Last reviewed 25 February 2022
Do you think you know all about Incoterms? What a dry subject. It has its place of course, but all it does is clarify risks and responsibilities when goods are moved between countries. Nothing to get excited about you might think, just one more thing that exporters and importers need to remember.
Here we show you what you might be missing
Incoterms, as you probably know, are a system of rules that exporters and importers can choose to apply to contracts for the supply of goods. They say a lot in just a few letters and help to avoid misunderstandings and mistakes.
So far, so good. But that is only part of the story.
You may know that the 11 rules in the Incoterms 2020 group are listed into four groups. I can list those groups in the order E, F, C, and D and in doing so list them in order of responsibility, with the first group putting most of the risk and responsibility on the buyer, the last on the seller. So it makes sense that it is advantageous for the seller if the chosen term is nearer the beginning of the list. And logically, the reverse is true for the buyer.
Or does it?
Let us take an example. An exporter of clothing is shipping an order to a buyer in the United States. The buyer has proposed CIF with delivery to New York. CIF is a very well-known Incoterm; it goes back to the earliest days and essentially it means that the buyer is asking for the seller to arrange pay for the freight to his country. CIF is also one of those rules that is only for sea freight. No problem there. The exporter is indeed delivering by sea freight. It is by far the cheapest option, and there’s no great urgency, so nobody is even going to consider air freight. Most long-distance freight is carried by sea, so CIF is surely a very useful rule?
But there’s something else. In the International Chamber of Commerce Guide (they’re the people who write the rules), we are told that, “where more than one mode of transport is to be used, which will commonly be the case where goods are handed over to a carrier at a container terminal, the appropriate rule to use is CIP rather than CIF “1
That makes a difference, for a start. Most shipping freight is carried by containers, and this is no exception. It is less than a container load, so the goods will be delivered to a handler, where they will be loaded into a consolidated container with other goods. If the exporter used CIF, there would be a potential problem if something went wrong. If the recipient opened the container to find the goods were damaged in some way, he would look to the Incoterm to find out whether the loss was his or the seller’s. But CIF says that the risk passed to the buyer when the goods were loaded on the ship. Who knows when the damage occurred? So Incoterms would not have worked, because the buyer and seller would be in dispute about who should carry the loss.
Much better to use CIP, which is exactly what the book says. CIP is very similar to CIF but is for any mode of transport. The place of delivery can be named as the container terminal not the ship, meaning that if the goods are lost or damaged after the exporter hands them over, there is no doubt that the buyer carried the risk. (Always assuming that both parties actually understood the rule of course).
But it doesn’t end there. Under CIP, the seller needs to buy insurance for the benefit of the buyer. That is what the letter I in CIP stands for; insurance. And Incoterms stipulates that should be a high level of cover. Clause A under Institute Cargo Clauses to be precise, which is more expensive than the customary group C. The exporter is a regular shipper of goods and has their own maritime insurance policy, but that doesn’t cover this order, because it isn’t the exporter who is at risk.
So why not offer the customer a group D term? It carries less risk for the buyer and is therefore a more attractive offer. In fact, under Incoterm DAP, the only significant difference is that the exporter carries the risk of loss or damage right up until the point of arrival in New York. This will be much better for the buyer because the goods are not his problem until they arrive. If the container is lost, or there’s a fire, or if seawater gets into the container and spoils the goods, the solution is clearly agreed. The exporter pays. What’s not to like?
Curiously though, DAP might actually be a cheaper option than CIP for the exporter. Yes, he has to carry the risk, which he wouldn’t have had to do under CIP. But the risk is covered under his open insurance policy, which probably works out much cheaper than arranging special insurance for the customer, as CIP would have required him to do.
So simply by switching the Incoterm to a rule that clearly benefits the buyer, the seller is actually saving money and has a much happier customer.
Understanding the anomaly
Does everyone actually understand this anomaly in the C group terms? The seller arranges and pays for delivery to the buyer’s country, but it’s the buyer who carries the risk. It isn’t rational, not to me anyway. If my milkman smashes the bottle on the way to my door, that’s his problem. (Yes, I’m old school, I still have my milk delivered in a glass bottle to my doorstep). Why should international trade be any different? The answer is that Incoterms CIF (and FOB) are long-established terms, based on the customs and practice of another time. But they are also very widely used and recognised (but sadly, often misunderstood). I have seen numerous cases where there has been a loss under a C term and the dispute occurs because the buyer never really understood that the delivery was at his risk. If the order was for payment after delivery, good luck in getting the customer to pay for goods he either didn’t receive or received damaged. More than once, I’ve seen an exporter volunteer to stand the loss that wasn’t his because “they’re a good customer.” OK I get that; nobody wants an unhappy customer. But why use a particular Incoterm if you’re not going to enforce it? By giving the customer more (a D term instead of a C term) an exporter can potentially save money, avoid the prospect of an ugly, and potentially costly dispute, and worst of all, a possible loss of future business.
Why wouldn’t you?
1Incoterms® 2020 by the International Chambers of Commerce ICC Publication © International Chamber of Commerce 2019