Subpart 31.2 - Contracts with Commercial Organizations

Overview

FAR Subpart 31.2 establishes the cost principles and procedures for determining the allowability of costs in contracts with commercial organizations. It serves as the definitive guide for how contractors must account for, allocate, and justify expenses—ranging from direct labor to indirect overhead—to ensure the government pays only its fair share of reasonable and necessary costs.

Key Rules

• The Five Pillars of Allowability: For a cost to be allowable, it must meet five strict criteria:
  1. Reasonableness: It does not exceed what a "prudent person" would spend in a competitive business.
  2. Allocability: It is incurred specifically for the contract or benefits both the contract and other work.
  3. CAS/GAAP Compliance: It must comply with Cost Accounting Standards (CAS) if applicable, or Generally Accepted Accounting Principles (GAAP).
  4. Contract Terms: It must not be prohibited by specific terms within the contract.
  5. FAR Limitations: It must comply with the specific cost principles in Subpart 31.2.
• Consistency in Accounting: Costs must be treated consistently. A contractor cannot charge a cost as "direct" on one contract and "indirect" on another if the circumstances are the same.
• Treatment of Unallowable Costs: Costs that are expressly unallowable (e.g., bad debts, certain advertising) must be identified and excluded from any billing or proposal. Furthermore, "directly associated costs" (costs generated solely because an unallowable cost was incurred) are also unallowable.
• Credits: Any income, rebate, or allowance received by the contractor that relates to an allowable cost must be credited back to the government.
• Direct vs. Indirect:
  • Direct Costs: Specifically identified with a single contract.
  • Indirect Costs: Costs remaining after direct costs are identified, grouped into logical "pools" (like G&A or Overhead) and allocated using a logical base.

Responsibilities

• Contractors:
  • Responsible for accounting for costs appropriately and maintaining "adequate" records to demonstrate allowability.
  • Bears the burden of proof to establish that a cost is reasonable when challenged.
  • Must identify and segregate unallowable costs from government billings.
• Contracting Officers (CO/ACO):
  • Authorized to disallow any claimed cost that is inadequately supported.
  • Review and approve (or challenge) contractor accounting practices and compensation plans.
  • Negotiate "advance agreements" regarding specific costs (like statistical sampling methods) to avoid future disputes.
• Cognizant Auditors:
  • Review contractor records and provide input to the CO regarding the validity of cost accounting methods and statistical sampling.

Practical Implications

• Audit Preparedness: In real-world scenarios, the "burden of proof" rule means that if a contractor lacks a receipt or a written justification for a high-dollar expense, the government can automatically disallow it. Contractors must maintain a rigorous "paper trail."
• Compensation Sensitivity: Compensation for owners of closely-held corporations or high-level executives is scrutinized heavily. If a salary exceeds industry benchmarks for a company of similar size, the CO will likely deem the excess "unreasonable" and unallowable.
• Business Development Restrictions: While a contractor may spend heavily on "image-building" or general advertising to grow their business, FAR 31.205-1 makes most of these costs unallowable for government reimbursement. Only very specific costs, such as those for recruiting or disposing of scrap, are typically permitted.
• Subcontractor Oversight: Prime contractors are responsible for ensuring that their subcontractors' cost-reimbursement claims also comply with these FAR principles. A failure in the subcontractor's accounting can lead to a disallowance of costs for the prime contractor.