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Management Accounting pp 247–305 Cite as

Transfer Prices and Cost Allocations

  • Peter Schuster 4 ,
  • Mareike Heinemann 5 &
  • Peter Cleary 6  
  • First Online: 05 February 2021

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Part of the Springer Texts in Business and Economics book series (STBE)

This chapter considers one of the most important issues in management: transfer prices and cost allocations. Cost allocations can be understood as a special form of transfer prices. Both relate to influencing decentralised decision-making. Transfer prices based on costs, market prices and negotiations are examined for their coordination efficiency. With regard to cost allocations, several possible reasons for the allocation of fixed costs to divisions (cost centres) are shown.

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Wagenhofer, A. (1992). Verrechnungspreise zur Koordination bei Informationsasymmetrie. In K. Spreman & E. Zur (Eds.), Controlling – Grundlagen, Informationssysteme, Anwendungen (pp. 637–656). Wiesbaden.

Zverovich, S., & Schuster, P. (2019). Transfer pricing in non-linear revenue settings. In W. D. Nelson (Ed.), Advances in business and management (Vol. 16, pp. 151–175).

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Faculty of Business and Economics, Schmalkalden University of Applied Sciences, Schmalkalden, Germany

Peter Schuster

VALNES Corporate Finance GmbH, Frankfurt am Main, Germany

Mareike Heinemann

Cork University Business School, University College Cork, Cork, Ireland

Peter Cleary

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Schuster, P., Heinemann, M., Cleary, P. (2021). Transfer Prices and Cost Allocations. In: Management Accounting. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-62022-6_8

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The cost plus transfer pricing method (with examples).

Posted by Valentiam Group on February 11, 2021

The Cost Plus Transfer Pricing Method - Valentiam

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.

How The Cost Plus Transfer Pricing Method Works

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.)

Download Now: A Work Plan For Meeting OECD BEPS Requirements

Cost plus transfer pricing examples.

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.

Benefits & Risks Of The Cost Plus Method

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.

We’ll Help You Navigate Transfer Pricing

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.

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Understanding transfer pricing and its implications for businesses on global commerce.

By Michael Milazzo , Partner, Tax & Business Services

Understanding Transfer Pricing and Its Implications for Businesses on Global Commerce

With exponential advances in technology, transportation and communication over the past few decades, many multinational companies (MNCs) have had the ability to place their enterprises, and conduct their activities, anywhere in the world. When an MNC engages in the practice of cross-border intercompany transactions, there are a variety of direct and indirect implications, including the effects of those transactions on tax rates, shareholder wealth, governmental tax revenue, corporate after-tax cash flow and more.

For an MNC itself, the implications can seem fairly straightforward. For example, when viewed solely from the standpoint of management accounting and reporting, expenses and returns to subsidiaries in different countries can be apportioned through several widely accepted approaches. That said, national governments focus exclusively on statutory returns to an MNC’s local entity. In the wake of the recent global recession, governments everywhere seek to maintain or boost their tax bases. Therefore, intercompany transactions – and their tax implications to the governments in which subsidiaries reside – remain solidly in the crosshairs of government officials across the globe.

Circle back to MNCs for a moment and consider how significantly transfer pricing can impact shareholder wealth, owing to its influence on how taxable income gets distributed among countries with different tax rates.

Transfer pricing is one of the top audit issues for the IRS and other revenue-strapped tax authorities, and global businesses could risk incurring steep penalties of 20-40 percent on transfer pricing adjustments if they are not in compliance. It is now more important than ever for global companies to fully grasp the concept of transfer pricing and use it to maximum advantage.

Transfer Pricing Basics

Consider Switch Corp, which manufactures electric switches for consumer and industrial products. One day, Switch Corp is purchased by Umbrella Corp—and Umbrella Corp also owns Ballast Corp, which manufactures lighting ballasts.

Soon, Ballast Corp seeks to purchase switches from Switch Corp. These companies now share a parent company – Umbrella Corp – so to support these sale prices, they must use a transfer price.

