The Deceptive Cost-plus Method
It was more than 10 years ago, when I listened to a European transfer pricing expert, at a prestigious transfer pricing conference, talk about how he applies a cost-plus method with a cost-plus markup of 5% on fully loaded costs. I found myself confused because once you look at fully loaded costs, it’s really the transactional net margin method (TNMM) with a net cost-plus profit-level indicator.
But this is déjà vu. I had heard this before, where experts talk about the cost-plus method when they’re really speaking about the TNMM. And after 20 years in transfer pricing, I’m hoping to clarify the potential confusion caused by transfer pricing practitioners utilizing different nomenclature to describe the application of the same economic analysis.
Let’s start with some basics:
OECD Guidelines defines the cost-plus method as a “traditional transaction method,” and a “method using the costs incurred by the supplier of property (or services) in a controlled transaction… [where] an appropriate cost-plus markup is added to this cost.” The application of the cost-plus method depends on the contractual terms of comparable third-party transactions.
For example, let’s say, Fonda Motor Company sells cars to its subsidiary, SubCo, for distribution, but it also sells similar cars to an unrelated customer, Rentacar. If we are able to identify Fonda’s cost of manufacturing the cars plus the markup on these costs, we could apply the cost-plus method to analyze Fonda’s manufacture and intercompany sale of cars (assuming all other comparability factors are true).
However, in practice, these types of transactional details and customer-specific data aren’t always available, or they fail to meet the rigorous comparability requirements to apply a transactional method. Remember, in the application of a transactional method, the underlying product matters, which means that in our Fonda Motor example, there could be comparability challenges if the cars sold to SubCo are trucks while the cars sold to Rentacar are limited to sedans.
Now, let’s apply this to services transactions, which is where I see even more complexity. Fonda, a U.S.-based company, provides accounting support services to subsidiary SubCo using a cost-plus-10% markup. Fonda also provides accounting support services to unrelated Rentacar using a cost-plus-10% markup. In this situation, the cost-plus transaction-based method could be applied because Fonda has access to uncontrolled transaction data and Fonda can confirm comparability of services because it is the service provider in both the controlled and uncontrolled situations. Sounds simple, but the issue is alignment of the underlying costs on which the markup is applied.
Let’s look at a different application of this method to the same services transaction.
What if you are not able to identify this type of comparable internal or external third-party transaction? Can you still apply a cost-plus method? Yes, you can apply a profit-based version of the cost-plus method by looking at comparable companies, or specifically, a company’s profitability for sales or services to all customers, versus an individual customer.
Now, let’s revisit the complexity of delineating the boundaries of the underlying costs to be evaluated. The calculation of the profit-level indicator is ultimately the difference between a profit-based cost-plus method versus the transactional net margin method. The key difference is that the TNMM is looking at net margins while the cost-plus looks at gross margins. So, if you end up considering the cost-plus method, but realize you have to account for direct costs, indirect costs, and operating expenses, then the cost-plus method converges with the TNMM, and in fact, the economic analysis is the same.
You might think I’m advocating that the TNMM and profit-based cost-plus method are the same thing. However, I respect the fact that transfer pricing regulations are very specific about the methods to be applied, like the U.S., which formalized new services regulations in 2009 to specifically identify a new method called the cost-of-services-plus method. My point is that I’m done being confused or defending my application of the TNMM with a net cost-plus markup instead of the cost-plus method. Let’s all just get aligned by focusing on what’s really important: the economic analysis and associated explanation, as opposed to the name of the method.