Transfer Pricing-Traditional Transaction Methods: Cost Plus Method 

Introduction: Dive into the fundamentals of the Cost Plus Method, a crucial tool in transfer pricing for controlled transactions. Understand its application in sales of tangible property and services, along with the methodology focusing on costs, mark-ups, and comparability.

1. Introduction to Cost Plus Method

– Overview: 

• The Cost-Plus Method is a traditional transaction method applied in controlled transactions, primarily focusing on the related manufacturing company when dealing with the sale of tangible property. 
• In the case of services, the service provider becomes the designated tested party. 

– Methodology: 

• The Cost-Plus Method initiates by examining the costs incurred by the supplier (manufacturer or service provider) in a controlled sale to a related party. 
• An appropriate cost-plus mark-up is then added to these costs, considering factors such as functions performed, risks assumed, assets used, and prevailing market conditions. 

– Applicability: 

• The Cost-Plus Method finds common application in the analysis of transfer pricing concerning tangible property or services. 
• It is typically employed in scenarios involving manufacturing, assembling activities, and relatively straightforward service providers. 
• The method evaluates the arm’s length nature of an intragroup charge by comparing the gross profit mark-up on costs earned by the tested party to the mark-ups earned by independent suppliers in comparable uncontrolled transactions. 

Key Considerations:

• Manufacturing and Assembling Activities: The method is well-suited for transactions involving the production or assembly of goods. 
• Service Providers: Relatively simple service providers are considered under this method. 
• Comparability: The analysis involves comparing the gross profit mark-ups of the tested party to those earned by comparable independent companies engaged in similar transactions.
• Functions, Risks, and Assets: The determination of an appropriate mark-up considers the functions performed, risks assumed, and assets used by the tested party. 

Cost Plus Method

Associated Enterprise 1———————————————> Associated Enterprises 2

Arms Length Price ?

Cost Of Associated Enterprise 1	500
+ Gross Profit Mark up (50%)	250
Arm’s Length Price	750

Application of Cost Plus Method:

Scenario Overview: 

• Assuming Cost of Goods Sold (COGS) as in above Figure is $500. 
• Arm’s length gross profit mark-up for Associated Enterprise 1, based on identified comparable, is 50%. 

Transfer Price Calculation: 

• The Cost Plus Method, akin to the Resale Price Method, operates as a gross margin method. 
• It aims to establish an arm’s length gross profit by applying a mark-up to COGS. 
• In this case, the calculated transfer price between Associated Enterprise 1 and Associated Enterprise 2 is $750 (i.e., $500 x (1 + 0.50)). 

Explanation:

• Associated Enterprise 1, an electrical goods manufacturer in Country 1, produces goods under contract for Associated Enterprise 2. 
• Associated Enterprise 2 provides instructions regarding the quantity and quality of the goods, guaranteeing sales to Associated Enterprise 1 and assuming minimal risk.
• The analysis designates Associated Enterprise 1 as the tested party due to its simpler functions, fewer assets, and lower risks compared to Associated Enterprise 2.
• The Cost Plus Method becomes the preferred analysis method in this scenario, focusing on the arm’s length gross profit mark-up earned by Associated Enterprise 1.
• As a simple manufacturer, the Cost Plus Method assesses whether the gross profit mark-up aligns with arm’s length standards by referencing margins earned by comparable entities providing goods or services to unrelated parties.
• Notably, the Cost Plus Method does not directly compare prices; instead, it indirectly assesses the arm’s length nature of the transfer price by evaluating gross profit margins.

Method Characteristics: 

• Focus on Gross Profit: The method centers on deriving an arm’s length gross profit through a mark-up on COGS.
• Less Direct (Transactional): Unlike the Comparable Uncontrolled Price (CUP) Method, the Cost Plus Method is less transactional and does not directly compare prices. 

2. Mechanism of the Cost Plus Method:

Overview: 

• The Cost Plus Method, when applied to sales of tangible property, establishes an arm’s length price by adding an appropriate gross profit mark-up to the controlled party’s cost of producing the tangible property.
• The mark-up is determined by referencing the ratio of gross profit to the cost of goods sold (COGS) in comparable uncontrolled transactions.

Transfer Price Formula:

The formula for calculating the transfer price in inter-company transactions involving products is expressed as:

TP=COGS×(1+Cost Plus Mark-up) 

Key Variables: 

TP (Transfer Price): Represents the arm’s length price for a product sold between a manufacturing company and a related company. 

COGS (Cost of Goods Sold): Signifies the cost incurred by the manufacturing company in producing the tangible property. 

