The Cost-Plus Method (CPM): Gross profit margin data expressed as a mark-up of production costs incurred in uncontrolled transactions. OECD GL paragraph 2.45 states that 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 an associated purchaser. An appropriate cost-plus mark-up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.
This method probably is most useful where semi-finished goods are sold between associated parties, where associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services.
However, the following comparability factors might be useful when performing adjustments;
- Differences between the compared enterprises, e.g., regarding management and operational efficiency, could affect comparability and may require adjustments.
- Different cost bases affecting the mark-up size, e.g., leased production assets vs. owned production assets.
- Differences in expenses, such as expenses reflecting a functional difference, Distinct unrelated functions which may require separate unrelated compensation and expenses related to non-arm’s length capital structures.
- Accounting differences, e.g., some costs may be found in net profits only for one enterprise and in gross profits for another. Inclusion of operating expenses trigger issues requiring remedies.
There are three cost categories: direct production costs (e.g., raw materials); indirect production costs (general repairs across products); and operating expenses (general, supervisory and admin). Generally, the cost-plus method uses direct and indirect costs; some countries include some operating expenses.
Note that when applying the CPM, the key issues will be;
- functional comparability of tested party
- Cost base (full vs partial costs, budgeted and actual costs) which needs to be clearly defined ex-ante and must be consistent with functional profile of tested party.
- Price setting can or will often be based on standard or normal costs ensuring arm’s length conditions necessitate the inclusion of an adjustment mechanism to ensure the payments made do in fact reflect the ex-post costs to be covered and margin to be allotted (Outcome testing)
Therefore, when applying the cost-plus method, the following steps should form as a guide;
- Are we able to identify a tested party performing routine functions?
- If yes, then we should apply the CPM on the basis of full and actual costs in the context of an analysis of net profitability of the service provider.
- If no, double and triple check. Fight for a strict application of the basic tenant of the CPM that is, isolating the service provider from market risk.
- Are we dealing with a tested party performing non-routine functions?
- If yes, then you should be able to substantiate your analysis based on internal comparable with a benchmark (net profitability). Remember at this point a secondary method maybe utilized that PSM to validate the arm’s length nature of profit allocation.
- If no, adhere to strict application of the basic tenant of the CPM by isolating the service provider from market risks.
Third Series: Navigating Transfer Pricing Method: Strategies for Effective Selection and Application
The Cost-Plus Method (CPM): Gross profit margin data expressed as a mark-up of production costs incurred in uncontrolled transactions. OECD GL paragraph 2.45 states that 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 an associated purchaser. An appropriate cost-plus mark-up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.
This method probably is most useful where semi-finished goods are sold between associated parties, where associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services.
However, the following comparability factors might be useful when performing adjustments;
- Differences between the compared enterprises, e.g., regarding management and operational efficiency, could affect comparability and may require adjustments.
- Different cost bases affecting the mark-up size, e.g., leased production assets vs. owned production assets.
- Differences in expenses, such as expenses reflecting a functional difference, Distinct unrelated functions which may require separate unrelated compensation and expenses related to non-arm’s length capital structures.
- Accounting differences, e.g., some costs may be found in net profits only for one enterprise and in gross profits for another. Inclusion of operating expenses trigger issues requiring remedies.
There are three cost categories: direct production costs (e.g., raw materials); indirect production costs (general repairs across products); and operating expenses (general, supervisory and admin). Generally, the cost-plus method uses direct and indirect costs; some countries include some operating expenses.
Note that when applying the CPM, the key issues will be;
- functional comparability of tested party
- Cost base (full vs partial costs, budgeted and actual costs) which needs to be clearly defined ex-ante and must be consistent with functional profile of tested party.
- Price setting can or will often be based on standard or normal costs ensuring arm’s length conditions necessitate the inclusion of an adjustment mechanism to ensure the payments made do in fact reflect the ex-post costs to be covered and margin to be allotted (Outcome testing)
Therefore, when applying the cost-plus method, the following steps should form as a guide;
- Are we able to identify a tested party performing routine functions?
- If yes, then we should apply the CPM on the basis of full and actual costs in the context of an analysis of net profitability of the service provider.
- If no, double and triple check. Fight for a strict application of the basic tenant of the CPM that is, isolating the service provider from market risk.
- Are we dealing with a tested party performing non-routine functions?
- If yes, then you should be able to substantiate your analysis based on internal comparable with a benchmark (net profitability). Remember at this point a secondary method maybe utilized that PSM to validate the arm’s length nature of profit allocation.
- If no, adhere to strict application of the basic tenant of the CPM by isolating the service provider from market risks.
Author: Eddie Opiyo