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How to price contract and toll manufacturing arrangements: tested party selection, cost plus vs TNMM, cost-base design, capacity utilization, inventory and warranty risk, benchmarking, documentation, and audit issues.
Borys Ulanenko
CEO, ArmsLength AI
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A contract manufacturer usually earns a routine manufacturing return when it produces goods to an affiliate's specifications and the principal controls product IP, market strategy, and material entrepreneurial risks. The usual tested-party answer is the manufacturer. The usual profit indicator is a cost-based return, either a traditional cost plus gross mark-up or TNMM with Net Cost Plus.
That answer depends on facts. A toll manufacturer that never owns materials normally earns a return on conversion activities. A contract manufacturer that takes title to inventory may need compensation for working capital and operational risk. A full-fledged manufacturer that controls product design, procurement, production strategy, inventory, warranty, and market risk usually cannot be treated as routine.
For the broader methods framework, see the transfer pricing methods guide. For the gross-method mechanics, see cost plus in transfer pricing. For tested-party logic, see tested party selection.
The label in the intercompany agreement is only a starting point. The transfer pricing result follows the actual functions, assets, and risks.
| Profile | Materials and inventory | Decision rights | Typical return |
|---|---|---|---|
| Toll manufacturer | Principal owns raw materials and finished goods | Converts materials under principal instructions | Conversion cost plus routine return |
| Contract manufacturer | Manufacturer may take title, but output is usually committed to the principal | Operates plant and executes production plan | Cost plus or TNMM return on manufacturing costs |
| Full-fledged manufacturer | Owns materials and finished goods, sells into market | Controls procurement, production, product, warranty, and market choices | Entrepreneurial return, often not a routine tested party |
A toll manufacturer usually provides capacity, labor, production know-how, and plant operations. It does not buy raw materials for its own account and does not own the finished goods. Pricing normally starts with conversion costs: direct labor, production overhead, quality control, and plant support costs tied to the tolling activity.
The main cost-base question is whether any third-party charges are true pass-throughs. If the toller coordinates logistics, subcontracting, or testing and adds value, a zero mark-up pass-through may be too thin. If it merely pays an invoice as agent for the principal, including that amount in the mark-up base can overstate the toller's return.
A contract manufacturer may take title to materials and finished goods, but the principal usually commits to purchase output, owns product intangibles, sets specifications, and bears demand risk. This profile is common in electronics, medical devices, automotive components, industrial goods, and consumer products.
The manufacturer is normally the tested party if it does not own unique intangibles and comparable independent manufacturers can be found. The benchmark should match the actual risk package. A manufacturer with purchase commitments and principal-funded tooling should not be compared to independent producers that carry open-market demand risk.
A full-fledged manufacturer controls more of the value chain. It may design products, choose suppliers, own process or product IP, take market risk, manage inventory for its own account, handle warranty exposure, and sell to independent customers.
Treating this entity as a routine cost-plus manufacturer creates audit risk. If the manufacturer controls unique production processes, valuable know-how, or product decisions, a one-sided routine return may strip profit away from the entity that actually creates value.
Under OECD guidance, the tested party for one-sided methods is generally the party to which the method can be applied most reliably, often the less complex party. Contract manufacturers often fit that profile because independent comparables exist for routine production activities. See and .
Use a tested-party matrix before selecting the method:
| Factor | Routine manufacturer answer | Warning sign |
|---|---|---|
| Product IP | Principal owns and controls it | Manufacturer develops product technology |
| Production process | Standard process execution | Manufacturer owns unique process know-how |
| Inventory risk | Principal commits to buy output or covers obsolete stock | Manufacturer sells output into uncertain demand |
| Warranty risk | Principal bears product warranty | Manufacturer bears field failure costs |
| Capacity risk | Principal commits volumes or compensates underutilization | Manufacturer absorbs idle plant cost |
| Procurement | Principal approves suppliers and specs | Manufacturer controls strategic sourcing |
| Comparables | Independent contract manufacturers exist | Only full-risk manufacturers are available |
If the manufacturer controls the risks that drive profit, do not force a routine tested-party answer. Revisit the accurate delineation of the transaction before selecting TNMM or cost plus.
