Profit Level Indicator Selection: How to Choose the Right PLI for Your Benchmarking Study

Quick Answer: Which PLI Should I Use?

The right Profit Level Indicator depends on what drives profitability in your tested party's transaction:

• Operating Margin (OM) → For revenue-driven businesses (distributors, service providers, sales entities)
• Net Cost Plus (NCP) → For cost-driven operations (contract manufacturers, R&D services, shared services)
• Berry Ratio → For pass-through activities where operating expenses are the value driver (limited-risk distributors, agents)—but only when OECD conditions are met
• Return on Assets (ROA/ROOA) → For asset-intensive businesses where capital employed drives returns

OECD Guidelines emphasize that the selection of the most appropriate net profit indicator should take account of the facts and circumstances of the case, in particular through a functional analysis (OECD Guidelines ¶2.82). Always match the PLI to what drives the tested party's profitability.

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What is a Profit Level Indicator?

A Profit Level Indicator (PLI) is the ratio used to measure profitability in a TNMM or CPM benchmarking analysis. The PLI you choose determines how you'll compare your tested party's results against independent companies.

US Treasury Regulations §1.482-5(b)(4) defines PLIs as "ratios that measure relationships between profits and costs incurred or resources employed." The key insight is that different PLIs capture different aspects of what makes a business profitable—and the right choice depends on your tested party's economic substance.

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The Five Main PLIs Explained

1. Operating Margin (OM)

Formula: Operating Margin = Operating Profit ÷ Net Revenue

Operating Margin measures profitability as a percentage of sales. It's the most widely used PLI globally—accounting for approximately 60% of US APAs where CPM was applied to tangible and intangible transfers (per Deloitte's summary of IRS 2023 APA statistics).

Best For:

• Full-fledged and limited-risk distributors
• Service providers with revenue-based pricing
• Sales agents and marketing entities
• Any entity where sales volume is the primary value driver

Advantages:

• Financial data widely available
• Easy to calculate and understand
• Intuitive interpretation for auditors
• Universal acceptance across jurisdictions

Limitations:

• Sensitive to revenue fluctuations and pricing strategy
• May not capture asset-intensive operations well
• Pass-through revenue can distort results (agency/commissionaire arrangements)

Typical Application: A European distribution subsidiary buys products from its US parent and resells to third-party customers. Its value comes from sales execution—customer relationships, logistics, and market knowledge. Operating margin captures whether its return on sales is arm's length.

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2. Net Cost Plus (NCP) / Return on Total Costs

Formula: Net Cost Plus = Operating Profit ÷ Total Costs = Operating Profit ÷ (COGS + Operating Expenses)

Net Cost Plus (also called Full Cost Plus or Return on Total Costs) measures the markup earned on the total cost base. It's the standard PLI for cost-driven operations.

Best For:

• Contract manufacturers
• Toll manufacturers
• R&D service providers
• Shared service centers
• Any entity where cost efficiency is the value driver

Advantages:

• Appropriate when the tested party's value comes from cost control
• Less affected by pricing strategy variations
• Works well for cost-plus service arrangements

Limitations:

• Requires accurate cost allocation and segmentation
• Pass-through costs must be identified and treated consistently
• Affected by accounting treatment differences

Cost Base Design Matters: If subcontracted costs are pure pass-through (no value added by the tested party), including them in the denominator mechanically depresses the NCP. Define your cost base clearly and be consistent with comparables.

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3. Berry Ratio

Formula: Berry Ratio = Gross Profit ÷ Operating Expenses

The Berry Ratio, named after economist Dr. Charles Berry who testified in Sundstrand Corporation v. Commissioner (1991), measures gross profit relative to operating expenses. It's designed for situations where operating expenses—not revenue or assets—drive the tested party's value.

When Berry Ratio is Appropriate (OECD ¶2.106-2.108):

• The tested party's value-add is captured in operating expenses
• COGS is largely pass-through (the tested party doesn't add significant value to the goods themselves)
• No significant intangibles or risks beyond routine activities
• The tested party isn't performing additional functions that warrant a different return

When Berry Ratio is NOT Appropriate:

• The tested party bears meaningful inventory risk or pricing risk
• COGS includes value-adding activities (manufacturing, processing)
• Operating expenses don't capture the full scope of value creation
• The comparable set has inconsistent cost classifications

The Classification Sensitivity Problem:

Berry ratio is "very sensitive" to cost classification, as the UN Practical Manual warns. Consider this example:

Same operating profit, same economics—different Berry ratio solely due to accounting classification. This is why Berry disputes are common in jurisdictions like India.

