CUP, cost plus and TNMM: where do you measure the arm’s length price?

All three methods look for the price independent parties would have agreed. They just test it on a different line of the income statement. The deeper you measure, the looser the comparability requirements, but the more lies between the price and the point you measure.

Three test points in one income statement

CUP tests at the top, on the price. Cost plus tests one level down, on the markup over production costs. TNMM tests at the bottom, on operating profit, and so takes all costs into account (dashed bracket).

What each method compares

CUP

Compares: The price in the controlled transaction with the price between independent parties for the same product.
Source of comparables: Internal (the same seller also supplies a third party) or external (two third parties, or a quoted market price).
Works well for: Commodities, standard products, interest, royalties with a real market.

Cost plus

Compares: The gross markup on cost of goods sold with that of independent manufacturers.
Source of comparables: Third parties performing the same functions with a cost base built up the same way.
Works well for: Contract and toll manufacturing, routine intra-group services.

TNMM

Compares: A net profit indicator, usually EBIT on total costs, with a set of comparable companies.
Source of comparables: A database benchmark, with the outcome expressed as an interquartile range.
Works well for: The least complex party without unique intangibles, such as a free-zone plant or a routine distributor.

How strict is the comparison?

With cost plus the weak spot is often the accounting. If the comparable company books depreciation or overhead in cost of goods sold and the tested party does not, you are comparing two different markups.

Worked example: one product, three outcomes

A plant in a Costa Rican free zone makes a medical device for its US parent company. The figures are invented and serve only as an illustration.

Cost per unit (USD)	Amount
Direct materials	40.00
Direct labour	20.00
Production overhead	10.00
Cost of goods sold	70.00
Operating expenses	15.00
Total costs	85.00

The same supply, three outcomes. The gap between CUP and the other two is a signal: is the product the plant also sells to a third party really the same, or does that third party bear different risks?

Method	Input from comparables	Calculation	Price
CUP	The plant sells the same product to a third party for 100.00	take over the price	100.00
Cost plus	Gross markup of independent contract manufacturers: 30%	70.00 × 1.30	91.00
TNMM	EBIT on total costs of comparable companies: quartiles 6%, 8%, 11%	85.00 × 1.06 / 1.08 / 1.11	90.10 – 94.35

If the actual price falls within the TNMM range, there is usually no adjustment. If it falls outside, many countries adjust to the median. Which rule applies differs by jurisdiction.