Every dollar you claim must pass a gauntlet of scrutiny in the high-stakes world of federal contracting. Whether you’re a small business navigating a Small Business Innovation Research (SBIR), Small Business Technology Transfer (STTR) award, or a seasoned contractor managing a multimillion-dollar deal, understanding cost allowability, reasonableness, and allocability is non-negotiable. These three pillars, rooted in the Federal Acquisition Regulation (FAR), determine whether your costs survive an audit or get tossed out, costing you time, money, and credibility. Let’s explain these terms, why they matter, and how to bulletproof your cost claims.
The Big Three: Allowability, Reasonableness, Allocability
The FAR, specifically Part 31.201, lays out the holy trinity of cost principles that govern federal contracts. These principles aren’t just bureaucratic hoops. They’re the guardrails that ensure recipients spend taxpayer dollars wisely. Get them right, and you’re in the clear. You get them wrong and invite a government (Defense Contract Audit Agency (DCAA)) audit.
1. Allowability: Is the Cost Permissible?
A cost is allowable if it complies with the FAR, the contract terms, and applicable agency regulations. FAR 31.201-2 lists five key criteria:
- Reasonableness: The cost must make sense (more on this below).
- Allocability: The cost must benefit the contract (we’ll get to that, too).
- Generally Accepted Accounting Principles (GAAP): Your accounting must follow standard practices.
- Contract Terms: The cost must align with the specific agreement.
- Regulatory Limits: Some costs, like entertainment or lobbying, are explicitly unallowable under FAR 31.205.
For example, paying for a team lunch to boost morale might seem like a great idea, but it’s unallowable if the contract doesn’t permit it. Conversely, direct labor costs for engineers working on an SBIR Phase II project are typically allowable if appropriately documented.
Pro Tip: Always check FAR 31.205 for a list of unallowable costs. Items like alcohol, fines, or advertising to promote your brand are red flags. When in doubt, consult your contract or a DCAA compliance expert.
2. Reasonableness: Does the Cost Make Sense?
A cost is reasonable if it doesn’t exceed what a prudent person would spend in similar circumstances (FAR 31.201-3). These determinations are subjective and contextual. Reasonableness hinges on two questions:
- Is the cost necessary for contract performance? Paying $10,000 for a laptop when a $1,500 model meets the need raises eyebrows.
- Does it reflect market norms? If you’re paying twice the going rate for a consultant, you’d better have a rock-solid justification.
Reasonableness is critical for SBIR/STTR recipients when justifying costs like subcontractor fees or specialized equipment. Auditors will compare your costs to industry benchmarks, so documentation, like quotes from multiple vendors, is your best defense.
Real-World Trap: A small business once claimed $50,000 for “miscellaneous supplies” without receipts. The DCAA disallowed the entire amount, citing a lack of evidence. Don’t let vague records sink your claim.
3. Allocability: Does the Cost Benefit the Contract?
A cost is allocable if a specific contract caused it or benefits multiple contracts in a reasonable proportion (FAR 31.201-4). Think of allocability as the “who pays?” test. Costs fall into three buckets:
- Direct Costs: Tied to one contract, like salaries for staff working exclusively on an SBIR project.
- Overhead Indirect Costs: Shared across many contracts, like rent or utilities, allocated via an overhead rate.
- General and Administrative Indirect Costs: Benefit all aspects of the business, including contracts and other work. Cost allocations use a cost basis (direct costs, direct labor, total costs, etc.) to assign a portion of the expenses to projects, etc. They require careful analysis to develop allocations (e.g., a server used 60% for the contract and 40% for commercial work).
For SBIR/STTR recipients, allocability is a hot-button issue. If you’re using a lab for federal and commercial projects, you must allocate costs based on actual usage. Guessing won’t cut it. Timekeeping systems and detailed records are essential to prove the split.
Pro Tip: Use a DCAA-compliant timekeeping system integrated with accounting software and project management to track employee hours by project. A robust, integrated timekeeping system ensures direct labor costs are accurately allocated and defensible during an audit.
Why These Principles Matter
Getting allowability, reasonableness, and allocability correct isn’t just about passing an audit. It’s about protecting your bottom line. Unallowable costs get clawed back, reasonable costs without documentation get questioned, and misallocated costs can trigger penalties or contract termination. For small businesses, especially SBIR/STTR recipients, a single audit finding can devastate resources and damage your reputation.
Conversely, mastering these principles builds trust with contracting officers and auditors. It shows you’re a reliable partner who respects taxpayer dollars. Plus, it streamlines your accounting, making it easier to scale as you win more contracts.
Common Pitfalls and How to Avoid Them
Even seasoned contractors stumble over these principles. Here are three traps to watch for, and how to sidestep them:
- Pitfall: Inadequate Documentation
- Problem: Claiming costs without receipts, timesheets, or vendor quotes invites disallowance.
- Fix: Maintain a paper trail for every cost. For example, save three vendor quotes for major purchases to prove reasonableness. Use a cloud-based system to organize records for easy audit access.
- Pitfall: Mixing Personal and Contract Costs
- Problem: Using a company credit card for personal expenses or claiming overhead costs unrelated to the contract can trigger red flags.
- Fix: Segregate business and personal accounts. Calculate overhead rates for indirect costs using a DCAA-approved methodology, such as total cost input or direct labor dollars.
- Pitfall: Ignoring Contract-Specific Rules
- Problem: SBIR/STTR contracts often have unique cost restrictions, like caps on travel or equipment. Ignoring these can render costs unallowable.
- Fix: Read the contract cover to cover. Create a checklist of allowable costs and review it before submitting any claims.
Your Cost Compliance Toolbox
Ready to take control? Here’s a starter kit to ensure your costs pass muster:
- Checklist for Cost Claims:
- Is the cost allowable under FAR 31.205 and contract terms?
- Is the cost reasonable compared to market norms?
- Is the cost properly allocated to the contract?
- Do I have receipts, timesheets, or quotes to back it up?
- Timekeeping System: Invest in software like Clockify, QuickBooks Time, or another DCAA-compliant application to track employee hours by project. Using compliant timekeeping is a must for SBIR/STTR recipients.
- Vendor Quote Template: Request at least three quotes for purchases over $10,000. In your records, include a table comparing prices, features, and delivery terms.
- Training: Educate your team on FAR cost principles. A one-hour session can prevent costly mistakes.
The Road to Compliance
Cost allowability, reasonableness, and allocability aren’t just regulatory buzzwords. They’re the foundation of a successful federal contracting operation. By understanding the FAR’s rules, documenting every dollar, and staying proactive, you can confidently navigate audits and keep your focus on delivering value. Small businesses, especially SBIR/STTR recipients, face unique challenges. However, the right approach can turn compliance into a competitive edge.
So, grab your checklist, review your records, and take charge of your costs. The government is watching, but you’ll be ready with these tools.
