A transfer price is the price a company pays to buy products and services from itself, either trading between departments or between subsidiaries. A car manufacturer with a subsidiary that handles the production of the electrical systems, for example, would pay a transfer price for each electrical system it buys from the subsidiary. Because these prices are determined internally, they are not subject to the same market forces that dictate pricing on the open market. This is a cause for concern in some regions, especially when it comes to tax agencies that are worried about not collecting their fair share.
Companies use transfer pricing to clearly keep track of profit and loss for different departments and subsidiaries. If goods and services were transferred at no cost, it would be difficult to determine their value at different stages of the manufacturing process. This in turn would make it challenging to set a price on the open market for the finished product, and to determine how much of a profit the company is really making.
Sometimes, the transfer price is set as the open market value for the product or service in question. If there is a known market for the product or service, it can be very easy to determine a fair price. Other companies may discount their transfer pricing. Paying too little for products and services, however, deprives the department or subsidiary that is selling them. Significant price disparities can be questioned by shareholders who may wonder why a subsidiary is not selling to outside companies that pay more.
Conversely, if a transfer price is too high, it raises questions about why the company is not sourcing the product or service more cheaply somewhere else. While individual departments need to make a profit as well, if they are profiting at the expense of the parent company, it suggests that they need to be reorganized to change their pricing structure and operations. One problem that can arise occurs when companies commit to buying products and services from a subsidiary in a specific country, while competitors in other nations offer the same things at much lower prices.
Tax authorities are interested in the transfer price primarily when it concerns international transactions. If a company pays a low transfer price for products manufactured overseas, that nation's government collects fewer taxes, while the profit is concentrated in the company's home nation and the tax authorities there collect more taxes. Laws have been passed to address this problem and ensure that pricing is fair and honest.