Simply put, a transfer price is defined as the price at which different parts of a given company transact with one another in an arm’s-length manner. Like our three companies above, transfer prices are often used by multi-entity firms in cases where the firm’s individual units are treated separately. Also, contrary to popular belief, transfer pricing isn’t limited to international transactions—it also applies to domestic companies that do business with related parties across state lines.

Generally speaking, transfer prices stay fairly in line with market prices (i.e., arm’s-length manner). Why is that? If a different price were to be set, one of the firm’s units would always come up short in the transaction. This, in turn, could affect the unit’s performance and therefore the overall financial health of the multi-entity company.

This concept of transfer price and market price being generally aligned is referred to as the arm’s length principle (ALP). In other words, the transfer price should be within reach of the current market price.

That’s the theory. If only it were that simple in practice. Things start to get complex when you consider that the transfer price affects the income of the two entities involved—and therefore, it also impacts the tax base of the countries in which the entities are located.

Owing to this, transfer pricing must account for jurisdiction, allocation and valuation issues. We’ll briefly cover each issue below.

Jurisdictional issues

As the global economy becomes more and more connected, it is difficult to determine which country has the right to tax the transaction. In select cases, companies have utilized this complexity and ambiguity to avoid tax liabilities.

Allocation issues

The multinational entities (MNEs) still share common resources and overheads; therefore, allocation of resources among MNCs is essential. Yet countries in which MNCs reside are concerned about efficient allocation for tax reasons, and consequently, this issue can materially affect transfer pricing.

Basic Methods Used to Calculate a Transfer Price

There are several methods that companies use to set transfer prices. The most commonly used methods are described below.

Market rate transfer price (or comparable uncontrolled price)

Market rate is generally the most straightforward method of calculating a transfer price. Put simply, it means the transfer price is the same as the current market price for the goods or services in question.

With market rate transfer price, the upstream unit can sell its goods or services either by conducting its sale internally or externally. Under both methods, the profit for the unit remains the same.

Adjusted market rate transfer price

The adjusting market rate method is often used to derive a transfer price when the market rate method is unavailable. This method accounts for an adjustment to current market price to some stated degree.

For example, a company may choose to use a reduced price to eliminate the risk of late payments. In most cases, this stills falls within the arm’s length principle.

Negotiated transfer pricing

With negotiated transfer pricing, specific corporate units negotiate a price regardless of the market baseline price. In fact, it can be quite different than the prevailing market price.

Companies often opt for this method in situations where the market price is difficult to calculate; the market for the goods or service is limited; or the item in question is highly customized.

Contribution margin transfer price

Companies tend to use the contribution margin transfer price method in cases where no set market price for the goods or services being sold exists. Under this method, companies calculate a market price “alternative” based on the unit’s contribution margin.

Cost-plus transfer price methodology

Cost-plus transfer price methodology is another method that’s used when no valid market price exists. This method is often used in cases where the item in question is a manufactured good.

When calculating the cost-plus transfer price, companies tend to add a margin on the cost of the good by adding the standard cost onto a standard profit margin.

Cost-based transfer pricing

Some companies choose to sell their goods or services to other units by simply using the production cost as the price point. If that product or service is then sold to a third party, that unit can add its own costs to the final price.

Under the cost-based transfer pricing method, the company that makes the final sale receives the entire profit of the goods or service. This method is often used as a tax avoidance strategy.

For questions about international tax issues, please contact Michael Milazzo , Partner, Tax & Business Services

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Transfer Pricing considerations for intra-group services

Almost all groups will have intra-group services of some kind. Often, the services arise because it is more efficient and economic to centralise certain activities, such as various back-office services (e.g. IT, legal, finance, management, marketing, research and development etc.). These services are typically carried out by the parent company or by a group service centre or by a head office.

Some countries have specific legislation, regulations or guidelines on this, but in most cases many rely on the guidance included in the OECD Transfer Pricing Guidelines (TPG). 

With respect to Malta, currently there are no sophisticated Transfer Pricing (TP) rules, however the Commissioner for Revenue is expected to publish TP Rules during the last quarter of 2022, which should make reference to the OECD TPG. Following which, we should also expect to have some guidelines.

In this short read we shall briefly explain the main key points of an intra-group service.

Did you receive a service?