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4. Return on Assets (ROA)

Formula: Return on Assets = Operating Profit ÷ Total Assets = EBIT ÷ Average Total Assets

China SAT Notice No. 6 specifies using average total assets: (opening balance + closing balance) ÷ 2.

Best For:

• Asset-intensive manufacturers
• Warehousing and logistics operations
• Distributors with significant inventory and warehousing facilities
• Any entity where capital investment drives returns

Advantages:

• Captures asset intensity that other PLIs miss
• Appropriate when returns should relate to capital employed
• Useful when comparables vary significantly in asset intensity

Limitations:

• Affected by depreciation policies (straight-line vs. accelerated)
• Accounting treatment varies (leased assets, intangibles, revaluations)
• Requires balance sheet data (not always available for comparables)
• Definition disputes: total vs. average, gross vs. net PPE

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5. Return on Operating Assets (ROOA)

Formula: ROOA = Operating Profit ÷ Operating Assets

Operating Assets = PP&E + Inventory + Trade Receivables − Trade Payables (or variants excluding non-operating items)

ROOA refines ROA by focusing only on assets used in operations, excluding cash, investments, and other non-operating assets.

Best For:

• Manufacturing operations where non-operating assets would distort ROA
• Entities with significant financial investments or excess cash
• Capital-intensive operations requiring clean asset mapping

Limitations:

• More complex to calculate
• Requires detailed balance sheet segmentation
• Less commonly used than ROA
• High audit risk if balance sheets aren't comparable across accounting standards

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How to Select the Appropriate Profit Level Indicator (5 Steps)

PLI selection is not a “preference” question—it’s a reliability question. A defensible workflow is:

1. Start with functional analysis (FAR) — What functions are performed, what assets are used, and what risks are assumed?
2. Identify the tested party — Typically the less complex entity without unique intangibles.
3. Identify the value driver — Is compensation primarily tied to sales execution, cost efficiency, OPEX-driven intermediation, or capital employed?
4. Check data availability and definition risk — Can you calculate the PLI reliably for both tested party and comparables with consistent accounting mappings (COGS vs OPEX vs operating assets)?
5. Select the most reliable PLI and document “why not the alternatives” — If two PLIs are plausible, pick the one with better data reliability and explain why the other would be less reliable in your facts.

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PLI Selection by Transaction Type

Use this decision matrix as a starting point, then validate against your specific facts and circumstances:

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Jurisdictional Preferences

Tax authorities have different "comfort zones" for PLI selection. Understanding these preferences helps you anticipate audit questions.

United States (IRS)

• Primary Method: CPM under §1.482-5
• Common PLIs: Operating margin (~60% of APAs), Berry ratio for appropriate distributor cases, ROA
• Guidance: §1.482-5(d) provides detailed definitions for sales revenue, gross profit, operating expenses, and operating profit
• Berry Acceptance: Explicitly recognized; IRS practice units include Berry formula examples

Germany (BMF)

• Guidance: BMF Administrative Principles (December 2024) explicitly follow OECD profit-indicator approach
• Key Rule: Non-operating items are generally excluded per ¶2.86; points to OECD ¶2.92+ for denominator selection
• Preference: Operating margin commonly used; Berry ratio appears less common in practice
• Sample Size: German tax authorities sometimes expect larger comparable sets

United Kingdom (HMRC)

• Key Warning: HMRC criticizes TNMM applications "based on little more than a list of supposedly comparable companies" (INTM421080)
• Best Practice: Start with internal comparable net margin first, then external if unavailable
• Acceptance: TNMM widely used, but justify your PLI choice clearly

India

• Legal Basis: Rule 10B(1)(e) permits net profit margin relative to costs, sales, assets, or "other relevant base"
• Range: Rule 10CA uses 35th-65th percentile (narrower than OECD IQR)
• Berry Ratio: Accepted but frequently challenged by TPOs—denominator logic is heavily litigated
• Key Cases: Mitsubishi, Marubeni Itochu, Sumitomo (Berry ratio disputes)

China (SAT)

• Guidance: SAT Public Notice [2017] No. 6, Article 20 explicitly lists acceptable PLIs with official formulas
• Recognized PLIs: Operating margin, full cost mark-up, ROA, Berry ratio
• Key Principle: "The profit level indicator selected should reflect the functions performed, risks assumed and assets used"

