Six Essential Tips for Complying with FAR Cost Principles

In honor of the release of the 6th Edition of the Government Contracts Compliance Handbook, we are sharing six essential tips for government contractors to ensure compliance with the Federal Acquisition Regulation (FAR) cost principles. For contractors doing business with the federal government, understanding cost allowability is critical to maintaining compliance and avoiding costly disputes, penalties, or even allegations of fraud. The FAR cost principles dictate what expenses are reimbursable under government contracts and impose strict accounting and certification requirements. These six tips will help contractors navigate this complex regulatory environment while mitigating risk.  

1. Understand the FAR Cost Principles and Their Scope

FAR Part 31, commonly referred to as the “cost principles,” governs which costs are allowable, unallowable, or subject to limitations when billing the government. These rules apply to:   

- Cost-reimbursement contracts (e.g., cost-plus-fixed-fee contracts)   

- Negotiated contracts requiring cost analysis   

- Termination settlements   

- Pricing changes, redeterminations, and other contract modifications   

The cost principles ensure that only reasonable, allocable, and allowable costs are reimbursed. However, exceptions exist, particularly in commercial contracts, where FAR cost principles generally do not apply. Contractors must first determine if their contract falls under FAR Part 31 before applying these rules.   

2. Ensure Costs Meet the Five-Part Test for Allowability

For a cost to be allowable under FAR Part 31, it must meet five key criteria:   

i. Reasonableness – The cost must be one a prudent business would incur under similar circumstances. Costs that seem excessive, wasteful, or beyond industry norms may be challenged.   

ii. Allocability – The cost must directly benefit the contract or reasonably relate to the contractor’s overall operations. Costs benefiting multiple contracts should be proportionately allocated.   

iii. Accounting Standards – The cost must conform to Cost Accounting Standards (CAS) (if applicable) or Generally Accepted Accounting Principles (GAAP).   

iv. Contract Terms – The cost must comply with specific contract provisions, which may impose additional restrictions beyond the FAR cost principles.   

v. FAR Subpart 31.2 Limitations – Certain costs are expressly unallowable under FAR Part 31, such as lobbying expenses, alcohol, and bad debts.   

Understanding and applying these five criteria consistently can help prevent audit findings and disputes with contracting officers. 

3. Identify and Avoid Unallowable Costs

FAR Part 31.205 identifies specific costs that are either expressly unallowable or subject to limitations. Some of the most commonly challenged costs include:   

- Entertainment, gifts, and alcoholic beverages   

- Lobbying and political activity expenses 

- Fines, penalties, and legal costs associated with government enforcement actions 

- Bad debts and losses on other contracts 

- Unreasonable executive compensation exceeding statutory limits 

The government imposes strict penalties on contractors who attempt to charge unallowable costs. The Penalties for Unallowable Costs Clause (FAR 42.709) allows contracting officers to impose double penalties if a contractor knowingly includes unallowable costs in an indirect cost rate proposal.   

To prevent such issues, contractors should:   

- Maintain detailed cost segregation in their accounting systems.   

- Establish internal controls to review costs before submission.   

- Conduct regular training for employees involved in cost reporting and accounting.   

4. Implement a Strong Indirect Cost Accounting System

Indirect costs—such as overhead and general & administrative (G&A) expenses—must be properly classified and allocated to contracts in accordance with CAS 405 and FAR Part 31. Contractors should:   

- Segregate unallowable costs to prevent them from being included in indirect cost pools.   

- Use appropriate cost allocation bases, ensuring costs are distributed equitably among contracts that benefit.   

- Follow written accounting policies that comply with FAR and CAS requirements.   

- Monitor changes in business practices, such as corporate reorganizations, that might impact cost allowability or allocation.   

Failing to properly allocate costs can result in disputes, disallowed costs, and significant financial liability during government audits.   

5. Certify Indirect Cost Proposals with Caution

Government contractors must certify their final indirect cost proposals using the Certificate of Final Indirect Costs, which affirms that all costs submitted are:   

- Allowable under FAR cost principles   

- Correctly allocated   

- Free of expressly unallowable costs 

This certification carries legal risks—if a contractor knowingly includes unallowable costs in their indirect cost proposal, they may face penalties under the False Claims Act (FCA) or be referred for criminal investigation.   

To minimize liability:   

- Conduct internal audits before submission.   

- Use statistical sampling techniques (if permitted by the contracting officer) to review cost pools.   

- Seek legal counsel if uncertain about cost allowability before signing the certification.   

6. Respond Proactively to Cost Disallowance and Audit Findings

If a contracting officer disallows a cost, contractors have the right to:   

- Respond in writing with supporting documentation.   

- Appeal the decision under the Contract Disputes Act (CDA) if they believe the cost was improperly disallowed.   

- Negotiate with the government to resolve disputes before they escalate.   

The Defense Contract Audit Agency (DCAA) and other government auditors frequently review contractors' cost records. A proactive compliance approach—including regular internal audits, cost documentation best practices, and early engagement with government auditors—can reduce the risk of findings and ensure smooth contract performance.   

Complying with FAR cost principles is a fundamental requirement for government contractors. Failing to follow these rules can lead to cost disallowances, financial penalties, and potential legal liability. By implementing these six essential tips, contractors can improve compliance, mitigate risk, and strengthen their government contracting business.   

These insights, drawn from the 6th Edition of the Government Contracts Compliance Handbook, reflect our firm’s commitment to providing timely legal guidance to contractors navigating the complexities of government cost regulations. For tailored assistance in FAR compliance, cost allowability disputes, or government audits, our elite government contracts practice group is here to help.