For an intra-group service fee to be arm's length, you must be able to prove with verifiable evidence that you received the services for which you get a service charge. The service in question should provide the related party with economic or commercial value that enhances its commercial position. One of the tests that one can make is to determine whether a third party would be willing to pay for the same service that the related party has received.

If the answer is no, then the service should generally not be considered as an intra-group service under the arm’s length principle.

How do you determine an arm’s length service fee?

Having determined that a service has been rendered, the next step would be to determine the appropriate price to charge to the related party. Very briefly, the charge should be that which would have been made and accepted between independent parties in a comparable transaction.

Where there is evidence that the service provider renders similar services to both related and independent parties then the direct method (where associated enterprises receiving the service are charged directly for that service) will be the most preferred method. 

If, however, it is difficult to apply the direct method (because the same service is not provided to a third party), then the indirect method should be used. The indirect method is based on an apportionment amongst various associated enterprises which rely on estimation and allocation of costs. A typical example of the indirect method would be in a situation where there is a shared service centre. The shared service centre would be providing services such as legal, accounting, human resources etc. which are centralised for efficiency purposes. The shared service centre would allocate a cost to its related parties based on the usage of such services.

The European Union Joint Transfer Pricing Forum published a report on low value adding services. Low value adding intra group services are defined as those which are:

supportive in nature, 

are not part of the core business of the group, 

do not use or create unique and valuable intangibles, and 

do not involve the assumption, control or creation of significant risk. 

The simplified approach to the determination of arm’s length charges provides that where appropriate, the service provider shall apply a markup within a range of 3%- 10%, often around 5% of the relevant cost (subject to the facts and circumstances that may support a different markup). The markup under the simplified approach does not need to be justified by a benchmarking study.

In view of the fact that it's becoming very common to have groups having intra-group services it is recommended that groups should ensure that they have transfer pricing documentation in place.

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  • Transfer Pricing: Definition, Methods, Pros&Cons, Examples

What are Transfer Prices?

How does transfer pricing work, transfer pricing and taxes, transfer pricing and the irs, transfer pricing methods, market rate transfer price, adjusted market rate transfer price, negotiated transfer pricing, contribution margin transfer pricing, cost-plus transfer pricing, cost based transfer pricing, example of transfer pricing, importance of transfer pricing, advantages of transfer pricing, disadvantages of transfer pricing, what is the meaning of transfer pricing, what is transfer pricing explained with an example, what are the 5 methods of transfer pricing, what is the general rule of transfer pricing.

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Transfer Pricing Asia

March 17, 2017 by Transfer Pricing Asia

Five Transfer Pricing Methods With Examples

Are you looking into the five transfer pricing methods, and wish to see examples of each?

Below, we explain the common methods which you can use to determine transfer prices. We also explain for every method when, and how you should use it.

After reading this article you’ll have a better understanding of the different methods and how they can be applied to your firm’s transactions.

As of June 2023, this article has been read 250.000 times!

Before we continue, it is important to understand that the main purpose of transfer pricing methods is to examine the “arm’s-length” nature of “controlled transactions.” If these terms do not ring a bell, we advise you to first read our article What is transfer pricing?

What Transfer Pricing Methods Are There?

The good thing about transfer pricing is that the principles and practices are quite similar all around the world. The OECD Transfer Pricing Guidelines ( OECD Guidelines ) provide 5 common transfer pricing methods that are accepted by nearly all tax authorities.

The five transfer pricing methods are divided in “traditional transaction methods” and “transactional profit methods.”

Traditional Transaction Methods

Traditional transaction methods measure terms and conditions of actual transactions between independent enterprises and compares these with those of a controlled transaction.

This comparison can be made on the basis of direct measures such as the price of a transaction but also on the basis of indirect measures such as gross margins realized on a particular transactions.

Transactional Profit Methods

The transactional profit methods don’t measure the terms and conditions of actual transactions. In fact, these methods measure the net operating profits realized from controlled transactions and compare that profit level to the profit level realized by independent enterprises that are engaged in comparable transactions.

The transactional profit methods are less precise than the traditional transaction methods, but much more often applied. The reason is that application of the traditional transaction methods, which is preferred, requires detailed information and in practice this information is not easy to find.

