When it comes to a trade agreement, signing on the dotted line to get your products at a specified price and within a specified period is only a part of the challenge. The manufacturer can make arrangements regarding raw materials, labour and other sources of capital in order to manufacture the finished good. But that’s not the end of the issues that would be featured in a trading agreement. Free on board or FOB is a type of business agreement clause designed to answer key questions regarding shipping of finished products.
A common point of contention is – who would be responsible for getting the finished goods shipped to the destination or in other words, who pays the shipping charges. This is because transport of goods features potential problems ranging from delays and pilferage to spoilage and more. These problems have the potential of causing quite a dent in the profitability of the deal, hence the need to get the consignment insured arises. The cost of such insurance would definitely not be cheap and that’s the reason why the FOB concept takes this into account and helps clarify the responsibilities of the trading parties i.e. buyer and seller.
As mentioned in the earlier section, a FOB clause clarifies the responsibility of the buyer and seller signing the trade agreement regarding their responsibilities. In this section, we will discuss this in greater detail. Some of the key questions that a FOB clause clarifies include:
Carrier Selection: Selecting different carriers for different shipments is usually avoided as such agreements tend to have significantly higher costs. Hence most buyers and sellers tend to have long term contracts with specific carriers so that they get a discount on the per shipment cost, commonly termed as the contract rate. However, a problem commonly arises from the fact that not every carrier has an equally extensive network in all corners of the country or in various parts of the world. Hence, at certain times, it might be necessary for buyers/sellers to avail the services of a different carrier in order to meet specific transportation requirements. In all of these cases, the FOB clause of the agreement specifies who will select the carrier for the transport of the finished goods from the seller’s facility to the buyer’s facility.
Who bears freight charges: After the carrier has been selected, the next point of contention is usually the payment of freight charges. These freight charges include not just the cost of transporting the goods but also the charge of insuring the goods while in transit and payment of various duties when the goods pass across borders whether they be state or international borders. These costs especially insurance and import/export duty can be quite significant specifically in cases when the buyer and seller are engaging in international trade. Whoever pays these charges stands to lose a substantial portion of their profits and therefore they need to make arrangements to recoup these costs. Thus inclusion of a specific FOB clause in a transaction agreement ensures that the investor can make adequate plans including selling price adjustments to reduce the impact of paying the freight charges of the goods.
Goods Title Ownership: Goods title ownership refers to the one who owns the finished goods after they have left the seller’s facility. For starters, the seller would definitely own the title to goods before they are shipped out from its facility. Similarly, the ownership rights to the goods are equally clear after the goods have been received by the buyer i.e. the buyer would assume ownership along with associated risks at that point. The point of contention that exists in this regard is with ownership of the goods while they are in transit. The carrier usually has only a limited liability to ensure the timely transfer of the goods therefore the FOB clause needs to specify ownership of the goods while they are in transit. More often than not, ownership of the goods implies who will be paying the freight charges of the goods being transported. Other features of a trade agreement which are often considered beyond the scope of a standard FOB clause include place and time of delivery as well as penalties that are payable if one of the parties fails to meet their obligations.
In the following section the key types of FOB clauses are discussed briefly:
This is the default clause of free on board in case the agreement does not specify an alternative. Usually mentioned as FOB Mumbai, FOB Delhi, etc. this implies that the seller’s facility is based in the stated point of origin. The “free on board origin” clause means that the title of ownership regarding the goods has passed on to the buyer once it leaves the seller’s facility. This by extension also requires the buyer to pay all applicable freight and insurance charges to the carrier/insurer. Additionally, any damage, pilferage, etc. of goods would be the buyer’s responsibility in this case.
This is the most common format of the free on board clause used in international trade agreement. This clause specifies the place where the goods need to reach. Written as FOB Mumbai, FOB Chennai, etc. this indicates that the title of ownership of the shipped goods would change hands once the goods reach their destination as specified in the contract. Thus the FOB destination clause typically implies that the seller is responsible for ensuring that the goods reach their destination and charges for freight, insurance, etc. will be payable by the seller. Moreover, the ownership of the goods will remain with the seller till time they are delivered at the destination. Therefore any damages/spoilage/pilferage occurring during transport will be the responsibility of the seller.
In case of all types of businesses whether on the seller side or the buyer side, inventory costs account for a significant part of the overall expenses for the business. Inventory by its very definition includes all the raw materials, semi-finished goods and finished goods that are held in the warehouse or in transit. Hence in case of a FOB origin clause, the buyer would have to include the goods in transit as part of his/her inventory. In such a case, the cost of any damage or theft of goods will be added to the inventory costs of the buyer.
In case of a FOB origin situation, the seller would bear the responsibility of the goods while they are in transit. Therefore, the seller’s inventory cost will increase as these finished goods will be considered as part of the seller’s inventory while they are in transit. Therefore it would mean that in case of damage/pilferage to the consignment, such charges will be borne by the seller and it will get represented as part of the seller’s inventory costs.
The current internationally acceptable interpretation of “free on board” is according to the interpretation provided by the International Commerce Law as published in the Incoterms 2010 standard. Though the term FOB was originally applied to a much broader range of transport of goods, the Incoterms 2010 standard has limited its use to sea freight only. Additionally such sea freight refers to non-containerised freight being transported on inland waterways or by sea. Hence the currently acceptable format of international usage has shifted to “FOB port”. Prior to 2010 revision, the Incoterm definition of FOB applied to both domestic and international trade.
The case is slightly different in the US which follows its own system and there the “FOB Origin” and “FOB Destination” formats are still in use for domestic shipments. The use of these terms is in accordance with the UCC (Uniform Commerce Code), which is published by the relevant US body. Due to the confusion that may arise as a result of the difference between usage of the term FOB as per Incoterms 2010 and UCC, it is now mandatory to mention the usage criteria explicitly in the sales agreement. A few related terms in this context are FCA, CPT and DAP.
Free Carrier (FCA): The term “FCA” usually mentioned in the “FCA destination” format implies that the seller will deliver the goods subsequent to clearing customs at the stated destination as per the agreement. In most cases internationally, the “FCA destination” usage has replaced the “FOB destination” usage.
Carriage Paid To (CPT): The term “CPT” usually used as a replacement to all sorts of non-container sea freight earlier covered by the terms CFR and C&F (cost and freight). In case of CPT, the seller is liable to pay for the shipping charges up to the point mentioned as per the agreement. Once the goods are handed over to the carrier, the risk is transferred from the seller on to the buyer.
Delivered at Terminal (DAT): The term DAT or “Delivered At Terminal” is defined in the internationally recognized Incoterms 2010 standard. The DAT clause requires sellers to deliver goods at the terminal mentioned in the contract and the delivery is considered complete when all the goods have been unloaded at the terminal.