Cost Plus Mark-up: Denotes the gross profit mark-up, defined as the ratio of gross profit to the cost of goods sold in comparable uncontrolled transactions. 

Gross profit is defined as net sales minus cost of goods sold, focusing solely on the direct production costs and excluding operating expenses. 

Application Steps: 

• Identify COGS: Determine the cost of goods sold (COGS) incurred by the manufacturing company in producing the tangible property. 

• Determine Cost Plus Mark-up: 

i. Reference comparable uncontrolled transactions to identify the appropriate gross profit mark-up. 

ii. Calculate the mark-up as the ratio of gross profit to COGS in these comparable transactions. 

• Calculate Transfer Price: Apply the formula to calculate the arm’s length transfer price by multiplying COGS with (1+Cost Plus Mark-up). 

Significance of the Cost Plus Method: 

• The method ensures that the manufacturing company is remunerated adequately by considering the gross profit earned in comparable transactions. 
• By focusing on the gross profit margin, it aims to align the transfer price with the arm’s length principle, accounting for the functions performed, risks assumed, assets used, and prevailing market conditions. 

3. Arm’s Length Gross Profit Mark-up for Cost Plus Method:

– Introduction: 

• The Cost Plus Method evaluates the arm’s length nature of intragroup charges by focusing on the gross profit mark-up, defined as the ratio of gross profit to cost of goods sold (COGS) incurred by the supplier of products or services in a controlled transaction. 

– Gross Profit Definition: 

• Gross profit, within this context, is the difference between net sales and COGS.
• For manufacturing companies, COGS encompasses direct labor costs, direct material costs, and factory overheads associated with production.

– Consistency in Accounting: 

• Similar to the Resale Price Method, accounting consistency is crucial in applying the Cost Plus Method. 
• Consistent calculation of gross profit mark-ups for the tested party and comparable companies requires adjustments for potential differences in accounting principles. 
• For instance, variations in reporting certain costs (e.g., research and development costs) or differences in inventory valuation methods impact the uniform computation of the gross profit mark-up. 

– Costs and Expenses Categories: 

Costs and expenses generally fall into three groups: 

• Direct cost of producing a product or service (e.g., cost of raw materials). 
• Indirect costs of production (e.g., costs of a repair department servicing equipment used for various products). 
• Operating expenses (e.g., selling, general & administrative expenses or SG&A expenses). 

Gross Profit Margin Calculation:

• The gross profit margin used in the Cost Plus Method considers only the direct and indirect costs of production, excluding operating expenses. 
• In contrast to a net margin analysis that includes operating expenses, the gross profit margin focuses on core production costs. 
• Differences in accounting standards may necessitate adjustments to ensure consistency and comparability between the tested party and comparable companies. 

Consideration of Net Margin Method: In cases where it’s essential to consider certain operating expenses for consistency and comparability, a net margin method might be more reliable than the Cost Plus Method. 

– Example: Accounting Consistency Issue 

Scenario: 

• Associated Enterprise 1 (AE1): A bicycle manufacturer producing bicycles for Associated Enterprise 2 (AE2) under a contract. 
• Gross Profit Mark-up: AE1 earns a gross profit mark-up of 15% on its cost of goods sold (COGS). 
• Expense Classification: AE1 classifies certain expenses, like warranty expenses, as operating expenses, separate from COGS. 

Comparable Independent Manufacturers: 

• Four comparable independent manufacturers are identified with gross profit mark-ups ranging between 10% and 15%. 
• Expense Treatment: These comparables include warranty expenses in COGS, unlike AE1. 

Issue: 

• The unadjusted gross profit mark-ups of comparables and AE1 are not calculated based on the same cost components. 
• Specifically: Warranty expenses are treated differently – part of operating expenses for AE1 and part of COGS for comparables. 

– Challenge: 

• Consistency Challenge: Lack of uniformity in cost components used for calculating gross profit mark-ups hinders direct comparison. 

– Proposed Solutions: 

• Reliable Adjustments: If reliable adjustments can be made to align the calculation of gross profit mark-ups for uncontrolled transactions and AE1, the Cost Plus Method could still be viable. 
• Net Margin Method: In the absence of reliable adjustments, adopting a net margin method may provide a more reliable approach. This method would consider all relevant operating expenses, including warranties, providing a holistic view of profitability. 

4. Transactional Comparison Versus Functional Comparison

– Introduction: 

• The determination of an arm’s length price or margin for a controlled transaction can be achieved through either a functional comparison or a transactional comparison. 
• Comparable Functionality: This involves looking at manufacturers engaged in broadly similar types of products. 
• Transactional Comparison: Analyzing each transaction the tested party undertakes concerning comparable products, such as the manufacturing of different types of bicycles. 