  • Traditional transaction methods rely on actual transactions.
  • Traditional profits method rely on profit levels.

The Five Transfer Pricing Methods

As mentioned, the OECD Guidelines discuss five transfer pricing methods that may be used to examine the arm’s-length nature of controlled transactions. Three of these methods are traditional transaction methods, while the remaining two are transactional profit methods.

We list the methods here, and provide a handy graph we created:

Traditional transaction methods:

  • Resale price method
  • Cost plus method

Transactional profit methods:

  • Transactional net margin method (TNMM)
  • Transactional profit split method.

Five OECD Transfer Pricing Methods

The OECD Guidelines provide that you as a taxpayer should select the most appropriate transfer pricing method. However, if a traditional transaction method and a transactional profit method are equally reliable, the traditional transaction method is preferred.

In addition, if the CUP method and any other transfer pricing method can be applied in an equally reliable manner, the CUP method is to be preferred.

We’ll explain each of these methods in more detail now.

Transfer Pricing Method 1: The Cup Method

The CUP Method compares the terms and conditions (including the price) of a controlled transaction to those of a third party transaction. There are two kinds of third party transactions.

  • Firstly, a transaction between the taxpayer and an independent enterprise (Internal Cup).
  • Secondly, a transaction between two independent enterprises (External Cup).

The below example shows the difference between the two types of CUP Methods:

five transfer pricing methods lesson 1

In the article the CUP method with example we look at the details of this transfer pricing method, provide a calculation example and indicate when this method should be used.

Transfer Pricing Method 2: The Resale Price Method

The Resale Price Method is also known as the “Resale Minus Method.”

As a starting position, it takes the price at which an associated enterprise sells a product to a third party. This price is called a “resale price.”

Then, the resale price is reduced with a gross margin (the “resale price margin”), determined by comparing gross margins in comparable uncontrolled transactions. After this, the costs associated with the purchase of the product, like custom duties, are deducted.

What is left, can be regarded as an arm’s length price for the controlled transaction between associated enterprises.

The below image is an example of the Resale Price Method:

five transfer pricing methods example 2

In the article the Resale Price Method with example we look at the details of this transfer pricing method, provide a calculation example and indicate when this method should be used.

Transfer Pricing Method 3: The Cost Plus Method

[Edit September 2018: Re-written to explain this method better]

The Cost Plus Method compares gross profits to the cost of sales. The first step is to determine the costs incurred by the supplier in a controlled transaction for products transferred to an associated purchaser. Secondly, an appropriate mark-up has to be added to this cost, to make an appropriate profit in light of the functions performed. After adding this (market-based) mark-up to these costs, a price can be considered at arm’s length.

The application of the Cost Plus Method requires the identification of a mark-up on costs applied for comparable transactions between independent enterprises. An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions among independent enterprises.

The following image explains this in more detail, using a simple sale of manufactured goods to a distributor:

Cost-Plus Method Illustration

In the article the Cost plus Method with example we look at the details of this transfer pricing method, provide a calculation example and indicate when this method should be used.

Transfer Pricing Method 4: The Transactional Net Margin Method

With the Transactional Net Margin Method (TNMM), you need to determine the net profit of a controlled transaction of an associated enterprise (tested party). This net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent enterprises.

As opposed to other transfer pricing methods, the TNMM requires transactions to be “broadly similar” to qualify as comparable. “Broadly similar” in this context means that the compared transactions don’t have to be exactly like the controlled transaction. This increases the amount of situations where the TNMM can be used.

A comparable uncontrolled transaction can be between an associated enterprise and an independent enterprise (internal comparable) and between two independent enterprises (external comparables).

Let’s see how this looks in this example:

tp method model 4

In the article the Transactional Net Margin Method with example we look at the details of this transfer pricing method, provide a calculation example and indicate when this method should be used.

Transfer Pricing Method 5: The Profit Split Method

Associated enterprises sometimes engage in transactions that are very interrelated. Therefore, they cannot be examined on a separate basis. For these types of transactions, associated enterprises normally agree to split the profits.

