Engineering and design firms that perform work for the US federal government operate in a highly regulated environment where technical excellence alone isn’t enough.

One of the most persistent challenges these firms face is navigating cost allowability risks, particularly under Federal Acquisition Regulation (FAR) Part 31. These rules determine whether costs charged to government contracts are allowable, allocable, and reasonable—and they are a frequent focus of DCAA and agency audits.

Common FAR cost allowability pitfalls for engineering and design firms remain a leading source of government agency audit findings, but they are largely preventable.

Cost allowability issues are a leading driver of audit findings, questioned costs, delayed contract payments, and in some cases, penalties or repayments. This is typical at engineering and design firms across the defense, infrastructure, environmental, and professional services sectors.

Labor charging, indirect costs, bonuses, travel, and unallowable expenses continue to be top risk areas, and each carries potential income tax consequences if not properly managed. Importantly, these same issues often carry hidden income tax consequences that firms don’t recognize until much later, but, with the right strategy, can be mitigated before posing risk.

Firms that take a proactive, integrated approach—combining FAR compliance, accounting discipline, and tax planning—are far better positioned to withstand DCAA and IRS scrutiny while supporting sustainable growth in the federal marketplace.

Explore the most frequent FAR Part 31 cost allowability issues and how your firm can reduce both contract compliance and income tax risk.

• Understanding FAR Part 31 and why it matters
• Labor charging errors: the highest risk area
• Indirect cost pitfalls and allocation errors
• Bonus and incentive compensation challenges
• Travel costs: small dollars, frequent findings
• The overlooked income tax impact of FAR cost allowability
• FAR-unallowable doesn’t always mean nondeductible for tax
• Expressly unallowable costs: a persistent risk
• Six common questions on FAR cost allowability and tax considerations

Understanding FAR Part 31 and Why It Matters

FAR Part 31 establishes the cost principles governing federal contracts. To be allowable, a cost must be:

• Reasonable for the work performed
• Allocable to the contract
• Consistent with Cost Accounting Standards, if applicable, otherwise consistent with generally accepted accounting principles and practices appropriate to the circumstances
• Compliant with FAR Part 31 and contract terms

Engineering and design firms are particularly exposed because they often:

• Perform both commercial and government work
• Operate labor-intensive cost structures
• Use complex indirect rate pools
• Offer incentive-based compensation to attract technical talent

Without strong policies and controls, these characteristics significantly increase audit exposure.

Labor Charging Errors: The Highest-Risk Area

Labor is typically the largest cost element on engineering and design contracts—and the most scrutinized during audits. Many issues originate with weak labor charging controls.

Frequent Labor Issues

• Employees charging incorrect projects or contracts
• Retroactive labor transfers without proper justification
• Informal or undocumented timekeeping practices
• Supervisors directing employees to adjust time after submission

Auditors view labor charging failures as indicators of broader internal control weaknesses.

Risk Mitigation Strategies

• Implement formal, written timekeeping and labor charging policies
• Require employee certifications for timesheet accuracy
• Prohibit retroactive changes without documented approval
• Conduct internal labor audits and refresher training annually
• Ensure supervisors don’t have edit rights to employee time entries

Indirect Cost Pitfalls and Allocation Errors

Indirect costs are another frequent source of FAR audit findings. FAR 31.203 requires indirect costs to be accumulated in logical cost groupings and allocated on bases that reasonably reflect causal or beneficial relationships.

Common Issues Observed

• Misclassification of direct and indirect costs
• Inclusion of unallowable costs in indirect pools
• Inconsistent allocation bases
• Poor documentation of rate methodologies

Engineering firms that grow quickly or acquire new entities often struggle to maintain consistency, increasing audit risk.

Responsible Practices

• Clearly define direct versus indirect costs in accounting policies
• Segregate unallowable costs at the general ledger level
• Review indirect rate structures at least annually
• Perform mock audits prior to rate submissions

Bonus and Incentive Compensation Challenges

Incentive compensation is essential for recruiting and retaining engineers, but it remains a high-risk area under FAR Part 31.

Typical Findings

• Bonuses paid without written plans
• Incentives not tied to objective performance metrics
• Payments resembling profit distributions
• Unsupported accruals

To be allowable, bonuses must be reasonable, consistently applied, and supported by written plans established in good faith before the services are rendered.

Compliance Responsible Practices

• Maintain written bonus and incentive plans approved in advance
• Tie awards to measurable individual or company performance
• Retain documentation supporting calculations and approvals
• Benchmark compensation for reasonableness

Travel Costs: Small Dollars, Frequent Findings

Travel costs often represent a modest portion of total contract spend but are disproportionately cited in audit reports. Absent specific contract terms, travel costs are generally evaluated against General Services Administration (GSA) per diem limits.

