Transfer pricing involves the trade of goods or services between two related companies, and both can come out the winner. Transfer pricing improves business efficiency and simplifies the accounting process. Precious man hours can be saved with heightened efficiency and streamlined accounting, leading to greater profitability and focus on business strategy. Included in the cost of transfer pricing are packaging, shipping, and insurance costs, plus customs charges where applicable.

A transfer pricing arrangement can be between a parent company and subsidiary, or between two subsidiaries of the parent company. Take for example a North American company that manufactures tires for cars, trucks, and buses. That company has a wholly owned subsidiary, a rubber plantation in South America. Transfer pricing assures the parent company a steady supply of the raw material it needs to manufacture its products, while the subsidiary is guaranteed a fixed market for its rubber.

Ordinarily, the agreed-upon prices hew closely to the prevailing fair market price. Since transfer pricing involves sister companies, it does not make sense for one to sell at above market price or for the other to buy below market price. Doing so would result in a drop in the performance of one while unfairly boosting the bottom line of other.

A company manufacturing electrical harnesses may be a wholly owned subsidiary of a car manufacturer, but it can still sell its harnesses to competing car manufacturers at essentially the same prices. This is known as the arm’s length pricing principle, in which a parent company must apply the same pricing to its divisions and subsidiaries as it would with an outside party or supplier.

In a less-than-perfect world, transfer pricing legally allows companies to avoid paying income taxes when sales in one country are converted to profits in another. This is true for multinational drug companies such as Pfizer and Eli Lilly. The tax issues behind transfer pricing are more complex since different countries have different tax structures.

Less than a decade ago, Bloomberg estimated that various U.S.-based companies avoided paying taxes on $1 trillion in foreign profits because of transfer pricing. This estimate was backstopped by a former tax economist for the Treasury Department who claimed an artificial shifting of profits had occurred as a result of transfer pricing.

Transfer pricing can be treated as an option for large companies with nationwide or global operations. A parent company may be able to purchase goods from one of its subsidiaries for redistribution to its other subsidiaries rather than for its direct use. However, due to the redistribution cost, it may be more cost-effective for some of the subsidiaries to source those same goods locally, or at least closer to their bases of operations.