Incoterms are a pre-defined set of three letter codes created by the International Chamber of Commerce (ICC) which were established so there would be clear international commercial terms, as far as where costs and risks lie within each party (the buyer or the seller) when making an agreement in moving goods from the source to the destination, hopefully reducing issues within a supply chain.
Think of Incoterms as code words that are used within international trade that make it 100% clear where the buyers and sellers responsibilities lie, as far as the place of delivery, the division of cost and where the risk transfers to the buyer.
Incoterms Explaination With Examples
Our Incoterms 2020 explained video on YouTube uses examples and explains what Incoterms are and why we use them in logistics:
Quick History of Incoterms
Incoterms were very first created in 1923 but over the years they have been updated and amended. So far, they’ve been updated 9 times since 1923 and we’re now using Incoterms 2020.
Incoterms is an acronym:
- IN stands for International
- CO stands for Commercial
- TERMS are obviously terms
- 2020 denotes the year of latest revision
Why Do We Need To Use Incoterms 2020?
When we buy something from eBay, we expect the seller to receive our money and send us the product that we’ve paid for to our named destination (usually our home address). If we don’t receive this product, we can contact the seller and address the problem or should that fail, contact either our credit card company and/or eBay and they will act on our behalf and settle the dispute.
Obviously in buying something on eBay the process is pretty simple but the seller may say once they put the product in the post and have the proof of postage, it’s no longer their problem.
If the package is lost in between, it could be the fault of the post office or maybe it was delivered to a neighbor. There are variables that come into play and if something goes wrong, the responsibility of the buyer and seller is not so clear. However, on this small scale it’s usually reasonably easy to resolve.
Incoterms, or these “code words” were developed to clear up any issues on exactly who is responsible (the buyer or seller) for each part of the logistics process and make sure that there cannot be any misunderstandings. The prime purpose in developing Incoterms is to identify where the buyer and where the sellers’ responsibilities lie under three main areas:
- The place of delivery from the seller to the buyer.
- The transfer of risk from the seller to the buyer.
- The division of costs between the seller and buyer.
Essentially it stops any confusion for what the buyer and seller pays for.
You may have heard of a few of them already such as:
EXW – Ex Works
FOB – Free Onboard
CIP – Carriage and Insurance Paid
DAP – Delivered at Place
DDP – Delivered Duty Paid
How Many Incoterms Are There?
There are 11 Incoterms that are divided into 4 categories. There are the new Incoterms for 2020 in use on the international logistics stage today.
The following apply to any modes of transport:
- EXW – Ex Works
- FCA – Free Carrier
- CPT – Carriage Paid To
- CIP – Carriage and Insurance Paid To
- DPU – Delivered at Place Unloaded
- DAP – Delivered at place
- DDP – Delivered Duty Paid
For sea and inland waterway transport:
- FAS – Free Alongside Shipping
- FOB – Free on Board
- CFR – Cost and Freight
- CIF – Cost, Insurance and Freight
Which Incoterm Should I Use?
It’s beyond the scope of this blog to go into detail and explain each Incoterm as it would take quite some time but as you’ve probably guessed, which Incoterm(s) you should be using depends on various circumstances. Not least, your customer may ask you to deliver under a preferred set of Incoterms, so it’s wise to be well informed on what all 11 Incoterms mean and how to use them.
In my experience, the majority of companies that I deal with, tell me that they try to trade under EXW as its ‘Easy” and requires the minimum involvement in the logistics of delivering the goods to their overseas customer.
Two Very Different Incoterm Examples
Using the following two examples, you can see there are two very different ways to achieve the same thing, namely getting a delivery of your goods to your customer.
Scenario One: Using The Incoterm EXW
Here’s an example of what’s needed if you as a seller were to export under the Incoterm EXW (Ex Works):
- Place of Delivery: The sellers warehouse door
- Risk Passes: At the sellers warehouse door
- Cost: Cost of production plus profit (or the price on the invoice)
- Export packing (if required)
As you can see, by using EXW, you have very little work to do other than preparing the goods, boxing them up and have the shipment waiting at the named place (usually your warehouse door) ready for collection.