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Practical Examples

Example 1: Same Distributor, OM vs Berry Give Different Answers

Facts:

• Sales: 1,000
• COGS: 850
• Gross Profit: 150
• Operating Expenses: 120
• Operating Profit: 30

PLI Results:

Comparable Ranges (illustrative):

• Operating Margin: 1.5% – 3.5% → Tested party (3.0%) is in range
• Berry Ratio: 1.35 – 1.55 → Tested party (1.25) is below range

Interpretation: If COGS isn't truly pass-through (the distributor bears inventory risk, pricing risk, or adds value to products), Operating Margin may be the appropriate PLI. Berry ratio could wrongly "penalize" the high COGS intensity.

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Example 2: Contract Manufacturer—NCP vs ROA Diverge

Tested Party:

• Operating Profit: 20
• Total Costs: 400
• Total Assets: 300

PLI Results:

Comparable Analysis:

• Comparable A (asset-light): NCP 5.0%, ROA 10.0%
• Comparable B (asset-heavy): NCP 5.0%, ROA 5.5%

Takeaway: If your comparables vary in asset intensity, NCP can "hide" major differences. ROA may align better with value driver when assets are material to the business model.

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Example 3: Routine Service Provider—Net Cost Plus and Pass-Through Costs

Facts (tested party):

• Operating Profit: 12
• Internal labor + overhead (value-adding OPEX): 180
• Pass-through subcontractors billed at cost (no value-add): 120

Two denominator choices (why definition matters):

Takeaway: For NCP, your cost base definition often drives the result. If subcontractor costs are pure pass-through, including them can mechanically depress the markup. Whichever approach you choose, apply it consistently to both tested party and comparables and document the rationale.

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Example 4: Intermediary / Agent—When Berry Ratio is the Better Fit

Facts (tested party):

• Sales: 1,000 (high pass-through)
• COGS: 920 (pass-through purchases)
• Gross Profit: 80
• Operating Expenses (value-add OPEX): 60
• Operating Profit: 20

PLI results:

Interpretation: If the entity's value-add is mainly in operating expenses (sourcing, coordination, order management) and COGS is genuinely pass-through, Berry can be more diagnostic than OM. But because Berry is sensitive to cost classification, document how ¶2.107 conditions are satisfied and show consistent COGS/OPEX mapping in comparables.

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Defending PLI Selection in Tax Audits

Tax authorities typically challenge PLI selection on coherence (does the PLI match the FAR and value driver?) and reliability (is it computed consistently and comparably across parties?).

What to document (audit-ready):

• Value driver narrative tied to functional analysis (why sales vs costs vs assets vs OPEX is the right base)
• PLI definition memo (what you included/excluded in operating profit, COGS, OPEX, operating assets; and why)
• Why alternatives are less reliable (data limitations, definition volatility, accounting classification sensitivity)
• Consistency proof: same PLI and same definitions for tested party and all comparables
• Sensitivity checks: show how conclusions change if you switch PLI or adjust the denominator definition (and why your choice is still most reliable)

Common PLI Selection Mistakes

1. Using the "industry standard" without analysis — There's no universal "right" PLI for an industry. Match it to your tested party's specific facts.

2. Ignoring denominator definition — Your accounting mapping memo (what counts as OPEX vs. COGS vs. operating assets) often matters more than the PLI name.

3. Selecting Berry ratio without meeting conditions — If COGS isn't pass-through, Berry will produce unreliable results. Document how ¶2.107 conditions are satisfied.

4. Inconsistent PLI between tested party and comparables — The same PLI and same definitions must apply to both.

5. Switching PLIs mid-analysis — If working capital differences affect OM, make adjustments rather than switching to a different PLI.

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Related Topics

Benchmarking Guides:

• Complete Benchmarking Study Guide — Step-by-step methodology
• Berry Ratio Complete Guide — When and how to use Berry Ratio
• CPM vs TNMM: What's the Difference? — Methods comparison
• Tested Party Selection Guide — Choosing the right entity

Documentation Guides:

• Transfer Pricing Documentation Guide — Complete documentation hub
• Local File Best Practices — Documenting PLI selection in Local Files

Glossary:

• Profit Level Indicator (PLI) — Definition and overview
• Operating Margin — Formula and application
• Net Cost Plus — Cost-based PLI explained
• Berry Ratio — Pass-through activity PLI
• Return on Assets (ROA) — Asset-based PLI
• Tested Party — Entity selection criteria

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Related OECD Guidance

This article is based on guidance from the OECD Transfer Pricing Guidelines (2022):

• Chapter II: Transfer Pricing Methods — Section B.3 on TNMM and PLIs (¶2.64-2.107)
• Key Paragraphs: ¶2.82 (PLI selection based on functional analysis), ¶2.86 (operating vs non-operating items), ¶2.106-2.108 (Berry ratio conditions)

→ Search the full OECD Guidelines

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Frequently Asked Questions

What profit level indicator should I use for a limited-risk distributor?

