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Transfer pricing verification methods – the cost-plus method

The cost-plus method – also referred to as the reasonable margin method – is one of the basic transfer pricing verification methods.  It is used to calculate the remuneration of entities that are engaged in simple, routine production or service activities. The calculated price is intended to cover the costs associated with the production of the products or services in question and to ensure a profit at the market level. Below, we will try to explain the assumptions and application of this method.

What is the focus of the cost-plus method?

First of all, the cost-plus method focuses on analysing the costs (cost base) that have been incurred by an entity involved in a transaction, e.g. in connection with a transaction for the sale of a manufactured product. The determination of the price is based on the addition of a market mark-up to these costs, the amount of which depends on the functions, risks and assets involved in the transaction by that entity. The aforementioned cost base to be analysed is:

  • the sum of costs directly attributable to the in-house production or acquisition of the subject of the controlled transaction (e.g. salary costs or the cost of purchased materials), i.e. general and administrative expenses, selling costs and departmental costs are excluded from the cost base, or
  • the sum of costs directly or indirectly attributable to in-house production or acquisition of the object of a controlled transaction.

Just as important as the correct calculation of the cost base is the correct performance of the functional analysis, on which, among other things, the amount of the mark-up depends. If it is performed incorrectly, there is a risk of wrongly concluding that the described method is appropriate for the valuation of this transaction. The cost-plus method should primarily be applied to entities with a simpler functional profile, i.e. entities that involve, for example, simple assets in the form of a production line with basic know-how. For an entity that has an innovative production line with specialised, unique know-how, it will not be possible to apply this method. It is also important to have reliable and clear comparative data.

To summarise the above, the cost-plus method is applicable, inter alia, in transactions where:

  • we have contract manufacturing (e.g. with standardised products),
  • intermediate processing services are provided,
  • distribution with limited risk (simpler functional profile),
  • low-value-added services are provided (the cost-plus method can be used for safe harbour).

How to determine the profit margin?

A profit mark-up is a value that we want to calculate in order to verify that the price has been set at market level. It is added to the cost base to determine the selling price of an item or service. With the cost-plus method, the mark-up is usually determined as a percentage. The formula for calculating the profit mark-up in percentage terms is as follows:

Profit mark-up = (Selling price – Cost base)/ Cost base * 100%

In other words, it is determined on the basis of an established cost base by comparing it with the level of profit used by the same entity in similar transactions with independent parties (internal comparison), or with the profit used in similar transactions by independent parties (external comparison). The internal comparison, due to the availability and consistency of data, is considered the method that gives the best results in determining the transfer price, as long as controlled transactions are comparable to uncontrolled transactions.

Advantages and disadvantages of the cost-plus method

Advantages of the method described include:

  • resistance to differences in the characteristics of goods and services, which makes it relatively universal and flexible,
  • ease of application, especially when comparative data are available, which facilitates rapid and efficient pricing,
  • the full availability of data for internal comparisons, which enhances the credibility of the analysis,
  • assurance of a stable level of remuneration while maintaining comparability of transactions.

In contrast, disadvantages of this method include:

  • limited suitability for transactions with complex functional profiles or unusual operations,
  • difficulties in verifying a comparable cost base in external comparisons, which may lead to incorrect conclusions,
  • complications related to different accounting treatment (e.g. different variants of the P&L, differences in cost recognition),
  • the assumption that the cost level reflects the price may be inappropriate as market prices may differ significantly from production costs, e.g. due to market trends, geopolitical situation or technological level.

Evaluation of the cost-plus method

In conclusion, the cost-plus method is an important tool in transfer pricing management, offering many advantages such as robustness to differences in the characteristics of goods and services and ease of application, especially with the availability of comparative data. However, its limitations, such as the difficulty in verifying external comparisons and the assumption that costs reflect prices, can lead to erroneous conclusions. Therefore, it is important to use the method with caution and take into account its limitations, and to consider alternative approaches depending on the specifics of the transaction and the market. Despite some challenges, the cost-plus method remains an important tool in ensuring transfer pricing compliance and minimising tax risks for companies operating internationally.