FAR 31.205-26—Material costs.
Plain-English Summary
FAR 31.205-26 explains how contractors must identify, measure, and allocate material costs when those costs are claimed as allowable contract costs. It covers what counts as material costs, including raw materials, parts, subassemblies, components, manufacturing supplies, and related collateral items such as inbound transportation and in-transit insurance. It also addresses how to treat overruns, spoilage, defective work, credits and offsets such as discounts, rebates, scrap, salvage, and returns, as well as inventory adjustments between physical and book counts. The section further explains how to price materials issued from stores, how to handle interorganizational transfers between commonly controlled entities, and when transferred items may be priced at something other than cost. For commercial products and services transferred at catalog or market price, it adds rules for quantity-based adjustments and possible modification-cost adjustments. In practice, this section is important because it determines whether material charges are properly supported, consistently priced, and free of double counting or inflated costs, which directly affects cost allowability, billing, and audit risk.
Key Rules
What counts as material costs
Material costs include raw materials, parts, subassemblies, components, and manufacturing supplies, whether purchased or manufactured by the contractor. They may also include related collateral items such as inbound transportation and in-transit insurance.
Account for overruns and spoilage
When computing material costs, the contractor must consider reasonable overruns, spoilage, and defective work unless another contract provision on inspecting and correcting defective work says otherwise. The key test is reasonableness and whether another clause already governs the loss.
Reduce costs by credits
Material costs must be adjusted for income and other credits, including trade discounts, refunds, rebates, allowances, cash discounts, and credits for scrap, salvage, and returned material. These credits must be recognized so the Government is not charged for amounts the contractor recovered or should have recovered.
Choose a proper credit method
Credits may be applied directly to the material cost or allocated as a credit to indirect costs. If the contractor can show that not taking a cash discount was reasonable, the contractor does not have to credit the lost discount.
Use inventory adjustments carefully
Reasonable differences between periodic physical inventories and book inventories may be included in cost, but only if the adjustments relate to the contract performance period. Inventory write-ups or write-downs outside the performance period are not covered by this rule.
Charge specifically purchased materials at actual cost
If materials are purchased specifically for and identifiable solely with a contract, the actual purchase cost should be charged to that contract. If materials are issued from stores, any generally recognized pricing method is acceptable if it is consistently applied and produces equitable results.
Price interorganizational transfers at cost by default
Materials, supplies, and services transferred between commonly controlled divisions, subsidiaries, or affiliates must generally be allowed at cost incurred under this subpart. This prevents profit loading within a controlled corporate family unless an exception applies.
Limited exceptions allow transfer price
A transfer may be allowed at price if the transferring organization’s established commercial practice is to use other-than-cost pricing and the item qualifies for an exception under FAR 15.403-1(b), provided the contracting officer has not found the price unreasonable. Both conditions must be met.
Adjust catalog or market prices
For commercial products or services transferred at a catalog or market price, the contractor should adjust the price to reflect the quantities being acquired. The contractor may also adjust the price to reflect the actual cost of modifications required by the contract.
Responsibilities
Contractor
Identify material costs correctly, include allowable collateral items, and ensure costs are reasonable and properly supported. The contractor must reduce material costs by applicable credits, apply a consistent and equitable inventory pricing method, and use cost-based pricing for interorganizational transfers unless a valid exception applies.
Contracting Officer
Review claimed material costs for allowability and reasonableness, including whether credits were properly taken, whether inventory adjustments are tied to the performance period, and whether any interorganizational transfer price exception is justified. The contracting officer may also determine that a claimed transfer price is unreasonable.
Auditors or DCAA
Examine whether material costs are properly adjusted for discounts, rebates, scrap, salvage, returns, and inventory differences, and whether the contractor’s pricing methods are consistently applied. They also assess whether intercompany transfers comply with the cost principle and whether commercial pricing adjustments are appropriate.
Commonly Controlled Affiliates or Divisions
When transferring materials, supplies, or services within the controlled corporate structure, these entities must generally support transfers at cost unless the commercial-practice and exception requirements for pricing at other than cost are met.
Practical Implications
This section is a frequent audit issue because material cost claims often include hidden markups, unclaimed credits, or inconsistent inventory pricing methods. Contractors should maintain clear documentation showing how each material charge was derived and how credits were applied.
Failure to net out discounts, rebates, scrap, salvage, and vendor returns can overstate allowable costs and create questioned costs. Contractors should have a routine process to capture and post these credits promptly.
Intercompany transfers are especially sensitive: if a parent, subsidiary, or affiliate charges more than cost without meeting the exception requirements, the excess may be unallowable. Contractors should verify whether the transfer item qualifies under FAR 15.403-1(b) and whether the pricing practice is truly established for commercial work.
Inventory adjustments must be tied to the contract performance period. Large year-end physical inventory variances that are not well explained or not linked to the right period can be disallowed or reclassified.
For materials issued from stores, consistency matters as much as the pricing method itself. A method that is generally recognized but applied inconsistently can still be challenged as inequitable or unsupported.
Official Regulatory Text
(a) Material costs include the costs of such items as raw materials, parts, subassemblies, components, and manufacturing supplies, whether purchased or manufactured by the contractor, and may include such collateral items as inbound transportation and in-transit insurance. In computing material costs, the contractor shall consider reasonable overruns, spoilage, or defective work (unless otherwise provided in any contract provision relating to inspecting and correcting defective work). (b) The contractor shall- (1) Adjust the costs of material for income and other credits, including available trade discounts, refunds, rebates, allowances, and cash discounts, and credits for scrap, salvage, and material returned to vendors; and (2) Credit such income and other credits either directly to the cost of the material or allocate such income and other credits as a credit to indirect costs. When the contractor can demonstrate that failure to take cash discounts was reasonable, the contractor does not need to credit lost discounts. (c) Reasonable adjustments arising from differences between periodic physical inventories and book inventories may be included in arriving at costs; provided such adjustments relate to the period of contract performance. (d) When materials are purchased specifically for and are identifiable solely with performance under a contract, the actual purchase cost of those materials should be charged to the contract. If material is issued from stores, any generally recognized method of pricing such material is acceptable if that method is consistently applied and the results are equitable. (e) Allowance for all materials, supplies and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred in accordance with this subpart. However, allowance may be at price when- (1) It is the established practice of the transferring organization to price interorganizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate of the contractor under a common control; and (2) The item being transferred qualifies for an exception under 15.403-1 (b) and the contracting officer has not determined the price to be unreasonable. (f) When a commercial product or commercial service under paragraph (e) of this section is sold or transferred at a price based on a catalog or market price, the contractor— (1) Should adjust the price to reflect the quantities being acquired; and (2) May adjust the price to reflect the actual cost of any modifications necessary because of contract requirements.