One of the exciting events in a track and field sports is a relay race. Members of a team one after the other complete a part of the racecourse and pass a baton to the other team member. The other team members do the same until the baton reaches the ultimate team member who races towards the finish line to finish the race. Although the performance of a team member is limited to the part of the racecourse he is expected to run, the outcome of the race is dependent on how the team performs as a unit. Well, most corporates today follow a similar business model – only one company deals with the ultimate customers, however, there is a chain of group companies who are actually manufacturing the product, and passing it to the other, each company playing its role. Such transactions are covered by Transfer Pricing and one of the widely used method of measuring the arm’s length price – Cost Plus Method, is devised on the same understanding.
Key Terms Used
Before we explain the method, let’s understand a few important terms used in our discussion ahead:
Cost of Goods Sold (COGS): Thedirect costs incurred in relation to the product being sold or service being provisioned is called as Cost of Goods Sold, also referred to as Cost of Sales or Cost of Services. It includes all the costs which are directly associated with the production of goods or provisioning of service. This includes the material, labour and overheads in proportion to the quantity sold, eliminating the costs incurred towards goods held as inventory.
Cost Markup (M): The ratio of profit to the cost that the enterprise has incurred towards goods or services being transferred, to cover its selling and administration expenses, and the rewards for risks incurred, is called as the ‘Cost Markup’. For e.g., IfCOGS of a product is INR 400 per piece, and the selling companyintends to earn INR 100 per piece, the Cost Markup would be 20%.
What is the Cost Plus Method?
The Cost Plus Method focusses on the value chain of the production of goods or provisioning of services. According to this method, the starting point should be the cost incurred towards the product or service being transferred and a general profit margin should be added towards the selling costs and profits. As every selling enterprise adds value to the product and the transfer price keeps accumulating all the costs which have incurred since the inception of the production till it reaches its customers, this method ensures that the product is priced appropriately. Further, it ensures that each intermediate enterprise receives an appropriate share of the profit in proportion to the costs they incurred or the value they have added to the product or service before transferring the same.
Thus, if we formulate the transfer price under Cost Plus Method, it would be equal to ‘COGS+ Markup’,where Markup is arrived by ‘COGS x Markup %’. Thus, TP = COGSx (1 + M%).
For e.g. Alpha produces an item and transfers it to its associated enterprise Beta who sells it to the ultimate customers. Alpha buys raw materials of 8 million, incurs labour costs of 1 million and other overheads of 1 million, to produce 10,000 pieces. Out of these, it sells 8,000 pieces to Beta and 2,000 to another independent entity ABC Ltd. While selling it to Beta it incurs additional expenses of 0.8 million towards special addons and specification. Now, the COGS in this case would be 10 million towards 10,000 pieces, thereby, 1,000 per piece. However, for goods sold to Beta it would be 1,000 plus 100 (0.8 million special costs incurred for 8,000 pieces) i.e. 1,100 per piece.
This product is sold by Alpha to ABC Ltd at INR 1200 per piece, as the same is the market price. This would mean Alpha adds a markup of 200 per piece i.e. 20% cost markup. Thus, Transfer Price for goods sold to Beta in such case would be = 1100x (1+20%) = 1,320 per piece. This would cover Alpha against all the costs incurred and still leaving the enterprise with appropriate profits.
From the example, it is clear that the Cost Markup is the key constraint, as costs are generally known. In fact, it’s the computation of Arm’s Length Cost Markup (Range) would ultimately decide the Arm’s Length Price.Based on the types of transactions used as comparables, there can be two methods of determining the Gross Profit Margin:
- By Transactional Comparison –Comparable transactions which have taken place with other independent enterprises can be used to determine the cost markup.
E.g. If Alphasells to both Beta (Associated Enterprise) and ABC Ltd (Independent Enterprise), then the Cost markup added while selling to ABC Ltd can be used as Cost markupfor the transactions with Beta.
- By Functional Comparison– Transactional comparison may not be always possible, as the enterprise may be dealing exclusively with an associated enterprise for procurement of specific item or service. In such cases, a functional comparison with peers in the industry may be used to determine the Cost Markup. Thus, instead of finding comparable transactions, this method focuses on finding comparable enterprises.