For limited-risk distributors, Operating Margin is the standard choice because sales volume drives the entity's value. However, if the distributor truly has pass-through COGS (no inventory risk, no pricing risk), Berry Ratio may be appropriate—but only if you can demonstrate that operating expenses capture the value-add and OECD conditions in ¶2.107 are satisfied. Document your reasoning carefully; Berry ratio selection is frequently challenged.

When is Berry Ratio actually appropriate?

Berry Ratio is appropriate when: (1) the tested party's value-add is captured in operating expenses, (2) COGS is largely pass-through without significant value creation, (3) there are no significant unique intangibles or non-routine risks, and (4) the comparable set has consistent cost classifications between COGS and OPEX. These conditions come from OECD Guidelines ¶2.106-2.108 (specifically ¶2.107) and were confirmed by the EU General Court in the Apple state aid case (2020).

How do I choose between Operating Margin and Net Cost Plus?

Ask: "What does the tested party get paid for?" If the entity earns returns based on sales execution (volume, customer relationships, market access), use Operating Margin. If it earns returns based on cost efficiency and delivering services/products at a markup on effort, use Net Cost Plus. For many distributors, OM is appropriate; for most contract manufacturers and service providers, NCP is preferred.

What exactly counts as "operating profit" for PLI calculation?

Operating profit should reflect profits from ordinary operating activities—typically EBIT (Earnings Before Interest and Taxes). ¶2.86 states that "non-operating items such as interest income and expenses and income taxes should be excluded from the determination of the net profit indicator." Exclude interest income/expense, investment income, foreign exchange gains/losses (unless integral to operations), and extraordinary items. Be consistent between tested party and comparables, and document any inclusions/exclusions.

Can I use different PLIs for different comparables?

No. The same PLI must be applied consistently to both the tested party and all comparables. If some comparables don't have data for your chosen PLI, exclude them rather than mixing PLIs. Consistency is essential for reliable benchmarking.

How do I handle pass-through costs in a Net Cost Plus analysis?

Pass-through costs (where the tested party adds no value—just passes costs through at no markup) should be excluded from the cost base denominator, or included only if comparables treat them the same way. If you include pass-through subcontracting costs in "total costs," it mechanically depresses your NCP result. Define your cost base clearly and document the treatment.

What if my PLI analysis gives different results than another PLI?

This is common and expected—different PLIs measure different things. The question is which PLI best reflects the tested party's value driver. If OM shows the tested party in range but Berry shows it below range, you need to determine whether revenue or operating expenses is the true value driver. Document your analysis and explain why your chosen PLI is most reliable for the specific transaction.

How do tax authorities view ROA vs. ROOA?

Both are accepted, but ROA is more commonly used because data is more widely available. Use ROOA when the tested party has significant non-operating assets (excess cash, financial investments) that would distort a straight ROA comparison. ROOA requires clean operating asset mapping, which increases documentation burden but may produce more reliable results for capital-intensive operations.

Should I use a 3-year rolling average for PLI calculations?

Multi-year averaging is standard practice and recommended by OECD (¶3.75-3.79). A 3-year weighted average smooths economic cycles and anomalies. The typical formula is: (OP₁ + OP₂ + OP₃) ÷ (Revenue₁ + Revenue₂ + Revenue₃) for Operating Margin, or the equivalent for your chosen PLI. This approach is commonly used in APA structures.

How do I defend my PLI choice in an audit?

Document three things: (1) What drives profitability for the tested party—link to your functional analysis; (2) Why this PLI is most reliable—reference OECD ¶2.90-2.92 and explain why other PLIs would be less appropriate; (3) How you applied it consistently—show the same definitions and formulas for tested party and comparables. Courts focus on whether the PLI reflects the economic substance of the transaction, as seen in the EU Apple case where Berry ratio was upheld because the conditions were properly documented.