– Establishing Arm’s Length Gross Profit Mark-up(s): 

Arm’s length gross profit mark-ups can be determined through: 

• Transactional Comparison: Examining the gross profit mark-up earned by the related party manufacturer when selling goods to an independent enterprise in a comparable uncontrolled transaction. This may involve initially rejected internal comparables due to product differences, which are still considered broadly similar. 
• Functional Comparison: Analyzing the gross profit mark-ups earned by independent companies engaged in functions and risks comparable to those of the related party manufacturer. This approach involves searching for comparable manufacturing companies. 

– Practical Considerations: 

• Transactional Comparisons Advantages: 

a) More likely to achieve broad product and accounting consistency required for the Cost Plus Method. 

b) Availability of detailed information about controlled and uncontrolled transactions, including contractual terms. 

• Functional Comparisons Challenges: 

a) Relies on publicly available databases and annual reports, providing less specific information on functions and risks. 

b) Higher likelihood of using a net margin method due to limited data. 

-Arm’s Length Range Determination: 

• Benchmarking and financial analyses are conducted to establish an arm’s length range of gross profit mark-ups earned by comparable independent manufacturers. 
• If the related party manufacturer’s gross profit mark-up falls within this range, its transfer price is considered arm’s length. 

5. Comparability

– Criteria for Comparability: 

An uncontrolled transaction is deemed comparable to a controlled transaction under the Cost Plus Method if: 

• There are no material differences between the transactions being compared that significantly affect the gross profit mark-up. 
• Reasonably accurate adjustments can be performed to eliminate the effect of such differences. 

– Importance of Functional Comparability: 

• Similar to the Resale Price Method, close product similarity is less critical under the Cost Plus Method than the Comparable Uncontrolled Price (CUP) Method. 
• Functional comparability, including risks assumed and assets used, becomes more crucial. 
• While significant differences in products may be tolerated, they should ideally involve the provision of similar services or manufacturing of products within the same product family. 

– Necessity of Functional Comparability: 

• The gross profit mark-up compensates a manufacturing or service company for its functions. 
• The Cost Plus Method requires functional comparability. 
• If there are material differences in functions, assets, or risks affecting gross profit mark-ups in controlled and uncontrolled transactions, adjustments should be made. 
• Comparability adjustments are generally performed on the gross profit mark-ups of uncontrolled transactions. 
• Operating expenses related to functions performed may need consideration as service providers might lack Cost of Goods Sold (COGS). 

6. Determination of Costs

– Challenges in Determining Costs: 

• Weak Link Between Costs and Market Price: The link between costs incurred and market prices can be weak, resulting in significant variations in gross profit margins annually. 

• Comparable Mark-up to Comparable Cost Base: It is crucial to apply a comparable mark-up to a comparable cost base, ensuring consistency and reliability in the analysis. 

• Identification of Differences: 
  • Differences between the tested party and potential comparable should be identified. 
  • Consider differences in the level and types of expenses related to functions performed, assets used, or risks assumed. 
  • If differences reflect differing efficiencies without additional functions, no adjustment to the gross profit mark-up is necessary. 
  • Additional returns may be warranted for unique functions performed by the tested party or comparables. 
• Exclusion of Certain Costs:
  • Careful consideration is required to determine which costs should be excluded from the cost base. 
  • Example: Costs passed-through (explicitly not subject to mark-up) in both tested party and comparable transactions should be excluded. 
• Accounting Consistency: Consistency in accounting practices is crucial for calculating gross profit mark-ups uniformly for associated and independent enterprises. 

• Attribution of Historical Costs: 
  • Historical costs should ideally be attributed to individual units of production. 
  • If costs vary over a period, average costs over that period may be used. 
• Use of Budgeted or Actual Costs: 
  • The Cost Plus Method allows for the use of either budgeted or actual costs. 
  • Actual costs reflect the risks faced by a contract manufacturer but may differ from market practices where budgeted costs are typically used. 
• Allocation of Costs: 
  • The allocation of costs between the manufacturer or service provider and the purchaser can be challenging. 
  • Careful consideration is needed to appropriately allocate costs and avoid distortions in the Cost Plus Method analysis. 

7. Strengths and Weaknesses of the Cost Plus Method

– Strengths: 

• Basis on Internal Costs: 
  • The method relies on internal costs, which are typically readily available within the multinational enterprise. 
  • Internal cost information is generally easier to access compared to external market data. 

