What the method is actually for?
When two companies in the same group trade with each other, no real market sets the price. The price is set internally. For tax authorities that is a problem, because the price moves profit between countries — and with it, tax.
This is why the arm's length principle exists: the internal price has to match what two independent companies would have agreed. The difficulty is proving it.
Sometimes that is easy. If the same product is also sold to outside customers, you have a comparison price. Often it is not. There is no market price for "manufacturing this specific component to these specific instructions". So you turn the question around. Instead of asking what the product costs on the market, you ask what the work cost to perform, and what profit an independent supplier could expect on top.
That is the cost plus method.
When the method fits
The method fits where the supplying company has a limited role in the group. It carries out; it does not decide. Three situations come up most often.
- Contract and toll manufacturing. A production company manufactures to the parent's specification. It does not decide what gets produced, it does not find customers, and it is not left holding unsold stock. Its risk is low and its task is clearly bounded.
- Contract research and development. One company researches or develops on behalf of another. It has its costs reimbursed plus a mark-up. Whatever comes of the results — success or failure — affects the commissioning party, not the researcher.
- Intra-group services. One unit handles accounting, IT or HR administration for other group companies.
When the method does not fit: where the supplying company uses valuable brands, patents or other know-how, where it carries real entrepreneurial risk, or where it decides for itself what happens in the market. The underlying idea is simple. Paying cost plus a mark-up pays for routine. Where value is genuinely being created, paying for routine is paying too little — and an audit will find it.
A note on choosing the method. The OECD applies a "most appropriate method" standard, which means no method has automatic priority. Several countries have brought their domestic rules into line. Germany, for example, used to have a fixed order of methods and abolished it; § 1(3) of the Foreign Tax Act (AStG) now requires the most appropriate method for the case at hand. In practice you have to explain why cost plus is right here. "A price comparison was not possible" is no longer a sufficient reason on its own.
In practice
Building block 1: the cost base
This is where the result is decided. Not at the mark-up — at the costs.
There are two common definitions.
- Production costs are everything spent on making the product: materials, wages of production staff, and manufacturing overheads such as rent and electricity for the plant or depreciation on the machines.
- Total costs are the production costs plus costs incurred outside production that can be attributed to the supply — administration, accounting, selling.
The gap between them is rarely small. In the example below, EUR 500,000 separates the two.
Two further decisions follow.
- Actual or budgeted costs? Do you price on the costs actually incurred, or on the planned figures? Either is acceptable. If you use budgeted costs, agree in writing beforehand what happens when actual costs differ. Otherwise every variance becomes a year-end discussion that one sentence in the contract would have prevented.
- Pass-through costs. Some costs are only passed along, with the supplying company adding nothing — a licence bought centrally and redistributed, for instance. Whether a mark-up belongs on those depends on what the company actually does. Forwarding an invoice is not a service that earns a profit mark-up.
Building block 2: the mark-up
The mark-up answers one question: what percentage of profit would an independent company charge for a comparable supply? There are two routes to the number.
- The internal comparable. If your company also sells the same service to unrelated customers, you already know the mark-up. This is the most reliable case, and the rarest.
- The database study. More often you look for independent companies doing something comparable — similar industry, similar size, similarly simple role. Their published figures produce a range of mark-ups, and the median of that range serves as the reference point. This exercise is called a benchmarking study.
- The critical point: a mark-up from a database always belongs to a particular cost base. A rate calculated on production costs must not be applied to total costs. The example shows how much that matters.
Building block 3: the transfer price
Transfer price = cost base × (1 + mark-up)
Worked example, step by step
A German principal engages a Czech subsidiary as a contract manufacturer. The manufacturer's costs for the financial year:
Step 1 — fix the cost base. We choose production costs: EUR 7,000,000. This choice is documented, so that later it is clear what everything else refers to.
Step 2 — establish the mark-up. The database study returns a median mark-up on production costs of 12% for comparable contract manufacturers. Note the wording: on production costs, not on total costs.
Step 3 — calculate the mark-up amount. EUR 7,000,000 × 12% = EUR 840,000
Step 4 — form the transfer price. EUR 7,000,000 + EUR 840,000 = EUR 7,840,000
What does the manufacturer keep? It receives EUR 7,840,000, has production costs of EUR 7,000,000, and also carries EUR 500,000 of administrative and selling costs. Its operating profit is therefore EUR 340,000, which is 4.53% of its total costs.
The most common error
Take the same 12% and apply it to total costs by mistake, because nobody ever fixed which cost base applied:
EUR 7,500,000 × 1.12 = EUR 8,400,000
That is EUR 560,000 more than it should be — an overpricing of 7.1%. And it is not an arithmetic error. The arithmetic was fine. What went wrong is that the rate and the cost base did not match, and nobody had written down which base was meant.
An auditor finds this easily, because both cost figures are visible in the accounts.
