Question

Which transfer pricing method works with (a) service contracts, (b) distribution/sales, and (c) manufacturing? Describe how the specific method is applied in each case.

Answer 1

a) Service Contracts - The Comparable Uncontrolled Price(CUP method)

The CUP Method compares the price of goods or services in an intercompany transaction to the price changed between independent parties. It’s important that goods and services are assessed under comparable conditions to get an accurate price that tax authorities will accept.

This can also be referred to as market-set pricing because, unlike other methods that focus on margins, the CUP Method is based on fair market price. If an organization manufactures a product, they have to consider what they could earn by selling it to the “outside world.” The company wants to maximize profit margins, so it should obviously exercise good habits, including charging fair market prices for goods or services delivered within the organization.

b) Distibution/ Sales - The Resale Price Method.

The Resale Price Method looks at the gross margin, or the difference between the price at which a product or service is purchased and the price at which it is sold to a third party. While similar to the Cost-Plus-Percent Method, the Resale Price Method only counts the margin as the transfer price. For this reason, it is most appropriate for distributors and resellers, as opposed to manufacturers.

c) Manufacturing - Cost Plus Percent Method.

Cost-Plus-Percent Method is an approach favored by some manufacturers and is popular with the aerospace industry. It’s a transaction method that compares gross profit to costs of sales. The division supplying goods or services determines the cost of the transaction, then adds a markup for profit on the goods or services delivered. The markup should be equal to what a third party would earn for transactions in a comparable situation, including similar risks and market conditions.