36 | Allowable if reasonable. Rental costs under sale-and-leaseback or less-than-arms-length transactions have special limitations. |
| Severance pay | Conditional | 31.205-6(g) | Allowable if required by law, employer-employee agreement, or established policy. Foreign national severance subject to additional conditions. |
| Training and education | Conditional | 31.205-44 | Allowable when related to the contractor's business or the employee's current or reasonably anticipated duties. Includes tuition, books, and fees. |
| Travel costs | Conditional | 31.205-46 | Allowable when travel is necessary for contract performance. Airfare limited to lowest available class unless exceptions apply. Lodging and meals must be reasonable. |
Costs That Are Always Unallowable
FAR 31.205 designates certain cost categories as unallowable regardless of circumstances. These costs must be identified in your accounting system and excluded from all direct charges and indirect cost pools before billing the government. Per CAS 405, failure to segregate unallowable costs can result in penalties.
- Alcoholic beverages (FAR 31.205-51)
- Bad debts (FAR 31.205-3)
- Contributions and donations (FAR 31.205-8)
- Entertainment costs (FAR 31.205-14)
- Fines and penalties (FAR 31.205-15)
- Goodwill (FAR 31.205-49)
- Interest on borrowings (most cases) (FAR 31.205-20)
- Lobbying and political activity (FAR 31.205-22)
- Losses on other contracts (cross-charging) (FAR 31.205-23)
- Organizational costs (mergers, acquisitions) (FAR 31.205-27)
- Promotional advertising (FAR 31.205-1(d))
Costs That Are Conditionally Allowable
Most cost categories fall into the "conditional" bucket. The cost is allowable in principle but must satisfy specific conditions. The most common conditions are:
Reasonableness of amount
Compensation, professional services, rent, and travel are allowable only up to an amount a prudent person would pay. DCAA benchmarks these against published compensation surveys, GSA per diem rates, and market-rate rental comparables. Per FAR 31.201-3, the burden of proof is on the contractor to demonstrate reasonableness.
Prior approval or advance agreement
FAR 31.109 allows contractors to request advance agreements on the treatment of specific costs. For unusual relocation packages, special severance arrangements, or unique consulting engagements, an advance agreement with the contracting officer removes the risk of after-the-fact disallowance.
Compliance with specific FAR subsection criteria
Many FAR 31.205 subsections include detailed requirements. For example, travel costs under FAR 31.205-46 must use the lowest available airfare class unless specific exceptions apply. Depreciation under FAR 31.205-11 must be based on acquisition cost, not appraised or replacement value. The specific subsection controls.
How Allowability Affects IT Services Contractors (NAICS 541512)
IT services contractors under NAICS 541512 (Computer Systems Design Services) face specific cost allowability issues because of their labor-intensive cost structure and reliance on indirect rate pools:
Labor rates dominate the cost structure
With labor typically representing 60-80% of revenue, the reasonableness of compensation (FAR 31.205-6) is the single highest-impact allowability determination. DCAA will compare salaries against Bureau of Labor Statistics data and industry surveys for the geographic area. Ensure salary surveys supporting your rates are current and documented.
Indirect rate sensitivity
IT firms typically carry fringe, overhead, and G&A pools. A single misclassified unallowable cost in an indirect pool affects every contract billed through that pool. CAS-compliant cost segregation is essential. Failure to exclude unallowable costs from indirect pools is the most common DCAA finding for IT services firms.
Training and certification costs
Cloud certifications, security clearance training, and technical courses are generally allowable under FAR 31.205-44 when related to the employee's duties. However, broad professional development not tied to current contract work may be questioned. Document the business purpose for each training expenditure.
Subcontractor and 1099 costs
IT contractors frequently subcontract specialized work. Subcontractor costs are allowable direct costs but must still pass the reasonableness test (FAR 31.201-3). Sole-source subcontracts at rates significantly above market will draw auditor scrutiny. Maintain competitive quotes or justification documentation.
DCAA Audit Implications
The Defense Contract Audit Agency (DCAA) is the primary auditor for government contract costs. Understanding what DCAA looks for helps you prepare your accounting system before an audit, not after.
Accounting system adequacy (SF 1408)
Before you can bill on a cost-reimbursement contract, DCAA must determine your accounting system is adequate. The Standard Form 1408 checklist includes the ability to segregate unallowable costs, accumulate costs by contract, and produce timely and accurate financial reports. A system that cannot identify and exclude FAR 31.205 unallowable costs will fail this review.
Incurred cost submissions
Contractors must submit annual incurred cost proposals (ICE model or equivalent) within 6 months of the fiscal year end per FAR 52.216-7. DCAA audits these submissions to verify that claimed costs comply with FAR Part 31. The audit tests for unallowable costs in indirect pools, checks direct/ indirect consistency, and verifies compensation reasonableness.
What triggers deeper scrutiny
DCAA risk-based audit selection flags contractors with: large year-over-year indirect rate swings, high executive compensation relative to benchmarks, significant consultant or subcontractor costs, late incurred cost submissions, or prior audit findings. First-time cost-reimbursement contractors almost always receive a pre-award accounting system audit and a floor check within the first year.
Common Mistakes That Lead to Disallowed Costs
These are the errors DCAA auditors and contracting officers encounter most frequently. Each one is preventable with proper accounting system configuration and internal controls.
Failing to segregate unallowable costs
CAS 405 requires contractors to identify and exclude unallowable costs from billing. If your accounting system cannot flag and remove unallowable expenses before they hit an indirect cost pool, every invoice you submit is at risk.
Charging alcohol or entertainment as "business meals"
DCAA auditors specifically test meal receipts for alcohol line items. Entertainment disguised as business development is still unallowable under FAR 31.205-14.
Excessive executive compensation
Compensation above the FAR 31.205-6(p) benchmark cap is unallowable. For fiscal years beginning in 2026, verify the current NDAA-set ceiling, which adjusts annually.
Missing timekeeping discipline
Direct labor charged without adequate time records is a top DCAA finding. Every direct charge needs contemporaneous, employee-signed timesheets showing daily hours by project.
Lobbying costs buried in professional services
Payments to consultants for legislative monitoring or government relations work are unallowable lobbying costs under FAR 31.205-22, regardless of how the vendor invoice categorizes them.
Applying the wrong indirect rate structure
Misallocating overhead vs. G&A pools, or failing to consistently treat like costs the same way across contracts, triggers CAS noncompliance and potential cost disallowances across your entire portfolio.
Not getting advance agreements for unusual costs
FAR 31.109 allows contractors to request advance agreements on the allowability of particular costs. Skipping this for relocation, severance, or unusual compensation structures invites disputes after the fact.
Claiming unallowable costs on T&M/labor-hour contracts
Some contractors assume cost allowability rules only apply to cost-reimbursement contracts. In practice, DCAA applies FAR Part 31 to the material and ODC portions of T&M contracts and to indirect rates on all contract types.
Need to check whether a specific cost is allowable?
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