The cost plus method is one of the five primary transfer pricing methods. It looks at comparable transactions and profits of similar third-party organizations to ensure companies are fairly allocating their international profit. (To get an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)
The cost plus transfer pricing method is a traditional transaction method, which means it is based on markups observed in third party transactions. While it’s a transaction-based method, it is less direct than other transactional methods and there are some similarities to the profit-based methods.
The first step to applying this method is to determine the manufacturing costs incurred by the supplier in a controlled transaction (one made internally between related companies). Then, a market-based markup is added to that cost to account for an appropriate profit. (This is essentially the “plus” in the cost plus method.)
To determine that a transfer price follows the arm’s length principle, the markup is compared to the markups realized in comparable transactions made between unrelated organizations. (The arm’s length principle specifies that a company must charge a similar price for an internal transaction as it would for a transaction with a third party. In other words, the transaction amount must be a fair market price.)
The cost plus method is most commonly applied to the routine manufacturing and sale of tangible goods. Let’s say a French corporation produces products under contract for its parent company located in Germany. The French manufacturer needs to determine the appropriate gross cost plus, which is essentially how much the company should mark up the cost of the finished goods it produces when selling to their German partner.
The most reliable way to apply the cost plus transfer pricing formula is to find actual examples of similar third party transactions made by the company to determine if they’re sufficiently comparable to the sale transactions between France and Germany. In the event that the company has made similar transactions with third parties, this information can be used to apply the cost plus method.
When comparable internal transactions are not available, external comparable data can be used instead. This works by identifying several companies that are similar to the French manufacturer, and looking at the gross cost plus those companies earn on average.
The cost plus transfer pricing method can also be applied to services provided by one company to other related companies. Suppose a U.S. parent corporation has subsidiaries in Japan and Germany and provides HR services for these German and Japanese companies. While the U.S. defines this as a “cost of services plus” transaction, it is handled as a cost plus transaction under OECD BEPS regulations.
In this scenario, you can set the price by determining the cost of services provided and a profit markup. The profit markup can be established by considering your internal markup—the markup you use for internal accounting purposes to allocate the value of services provided to units that are included under the parent company’s organizational umbrella (units that are not subsidiaries or independently organized as separate business entities).
Alternatively, if the company provides HR services to other unrelated third parties, you can look at the markup applied to those transactions and apply that markup to the intra-company transactions.
If the company does not provide services to unrelated third parties, you can use external benchmarks. Identify several companies who provide similar services to third parties and determine the gross plus these companies earn on average to calculate their markups. Then, apply the comparable markup to the cost of the HR services the company provides for its German and Japanese subsidiaries.
For low-risk, routine transactions without many variables, such as the assembly and sale of tangible goods, the cost plus method works very well. Most companies find it’s relatively easy to understand and to apply, particularly because the cost plus transfer pricing method doesn’t require the same precision as the other transactional methods.
That said, there are also pitfalls—especially when comparable data isn’t readily available. While similar companies may exist, there are almost always going to be differences in the way they manage their finances. An apples-to-apples comparison is absolutely critical when calculating the gross cost plus, and even minor differences in the way two companies transact and manage their cost accounting can completely distort the results of this method. In circumstances where reliable data is unavailable, a different method should be used to determine transfer prices.
If you’re struggling to make sense of transfer prices and the different methods for calculating them, we can help. Get in touch to learn more about Valentiam and how we partner with global organizations to help maximize profits and mitigate risk.