The Profit Split Method examines the terms and conditions of these types of controlled transactions by determining the division of profits that independent enterprises would have realized from engaging in those transactions.

An example of this method is shown in this image:

illustration transfer pricing method profit split

In the above example, we see two comparable joint ventures. Joint Venture I is owned by associated enterprises Y and X. Opposite to that, Joint Venture II is owned by independent enterprises A and B.

Let’s say that we need to determine the transfer prices to be charged for the transactions related to Joint Venture I. For that, we can compare the terms and conditions of the controlled transactions by determining the division of profits of comparable uncontrolled transactions. In this example, this means that we can compare Profit Split I with Profit Split II.

In the article the The Profit Split Method Example we look at the details of this transfer pricing method, provide a calculation example and indicate when this method should be used.

The Five Transfer Pricing Methods With Examples – Conclusion

Transfer pricing methods are quite similar all around the world. The OECD Guidelines provide five transfer pricing methods that are accepted by nearly all tax authorities. These include 3 traditional transaction methods and 2 transactional profit methods.

A taxpayer should select the most appropriate method. In general, the traditional transaction methods is preferred over the transactional profit methods and the CUP method over any other method.

In practice, the TNMM is the most used of all five transfer pricing methods, followed by the CUP method and Profit Split method. Cost Plus Method and Resale Margin Method are barely used.

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Transfer Price vs. Standard Cost: What's the Difference?

cost allocation method transfer pricing

Transfer Price vs. Standard Cost: An Overview

Accounting is a very important part of business. It is defined as the recording of financial information and transactions of a business or organization. This information is outlined in financial statements prepared by the company for both auditors , regulators, and, in the case of publicly-traded companies, the general public. These statements provide an insight into the financial health of a company, and summarize its operations. Two accounting terms this article will look at are transfer price and standard cost.

While an item's standard cost can be used to determine its transfer price , the two values are inherently different. An item's transfer price is the sales price charged for a good or service in a transaction between two entities under common ownership. Its standard cost, on the other hand, is simply the anticipated cost of all of the item's component parts.

Key Takeaways

  • A transfer price is what one division of a company charges another for materials used in the production of goods and services.
  • Standard costs are the average or anticipated costs of producing an item under normal circumstances.
  • Transfer prices are closely monitored and must be reported on financial statements.
  • Standard costs are used for to help businesses budget, make predictions for the future, and to analyze their performance.

Transfer Price

When one entity purchases goods from another entity under the same ownership, a sales price is charged, just as it would be to an outside customer. This price is called the transfer price. In this case, the sale is made to another entity as part of the production process rather than to the end-user. These prices are generally used when selling goods between divisions of the same company, especially when there are international segments.

Assume companies A and B are two separate divisions of Corporation X, which sells laptop computers. Company A manufactures microchips and assembles the laptops. Company B, on the other hand, is the corporation's public brand and is responsible for sales. To avoid operating at a loss, company A must charge company B a transfer price for each laptop it purchases to sell to the public. The optimal transfer price is based on a number of factors, including the cost of the item and which entity receives the benefit of profits.

If management believes it benefits the corporation as a whole for company A to realize 100% of the profits, the transfer price is set using the market price of the product.

The transfer price does not differ much from the market price.

For example, if a laptop costs $100 to produce but can sell for $700 on the open market, then company A charges company B $700 per laptop. Company B then sells the finished product to the consumer at or above this same price. Company A absorbs all the costs and profits associated with the production of the item, while company B essentially breaks even.

Depending on the actual sales price, company B may realize a small profit or loss. While corporation X's total profits do not change, it does not encourage company B to push sales of laptops; there is little to no financial benefit to that entity.

If company B receives the profit generated by the sale of goods, then the transfer price is set using the cost of manufacturing the product, rather than its market value .

Taxing authorities have fairly strict rules and regulations when it comes to transfer pricing policies. They do so in order to keep companies from shifting profits to divisions that are in tax haven countries. Assume that Company A is in a low-tax country and Company B is in a high-tax country, Corporation X can make Company A profitable by charging Company B higher prices, thereby reducing its tax burden.

These prices are monitored closely, and they must be reported in the company's financial statements for auditors and regulators.