Cost plus or net cost plus?
These two get mixed up constantly. The difference is straightforward.
- Cost plus works from production costs. The mark-up therefore has to cover the supplier's own administrative costs as well; what remains after that is its profit. What you are measuring is a gross margin — the margin before the company's own admin costs come off.
- Net cost plus (NCP) works from total costs. Administrative costs are already inside the base, so the mark-up is pure profit. What you are measuring is a net margin, the operating result. Strictly speaking this is no longer the cost plus method but the transactional net margin method (TNMM).
In our example, a properly derived net cost plus of 6% on total costs gives EUR 7,500,000 × 1.06 = EUR 7,950,000. A different figure from the EUR 7,840,000 above — and both are defensible, as long as each rate sits on its matching base.
This is why many companies reach for net cost plus. The reason is practical rather than theoretical: gross margins are hard to compare meaningfully between companies that book costs differently, whereas operating results are not. That reasoning belongs in the documentation as stated — a decision about the available data, not something self-evident.
The right database matters too!
The mark-up is the heart of the documentation, and it is only as good as the comparable companies behind it. Which database you use is therefore not a technical detail but a substantive choice. Five things make the difference.
- Private companies. Contract manufacturers, contract researchers and shared service centres are almost never listed. A database holding only listed groups will not find suitable comparables for exactly these cases. You need access to private company accounts.
- Standardised financials. A Czech and a Portuguese set of accounts are built differently. If the figures have not been mapped onto a common format, you are comparing ratios that do not measure the same thing — and that is precisely what an audit probes.
- Industry classification. SIC or NAICS codes are how you find companies genuinely doing something similar. Without a defensible industry basis the selection becomes arbitrary, and an arbitrary selection cannot be defended.
- Screening criteria. A comparable that itself belongs to a group is not independent and does not work as a benchmark. Persistent loss-makers pull the range down; research-heavy companies pull it up. The database has to let you exclude such cases in a way you can explain.
- The right ratio. This closes the loop with the section above. If you work from production costs you need gross margins. If you work from total costs you need net cost plus. A database that offers only one of the two decides your method for you — and for the wrong reason.
- And a sixth point that usually surfaces during an audit: you have to be able to document the search so that it can be repeated. In Germany the deadline for producing documentation has been 30 days since 1 January 2025. If you cannot then show which search criteria produced which selection, you have a number but not evidence.
How smartZebra solves this?
Transfer Pricing Pro is built for exactly this step of the work:
- Over 500,000 private companies with standardised financial data, private and listed, across the major tax jurisdictions
- SIC and NAICS classification for finding comparable functions
- Six profit level indicators — operating margin (EBIT/revenue), net cost plus (EBIT/costs), Berry ratio, return on assets, ROCE and gross margin. For the cost plus method the two that matter are gross margin and net cost plus, and both are available
- Intelligent screening for independence, loss years and R&D intensity
- Automatic calculation of the interquartile range and median
- Traceability back to the original financial statements — the thing that counts when an auditor asks
- One-click export of the study with full documentation
In practice: a solid benchmarking study in minutes rather than weeks, methodologically aligned with Chapter III of the OECD Guidelines → See smartZebra's Transfer Pricing solution.
Documentation checklist
- The cost base is defined in writing. It says whether production costs or total costs are meant, and which items are included.
- The mark-up sits on the same cost base it is applied to.
- Actual or budgeted costs has been decided, and for budgeted costs the treatment of variances is agreed.
- The treatment of pass-through costs is reasoned.
- The database used covers private companies and supplies the ratio matching the chosen cost base.
- The search steps are documented well enough that the selection of comparables can be repeated.
- There is a stated reason why cost plus is the most appropriate method for this transaction.
- The derivation exists as a document, not as knowledge in somebody's head.
Legal basis & deadlines
- OECD: Transfer Pricing Guidelines, consolidated January 2022 edition, Chapter II Part II.
- National rules vary, and they are tightening. Germany is a useful illustration. § 1 AStG sets out the arm's length principle and requires the most appropriate method in subsection 3; the tax administration's position is set out in the Administrative Principles on Transfer Pricing 2024, the Federal Ministry of Finance circular of 12 December 2024.
- Deadlines: since 1 January 2025 the German tax authority can request transfer pricing documentation at any time under § 90(3) of the Fiscal Code, not only during an audit. The deadline for producing it is 30 days, and the submission has to include a transaction matrix.
For cost plus that is the point that really matters, and it applies wherever deadlines are short. The derivation of the cost base has to be ready when the request arrives. Thirty days is not enough to rework a cost accounting system for transfer pricing purposes after the fact.
Next step: A mark-up is only as reliable as the comparables behind it. How a database study for routine functions is built — searching, screening, arriving at a range — is covered in the article on the transfer pricing benchmarking study.
.png){kind=spacer}
%20Loans%20in%20Private%20Credit.png)
