International Trade (Intl Trade) 101: Incoterms 2020 - Allocation of Costs and Risks, Transfer of Risk Point Cost Division

What This Is

The allocation of costs and risks in international trade refers to the division of expenses and responsibilities between buyers and sellers. This concept is crucial in global trade as it affects the financial and logistical aspects of a shipment. For instance, consider a shipment of electronics from China to the US. If the seller agrees to deliver the goods FOB (Free on Board) Shanghai, the buyer will bear the costs and risks from the moment the goods are loaded onto the vessel at the Shanghai port. However, if the seller agrees to deliver the goods CIF (Cost, Insurance, and Freight) New York, the seller will bear the costs and risks until the goods are delivered to the buyer's destination.

Key Terms & Rules

• FOB (Free on Board): Buyer bears costs and risks from the moment the goods are loaded onto the vessel at the seller's premises. This is a common Incoterm used in international trade.
• CIF (Cost, Insurance, and Freight): Seller bears costs and risks until the goods are delivered to the buyer's destination. This Incoterm includes the cost of insurance and freight.
• EXW (Ex Works): Seller bears no costs or risks after delivering the goods at their premises. This is the most seller-friendly Incoterm.
• DAT (Delivered at Terminal): Seller bears costs and risks until the goods are delivered to the terminal designated by the buyer. This Incoterm is commonly used for inland transportation.
• DPU (Delivered at Place Unloaded): Seller bears costs and risks until the goods are delivered to the designated place and unloaded. This Incoterm is commonly used for inland transportation.
• UCP 600 (Uniform Customs and Practice for Documentary Credits): This set of rules governs Letter of Credit (LC) transactions globally.
• URC 522 (Uniform Rules for Collections): This set of rules governs collections in international trade.
• Incoterms: A set of standardized trade terms developed by the International Chamber of Commerce (ICC) to clarify the responsibilities of buyers and sellers in international trade.
• Letter of Credit (LC): A payment guarantee issued by a bank on behalf of the buyer to the seller, ensuring payment upon presentation of compliant documents.
• Documentary Credit: A payment guarantee issued by a bank on behalf of the buyer to the seller, ensuring payment upon presentation of compliant documents.

Step-by-Step Process

1. Determine the Incoterm: Identify the Incoterm agreed upon by the buyer and seller to determine the allocation of costs and risks.
2. Identify the Transfer of Risk Point: Determine the point at which the risk of loss or damage transfers from the seller to the buyer based on the agreed Incoterm.
3. Calculate Costs: Determine the costs borne by each party based on the agreed Incoterm and the terms of the sale.
4. Verify Documents: Ensure that all documents presented under a Letter of Credit or other payment guarantee comply with the agreed terms and conditions.
5. Settle Disputes: Resolve any disputes that may arise regarding the allocation of costs and risks or the presentation of documents.

Common Mistakes

• Mistake: Confusing CIF and CIP.
• Correction: CIF includes the cost of insurance and freight, while CIP (Carriage and Insurance Paid To) includes only the cost of carriage and insurance.
• Example: A seller agrees to deliver goods CIF New York, but the buyer is charged for the cost of insurance. The seller is liable for the cost of insurance.
• Mistake: Assuming "open account" is risk-free.
• Correction: Open account transactions do not involve a Letter of Credit or other payment guarantee, and the buyer bears the risk of non-payment.
• Example: A seller agrees to deliver goods on open account, but the buyer fails to pay. The seller bears the risk of non-payment.
• Mistake: Misusing "free on board" with air freight.
• Correction: "Free on board" is typically used for sea or inland waterway transportation, not air freight.
• Example: A seller agrees to deliver goods FOB Shanghai, but the goods are transported by air. The seller is liable for the cost of air freight.

Exam / Certification Tips

• FOB vs FCA: FOB (Free on Board) transfers risk at the loading point, while FCA (Free Carrier) transfers risk at the carrier's premises.
• Confirmed vs Unconfirmed LC: A confirmed Letter of Credit is guaranteed by the buyer's bank, while an unconfirmed Letter of Credit is not guaranteed.
• DPU successor to DAT: DPU (Delivered at Place Unloaded) has replaced DAT (Delivered at Terminal) as the standard Incoterm for inland transportation.
• Memory Aid: Use the acronym "FOB" to remember that the buyer bears costs and risks from the moment the goods are loaded onto the vessel.

Quick Practice Scenario

Scenario: A Chinese exporter sells goods to a US importer under FOB Shanghai. Who pays for the main carriage?

Answer: The buyer pays for the main carriage.

Explanation: Under FOB, the buyer bears the costs and risks from the moment the goods are loaded onto the vessel at the seller's premises.

Last-Minute Cram Sheet

• Under FOB, risk transfers when goods are on board the vessel – not at the port gate or on the dock.
• CIF includes the cost of insurance and freight.
• CIP includes only the cost of carriage and insurance.
• EXW is the most seller-friendly Incoterm.
• DAT has been replaced by DPU as the standard Incoterm for inland transportation.
• A confirmed Letter of Credit is guaranteed by the buyer's bank.
• A documentary credit is a payment guarantee issued by a bank on behalf of the buyer to the seller.
• The buyer bears the risk of non-payment in open account transactions.
• FOB transfers risk at the loading point.
• FCA transfers risk at the carrier's premises.