Reasonable and Necessary

Enjoy this excerpt from the best-selling self-study course Uniform Guidance Cost Principles where Sefton Boyars and Bill Allen explain how only reasonable and necessary costs can be charged to a federal grant.  

Reasonable and Necessary

Reasonable people may have different concepts of what is a necessary cost. My spouse thinks a DVD library of every Disney movie ever made is necessary to entertain children; I don’t. I think staying in a Motel 6 is unacceptable; my spouse thinks it is more than fine.

While not specifically stated, the cost principles recognize this conundrum and set out some basic criteria related to determining the reasonableness of costs incurred in the performance of federal projects.

Basketball Tickets

Over many years, we conducted numerous audits of the U.S. Department of Education’s Title I program. This program is designed to help children who are functioning below average to perform at their grade level.

During these audits, we found many instances of schools conducting activities, particularly field trips, which did not seem designed to improve educational achievement. Schools had taken kids to Disneyland, Knott’s Berry Farm, and roller rinks under the Title I program.

One school district even paid for the junior high prom dinner with Title I funds. Another district took about 30 children to a professional basketball game and charged the tickets to the Title I program. They classified the activity as part of the reading program…?

As a side note, after we reported on a number of these abusive practices, the audit reports became public. The districts were severely criticized in the newspapers (for you younger folks, newspapers were the predecessors to blogs). After the publicity, the number of field trips and conferences charged to Title I reduced significantly.

The Prudent Person Rule

The cost principles make it clear that to be reasonable, a cost may not be more than a “prudent person” would spend in its nature and amount at the time of the decision.

2CFR 200.404 Reasonable costs.

A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person under the circumstances prevailing at the time the decision was made to incur the cost. …

The prudent person rule is also used in the Government Auditing Standards (also known as the Yellow Book, and generally abbreviated as GAGAS) to define abuse. Under GAGAS, “Abuse involves behavior that is deficient or improper when compared with behavior that a prudent person would consider a reasonable and necessary business practice given the facts and circumstances.”

Therefore, to determine whether a cost is reasonable in a given situation, we must consider whether a “prudent person” would have expended it.

Needless to say, determining what is reasonable is quite subjective (since I am the only prudent person I know!). However, the cost principles try to supply some guidance.

Factors Used to Determine Reasonableness

The determination of whether a cost is reasonable requires the application of the following sub‑criteria:

4. The cost generally would be recognized as ordinary and necessary for the operation of the governmental unit or the performance of the federal award.
5. The cost considers market prices for similar goods in the geographical area.
6. The cost conforms to:
   • Sound business practices,
   • Arm’s length bargaining,
   • Laws and regulations, and
   • Terms and conditions of the federal award.
7. The cost was incurred using the organization’s established practices. (Significant deviations from established organizational practices of the governmental unit may unjustifiably increase the federal award’s cost.)

2 CFR 200.404 Reasonable costs.

… The question of reasonableness is particularly important when the non-Federal entity is predominantly federally-funded. In determining reasonableness of a given cost, consideration must be given to:

      (a) Whether the cost is of a type generally recognized as ordinary and necessary for the operation of the non-Federal entity or the proper and efficient performance of the Federal award.

      (b) The restraints or requirements imposed by such factors as: sound business practices; arm’s length bargaining; Federal, state and other laws and regulations; and terms and conditions of the Federal award.

      (c) Market prices for comparable goods or services for the geographic area.

      (d) Whether the individuals concerned acted with prudence in the circumstances considering their responsibilities to the non-Federal entity, its employees, where applicable its students or membership, the public at large, and the Federal government.

      (e) Whether the non-Federal entity significantly deviates from its established practices and policies regarding the incurrence of costs, which may unjustifiably increase the Federal award’s cost.

Flying first class

If employees of an organization normally do not travel first class, they do not have permission to fly first class simply because a federal award is paying the tab. In general, the rules do not permit flying first-class. However, suppose that your boss informs you that you need to fly across the continent immediately. The only coach seats available are on a red-eye that makes two stops and arrives around noon the next day. Since such a trip would be considered unreasonable, you may very well justify flying first-class.

In addition, some entities have a policy that permits employees to fly business class for particularly long flights (over 10 hours, for example). Such policies would be acceptable if applied uniformly and if reasonable. A policy that permitted business class for flight over two hours would almost certainly be considered unreasonable.

Is a retreat reasonable and necessary?

What about charging the costs of an out-of-town meeting for the staff of an organization to a grant? Let us assume, for purposes of this example, that the meeting is necessary for the efficient delivery of grant services. It could be argued that, to assure uninterrupted training, holding the meeting at a location other than the grantee’s place of business is necessary.

But, if a federal reviewer finds that the costs or the location selected is inappropriate, then the costs may be disallowed as unreasonable and not necessary to properly administer the federal award.

An inappropriate venue for a mainland organization to hold a meeting would be Honolulu or a five-star hotel.

Are government employees supposed to suffer?

The rules do not expect grantees to suffer the use of poor-quality equipment, beg for supplies on the street corner, or work for food. The rules simply require the wise use of federal award funds by grantees. The delivery of grant services should always be paramount but within the constraints of the cost principles.

The newspaper test

One guideline that often is used is the “Washington Post” test (or substitute the name of your local newspaper). If the paper got word of what you were doing, would they report it on one of the first three pages? They don’t put the good news on those pages. If the newspaper were to consider it reportable, then it wouldn’t consider the cost to be reasonable. That “prudent person” probably wouldn’t consider it reasonable either.

The ‘giggle’ test

There are other similar tests. The “red-face” test asks whether you can explain the cost without blushing. The “giggle” test asks whether people start to giggle as they explain why the cost is acceptable.

I often use the giggle test when I am teaching a class. A student will ask about the acceptability of a cost with which he is clearly not comfortable. I sometimes pretend not to have understood the question and ask the student to ask it again. The second time the student starts to smile as he asks the question. I will then point out that he is failing the giggle test. These costs are not allowable.

For more on these topics:

Uniform Guidance Cost Principles

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