The method choice turns on data reliability, not preference.
The cost plus method starts with manufacturing costs and adds an arm's length gross mark-up. OECD Chapter II describes cost plus as useful for semi-finished goods, long-term buy-and-supply arrangements, and services. HMRC's cost plus manual also cautions that a cost plus label does not make an arrangement arm's length by itself.
Cost plus is strongest when:
TNMM tests operating profit against an appropriate base. For manufacturers, the usual PLI is Net Cost Plus, calculated as operating profit over total costs. See Net Cost Plus for the formula.
TNMM is often more practical when:
| Issue | Cost plus | TNMM with Net Cost Plus |
|---|---|---|
| Profit level | Gross mark-up | Operating profit mark-up |
| Cost base | Usually production or service costs | Usually total operating costs |
| Data source | Internal contracts, gross-level public data where available | Commercial comparable-company databases |
| Main weakness | Cost classification sensitivity | Can mask product and functional differences |
| Best use | Clear gross comparability | Routine manufacturer with reliable net comparables |
The mark-up often gets attention, but audits usually move to the denominator: which costs were marked up, excluded, normalized, or passed through.
For contract manufacturers that buy materials, raw materials may be part of the cost base if the manufacturer performs procurement, quality, storage, and inventory functions. For toll manufacturers, principal-owned materials are usually outside the toller's cost base.
A pass-through cost should have a clear agency or no-value-add fact pattern. If the manufacturer coordinates vendors, controls quality, bears delay risk, or manages the supplier relationship, a tax authority may expect compensation for that activity.
Tooling can sit in several places: owned by the principal, owned by the manufacturer, reimbursed at cost, capitalized, leased, or embedded in unit price. The documentation should show who funded the tooling, who controls it, who bears obsolescence risk, and whether depreciation sits in the marked-up base.
Start-up costs, abnormal scrap, product launch inefficiencies, flood or fire losses, and one-off restructuring costs should be analyzed separately. Independent manufacturers may not pass all abnormal costs to customers. If the principal caused the cost or agreed to absorb it, the contract and conduct should support that treatment.
Idle capacity can distort a cost-plus model. A manufacturer with a 50% utilized plant may show high unit costs, and marking up all idle costs may overcharge the principal unless independent parties would do the same.
Document:
Risk allocation should follow both contracts and conduct. OECD Chapter I asks who assumes risk contractually, who controls it, and who has financial capacity to bear it.
A contract manufacturer may hold inventory on its balance sheet without bearing full inventory risk. Purchase commitments, buy-back clauses, principal-approved safety stock, and reimbursement for obsolete materials can shift the economic risk back to the principal.
Audit files should reconcile:
Warranty clauses are often too thin. Separate manufacturing-defect risk from product-design risk:
| Warranty issue | Usual owner in routine model | Evidence to keep |
|---|---|---|
| Manufacturing defect | Manufacturer may bear limited rework/scrap risk | Quality metrics, defect logs, service-level agreement |
| Product design failure | Principal | Engineering approvals, design ownership, customer claims |
| Field warranty program | Principal unless delegated and compensated | Warranty policy, reserve accounting, claim allocation |
Routine manufacturers still bear operating risk. They need to manage labor, yields, quality, and plant execution. The question is whether those risks are capped or entrepreneurial. A guaranteed margin with no accountability for poor quality may not match independent behavior. A manufacturer that absorbs all production losses may need a higher return or a different profile.
Start with the accurately delineated profile, then search for comparables that match it.
For TNMM benchmarking, a typical search screens for independent manufacturers by industry code, geography, ownership independence, financial data availability, and functional profile. The manual screening matters. Many "manufacturers" in databases are full-risk producers with brands, product R&D, or third-party sales exposure.
For cost plus, internal comparables should be considered first. If the same factory manufactures similar products for unrelated customers, the internal mark-up can be powerful evidence if volumes, specs, risks, assets, and terms are comparable.