– Weaknesses: 

• Weak Link Between Costs and Market Price: 
  • There might be a weak link between the level of costs incurred and the actual market price. 
  • Market dynamics, demand, and other external factors can influence prices independently of the production costs. 
• Data Comparability Issues: 
  • Data on gross profit mark-ups may lack comparability due to accounting inconsistencies and other factors. 
  • Differences in accounting practices and treatment of certain costs may hinder accurate benchmarking. 
• Accounting Consistency Requirement: 
  • Accounting consistency is crucial between the controlled and uncontrolled transactions for reliable results. 
  • Differences in accounting methods may lead to inconsistent calculations of gross profit mark-ups. 
• One-Sided Analysis: 
  • The analysis is one-sided, focusing exclusively on the related party manufacturer or service provider. 
  • It may not capture the broader market dynamics or conditions affecting pricing. 
• Incentive for Cost Control: 
  • Since the method is based on actual costs, there may be little incentive for the controlled manufacturer to control costs. 
  • This could potentially result in inflated costs and affect the reliability of the Cost Plus Method. 
• Market Price Influence: The method assumes that the gross profit mark-up derived from comparable uncontrolled transactions is appropriate for the tested party. 

However, the market price might not be solely determined by costs, impacting the reliability of the method. 

8. When to Use the Cost Plus Method

– Typical Applications: 

• Intragroup Sale of Tangible Property: 
  • The Cost Plus Method is commonly applied in cases involving the intragroup sale of tangible property. 
  • It is suitable when the related party manufacturer performs limited manufacturing functions. 
• Intragroup Provision of Services: 
  • Applied in cases of intragroup provision of services where the service provider has limited risks. 
  • Assumes that the costs incurred by the service provider better reflect the value added and, consequently, the market price. 

– Applicability to Specific Scenarios: 

• Contract Manufacturing: 
  • Suited for transactions involving contract manufacturers, toll manufacturers, or low-risk assemblers. 
  • Typically used when the manufacturer does not own valuable product intangibles and assumes minimal risks. 
• Complexity and Risk Considerations: 
  • Suitable when the customer involved in the controlled transaction is more complex. 
  • The manufacturer or service provider assumes low risks compared to the customer, making costs a more reliable indicator. 

– Limitations and Inapplicability: 

• Fully-Fledged Manufacturers with Valuable Intangibles: 
  • Generally unsuitable for transactions involving fully-fledged manufacturers with unique and valuable product intangibles. 
  • Difficult to find independent manufacturers with comparable intangibles, making it challenging to establish an appropriate profit mark-up. 
• Complex Transaction Structures: 
  • Not ideal for transactions involving a fully-fledged manufacturer with complex structures and valuable intangibles. 
  • Challenges in locating comparable independent manufacturers in such intricate scenarios. 
• Risk and Intangible Asset Ownership: 
  • When the fully-fledged manufacturer owns or develops unique and valuable product intangibles, the method may not be appropriate. 
  • Difficulty in establishing a comparable profit mark-up to adequately remunerate the manufacturer for its valuable intangibles. 

Example 1: 

Background: 

• Entities Involved: 
  • LCO: Domestic manufacturer of computer components. 
  • FS: Foreign distributor purchasing products from LCO. 
  • UT1, UT2, UT3: Domestic computer component manufacturers selling to uncontrolled foreign purchasers. 

Scenario:

Controlled Transaction: LCO sells computer components to its foreign distributor, FS. 

Uncontrolled Comparables: UT1, UT2, UT3 are uncontrolled manufacturers selling to foreign purchasers. 

Data Availability:

• Functions, Assets, Risks: 
  • Comprehensive data on functions, assets, and risks of UT1, UT2, UT3. 
  • Contractual terms in uncontrolled transactions are well-documented. 
• Accounting Consistency: Data ensures accounting consistency between LCO and uncontrolled manufacturers. 

Comparability Assessment:

Material Differences: All material differences between the controlled and uncontrolled transactions are identified. 

Reliable Adjustments: Reliable adjustments are made to account for the identified differences. 

Conclusion:

Arm’s Length Range: The available data allows for the establishment of an acceptable range of arm’s length cost-plus mark-ups. 

Example 2: 

Background: 

• Entities Involved: 
  • LCO: Domestic manufacturer of computer components. 
  • FS: Foreign distributor purchasing products from LCO. 
  • UT1, UT2, UT3: Uncontrolled domestic computer component manufacturers. 

Scenario: 

Controlled Transaction: LCO sells computer components to its foreign distributor, FS. 

