Adjusted cost of goods sold as a proxy for related party purchases in transfer pricing

by Ednaldo Silva, Ph.D.

Adjusting cost of goods sold (COGS) to remove the effect of one-year change in inventories is important to determine the arm’s length gross profits of intercompany (related party) inventory goods transactions. Adjusted COGS produce also a more reliable measure of the operating profits of the tested party (audited taxpayer) and the selected comparable companies.

RoyaltyStat’s online database of company financials (distributor of Standard & Poor’s Capital IQ Compustat) has been programmed so that Adjusted COGS is a built-in function, facilitating defensible transfer pricing analysis.

Cost of goods sold

Form 1125-A (Cost of Goods Sold), a schedule attached to the US corporate tax return, specifies that COGS consists of beginning inventory (equivalent to inventory at end of last year), plus purchases, minus ending inventory (inventory at the end of the current year). Manufacturers and value-added resellers include direct labor in COGS, but not distributors or retailers.

According to Form 1125-A, several accepted methods are used for valuing closing inventory, including purchase cost and market price. See Pamela Drake & Frank Fabozzi, Analysis of Financial Statements (3^rd edition), Wiley, 2012, pp. 56, 77-78.

If a LIFO inventory method is adopted during the tax year for any purchased goods, Form 1125-A must incorporate Form 970 (Application to Use LIFO Inventory Method), adding further complication to COGS comparability across companies.

Intercompany inventory goods transactions

In cases involving imports of intermediate goods by controlled manufacturers and imports of final goods by distributors and retailers, we must test inbound related-party purchases, which are an undisclosed component of COGS.

As a proxy for purchases, we can adjust COGS starting from an accounting relationship that is true by definition (i.e., this accounting identity is not subject to controversy):

(1) Beginning inventory + Purchases = COGS + Ending inventory, or

(2) Purchases = COGS + V(t) – V(t – 1),

where V(t) denotes current period-end inventory and V(t – 1) is inventory at end of last year. To get reassurance about this accounting identity (1), above, see Drake & Fabozzi, ibidem, pp. 108-109.

Above, we call equation (2) Adjusted COGS, which we posit as a proxy for Purchases.

COGS is a single accounting entry on the income statement of a selected corporation; beginning and ending inventory, used to compute Adjusted COGS, are single accounting entries reported on the balance sheet. Purchases and direct labor costs (for manufacturers and valued added resellers) are not disclosed.

A major advantage of Adjusted COGS is that it adjusts also for LIFO reserve.

Adjusted COGS & profit measures

We can improve the reliability of reported (or unadjusted) gross profits by using Adjusted COGS, thus removing the effect of one-year changes in inventories from COGS. Adjusted COGS are closer to the economic concept of variable costs.

In this way, the reliability of gross and operating profits is also improved (adjusted operating profits are adjusted gross profits less operating expenses), both before or after accounting for a “reasonable allowance for depreciation and amortization” under US Treas. Reg. 1.482-5(d)(3).

Adjusted COGS can be used to compute several measures of profits further downstream of the income statement of the selected company:

(3) Adjusted Gross Profit = Net Sales – Adjusted COGS.

(4) Adjusted Operating Profit BeforeDepreciation (OIBDP) = Adjusted Gross Profit – XSGA (where XSGA is Compustat’s acronym for Selling, General & Administrative Expenses (e., Operating Expenses)).

(5) Adjusted Operating Profit After Depreciation (OIADP) = Adjusted OIBDP – DP (where DP is Compustat’s acronym for Depreciation, Amortization & Depletion).

(6) Adjusted Operating Profit AfterDepreciation excluding Amortization = Adjusted OIADP + AM (where AM is Compustat’s acronym for amortization of acquired intangibles).

Testing the OMAD profit indicator

Using RoyaltyStat’s Adjusted COGS function, we can measure the reliability of unadjusted or reported OMAD vs. Adjusted OMAD with data from the selected comparables. (OMAD is Compustat’s mnemonic for Operating [Profit] Margin After Depreciation, Amortization and Depletion.) RoyaltyStat’s online Adjusted COGS function includes a comparison of the before and after adjustment of operating profits, computed as LN(Adjusted OMAD/OMAD), where LN denotes natural logarithms.

This inventory changes adjustment is important because OMAD is the mode (most frequent) profit indicator used to test the arm’s length nature of cross-border sales from suppliers to related-party manufacturers, distributors and retailers.

After the inventory changes adjustment is made we can use the coefficient of variation, or another measure of statistical reliability, such as the quartile coefficient of dispersion = (Q3 – Q1) / (Q3 + Q1), to compare the reliability of the selected profit indicator specified under the transactional net margin method (TNMM) (or under the comparable profits method in the US), and select the most reliable (adjusted or unadjusted) measure of arm’s length operating profits.

Otherwise, without this important adjustment to COGS, use of the TNMM (or the CPM in the US) is more vulnerable to audit challenges.