Cost plus and open book pricing: what to watch out for

In an environment where costs are increasingly unpredictable and escalating, pricing mechanisms based on cost plus a margin may seem an attractive option, at least for suppliers. But as we explain below, there are a number of pitfalls for the unwary – and it's vital to build in appropriate contractual protections. This is the fifth briefing in our series on pricing and payment clauses in commercial contracts.

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What are cost plus and open book pricing?

The aim of "cost plus" pricing is for the supplier to be paid its costs, plus a reasonable margin. It can often be supported by an "open book" approach, which involves the supplier sharing information with the customer about the costs it has incurred. This is intended to give the customer an assurance that the supplier is accurately reporting its costs.

When are they used and why?

In practice, cost plus-based pricing is often used in transitional services agreements (for interim service provision following carve-out acquisition) and intra-group arrangements and open book pricing is often used for certain types of service provision, such as logistics and warehousing arrangements.

From the supplier's perspective, cost plus is typically seen as attractive because if costs rise, the customer effectively bears the risk – but the supplier is still able to make a profit on the arrangement. The downside is that the customer is unlikely to agree to a particularly generous margin – whereas with closed book pricing, the customer's lack of visibility over costs may make it easier to build in a higher margin and there is more scope to improve it mid-contract if costs can be reduced).

Why do customers use cost plus and open book pricing?

Customers may agree to cost plus and open book pricing for a variety of reasons, including:

Lack of knowledge: Customers may not always have sufficient expertise to know what is a fair price on a closed book basis; in these circumstances (as is typically the case with transitional services agreements), cost plus is often seen as a way of giving the supplier a reasonable level of remuneration whilst obtaining some degree of comfort that pricing is not excessive. That said, as explained below, much depends on how costs are calculated and there is ample scope for suppliers to be both over and under-rewarded.
Control: Sometimes, customers agree to cost plus because it gives them greater commercial leverage over how the supplier performs the contract, without needing to have protracted debates over the cost implications for the supplier.
Tax issues: Finally, in an intra-group context, cost-plus mechanisms can be used to reduce the risk of falling foul of the rules on transfer pricing, which is explained below.

What is transfer pricing and why is it relevant to cost plus mechanisms?

Transfer pricing is where a business aims to produce an artificial reduction in profits of a group company in a high tax jurisdiction whilst increasing the profits of a group company in a lower tax jurisdiction, the aim being to engineer an overall saving in its tax bill. An example would be where Group Company A is based in a high tax jurisdiction. It agrees to provide services at below market rates to Group Company B, which is based in a low tax jurisdiction. This results in Group Company A making less profit and paying less tax, whilst Group Company B will pay more tax (as its profits will be higher). However, as Group Company B's profits will be taxed at a lower rate than Company A, this can be expected to produce an overall saving on the Group's tax bill. Transfer pricing rules aim to combat this by requiring that, for tax purposes, transactions between related parties take place on arm's length terms. Pricing methodologies such as cost plus can be used to demonstrate the arm's length nature of the transaction.

What are the key drafting pitfalls?

Once a decision has been made to opt for cost plus and open book pricing, it's important to consider how the following costs will be captured:

internal costs e.g. the cost to the supplier of staff salaries, pensions, business rates, depreciation and so on
external costs e.g. what the supplier pays its own suppliers and subcontractors, landlords and so on

A particularly difficult issue is the extent to which certain costs should be reduced to reflect the fact that they are shared with other customers of the supplier. It is crucial to identify which costs are regarded as being in this category and basis upon which they will be allocated to the customer (e.g. using a percentage or some other formula). This highlights how cost plus and open book mechanisms can sometimes prove to be quite complex and difficult to negotiate once the parties get into the detail. Where complicated formulae are used, we would also recommend using worked examples, as highlighted in this video briefing.

Verifying costs

Customers should also ensure that the cost-plus mechanism is supported by appropriate arrangements to enable them to verify the accuracy of the supplier's figures on costs, such as an audit clause, which we will be returning to in more detail later in this series. Suppliers, meanwhile, need to be alive to the risk that open ended rights for the customer to demand financial information may impose a significant and costly administrative burden, which is unlikely to be recoverable through the cost plus mechanism.

Finally, a key risk for customers is that cost plus mechanisms normally give the supplier limited incentive to control its costs – indeed, the more the supplier can claim as a cost, the higher its margin will also be. As a result, customers may find that they need to be quite "hands on" with the supplier to ensure that costs are being managed appropriately. It may be advisable to include provisions designed to support this, such as obligations on the supplier to notify the customer in advance of likely material cost increases and to hold good faith discussions on how to limit the impact. It may also be worth considering provisions stating that if costs increase beyond a certain level, the supplier should be required to "share some of the pain" by reducing its margin.