Net Cost Plus is common for routine contract manufacturers because costs drive the value contribution. Operating margin may be less intuitive for captive manufacturing where revenue is an intercompany price rather than a market sales measure. ROA or ROOA may be relevant for asset-intensive manufacturing if plant and equipment drive returns.
See PLI selection and benchmarking studies for the broader workflow.
The year-end true-up should be tied to the tested PLI and the contractual pricing policy. A policy that says "5% mark-up" but true-ups to a TNMM interquartile range should explain whether the legal policy is a gross cost plus method, a net TNMM policy, or a price-setting rule tested under TNMM.
A good contract manufacturer file should include:
| Document | What it should prove |
|---|---|
| Intercompany manufacturing agreement | Scope, title transfer, purchase commitments, risk allocation, pricing, true-up |
| Functional analysis | Who controls production, procurement, inventory, warranty, capacity, and IP |
| Cost-base mapping | ERP accounts included, excluded, and treated as pass-through |
| Benchmarking study | Search strategy, screens, manual rejections, selected PLI, range |
| Capacity analysis | Normal vs actual capacity and treatment of idle cost |
| Inventory and warranty support | Reserves, claims, obsolescence, rework, quality reports |
| Year-end calculation | Actual tested-party result, true-up, invoice support, local accounting entry |
Match the contract to operating evidence. If the agreement says the principal bears inventory risk, the file should include purchase forecasts, inventory write-off reimbursements, or buy-back mechanics. A clause without conduct rarely resolves an audit.
Tax authorities usually focus on a short list of pressure points:
The IRS transfer pricing materials emphasize fact development and whether intercompany results match economic reality. The same practical point applies outside the United States: labels, ranges, and contracts need to line up with plant-level facts.
Facts: HungaryCo manufactures industrial sensors for its Swiss principal. The Swiss principal owns product designs, approves suppliers, commits to buy all output, and bears market risk. HungaryCo buys materials in its own name but is reimbursed for obsolete inventory caused by forecast changes. HungaryCo owns plant equipment and manages production labor.
Method selection: HungaryCo is the tested party. No reliable internal gross mark-up data exists. External gross margins are inconsistent because comparables classify engineering and plant overhead differently. TNMM with Net Cost Plus is selected.
| Item | Amount |
|---|---|
| Revenue from principal | EUR 54,000,000 |
| Raw materials | EUR 32,000,000 |
| Direct labor | EUR 7,000,000 |
| Manufacturing overhead | EUR 9,000,000 |
| Operating expenses | EUR 3,000,000 |
| Total costs | EUR 51,000,000 |
| Operating profit | EUR 3,000,000 |
| Net Cost Plus | 5.88% |
The benchmarking study finds an interquartile range of 4.2% to 7.1% NCP for independent contract manufacturers. HungaryCo's 5.88% result falls within the range.
Capacity point: During Q2, principal forecast reductions created idle time. The principal reimbursed documented idle labor and fixed overhead under the agreement. The file includes forecast changes, plant utilization reports, and the reimbursement calculation. Those facts support treating the idle-cost recovery separately from HungaryCo's routine NCP.
Usually, but not always. The manufacturer is a strong tested-party candidate when it performs routine production, lacks unique intangibles, and reliable comparables exist. If it controls product design, process IP, warranty risk, or market decisions, the routine tested-party assumption may fail.
Use cost plus when reliable gross mark-up comparables exist and cost classifications are consistent. Use TNMM with Net Cost Plus when net-margin data is more reliable than gross mark-ups. The method should follow the facts and available data.
It depends on who owns and controls the material risk. Raw materials are often in the cost base for contract manufacturers that buy, store, and manage materials. Principal-owned materials in a toll model are often excluded.
Identify the cause. Idle capacity from principal forecast changes may justify separate compensation. Idle capacity from local inefficiency may sit with the manufacturer. Normal capacity, actual utilization, and contract terms should be documented.
The main risk is inconsistency: a "limited-risk" manufacturer that actually bears full production losses, warranty exposure, obsolete inventory, or market risk. That mismatch can undermine both the tested-party selection and the benchmark.