Transfer pricing is the cost of a particular product which is being sold from one part of the organization to another part of the same organization. The transfer pricing is important because the price of the products should not be inflated while one section of the company buys from another. Having guidelines help in resolving the problems that may occur during the internal audit.
The term Arms Length Transaction refers to the purchasing of products between two entities which are not related to each other. If a particular section of the company is selling a product to a company which is not related to them then the same price should be maintained for the transaction between the related section in the same company. By the term related companies it is meant that the section of the companies is part of a bigger business organization.
The first step to establish a fair price system is by analyzing the price other companies charge for the same product. By knowing about the price of the product one can set the price for own products inside the company. By setting the price between two different companies similar to the one within the company gives fair value for the product.
The second step is the comparison of the products price which was paid while purchasing the product from other companies. The prices which were given for the product in such instances can be set as a reference in the case of intercompany product selling. While taking the price in earlier instances proper importance should be given to the inflation rates and market changes during the period.