Application of Cost Plus Method

Application of Cost Plus Methods

Both the CPM and NCPM are suitable methods in case the service or product is supplied internally within the group, i.e. is not sold to external third parties. Examples include routine, low‑complexity intra‑group functions where costs provide a reliable indicator of value, and the value added by the tested party is low. Consequently, the risks born by such an entity are also low.

(Gross) CPM versus NCPM – cost base

Three main types of costs can be distinguished:

• Direct production costs, such as raw materials
• Indirect production costs, such as maintenance of equipment
• Operating expenses, such as overhead

The cost base using the CPM consists of both direct and indirect production costs. By contrast, the cost base of the NCPM also includes operating expenses which cannot be reliable attributed to a specific transaction. This is illustrated below using a simplified example P&L:

When taking a closer look at this new guidance, three specific topics are addressed in more detail: A) raw materials; B) budget versus actual costs; and C) the appropriate markup applied.

A)      Raw materials

The guidance clarifies which factors may indicate that the manufacturer has control over certain functions, assets and risks, in which case the raw material costs need to be included in the cost base. Examples include: transformation of raw materials into a finished product;  relatively high value added in the production process; decision making authority regarding the R&D process; or obsolescence risk. Contractual agreements are always the starting point of such analysis, but the actual conduct of parties with respect to the functions and risks are decisive whether or not to include the direct production costs into the cost base.

Other helpful indicators to determine whether the manufacturer is actively involved in activities related to the raw materials are: involvement in price negotiations; determination of specifications and volumes; hedging of price - and currency risks; and quality control. By publishing these concrete practical pointers, companies can better substantiate and defend whether these costs in fact belong in their cost base or not.

B)       Budgeted versus actual costs

Arm’s‑length arrangements typically rely on budgeted or standard costs. Helpful practical guidance is provided on what factors to consider when determining the appropriate cost base.

Efficiency / capacity / pricing results

• Taking a contract manufacturing (CM) set up as an example, controllable inefficiencies such as poor maintenance or high turnover of workforce should ordinarily be borne by the CM.
• Whether or not capacity risk or price fluctuations should be included in the cost base of the CM heavily depends on the agreements made with the Principal, and the activities performed by both parties in relation to the products or raw materials.
• In case the budgeted costs cannot be reliably determined, actual costs may be used as a proxy. Be mindful of the fact that in this case, all efficiency-, capacity- and price risks are borne by the Principal.

Specification of costs

• In case multiple products or services are provided, especially to multiple parties, it is advisable to specify which costs pertain to which product or service. This is in line with the latest guidance from the CGVP, increasingly moving to a more transaction-by-transaction approach of transfer pricing.

Financing costs and replacement costs

• In comparability analyses, one cannot simply exclude examining how the company is financed (debt versus equity). After all, in third party situations the cost plus margin is determined in such a way that the financing costs also need to be recovered.
• The same applies to replacement costs. In case these can reliably be determined, they need to be taken into account into the comparability analysis, as they would also significantly impact the cost base of comparable third parties.

Pass-through costs

• Costs that are in first instance paid by the contracting party but pertain to services provided by external parties (e.g. third party software license costs) can be on-charged, but should not be marked-up.

Fully loaded versus marginal cost

• Be careful with marginal cost prices lower than the fully loaded cost price. This lower price often has a specific reason (e.g. part of a market penetration strategy), which typically makes it incomparable to more standard situations.
  
  

C)       Mark-up itself

• As indicated before, when analyzing comparability (e.g. by performing a database study), be mindful of differences in cost base (are the raw materials included in the base of the comparables or not?) The same applies to the impact of financing costs.
• When such differences are found, these companies cannot reliable be used as comparables without appropriate adjustments. It needs to be demonstrated that this extra level of analysis has been performed, as it may have an impact on the appropriate mark-up to be used.
• For some low-value adding services, the 5% safe harbor rate can be applied, but only in case of very routine activities (activities such as core services, R&D and manufacturing are by default excluded of this safe harbor category).

What does it mean for companies? Immediate actions

• Too many companies spend a lot of time on supporting the mark-up, but don’t spend the same amount of time on explaining their cost base. The impact of the right cost base is often much larger!
• Perform a more detailed analysis of all relevant costs involved, on a transaction-by-transaction basis.
• It is not acceptable to exclude items like financing costs or replacement costs upfront. This puts more onus on your comparability analyses / benchmark studies, where you need to prove that these steps have been considered.
• A more detailed functional analysis is needed to support whether or not the raw material costs need to be included into the cost base, and similarly who bears the negative financial impact of inefficiencies, capacity and pricing risks.
• Be mindful that price testing is not the same as price setting – the former is used to defend your transfer prices after the fact  (for compliance purposes), the latter to set the correct prices upfront (for budgeting and operational transfer pricing purposes).

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For any questions on how to incorporate this practical guidance into your existing operational transfer pricing and compliance processes, please contact us. Our team of specialists is very keen to support you.