E.g. If Alphasells a software to Beta (associated), and Omega Ltd is another enterprise in the industry dealing in same software with Theta Ltd (associated with Omega Ltd), then the gross profit margin in case of Omega-Theta transaction can be applied to the Alpha-Beta transactions.
After computing the cost markup, one must take into account the product or services being transacted, the contractual terms, the economic circumstances under which such transaction has occurred and the business strategies surrounding the transaction. After considering results of such comparison, the cost markupof an uncontrolled transaction will be considered comparable if –
- There are no materially markup-altering differences in the transactions being compared, or
- If there are any material differences between the transactions, they can be adjusted with reasonable accuracy.
Computation of Arm’s Length Price under the Cost Plus Method
Step 1 – Determine the Direct and Indirect Costsof the product or service transferred tothe associate enterprise. This should include all the costs which have been incurred towards the production of goods or provising of the service. Any additional or incidental costs incurred specifically for the product should also be included. Accordingly, the Cost of Goods Sold (COGS) of the product or Cost of Services (COS) has to be determined.
Step 2 – Determinecomparable transactionswith unrelated parties or such other comparable transactions between two independent enterprises. Perform comparability analysis on the transactions being considered, and select the most appropriate transactions as comparables. Comparability analysis must consider the following points:
- Product Comparability – characteristics, quality, end-use, novelties, features, addon products, after-sales services, etc.
- Contractual Terms –the credit period offered, allied transactions, term period of the contract, the quantity contracted, the place of delivery, etc.
- Risk Incurred – In a transaction between Associated Enterprises, the associated enterprise may not be selling directly to end consumers. However, in an open market transaction, an independent entity is exposed to inventory risk and consumer default risk. These risks undertaken by the other associated enterprise must be quantified and adjusted to the price. There may be similar risks which may require adjustments.
- Geographical Factors – the location where the product is sold or produced, the Government regulations, the applicable taxes, the sources of raw materials, etc.
Step 3 – Analyse the differences between the controlled transactions and the uncontrolled transactions considered as comparable, which have an impact on the cost markup. Quantify the functional differences in terms of impact on the Cost Markup and make adjustments to arrive at Adjusted Cost Markup %.
Step 4 –Add the Cost Markup derived, to the Cost of Goods Sold, to arrive at the Transfer Price.
Advantages and Disadvantages of the Cost Plus Method
- The method is based on internal costs, the data for which is more reliable and accessible, as compared to other methods based on resale price or cost price of other transactions.
- The link between the costs incurred and the market price can be very weak and thus, gross profit margins may vary greatly every year.
- Unlike Resale Price Method, this method does not provide any incentive to the manufacturer to control the costs, as any cost incurred would be billed or transferred.
- Careful analysis of the costs is required, to decide which costs have to be excluded. This would also entail requirement to maintain detailed cost records.
- Establishing cost markup of an uncontrolled transaction and adjusting the same with reasonable accuracy is difficult and can often bea long process as it requires a detailed analysis of both the transactions, the products and the economic conditions.
When to use the Cost Plus Method?
The Cost Plus Method works only under specific circumstances and therefore, one must firstly brainstorm on the following points, before proceeding with this method, to ensure the viability of its results:
- Low Risk Transactions–The Cost Plus Method is influenced by the costs incurred and gives more attention to the value added than the risk involved in selling the product or the market price. Thus, in case of transactions which involve more risks than the costs, the cost plus method would not be suitable.
- Reliable calculation of Cost of Goods Sold–A reliable calculation of Cost of Goods Sold is pre-requisite to arriving at Cost Markup. Thus, if the COGS of the transaction cannot be established without any complications, the cost plus method may not produce reliable results.
- Heavy Value Additions – Where each company involved in the manufacturing and distribution chain adds heavy value to the product or service, the other methods of calculating arm’s length price would involve higher complexities in calculation. However, the cost plus method provides an easy and reliable method of deriving chain of enterprises dealing with the product before ultimate sale to customer as it may involve complex calculation of resale price at multiple levels.