Before explaining the Cost Plus Method, a summary of why certain Methods are chosen must be given. Also, please read the previous articles regarding Transfer Pricing principles before reading these Method articles.
The selection of a transfer pricing method serves to find the most appropriate method for a particular case. Considerations involved in selecting a method can include:
a. the respective strengths and weaknesses of each method;
b. the nature of the controlled transaction;
c. the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method; and
d. the degree of comparability between the controlled and uncontrolled transactions.
Cost Plus Method
In a controlled transaction involving tangible property, the Cost Plus Method focuses on the related manufacturing company as the tested party in the transfer pricing analysis. The Cost Plus Method may also be used in the case of services rendered.
The Cost Plus Method begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus markup is then added to this cost, to make an appropriate gross profit in light of the functions performed, risks assumed, assets used, and market conditions.
The Cost Plus Method is used to analyse transfer pricing issues involving tangible property or services. It is typically most applied to manufacturing or assembling activities and relatively simple service providers. The Cost Plus Method focuses on the related party manufacturer or service provider as the tested party in the transfer pricing analysis. The method evaluates the arm’s‐length nature of an inter-company charge by reference to the gross profit markup on costs incurred by suppliers of property (or services) for tangible property transferred (or services provided). It compares the gross profit markup earned by the tested party for manufacturing the product or for providing the service to the gross profit mark‐ups earned by comparable companies.
Like the Resale Price Method, the Cost Plus Method is a gross margin method; that is, it attempts to derive an arm’s length amount of gross profit, in this case through an arm’s length markup on the cost of goods sold.
The Cost Plus Method does not directly test whether the transfer price is at arm’s length by comparing prices. As such, it is a less direct (transactional) method as compared to the CUP Method.
Mechanism of the Cost Plus Method
Under the Cost Plus Method (when applied to sales of tangible property) an arm’s‐length price equals the controlled party’s cost of producing the tangible property plus an appropriate gross profit markup, defined as the ratio of gross profit to cost of goods sold (excluding operating expenses) for a comparable uncontrolled transaction.
The formula for the transfer price in inter-company transactions of products is as follows: TP = COGS x (1 + cost plus mark‐up), where:
TP = the Transfer Price of a product sold between a manufacturing company and a related company;
COGS = the Cost of Goods Sold to the manufacturing company; and
Cost plus markup = gross profit mark‐up defined as the ratio of gross profit to cost of goods sold. Gross profit is defined as sales minus the cost of goods sold.
Arm’s Length Gross Profit Mark‐up for Cost Plus Method
The financial ratio considered under the Cost Plus Method is the gross profit markup, which is defined as the gross profit to cost of goods sold ratio of a manufacturing company. As discussed above, gross profit equals net sales minus cost of goods sold. For a manufacturing company, the cost of goods sold equals the cost of producing the goods sold. It includes direct labour costs, direct material costs, and factory overheads associated with production.
As with the Resale Price Method, accounting consistency is extremely important in applying the Cost Plus Method. Application of different accounting principles to controlled and uncontrolled transactions may result in inconsistent calculation of the gross profit. Appropriate adjustments of accounting principles may be necessary to ensure that gross profit mark‐ups are calculated uniformly for the tested party and the comparable companies. For example, the comparable manufacturers may differ from the related party manufacturer in reporting certain costs (e.g. costs of R&D) as operating expenses or as cost of goods sold. Differences in inventory valuation methods will also affect the computation of the gross profit markup.
The costs and expenses of a company normally fall into the following three groups: (1) direct cost of producing a product or service (e.g. cost of raw materials); (2) indirect costs of production (e.g. costs of a repair department that services equipment used to manufacture different products); and (3) operating expenses. The gross profit margin used in the Cost Plus Method is a profit margin that is calculated by subtracting only the direct and indirect costs of production from the sales price. In contrast, a net margin analysis would also consider operating expenses. Due to differences in accounting standards between countries, the boundaries between the three groups of costs and expenses are not the same in each and every case. Suitable adjustments may need to be made. In a situation in which it is necessary to consider certain operating expenses to obtain consistency and comparability, a net margin method will typically be more reliable than the Cost Plus Method.
Strengths and Weaknesses
The strength of the Cost Plus Method is that the method is based on internal costs, the information on which is usually readily available to the multinational enterprise.
The weaknesses of the Cost Plus Method include the following:
- There may be a weak link between the level of costs and the market price;
- The data on markup gross margins may not be comparable due to accounting inconsistencies and other factors;
- Accounting consistency is required between the controlled and uncontrolled transactions;
- The analysis focuses only on the related party manufacturer; and
- Since the method is based on actual costs, there may be no incentive for the controlled manufacturer to control costs.
When to Use the Cost Plus Method
The Cost Plus Method is typically applied in cases involving the inter-company sale of tangible property where the related party manufacturer performs limited manufacturing functions or in the case of intra-group provision of services. The method usually assumes the incurrence of low risks, because the level of the costs will then better reflect the value being added and hence the market price.
The Cost Plus Method is also generally used in transactions involving a contract manufacturer, a toll manufacturer, or a low-risk assembler that does not own product intangibles and incurs little risk. The related customer involved in the controlled transaction will generally be much more complex than the contract manufacturer in terms of functions performed (e.g. conducting marketing and selling functions, coordination of production and sales, giving instructions to the contract manufacturer about the quantity and quality of production, and purchasing raw materials in some cases), risks incurred (e.g. market risk, credit risk, and inventory risk) and assets owned (product intangibles). The contract manufacturer is thus the less complex and as such should be the tested party in the transfer pricing analysis.
The Cost Plus Method is usually not a suitable method to use in transactions involving a fully-fledged manufacturer which owns valuable product intangibles as it will be very difficult to locate independent manufacturers owning comparable product intangibles. That is, it will be hard to establish a profit markup that is required to remunerate the fully‐fledged manufacturer for owning the product intangibles. In a typical transaction structure involving a fully‐fledged manufacturer and related sales companies (e.g. commissionaires), the sales companies will normally be the least complex entities involved in the controlled transactions and will therefore be the tested party in the analysis. The Resale Price Method is typically more easily applied in such cases.
This concludes Method 3; the Cost Plus Method. The next article will deal with the Transactional Net Margin Method.