What are Incoterms and how do they work?

When a buyer and a seller enter into RFQ or in negotiation of purchase order, incoterm is always used to define not only the responsiblity of either party in order fulfillment but also the price of sale contract

Introduction to Incoterm

The Incoterms (or International Commercial Terms) are a series of pre-defined commercial terms published by the International Chamber of Commerce (ICC) relating to international commercial law. They are widely used in international commercial transactions or procurement processes.

Each and every single term comprises of three letters and is intended primarily to clearly communicate the tasks, costs, and risks associated with the global or international transportation and delivery of goods.

In simple words, incoterms are commonly used guidance in shipping and trading.

Following the development in information technology and the ever increasing utilization of online marketplace, buyers nowadays no longer need to travel thousands mile to the site of manufacturer on other side of the world like they did in the old days. Instead, they could sit in front of their computer from the office, place the order, negotiate the terms and wait for the shipment to arrive.

In this sense, it would be of critical importance for the buyer to properly understand the definition and application of the terms while doing international trading business.

Incoterm classification

Rules for any mode of transport

EXW – Ex Works (named place of delivery)

FCA – Free Carrier (named place of delivery)

CPT – Carriage Paid To (named place of destination)

CIP – Carriage and Insurance Paid to (named place of destination)

DAT – Delivered At Terminal (named terminal at port or place of destination)

DAP – Delivered At Place (named place of destination)

DDP – Delivered Duty Paid (named place of destination)

Rules for sea and inland waterway transport

FAS – Free Alongside Ship (named port of shipment)

FOB – Free on Board (named port of shipment)

CFR – Cost and Freight (named port of destination)

CIF – Cost, Insurance & Freight (named port of destination)

Incoterm buyer/seller responsibility

Here is a quick illustration over responsibility between buyer and seller under respective incoterm

Common practice, Pros and Cons

Among all incoterms being introduced, here are the most common ones used

• EXW

• FCA

• FOB

• CIF

• DAP

When entering into a sales contract or purchase order with supplier, the price quoted is in accordance with the term applied.

Under EXW, buyer is getting the “net” purchasing cost as the seller hands the freight to buyer from their premises, normally at the factory or seller’s warehouse. Buyer will then arrange freight pickup from this point, through their nominated cargo agent or freight forwarder who subsequently transports the freight to the destination decided by buyer.

Keep in mind that under EXW, buyer is also responsible for customs clearance at the country of origin, which might be problematic in some cases especially when the buyer doesn’t have their established identity in that country.

FCA and FOB are similar in the way that seller hands the freight to “buyer” (normally to buyer’s nominated carrier) at any agreed place at origin, and buyer arranges international transportation through nominated cargo agent or freight forwarders from there. Under these terms, seller will be quoting slightly higher rate compared to EXW due to the fact that seller is responsible for pre-carriage (unless delivery occurs at seller’s premises under FCA) and customs clearance at origin.

FOB is a prevailing term of use as buyer is getting more deciding power in negotiating favorable cost with both seller and carriers.

The only difference between CIF and FOB is who pays the international transportation cost

Due to volatility in shipping where prepaid freight rates are commonly quoted on spot basis, it is very difficult for seller to predict what the freight rate would be like in a few weeks when the production is done. So, there is a tendency for seller to increase the selling rate quite a bit to ensure their profit margin could still be maintained in the situation of sudden shipping rate increase.

DAP is the most convenient way for Buyer where seller takes care of everything until shipment reaches agreed delivery place at destination, buyer will then proceed with customs clearance by themselves. Convenience does come with a price, purchasing cost under DAP is the highest since seller bears all the cost and risk up to the agreed destination point.

So, always keep in mind that the choice of incoterm affects not just the purchasing price, but also the logistics arrangment that comes along with