Cost Plus Method

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Cost, plus a gross markup

The formula is short: price = cost of production x (1 + gross markup). The gross markupGross markupGross profit divided by the cost of the goods or services sold. It is the measure the cost plus method compares. Unlike a net markup, it is measured before operating expenses.Open in the Glossary is gross profit divided by cost of goods sold, taken from comparable sales between independent parties. Under US rules it is ordinarily used for goods that a company makes or assembles and sells to related parties.

The best data is an internal comparableInternal comparableA comparable deal between one of the related companies and an unrelated party, such as the same seller selling the same goods to an outsider. Its facts are easy to check, so it is often, but not always, the most reliable comparable.Open in the Glossary: the same maker selling similar goods to an outside customer. Same factory, same books, so the costs line up. Next best are independent makers doing similar work. The products can differ more than under a price comparison (CUPComparable uncontrolled price (CUP)A method that compares the related-party price with the price charged in a comparable deal between unrelated parties. It is the most direct method when good comparables exist.Open in the Glossary), but the functions, risks and contract terms must be close, or you adjust for the differences.

The weak spot is accounting. One company books supervision, warehousing or quality checks in cost of goods sold, another books them as operating expenses. The gross markup changes with it. So you put the same costs on the same lines before you compare, as the calculator did with the factory supervision. For services, the US has a twin: the cost of services plus method. It adds a gross services markup to the costs of the service, and it is used most when the company sells the same service to outsiders.

Gross is not net

Now the Mexico contract manufacturerContract manufacturerA company that makes goods for another group company, to that company's orders and specifications, often using its technology. It bears little risk and earns a routine return, usually a markup on its costs.Open in the Glossary from the running story. The US Entrepreneur pays it cost plus 8%. Its numbers here are simple ones made up for this example, separate from the Price Dial's. That 8% is a net markup: operating profit over total costs, including its own operating expenses. It is the net cost plusNet cost plusOperating profit divided by total costs (cost of sales plus operating expenses). It is the usual profit level indicator for routine manufacturers and service providers.Open in the Glossary tested under the CPMComparable profits method (CPM)A US method that tests a company's operating profit against the operating profit of comparable companies, using a profit level indicator such as operating margin (Treas. Reg. § 1.482-5). It is close to the OECD's TNMM.Open in the Glossary, not the cost plus method. Same company, same year, two very different numbers:

A gross markup has to pay for the company's operating expenses and still leave a profit. A net markup is what is left after them. Never test one against the other.

Source: Treas. Reg. § 1.482-3(d), the cost plus method; § 1.482-9(e), the cost of services plus method; § 1.482-5(b), the CPM and its profit level indicators