Standard Cost

The standard cost is the average or anticipated cost of producing an item under normal circumstances. In other words, it's what a business would normally spend to produce goods or services. The standard cost can be adjusted over time to account for variances between the anticipated and actual costs of production. Management would take into account every stage of production and their costs, and then make adjustments accordingly.

Standard costs are divided into three different categories:

  • Materials : These are the substances used in the production process to manufacture goods and/or services.
  • Labor : The effort it takes from physical and mental effort to produce goods and services.
  • Overhead : This represents costs not directly associated with materials or labor in the production process. Regardless of how much the company produces or sells, overhead is a consistent business expense.

Most companies use standard costs for a variety of reasons. First, they include these costs in their operating budgets and profit plans. They are also used to predict for the business's next fiscal year. Standard costs also act as a way to analyze a company's performance. By using these costs as a target, businesses can determine whether they are meeting their goals as outlined.

Because the actual cost of manufacturing an individual item can vary due to operational inefficiencies, temporary shortages, or human error, the simplest way to set a cost-based transfer price is by establishing the item's standard cost.

Using the standard cost method in the above example, Company B would pay Company A $100 per laptop to cover the cost of manufacturing. Company B then sells the laptops at their market value. In this way, company A does not lose money on production, and company B receives 100% of the sales profits. However, as with market-based transfer pricing, the allocation of profits to one entity can discourage other entities from full participation.

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Cost-Plus Method : A Better Way To Assess Transfer Price?

  • Adv Ashish Parashar (Tax Couns
  • | Income Tax - Articles
  • Download PDF
  • 26 Oct 2022
  • 17,523 Views

Introduction

The transfer pricing rules are meant to prevent tax leakage and market distortion that may result from the prices set for transactions among related parties. While cost-plus is one of the most commonly used methods to assign an appropriate price for a product or service, it’s not the best method to follow in all cases. Let’s explore why the cost-plus method isn’t always a good idea when assigning a price tag to your transfer pricing transactions and why another method might be more suitable.

Assessing transfer price using the Cost-Plus Method

The cost-plus method is a commonly used method to determine transfer pricing for inter-company transactions. With the cost-plus method, the first step is to determine the total cost incurred in production or service delivery for the product or service in question. The cost is then apportioned to assign a cost to each unit produced or service delivered. The price is then set by adding a mark-up percentage to the cost to arrive at the transfer price, where the mark-up is generally set to reflect the company’s desired profit margin. The cost-plus method can be applied in several other ways depending on the circumstances, for instance, the cost-plus method may be used to set a transfer price by first calculating the cost of resources used in production and then using a formula to set the transfer price by adding a mark-up percentage to the cost. While the cost-plus method is a commonly used method to assess transfer price, it is not the best method to use in all cases. Let’s explore why the cost-plus method isn’t always a good idea when assigning a price tag to your transfer pricing transactions and why another method might be more suitable.

How to determine Profit Markup under Cost Plus Method

For determining Arm’s Length Price under Transfer Pricing, 2 components are considered namely Cost of production and Profit Markup. Computation of Cost of production is quite simple as entire data is available with assessee. However, figuring out Profit Markup is complicated. As per Rule 10B(1)(c) of Income Tax Rules, amount of normal gross profit markup is added to the cost to determine Arm/s Length Price.

Under Cost Plus Methods, components to be considered for determining cost of production are not defined under Income Tax Act and it shall be determined as per transaction entered. However, following category of costs are generally considered:

Direct costs- Cost of Raw Material, Freight Charges, Labour Expenses etc.

Indirect costs- Cost of repair and maintenance, rent, administration charges, Finance Charges etc

E.g., X Limited has transferred goods to its wholly owned subsidiary Y Limited for INR 1,00,000. X Limited has incurred following cost of production for such goods:

Cost of Raw Material: INR 60,000

Labour Cost: INR 15,000

Apportioned Indirect Cost: INR 20,000

Total Cost of production: INR 95,000

Profit Mark up: 20%

In this example, Arm’s Length Price for a transaction entered into with a wholly-owned subsidiary is INR 1,14,000 (INR 95,000 plus Profit Markup of 20%). Therefore, for the purpose of Income Tax, such transaction shall be deemed to be entered at INR 1,14,000.

