Every dollar a federal contractor bills against a cost-reimbursement or T&M contract has to clear a four-part test before it ever reaches an invoice. FAR Subpart 31.2 sets that test, and it also names, in specific detail, categories of cost the government will never pay no matter how reasonable they look on paper. Contractors who treat cost allowability as a bookkeeping afterthought instead of a compliance discipline are the ones who end up defending disallowances, or worse, penalties.
Background
FAR Subpart 31.2 governs cost principles for contracts with commercial organizations, and it applies whenever contract type ties payment to a contractor's actual incurred costs — cost-reimbursement contracts, and cost buildups used to price other contract types. The subpart does two things at once. First, it lays out the general framework a cost has to satisfy to be allowable at all. Second, in FAR 31.205, it runs through dozens of specific cost categories and either allows them with conditions, allows them only up to a cap, or bars them outright regardless of how the contractor justifies them internally.
This matters because allowability is not the same question as whether a cost was a legitimate business expense. A company can spend money reasonably, document it perfectly, and still be barred from billing the government for it because FAR 31.205 puts that category of cost off-limits on principle. Entertainment, lobbying, and fines are the classic examples, but the list runs much longer and catches contractors who assume "reasonable" is the only bar to clear.
Key Details
The general test in FAR Subpart 31.2 has four parts. A cost must be reasonable — meaning a prudent person operating in a competitive business environment would have incurred it, and the contractor carries the burden of proving that if the cost is challenged. It must be allocable, meaning it was incurred specifically for the contract, benefits the contract and other work in reasonable proportion, or is necessary to the overall operation of the business even if a direct relationship to any one contract can't be shown. It must comply with applicable Cost Accounting Standards or, where CAS doesn't apply, generally accepted accounting principles. And it must be consistent with the terms of the contract and any FAR limitations placed on that cost type.
Beyond that general framework, FAR 31.205 lists specific costs that are unallowable regardless of reasonableness or allocability. Among the categories: entertainment, amusement, and social activity costs, along with associated meals, lodging, and membership dues; fines and penalties resulting from violations of law; bad debts; charitable contributions and donations; contingencies set aside for indeterminable future events; and costs of lobbying and legislative advocacy. None of these become billable just because a contractor can show the spending was ordinary and necessary for running the business — the FAR excludes them by category.
Executive and employee compensation gets its own specific rule under FAR 31.205-6. For costs incurred on or after June 24, 2014, compensation above the annual benchmark amount set by the Office of Federal Procurement Policy is unallowable — and that cap applies to all contractor employees, not just a handful of senior executives. Contractors who assume the compensation cap only touches the C-suite are working from an outdated understanding of the rule.
The subpart also places an affirmative duty on contractors: unallowable costs have to be identified and excluded from any billing, claim, or proposal before submission. A contractor cannot submit a claim containing unallowable costs and simply wait to see whether the government catches it during audit. That distinction — between a cost that is merely unallowable and one that is expressly unallowable and claimed anyway — carries real consequences. Claiming a cost the FAR expressly bars, as opposed to a gray-area allocability dispute, can trigger statutory penalties layered on top of the basic disallowance, separate from simply having to give the money back.
What It Means for Contractors
The practical risk here isn't the obviously outrageous expense. It's the mid-size item that a contractor's accounting team books the same way it always has, without checking it against FAR 31.205 category by category. Client entertainment folded into a proposal's indirect rate, a holiday party charged to overhead, a legal settlement's associated fine treated as an ordinary cost of doing business — these get flagged in incurred cost audits with some regularity, and by the time a DCAA or agency auditor catches it, the contractor is negotiating a disallowance instead of avoiding one.
The fix is procedural, not just a matter of knowing the rules. Contractors billing on cost-reimbursement or T&M contracts need an accounting system that segregates expressly unallowable cost categories at the point of entry, not after the fact during proposal or invoice preparation. That means chart-of-accounts structure that separates entertainment, fines, lobbying, and similar categories into their own line items rather than burying them inside general overhead or G&A pools where they can ride along undetected into a billed rate.
Compensation deserves particular attention given how the 2014 benchmark change broadened its reach. Contractors should confirm their payroll and cost-allocation systems are actually applying the OFPP benchmark cap across the full employee population subject to it, not just named executives, and should revisit that check whenever the benchmark figure updates.
Finally, the burden-of-proof language in the reasonableness test is worth taking seriously on its own. If a cost's allowability gets challenged, the contractor — not the government — has to demonstrate that a prudent business operator would have incurred it under competitive conditions. Contemporaneous documentation showing the business rationale for a cost, kept at the time the cost is incurred rather than reconstructed after an audit request lands, is the difference between a defensible position and a costly one. Contractors that build this discipline into routine accounting practice avoid the scramble that comes with an incurred cost audit finding, and they keep unallowable costs out of proposals and invoices in the first place rather than negotiating them out after submission.
