incoterms-understanding-terms-of-sale-and-transfer-of-risk

Incoterms, short for International Commercial Terms, are a globally recognized set of rules established by the International Chamber of Commerce (ICC). They act as a common language for international trade contracts, clarifying the roles and responsibilities of both buyers and sellers throughout the entire delivery process.

These terms are crucial parts in your logistics process. Thus, we provide you a thorough walk-through on incoterms and the best how-tos. Scroll down for further details!

Understanding Incoterms

Incoterms define:

  • Tasks involved in shipping: Who arranges transport, clears customs, and handles documentation?
  • Risk and Cost Allocation: When does the risk of loss or damage transfer from seller to buyer? Who pays for each step of the journey?
  • Delivery Point: Where exactly does the seller’s responsibility for delivering the goods end?

There are four main categories of Incoterms, each with a different allocation of responsibilities:

  • E-Terms (Departure): The seller makes the goods available at their own premises (e.g., EXW – Ex Works).
  • F-Terms (Main Carriage Paid): The seller pays for the main carriage (e.g., FOB – Free On Board).
  • C-Terms (Cost & Freight): The seller contracts for carriage but doesn’t pay for insurance (e.g., CFR – Cost and Freight).
  • D-Terms (Delivered): The seller delivers the goods to the named place (e.g., DDP – Delivered Duty Paid).

Here’s a closer look at some common Incoterms:

  • EXW (Ex Works): The seller simply makes the goods available at their location. The buyer is responsible for all transportation costs and risks from that point onwards. This is the minimum obligation for the seller.
  • FOB (Free On Board): The seller is responsible for delivering the goods to the port of shipment, clearing them for export, and loading them onto the buyer’s chosen vessel. Once the goods are on board, the risk and costs transfer to the buyer.
  • CIF (Cost, Insurance, Freight): The seller covers the costs of transporting the goods by sea (including loading), obtaining minimum insurance against loss or damage, and unloading at the destination port. However, the risk transfers to the buyer once the goods are on board the vessel.
  • DDP (Delivered Duty Paid): The seller handles everything, including delivering the goods to the buyer’s specified location, clearing them through import customs, and paying any import duties or taxes. This offers maximum protection for the buyer but comes at a higher cost.

Importance of Incoterms in International Trade

International trade, while exciting, presents a unique set of challenges compared to domestic transactions. Different countries have varying laws, customs regulations, and transportation methods.

Incoterms, established by the International Chamber of Commerce (ICC), act as a bridge across these complexities, ensuring smooth and predictable transactions. Here’s how Incoterms play a vital role:

  • Specifying Obligations and Responsibilities: Incoterms clearly define what each party (seller and buyer) is responsible for in the international sale of goods. This includes tasks like arranging transport, clearing customs, handling documentation, and paying for specific costs. By having a clear understanding of these obligations from the outset, both parties can avoid misunderstandings and potential disputes down the line.
  • Transfer of Risk: One of the most crucial aspects of international trade is determining when the risk of loss or damage to the goods shifts from the seller to the buyer. Incoterms clearly define this point of transfer based on the specific term used.

Incoterms directly influence both cost allocation and risk management in international trade. Here are some examples:

  • Cost Allocation: Consider a scenario where a seller in China is exporting furniture to a buyer in the US. If they choose FOB (Free On Board), the seller only covers costs up to loading the goods onto the ship in China. The buyer then shoulders all transportation costs and risks from that point onwards. This might be a good option for the seller as they minimize their involvement in the complex and potentially expensive overseas leg of the journey.
  • Risk Management: Let’s say a company in Germany is importing delicate medical equipment from Japan. Choosing CIF (Cost, Insurance, Freight) would be prudent. While the risk transfers upon loading the ship, the seller arranges for minimum insurance coverage, mitigating the risk of financial loss for the buyer in case of damage during transport.

Key Considerations When Choosing Incoterms

Incoterms are a powerful tool, but selecting the right one for a particular international transaction requires careful consideration. Here are some key factors to keep in mind:

  • Risk Tolerance:
    • Are you a seller comfortable assuming responsibility until the goods reach the buyer’s door (DDP)?
    • Or are you a buyer seeking more control over the transportation process (FOB)?
  • Cost Allocation:
    • Incoterms determine who pays for specific parts of the journey.
    • EXW minimizes seller costs, while DDP maximizes them but offers the buyer more convenience.
  • Logistics Expertise:
    • Do you have the experience and infrastructure to handle customs clearance and complex international shipping (DDP)?
    • Or would it be better to choose an Incoterm where the seller handles these complexities (FOB)?
  • Nature of the Goods:
    • Are you shipping fragile items that require extra insurance (CIP)?
    • Are you dealing with bulk goods where cost minimization is key (FOB)?
  • Destination Country:
    • Some countries have complex import procedures (DDP might be better).
    • Research the destination country’s customs regulations to ensure a smooth handover.
  • Communication and Agreement: Clear communication and agreement between the buyer and seller are paramount.
  • Mitigating Risks:
    • Choosing the right Incoterms can significantly mitigate risks in international trade. Here’s how:
    • Clarity of Responsibilities: A clear Incoterm eliminates confusion about who is responsible for what, preventing disputes over tasks, costs, and risk transfer.
  • Risk Management:
    • For valuable cargo, choosing an Incoterm with insurance coverage (CIF, CIP) might be wise.
    • Operational Efficiency: Selecting an Incoterm that aligns with your logistical capabilities ensures a smooth flow of goods, minimizing delays and disruptions.

Common Misconceptions about Incoterms

  • Myth 1: Incoterms define ownership transfer.

Incoterms deal solely with the allocation of risks and responsibilities during the international sale of goods. Ownership (title) transfer is a separate legal concept governed by the sales contract itself. It’s crucial to clarify ownership transfer terms independently.

  • Myth 2: Specific Incoterms are always better for buyers or sellers.

There’s no “one size fits all” approach. The optimal Incoterm depends on the specific transaction. Consider factors like risk tolerance, cost allocation, and logistical expertise when choosing.

  • Myth 3: Incoterms handle customs clearance.

Incoterms define who is responsible for delivering the goods to a specific point, but they don’t dictate who handles customs clearance on either side. This responsibility needs to be explicitly addressed in the sales contract.

  • Myth 4: Incoterms are only for sea freight.

While some Incoterms were originally designed for maritime transport, they are now applicable to all modes of transport, including air, road, and even inland waterways.

  • Myth 5: Incoterms are too complex for small businesses.

Incoterms offer a standardized framework that can benefit businesses of all sizes. Start with basic Incoterms like EXW or FOB and graduate to more complex options as your international trade experience grows.

Conclusion

Incoterms seem complex, yet if you know its main principles and all the fundamentals, such insights can help you make better decisions to smooth. The benefits and breakdown of incoterms above can help you get a holistic approach to this crucial part of logistics.