Cough…cough…ahem…cough… Any contractor who has had the misfortune of dealing with the Defense Contract Audit Agency (DCAA) likely knows all too well that the agency is the Will Rogers of costs – it never met a cost it didn’t question.  Indeed, DCAA auditors typically question costs with reckless abandon and based often on a patent misreading of applicable regulations.  The net effect, of course, is that contractors have to expend significant time and money trying to explain to boards and courts why DCAA’s auditors are…uh…incorrect as a matter of fact and law.  A recent Memorandum for Regional Directors (MRD) provides some transparency into why this sort of thing happens with unfortunate regularity. Issued on May 14, 2019, the MRD (No. 19-PAC-002(R)), corrects…er…“revises” internal guidance issued in 2014 and 2015 relating to the identification of expressly unallowable costs.  The newly issued memo sets out DCAA’s current stance on identifying expressly unallowable costs under the cost principles codified at Federal Acquisition Regulation (FAR) Part 31 and Defense Federal Acquisition Regulation Supplement (DFARS) Part 231.  This MRD – like all MRDs – is intended to be used as a tool by well-meaning (but often overzealous) auditors when reviewing a contractor’s compliance with federal cost principles.  Contractors should, thus, pay careful attention to this MRD in order to be prepared for questions that may arise during DCAA-led frolics and detours.

The Basics: Unallowable Costs Defined

Under the FAR and Cost Accounting Standards (CAS), “expressly unallowable costs” are “a particular item or type of cost which, under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable.” FAR 31.001; 48 CFR § 9904.405-30 (CAS 405).  Of course, contrary to what many auditors may believe – or would have you believe – the burden of showing that a cost is expressly unallowable is borne by the government and requires the government to demonstrate that the contractor’s interpretation of the cost was unreasonable – i.e. the government must demonstrate that it was unreasonable for a person in the contractor’s position to conclude that the costs were allowable.  While the government may have to clear a high bar to meet its burden, if it succeeds, and can show that expressly unallowable costs were included in billings to the government, the contractor can be susceptible to interest-bearing fines, penalties, and potential disallowance proceedings initiated by the Defense Contract Management Agency (DCMA).

DCAA Guidance on Expressly Unallowable Costs

In the new MRD, DCAA takes expressly unallowable costs literally, instructing auditors to recognize that regulations actually mean what they say:

[F]or a cost to be expressly unallowable, the cost principle must state in direct terms that the costs are unallowable, or leaves little room for interpretation or differences of opinion as to whether the particular cost meets the allowability criteria.

In addition, the MRD includes a listing intended to be used by audit teams as a tool “to help determine whether a questioned cost is expressly unallowable.” Notably, in crafting this list, DCAA removed nearly 20 unallowable categories of cost it had previously (and wrongly) believed to have been expressly unallowable, specifically addressing certain costs associated with professional services and consultants, relocation, travel, and  independent research and development.  A summary of DCAA’s revised guidance, which encompasses nine discrete cost subjects, is as follows:

Clause Subject Revised DCAA Guidance Update
FAR 31.205-6(a)(6)(ii)(B) Compensation for personal services Compensation paid to owners of closely held corporations, members of limited liability companies, partners, sole proprietors or members of their immediate families, and persons who are contractually committed to acquire a substantial financial interest in the contractor’s enterprise are now expressly unallowable only if such compensation represents a distribution of profits.
FAR 31.205-6(g)(6) Costs of severance payments to foreign nationals As waiver authority is vested in the head of the agency and not the contracting officer, the waiver is not discretionary and the costs of severance payments to foreign nationals are expressly unallowable.
FAR 31.205-6(j)(1)(i) Pension costs Except for non-qualified plans using the pay-as-you-go cost method, pension costs assigned to the current year but not funded by the filing of the federal income tax return are expressly unallowable.
FAR 31.205-6(j)(2)(v) Increased pension costs resulting from the withdrawal and transfer of assets The cost principle gives the contracting officer the authority to enter into an advance agreement to allow the costs before they are incurred. However, costs not covered by the advance agreement are expressly unallowable.
FAR 31.205-6(o)(2)(iii)(G)(3) Funding of postretirement benefits (PRB) other than pensions costs PRB costs are expressly unallowable if they’re not funded or paid to an insurer or other recipient by the time set for filing the federal income tax return.
FAR 31.205-19(e)(2)(iii) Costs of property insurance premiums for insurance coverage The costs for premiums for insurance coverage in excess of the acquisition cost of the insured asset are expressly unallowable.
FAR 31.205-19(e)(2)(v) Costs of insurance on the lives of contractor personnel that do not represent additional compensation DCAA interpreted the cost principle in accordance with Thomas Assoc., Inc., 11-1 BCA P 34,764, noting that although the cost principle does not specifically identify the costs as unallowable, the Thomas Assoc. case held that these costs were expressly unallowable.
FAR 31.205-31 Reconversion costs The contracting officer has the discretion to allow certain costs if the costs are agreed to before they are incurred, but costs not agreed to in advance are expressly unallowable.
FAR 31.205-41(b)(3) Costs of taxes from which exemptions are available to the contractor based on an exemption afforded the government The exception in the cost principle for a situation in which a contracting officer determines that the administrative burden incident to obtaining the exception outweighs the corresponding benefits accruing to the government is only a determination of materiality of the benefit and not so discretionary as to eliminate the expressly unallowable nature of the cost.

It should be noted that while the MRD serves as a subtle mea culpa by DCAA, it does not in any way tie the hands of its auditors.  The memo notes that auditors may find some costs, which “based on unique facts and circumstances” appear expressly unallowable and which are not on the revised list.  That’s a disappointing, implicit direction for an auditor to follow his or her instincts, even if those instincts are uninformed or unjustified.

Contractors should not, however, be shy about challenging an auditor’s determination that a particular cost is unallowable. The disclaimer at the bottom of each page of the MRD makes clear that that the guidance does not represent the “legal position of the Government.”  In fact, DCAA’s interpretations of cost principles do not have the force of law and, as we (and Boards of Contracts Appeals) all know, DCAA is often…er…mistaken.  As such, it is always a good idea to get a second opinion from legal counsel on the validity of DCAA’s determination on the allowability of a particular cost before taking that determination as gospel.  As the very existence of this guidance reminds us, cost allowability is a dynamic landscape that is constantly shifting as the cost principles are interpreted by courts and boards of contract appeals.