Among the financial indicators used in applying the Transactional Net Margin Method (TNMM), the Berry Ratio holds a special place. Although its formula is simple, its application requires a rigorous functional analysis, as it is not suitable for every distributor.
The indicator is named after Professor Charles Berry, who used it as an expert witness in the case E.I. du Pont de Nemours & Co. v. United States, decided in 1979, in the context of analyzing compensation for marketing and distribution activities.
How is it calculated, and what does it measure?
The Berry Ratio is calculated as follows:
Berry Ratio = Gross Profit / Operating Expenses
Unlike an operating margin on sales, this indicator relates the gross profit earned by an entity to the operating expenses incurred in carrying out its activities.
Its economic rationale is based on the premise that, in certain routine intermediary or distribution activities, operating expenses can serve as a reasonable basis for estimating the resources employed and, therefore, the compensation associated with the functions performed. In these cases, the value of the goods purchased and resold may not adequately represent the value added by the entity.
Therefore, the Berry Ratio can be useful in certain routine intermediation or distribution activities when there is a sufficiently close relationship between the operating expenses incurred and the functions performed, and when the value of the distributed products does not materially affect the compensation the entity should receive.
This last point is fundamental: the Berry Ratio should not be selected simply because the entity is a distributor. Its application depends on there being a reasonable economic relationship between the basis used by the indicator and the functions that should be remunerated.
When is it appropriate to use it?
The OECD’s Transfer Pricing Guidelines state that the Berry Ratio may be appropriate, primarily, when certain economic and functional conditions are met. Among these, the following stand out:
- The value of the functions performed bears a reasonably close relationship to operating expenses.
- The value of the distributed products does not materially affect the value of the functions performed.
- The entity does not perform other significant functions that should be compensated separately or that would render operating expenses an inappropriate basis for measuring its profitability.
These criteria are relevant because the status of distributor, by itself, does not justify the application of the Berry Ratio.
If the entity performs significant sales or marketing functions, uses significant intangibles, employs economically significant assets, or assumes significant risks, it will be necessary to assess whether operating expenses continue to adequately represent the economic basis upon which its compensation should be determined.
When this relationship ceases to be sufficiently representative, the Berry Ratio may lose reliability as an indicator of profitability.
Accounting classification can distort the result
One of the most critical aspects of the Berry Ratio is the accounting classification of costs and expenses.
One company may record certain items as part of cost of sales, while another may classify them as operating expenses. This accounting difference can significantly alter the Berry Ratio, even when both entities engage in similar economic activities.
This occurs because the indicator uses only operating expenses as its denominator. If a particular cost that is economically related to the functions performed is recorded as cost of goods sold in one company but as an operating expense in another, the Berry Ratios of both entities may not be directly comparable.
Therefore, before comparing the results of the analyzed entity with those of comparable companies, it is necessary to verify that the financial information used has been prepared according to sufficiently consistent criteria or, where appropriate, to make the necessary adjustments to improve comparability.
The OECD specifically acknowledges that the Berry Ratio’s sensitivity to accounting classification is one of the main difficulties associated with its use.
When is it advisable to use another indicator?
The Berry Ratio may lose its representativeness when operating expenses do not constitute an adequate basis for estimating the economic value of the functions performed.
For example, its use should be evaluated with particular care when:
- The entity uses economically significant assets or inventory whose contribution to profitability is not closely related to its operating expenses.
- It performs significant commercial or marketing functions.
- It uses unique or valuable intangible assets.
- It assumes significant market, inventory, credit, or other economically significant risks.
- It performs additional functions that require specific compensation.
- There are significant differences in the accounting classification of costs and expenses between the entity under analysis and comparable companies.
In these circumstances, other profitability indicators—such as operating margin on sales or return on assets—may be more appropriate, depending on the functions performed, the assets used, and the risks assumed by the entity under analysis.
The selection of the indicator, therefore, must consider which basis best reflects the relationship between the profitability achieved and the economic factors that generate such profitability.
The indicator must be consistent with the functional analysis
The Berry Ratio can be a useful tool in Transfer Pricing analysis, but its application must be consistent with the actual economic characteristics of the transaction.
The selection of the financial indicator should not be made automatically simply because a company is classified as a distributor. It must be derived from functional analysis and the identification of the basis that best reflects the nature and value of the functions performed by the entity.
Consequently, before applying a Berry Ratio, it is necessary to analyze, among other aspects:
- the functions performed;
- the assets used;
- the risks assumed;
- the nature of the products distributed;
- the economic significance of inventories and other assets;
- the accounting classification of costs and expenses; and
- the comparability of the selected companies.
Ultimately, the question should not be whether a company is a distributor, but whether the Berry Ratio adequately represents the economic relationship between the resources employed in its functions and the remuneration it should obtain under conditions of perfect competition.
At TPC Group, we evaluate each distribution structure to determine whether the Berry Ratio is truly the most appropriate financial indicator or whether the characteristics of the operation require a different approach.
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