Transfer prices are those charged for intracompany movement of goods and services. Firms need to make transfer-pricing decisions when goods are transferred from the headquarters to the subsidiaries in another countries. This transfer prices are important because goods transferred from country to country must have a value for cross-border taxation purposes. There are three basic approaches to transfer pricing:
- Transfer at cost. The transfer price is set at the level of the production cost and the international division is credited with the entire profit that the firm makes. This means that the production center is evaluated on efficiency parameters rather than profitability.
- Transfer at arm´s length. Here the international division is charged the same as any buyer outside the firm. Problems occur if the overseas division is allowed to buy elsewhere when the price is uncompetitive or the product quality is inferior, and further problems arise if there are no external buyers, making it difficult to establish a relevant price. Nevertheless, this approach has now been accepted worldwide as the preferred (not required) standard by which transfer prices should be set.
- Transfer at cost plus. This is the usual compromise, where profits are split between the headquarters and the subsidiaries. The formula used for assessing the transfer price can vary, but usually it is this method that has the greatest chance of minimizing time spent on transfer-price disagreements, optimizing corporate profits and motivating the headquarters and subsidiaries.