Can Your Indirect Rates Stand Up to an Audit?

December 16, 2016

When you’re working with the Virginia Department of Transportation, or a department of transportation in any other state, the indirect rates you are charging have to comply with certain rules and regulations. According to FAR Part 31.201-2, a cost is only allowable when it is reasonable, allocable, follows generally accepted accounting principles and practices appropriate to the circumstances, and is complaint with contract terms.

What constitutes reasonable and allocable isn’t always black or white. Many of the costs that seem reasonable and allocable from the government contractor’s point of view often fall into a vast gray area that would not withstand audit testing. A contractor is responsible for accounting for costs appropriately and for maintaining records. Supporting documentation must adequately demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles.

What is the best way to judge whether the cost is reasonable? Under FAR Part 31.201-3, a cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business. Now, probably most of us, at least in business, would like to think of ourselves as “prudent” and arbitrarily could place a lot of activities into necessary to conduct a competitive business.

A good example of what would fall into a gray area is Employee Morale (FAR Part 31.304.13); vending machines, gifts, recreation (except sports teams) are unallowable.

Under FAR Part 31.201-4 a cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. A cost is allocable to a Government contract if it:

  • is incurred specifically for the contract;
  • benefits both the contract and other work, and can be distributed to them in a reasonable proportion to the benefits received;
  • or, is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.

Based on this information, have you looked at your costs lately and asked yourself:  Are the costs I am incurring reasonable, allocable, following GAAP and in compliance with the terms of the contract?  Here are few specifics to review:

  • Is your Executive Compensation all allowable? Do you know the limits?
  • Have you reviewed the National Compensation Matrix (NCM) or other nationally published salary surveys?
    • Have you compared the NCM to what you are paying your executives?
  • Is your bonus plan objective and performance-based?
    • Has the plan been documented and communicated to your staff, and used in determining bonus amounts?
  • Does your accounting system adequately segregate unallowable costs?
    • Are you familiar with Federal Acquisition Regulation Part 31.205 – selected costs:
  • Does your accounting system adequately segregate direct and indirect costs, overhead and G&A costs?

FAR Part 31 is a great guide for determining allowable costs and how to treat them, as well as unallowable costs.

Need help deciphering the costs you are incurring and where to bucket them? Contact Teresa Flynn at or 301.231.6247.