Delivery EXW is great if you can agree on that with your customer but what if they request any trade terms of delivery? This is where you’ll need to know and understand Incoterms rules.
Scenario Two: Using The Incoterm CFR
Now let’s say that you’ve negotiated and landed a large order, that’s a profitable deal with a new customer and they’re potentially going to make many more orders in the future.
They don’t want to organise the logistics of collecting their order from your warehouse but instead want you to organise the delivery to them. They ask you to complete the order under the Incoterm CFR and expect in this case, you, the seller delivers the goods. This very much changes the work involved from the sellers point standpoint:
- Place of Delivery: On board the vessel at named port (or inland waterway transport vessel)
- Transfer of Risk: When goods are placed on board the vessel
- Division of cost: Cost of production plus profit (or the price on the invoice)
- Export packing if required
- Export Entry Declared to HMRC
- Weight Certificate
- Transport to dock of Export
- Terminal Handling Charges
- Security check if required
Contrary to EXW, by trading under CFR there is much more work to do in preparing the order for export and transferring the shipment to the dock in order to be transported, not to mention you as the seller are extending your risk because you’re not “off the hook” until the goods are on the vessel.
There may also be a cost implication as you’ll have to cover modes of transport from your warehouse to the dock and the various documentation as listed above.
As a seller, EXW is preferable of course but there will be times where a buyer asks you for something different, so be prepared. In this case you would need to know that trading under CFR will require the following:
- You as the seller should have a basic knowledge of the export procedure
- Obtain Export Licence IF required
- Arrange transport to port of loading
- Make an export entry to HMRC
- Register for EORI status
- Obtain freight quotation from Freight Forwarder or direct from shipping line
- Issue Bills of Lading Instructions
- Arrange for Bills of Lading to be forwarded to the seller according to the method payment involved in the contract between seller and buyer
There’s much to understand in exporting your orders around the world and if you really want to grow to a global scale, you must have an excellent grasp of export procedure.
Before we dive too far into Incoterms, review our infographic below which illustrates where the obligation and risk passes from the seller to the buyer.
To embed this Incoterms infographic, copy and paste the code below:
Trade Terms: Contract of Carriage and Insurance
Incoterms also address such matters as:
- Contract of carriage and insurance
- Licences, authorisations, security clearance and other formalities
- Checking of packaging and markings
- Delivery document
Depending on the Incoterm used, it’s either the seller or buyers’ responsibility to undertake the contract of carriage and insurance. This is also very important.
By quoting a particular Incoterm the responsibility for delivery of the freight and its insurance, falls either upon the seller or the buyer, which is why it’s so extremely important to understand the Incoterm you’re trading under. If you misunderstand this, you may have to pay for transport of these costs when you’re not expecting to.
For example, under “EXW subject to Incoterms 2020” it is the responsibility of the buyer to arrange carriage and Insurance (should they want insurance).
However, under “CIF subject to Incoterms 2020” it flips to the sellers’ responsibility to arrange freight delivery and insurance.
Three letters can have a massive impact on a deal, costs and profit margins and must be understood.
Perhaps most importantly, make sure to pick up a copy of Incoterms 2020 from the International Chamber of Commerce and study this as it’s certainly time well spent!
Incoterms 2020 are the foundation of importing and exporting and you must make sure you understand all the costs that that the buyer bears as well as the seller’s responsibility. Without understanding the risks involved you are far more likely to get involved in a deal that could go badly.
Understand what insurance cover you need, whether it’s minimum cover or if you need more comprehensive protection. Know what responsibilites the seller bears and the buyer assumes.
On top that, make sure you understand what import duties you’ll have to pay and what documentation you’ll require for customs clearance but we’ll save that for another blog.
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