The Transaction Net Margin Method (TNMM) uses a profit level indicator (PLI) to be compared. The comparator used in this method is the net profit margin against an indicator (assets, sales or costs, will be explained below) of similar companies (business fields, functions, and risks). Click here to find out transfer pricing tax services, KAP Agus Ubaidillah dan Rekan.

The Transactional Net Profit Method (TNMM) uses a profit level indicator (PLI) as the object of the comparison to apply the arm's length principle for transfer pricing. The comparison used in this method is the net profit margin against a certain indicator (assets, sales or costs, will be explained below) of similar companies (line of business, functions, and risks). The other methods for transfer pricing, Cost Plus Method, Resale Price Method, Comparable Uncontrolled Price, and Profit Split Method has been described in the other article.

The Transactional Net Profit or TNMM method is the method that most widely used in determining the arm’s length of transfer pricing. In using the TNMM method, Selecting the profit level indicator ("PLI" level) that will be used is a critical aspect in TNMM implementation. Choosing the profit level indicator to be used will depend on the type of function or activity of the company to be tested. The following are indicators of profit levels that are generally used (UN TP Manual 2017):

  • Return on Assets (ROA)

Operating profit is divided by operating assets (only tangible assets, in general).

  • Return on Capital Employed (ROCE)

Operating profit divided by total capital used (total assets minus cash and investments)

  • Operating Margin (OM)

Operating profit divided by revenue. OM is generally applied to marketing, sales, and distribution functions. Operating margin is often used when the party's function under test does not approach a comparable function because differences in functions have less effect on operating profit than gross profit.

  • Return on Total Costs (ROTC)

Operating profit divided by total costs

  • Return on Cost of Goods Sold

Gross profit divided by the cost of goods sold. In general, gross margin is not a top choice as a PLI because categorizing costs as operating costs or cost of goods sold may be somewhat arbitrary or even manipulable, making comparisons between tested and comparable parties difficult or impossible.

  • Berry Ratio 

Gross profit divided by operating expenses.

Gross prodit divided by operating expenses. Berry Ratio can be used for distribution and service provider functions. For the Berry Ratio to be the most appropriate method of transfer pricing for determining the remuneration of controlled transactions (e.g. for product distribution), the following elements must be present: (i) the value of the function performed, taking into account the assets used and the risks taken, must be proportional to operational costs; (ii) the value of the functions performed, taking into account the assets used and the risks assumed, is not materially affected by the value of the products distributed; in other words, it is not proportional to sales; and (iii) the party under test does not perform any other significant function in the transaction under investigation must be rewarded using another method or profit rate indicator.

Which Profit Level Indicator to Use?

  • Operating Margin (OM) indicators are generally applied to marketing, sales, and distribution functions.
  • The Full-Cost Plus, ROCE, or ROA indicator is typically used for manufacturing activities and asset leasing (leasing) companies. This indicator uses assets that are actively used in the business. These tangible assets consist of all assets minus investment (for example, investment in financial assets and ownership of shares in subsidiaries), less cash and cash equivalents outside of the amounts required for working capital. In the case of ROA, deductions are also made for intangible assets such as goodwill.
  • This type of profit rate indicator (PLI) may be most reliable if the tangible operating assets have a high correlation with profitability. For example, a manufacturing operation's assets such as property, plant and equipment can have a greater impact on profitability than a distributor's operating assets, because often the primary value added by a distributor depends on the services rather than the operating assets.
  • The Profit Level Indicator that uses income statement items (OM, ROTC, and Return on Cost of Goods Sold) is often used when fixed assets do not play a significant role in generating operating profit. This Profit Level Indicator is suitable for wholesale distributors and service providers.
  • Berry's ratio reflects the return on the value-added function of a company with the assumption that this value-added function is included in its operating costs. The Berry ratio is used as PLI for distributors and service providers. Berry's ratio assumes that there is a relationship between the level of operating costs and the level of gross profit obtained by distributors and service providers in a situation where their value-added function can be considered to be reflected in operating costs.

A situation where it may be appropriate to use the Berry Ratio is if the selling or marketing entity is the service provider who is entitled to a refund of the cost of providing his services. Some of the limitations of the Berry Ratio are:

  1. The ratio is very sensitive to the function and classification of costs as operating costs;
  2. The Berry Ratio does not take into account the costs involved in maintaining the intangible property of an entity; and
  3. The reliability of Berry's ratio decreases if there is a difference in asset intensity (the efficiency used by the asset)

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