What Makes Up a Cost? Composition of Cost Under 2 CFR 200 (Sections 402 - 406)
If you manage federal grants, you've heard the phrase "composition of cost" thrown around in audits, budget narratives, and compliance trainings. But what does it actually mean, and why does it matter so much when you're reconciling an award or preparing for an audit?
In short: composition of cost is the uniform guidance framework (2 CFR 200, Subpart E, Sections 402 - 406) that determines how a cost is built and whether it can be charged to a federal award. It covers five interlocking rules: the total cost formula, allowability, reasonableness, allocability, and applicable credits. Every dollar charged to a federal grant has to satisfy all of them.
This post breaks down each section in plain language so you can apply it to your organization's day-to-day grants management.
The Total Cost Formula (2 CFR 200.402)
Every federal award budget comes back to one simple equation:
Total Cost = Direct Costs + Applicable Indirect Costs − Applicable Credits
That's the entire foundation of Subpart E. If an expense doesn't fit into one of these three categories, it doesn't belong in your total award cost. Section 402 also reinforces three baseline requirements for every cost charged to a grant:
It must be allowable
It must be properly classified as direct or indirect
It must be adjusted for applicable credits when they apply
Most compliance problems don't come from a "bad" expense. They come from a cost that was misclassified or calculated incorrectly, such as an indirect cost rate applied inconsistently across the organization.
Allowability: The Gatekeeper Test (2 CFR 200.403)
Before a cost can be charged to an award, it has to pass an allowability checklist. Under 2 CFR 200.403, a cost is allowable only if it meets all of the following:
It is necessary and reasonable for the project
It conforms to the award's terms and conditions and uniform guidance limits
It is consistent with your organization's policies
It receives consistent treatment as either a direct or indirect cost across the organization
It is accounted for in accordance with GAAP
It is not charged to more than one federal award (no double-dipping)
It is adequately documented
If a cost fails even one of these tests, it becomes unallowable, regardless of how well-intentioned the expense was or how directly it supported the project.
Reasonableness: Would a Prudent Person Approve It? (2 CFR 200.404)
A cost is considered reasonable if it does not exceed what a prudent person would have paid under the same circumstances, at the time the decision to incur the cost was made. Key factors include:
Whether the cost is ordinary and necessary for the project
Whether it aligns with market prices for comparable goods or services
Whether it reflects sound business practices
Whether it's consistent with your organization's written policies and procedures
Reasonableness is judged based on what was known at the time the decision was made, not in hindsight. That makes documentation critical: if an auditor ever questions a cost, your contemporaneous records are what prove the decision was sound.
Allocability: Can the Cost Be Tied to the Award? (2 CFR 200.405)
A cost is allocable to a federal award if it can be assigned in proportion to the benefit the award receives. Under Section 405, a cost qualifies as allocable if it is:
Incurred specifically for that award, or
Beneficial to multiple activities but reasonably distributable in proportion to benefits received, or
Necessary to overall operations and assignable in part to the award
Section 405 is also explicit about what allocability is not: you cannot shift costs between awards simply to solve a budget shortfall or dodge a restriction. Any allocation must be reasonable, documented, and defensible if questioned
Applicable Credits: Don't Forget to Net Them Out (2 CFR 200.406)
Applicable credits are transactions that reduce the cost charged to a federal award. Common examples include:
Purchase discounts
Rebates or refunds
Insurance recoveries
Adjustments for overpayments or billing errors
If a credit relates to an allowable cost, it must be credited back to the award, either as a direct cost reduction or a cash refund. Overlooking applicable credits is one of the most common (and most avoidable) compliance gaps organizations run into.
Why Sections 402 - 406 Work as a Package
These five sections aren't standalone rules. They function together as a single compliance framework:
200.402 governs the total cost formula and classification
200.403 governs allowability, the gatekeeper checklist
200.404 governs reasonableness, the prudent-person test
200.405 governs allocability, proportional benefit to the award
200.406 governs applicable credits, reducing the final charge
Miss one piece, and the structure starts to break down. A cost can be reasonable and allocable but still unallowable if it's inconsistently classified. It can be allowable but non-compliant if applicable credits were never netted out.
Frequently Asked Questions
What is composition of cost under 2 CFR 200?
Composition of cost refers to how a federal award's total cost is built: direct costs plus applicable indirect costs, minus applicable credits, as defined in 2 CFR 200.402.
What makes a cost allowable under the uniform guidance?
A cost is allowable under 2 CFR 200.403 if it is necessary, reasonable, consistent with organizational policy and GAAP, consistently classified, not double-charged across awards, and properly documented.
How is "reasonable cost" defined in 2 CFR 200.404?
A cost is reasonable if it reflects what a prudent person would pay under the same circumstances at the time the decision was made, judged against market prices and sound business practices, not hindsight.
What does "allocable" mean for a grant cost?
Under 2 CFR 200.405, a cost is allocable if it can be assigned to a federal award in proportion to the benefit that award receives, whether incurred specifically for the award or distributed across multiple benefiting activities.
What are applicable credits in grants management?
Applicable credits (2 CFR 200.406) are discounts, rebates, refunds, insurance recoveries, or error adjustments that must be netted against the cost charged to a federal award.
Composition of cost isn't just a technical formula. It's the backbone of grants compliance. Every expense charged to a federal award has to be allowable, reasonable, allocable, and adjusted for applicable credits before it belongs in your total cost calculation. Getting this right protects your organization at audit time and builds the internal controls that make grants management sustainable.
I go into even more real-world examples and practical tips for applying these rules in Season 3, Episode 2 of my podcast, Grants Management Experts: "What Makes Up a Cost? Composition of Costs (200.402–200.406)." Tune in wherever you get your podcasts.