Common Travel Pitfalls

• Exceeding per diem limits without justification
• Charging premium airfare without approval
• Including personal expenses in reimbursed travel
• Excluding or providing inadequate receipts

Risk Reduction Tips

• Align internal travel policies with federal per diem rules
• Require advanced approval for exceptions
• Train employees on allowable expenses
• Audit expense reports periodically

The Overlooked Income Tax Impact of FAR Cost Allowability

FAR compliance is commonly viewed through a contract audit lens, even though the same cost allowability decisions often affect income tax positions. Without coordination between FAR compliance and tax planning, firms increase the risk of exposure in IRS examinations and ASC 740 reviews.

Permanent and Temporary Book-Tax Differences

FAR-unallowable costs—such as lobbying, certain meals and entertainment, and some legal or marketing expenses—often create permanent book-tax differences. When these costs are not properly identified and segregated:

• Tax deductions may be overstated
• Effective tax rates may be understated
• ASC 740 provisions may be misstated

Embedding unallowable costs in indirect pools is a common root cause.

FAR-Unallowable Doesn’t Always Mean Nondeductible for Tax

A common misconception is that costs unallowable under FAR are automatically nondeductible for income tax purposes. In reality, FAR and the Internal Revenue Code (IRC) operate under different policy objectives, and the allowability of a cost for government contracting doesn’t determine its tax treatment.

Certain expenses that must be excluded from government contract billings—such as employee morale and welfare costs, company-wide events, business gifts, certain meals, and premium airfare—may still be partially or fully deductible for income tax purposes, subject to applicable IRC limitations and substantiation requirements. Proper identification and segregation of these costs allows firms to remain FAR-compliant while preserving legitimate tax deductions and accurately tracking book-tax differences.

Bonus Timing and Deductibility

Bonus and incentive compensation present a dual compliance challenge. Even if a bonus is allowable under FAR, it may not be deductible for income tax purposes in the same year.

Common Tax Issues

• Accrued bonuses deducted before meeting the all events test
• Payments contingent on future board approval
• Deferred compensation arrangements triggering IRC Section 409A concerns

These timing differences can materially impact taxable income and deferred tax balances.

Labor Charging and R&D Tax Credit Exposure

Engineering firms frequently claim the R&D tax credit while performing government contract work. Inaccurate labor charging can:

• Undermine wage substantiation for qualified research expenses
• Create inconsistencies between DCAA records and IRS filings
• Increase scrutiny during IRS examinations

Aligning FAR-compliant labor practices with tax credit documentation is critical. This risk is heightened where government funding or retained rights limit eligibility for the R&D credit.

Why Integration Matters

Managing FAR compliance and income tax planning in silos increases risk. A coordinated approach supports:

• Accurate identification of nondeductible costs
• Stronger ASC 740 positions
• Reduced exposure in both DCAA and IRS audits

Expressly Unallowable Costs: A Persistent Risk

Certain costs are expressly unallowable under FAR and must never be charged to government contracts. While some unallowable costs may still be deductible for tax purposes, expressly unallowable costs require heightened scrutiny due to the risk of penalties if claimed or included in amounts billed, claimed, or proposed to the government.

Unallowable Costs Examples

• Lobbying and political activities
• Entertainment expenses
• Alcohol
• Certain legal and public relations costs

Including these costs in indirect pools—even unintentionally—can result in increased audit scrutiny.

Unallowable Costs Prevention Strategies

• Use dedicated general ledger accounts for unallowable costs
• Train non-finance managers on cost allowability basics
• Perform monthly reviews of high-risk accounts

Six Common Questions on FAR Cost Allowability and Tax Considerations

1. What Is the Most Common FAR Audit Issue for Engineering Firms?

Labor charging errors remain the most frequent and highest-risk finding.

2. Are FAR-Unallowable Costs Always Nondeductible for Tax?

Not always, but many create permanent book-tax differences that must be tracked.

3. Can Bonuses Be Allowable Under FAR?

Yes, if they are reasonable, documented, and based on pre-established plans.

4. How Often Should Indirect Rates Be Reviewed?

At least annually, or more often during periods of growth or restructuring.

5. Do FAR Issues Increase IRS Audit Risk?

Yes. Poor documentation and inconsistent cost treatment often draw IRS scrutiny.

6. Is Annual Compliance Training Necessary?

Yes. Regular training reduces errors and demonstrates a strong compliance culture.

We’re Here to Help

To learn more about FAR cost allowability pitfalls that could impact your engineering or design business, contact your firm professional.

Additional Resources

• Government Contractors Practice