Data Availability: 

• Functions, Assets, Risks: Detailed data on functions, assets, and risks of UT1, UT2, UT3.
• Contractual Terms: Clear understanding of contractual terms in uncontrolled transactions.
• Accounting Consistency: 
  • LCO accounts for supervisory, general, and administrative costs as operating expenses not allocated to sales to FS. 
  • UT1, UT2, UT3 include these costs in the cost of goods sold, reflecting in their gross profit mark-ups. 

Comparability Assessment:

• Material Differences: Material difference in accounting treatment regarding supervisory, general, and administrative costs. 
• Adjustments for Consistency: Adjustment required for accounting consistency between LCO and uncontrolled manufacturers (UT1, UT2, UT3). 

Challenges:

• Insufficient Data on Accounting Differences: 

• Data may not be sufficient to determine whether accounting differences exist between the controlled and uncontrolled transactions. 

Impact on Reliability: 

Diminished Reliability: If data insufficiency persists, the reliability of the results may be diminished due to uncertainties in accounting consistency. 

Conclusion:

• Adjustment Consideration: 
  • Consideration should be given to adjusting the gross profit mark-ups of UT1, UT2, UT3 for accounting consistency with LCO. 
  • If data inadequacies persist, reliance on the method’s results may be affected. 

Example 3:

Background:

• Entities Involved: 
  • LCO: Domestic manufacturer of computer components. 
  • FS: Foreign distributor purchasing products from LCO. 
  • UT1, UT2, UT3: Uncontrolled domestic computer component manufacturers. 

Scenario: 

Controlled Transaction: LCO sells computer components to its foreign distributor, FS. 

Material Difference:

• Materials Consigned:
  • LCO, under its contract with FS, uses materials consigned by FS. 
  • UT1, UT2, UT3 purchase their own materials, and their gross profit mark-ups include the costs of materials. 

Risk Assessment:

• Inventory Risk:
  • LCO does not carry an inventory risk by using consigned materials. 
  • Uncontrolled producers (UT1, UT2, UT3) carry inventory risk as they purchase their own materials. 

Adjustment Consideration:

• Significant Difference: The difference in inventory risk is significant and may materially affect the gross profit mark-ups. 
• Adjustment Requirement: Adjustment may be necessary to account for the material effect of the difference in inventory risk on the gross profit mark-ups of uncontrolled producers (UT1, UT2, UT3). 

Challenges:

• Reasonable Ascertainment: Difficulty in reasonably ascertaining the effect of the inventory risk difference on the gross profit mark-ups. 

Impact on Reliability:

• Reliability Concern: Inability to reasonably ascertain the effect of the difference may impact the reliability of the comparison between the tested party (LCO) and uncontrolled producers (UT1, UT2, UT3). 

Conclusion:

• Adjustment Assessment: Assessment of adjustments should be conducted, and efforts made to reasonably ascertain the impact of the inventory risk difference on gross profit mark-ups for a more reliable comparison. 

 Example 4: 

Background: 

• Entities Involved:
  • FS: Foreign corporation producing apparel for PCO (parent corporation). 
  • PCO: Parent corporation providing designs for apparel production. 

Scenario:

• Controlled Transaction:
  • FS produces apparel for its parent corporation, PCO. 
  • FS purchases materials from unrelated suppliers and operates in the same geographic market. 

Comparables Identified:

• Uncontrolled Producers:
  • Ten uncontrolled foreign apparel producers identified by the local taxing authority.
  • Operate in the same geographic market and are similar to FS in many respects.

Data Availability:

• Data Completeness: Relatively complete data available regarding functions, assets, and risks for the uncontrolled producers. 

Adjustment Challenges: 

• Contractual Term Differences:
  • Sufficient data not available to determine all material differences in contractual terms. 
  • Unable to identify which parties in uncontrolled transactions bear currency risks. 

Impact on Reliability:

• Diminished Reliability: Inability to determine material differences in contractual terms may diminish the reliability of the results. 

Enhancement Efforts:

• Reliability Enhancement:
  • Efforts needed to enhance the reliability of results for comparables, for example, by investigating whether they incur currency risks. 
  • Reviewing annual reports and other available sources to understand the contractual terms and risks borne by uncontrolled producers. 

Challenges in Data Enhancement:

• Complexity in Determination: Difficulty in determining specific contractual terms, such as currency risks, due to data limitations. 

Conclusion:

Reliability Assessment: While the identified uncontrolled producers have relevant similarities, additional efforts are required to enhance the reliability of results by investigating specific contractual terms, especially those related to currency risks.