Limitations of the Cost-Plus Method

There are a few limitations of the cost-plus method that need to be considered when assessing transfer pricing using this method. Determining the cost is subjective:

The first limitation of the cost-plus method is that the cost is largely subjective. When determining the cost of a product or service, there are often several different ways to go about it, which means the final cost determined will vary from one person to the next, making it difficult to arrive at a common cost that can be applied to all transactions. – Transfer price becomes difficult to track Another limitation of the cost-plus method is that it can make it difficult to track the actual transfer price for specific transactions.: When a company uses the cost-plus method to assign a transfer price, it is generally required to keep records of the total cost incurred, the quantity produced or delivered, and the mark-up percentage applied to determine the transfer price. This means an audit or tax authority may not be able to easily track the actual transfer price that was used to assign a specific transaction.

Mark-up percentage may not be accurate:

A third limitation of the cost-plus method is that the mark-up percentage applied to the cost to determine the transfer price may not always be accurate. Depending on the circumstances, it may be difficult to determine the appropriate mark-up percentage to apply to the cost to arrive at the transfer price. Additionally, even if a company is able to determine an appropriate mark-up percentage, it may not be able to accurately predict its future cost, which can change from one year to the next.

When to use Cost Plus Method?

Section 92C of Income Tax Act, provides for following 5 methods for computation of Arm’s Length Price:

1. comparable uncontrolled price method;

2. resale price method;

3. cost plus method;

4. profit split method;

5. transactional net margin method;

6. such other methods as may be prescribed by the Board.

Though, Section 92C does not specify which method is to be used under which circumstance. Rather, as per Section 92C, the most appropriate method must be selected based on facts and circumstance of the case.

Following factors must be considered for selection of method:

  • Nature of transaction
  • Class of transaction
  • Class of associate persons
  • Functions performed
  • Other relevant factors

The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand.

The author can be reached at [email protected]

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COMMENTS

  1. PDF Transfer Pricing Considerations for Intragroup Service Transactions

    Such activities include: Costs relating to the juridical structure of the parent company itself, such as meetings of shareholders of the parent, issuing of shares in the parent company, stock exchange listing of the parent company and costs of the supervisory board

  2. Transfer pricing guide on cost-sharing arrangements and reimbursements

    (a) Description of the types of services provided; (b) Reasons for selecting a specific method of allocating costs; (c) Contributions by each related party; (d) Benefits that are anticipated; and (e) Details of the calculations used.

  3. PDF The new transfer pricing landscape A practical guide to the BEPS changes

    Step 1: Identify, on an annual basis, the pooled costs by category associated with the low value-adding services, excluding any costs that benefit only the service provider; passthrough costs in the cost pool should be identified. Step 2: Eliminate costs associated with services provided to only one group entity.

  4. Transfer Pricing: What It Is and How It Works, With Examples

    Transfer pricing accounting occurs when goods or services are exchanged between divisions of the same company. A transfer price is based on market prices in charging another division,...

  5. PDF Chapter 6 TRANSFER PRICING METHODS 6ntroduction to Transfer ...

    Transfer pricing methods are ways of establishing arm's length prices or profits from transactions between associated enterprises. The transaction between related enterprises for which an arm's length price is to be established is referred to as the "controlled transaction".

  6. 5 Transfer Pricing Methods: Approaches, Benefits & Risks

    1. Comparable Uncontrolled Price Method The comparable uncontrolled price (CUP) method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction between unrelated parties. To make this comparison, the CUP method requires what's known as comparable data.

  7. Transfer Prices and Cost Allocations

    Cost allocations can be understood as a special form of transfer prices. Both relate to influencing decentralised decision-making. Transfer prices based on costs, market prices and negotiations are examined for their coordination efficiency.

  8. The Cost Plus Transfer Pricing Method (With Examples)

    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. How The Cost Plus Transfer Pricing Method Works

  9. An Economic Perspective on Transfer Pricing

    Schiller shows that the cost-allocation method outperforms the traditional transfer pricing method if either revenue uncertainty is high or if controlling the manager's revenue-enhancing effort is important for the firm. 4. Transfer Pricing and Divisional Investment Incentives4.1. Transfer Pricing and the Hold-Up Problem

  10. US transfer pricing

    For further information on transfer pricing in the United States please contact: Steven Wrappe. T +1 202 521 1542. E [email protected]. Transfer pricing. An overview of transfer pricing rules in The United States and who to contact for expert guidance.

  11. Transfer Pricing Cube

    Features Cost Allocation: Allocation and classification of data (e.g. by function and recipient) via appropriate allocation keys. Calculation of transfer pricing values using agreed methodology. Invoicing: Automation of invoices for recipient entities and other reporting functionality as required.

  12. Cost Allocation and Transfer Pricing for Decision-Making

    Cost allocation and transfer pricing are two important tools for financial management that can help you improve your decision-making process. In this article, you will learn what they are,...

  13. Understanding Transfer Pricing and Its Implications for Businesses on

    Owing to this, transfer pricing must account for jurisdiction, allocation and valuation issues. We'll briefly cover each issue below. ... Under the cost-based transfer pricing method, the company that makes the final sale receives the entire profit of the goods or service. This method is often used as a tax avoidance strategy.

  14. Transfer pricing considerations for intra-group services

    The European Union Joint Transfer Pricing Forum published a report on low value adding services. Low value adding intra group services are defined as those which are: supportive in nature, are not part of the core business of the group, do not use or create unique and valuable intangibles, and. do not involve the assumption, control or creation ...

  15. Transfer Pricing: Definition, Methods, Pros&Cons, Examples

    Medtronic Importance of Transfer Pricing Advantages of Transfer Pricing Disadvantages of Transfer Pricing FAQ What are Transfer Prices? Transfer prices are the rates levied on goods, services, or intellectual property traded between different departments or subsidiaries of the same parent company.

  16. The Five Transfer Pricing Methods Explained

    Traditional transaction methods: CUP method Resale price method Cost plus method Transactional profit methods: Transactional net margin method (TNMM) Transactional profit split method. The OECD Guidelines provide that you as a taxpayer should select the most appropriate transfer pricing method.

  17. Overhead cost allocation changes in a transfer pricing tax compliant

    Using a case study research strategy, we carry out a dynamic analysis of the to overhead cost allocations in one MNE where transfer pricing tax compliance evolves from being a topic receiving limited managerial attention to occupying a position where it becomes an explicit tax management strategy.

  18. Understanding Transfer Price vs. Standard Cost

    Key Takeaways A transfer price is what one division of a company charges another for materials used in the production of goods and services. Standard costs are the average or anticipated...

  19. Optimal Transfer Pricing Method and Fixed Cost Allocation

    The transfer price under all forms is a cost-based markup price, and so both divisions are profit centers. 7 In a survey of Canadian companies that regularly transfer intermediate goods, Shih ...

  20. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax

    This January 2022 edition includes the revised guidance on the application of the transactional profit method and the guidance for tax administrations on the application of the approach to hard-to-value intangibles agreed in 2018, as well as the new transfer pricing guidance on financial transactions approved in 2020.

  21. Transfer Pricing Methods

    Transfer Pricing Methods Parts II and III of this chapter respectively describe "traditional transaction methods" and "transactional profit methods" that can be used to establish whether the conditions imposed in the commercial or financial relations between associated enterprises are consistent with the arm's length principle.

  22. Challenges of Cost-Plus Method for Transfer Pricing

    1 Accuracy of cost data. One of the main challenges of applying the cost-plus method for transfer pricing is ensuring the accuracy and consistency of the cost data used to calculate the markup ...

  23. Cost-Plus Method : A Better Way To Assess Transfer Price?

    The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The author can be reached at [email protected]. Tags: Transfer Pricing.

  24. KPMG LLP Secures New Transfer Pricing Patent Within AI-Powered Tool

    Helps multinationals comply with BEPS 2.0 and other global tax regulatory changes Enables expedited transfer pricing benchmarking; tax strategy optimization Powered by Microsoft Azure New York ...