What Are Incoterms and Why Are They Important?

What Are Incoterms?

International Commercial Terms, or Incoterms for short, are a collection of globally accepted guidelines that specify what purchasers and sellers are responsible for when it comes to the delivery of goods under sales contracts. These words, which were first published in 1936 by the International Chamber of Commerce (ICC), have developed to help promote international trade by making sure that all parties are aware of their responsibilities.
This ensures that both parties know their duties, including who is responsible for transportation, insurance, and any associated costs.
For businesses engaged in international trade, understanding what are Incoterms is crucial as they standardize complex logistics processes.

What does Incoterms mean in practice? It ensures clear communication, reduces legal risks, and helps businesses avoid costly misunderstandings, particularly concerning customs clearance, freight forwarding, and damage or loss during transit.

How to Understand Incoterms?

To fully understand what are Incoterms, it's important to know that these terms are updated periodically by the ICC to reflect changes in international trade practices. The current edition, Incoterms 2020, is the most up-to-date, although businesses still use the previous Incoterms 2010 edition depending on their preferences and agreements.
The essence of understanding Incoterms lies in identifying the responsibilities they outline. These terms define several key elements of a trade deal:

1. Delivery Point: The specific point during shipping when responsibility for the goods shifts from the seller to the buyer.
2. Cost Allocation: Who pays for transportation, loading, unloading, duties, and taxes.
3. Insurance Obligations: Whether the seller or buyer must cover insurance, and if so, which part of the journey is covered.

Each Incoterm assigns different responsibilities to the buyer and seller, making it essential to select the one that best suits both parties’ logistical and financial arrangements. Choosing the right term minimizes the risk of confusion or disagreement during the transaction process.

Rules for Any Mode of Transport

The Incoterms are categorized into two broad groups: those applicable to any mode of transport and those specific to sea and inland waterway transport.

For any mode of transport, the following Incoterms apply:

1. EXW (Ex Works): The customer assumes all transportation risks and expenses, and the seller makes the products available at their location. 
2. FCA (Free Carrier): The seller delivers the goods to a carrier selected by the buyer. The risk passes once the goods are handed over to the carrier.
3. CPT (Carriage Paid To): The seller pays for transportation, but the risk passes to the buyer once the goods are handed to the carrier.
4. CIP (Carriage and Insurance Paid To): Up until a certain point, the seller assumes all liability for insurance and transportation; after that, the buyer bears all liability until the products are turned over to the carrier.
5. DAP (Delivered at Place): The seller is responsible for delivering the goods to a named destination, excluding unloading. The buyer bears the unloading cost.
6. DPU (Delivered at Place Unloaded): The seller delivers the goods and is responsible for unloading at a specified destination. 
7. DDP (Delivered Duty Paid): The seller covers all costs, including import duties and taxes, and delivers the goods to the buyer at a specified location. The buyer bears no responsibility for shipping or customs formalities.

These Incoterms offer a high level of flexibility as they can be used for any form of transportation, including air, rail, road, or a combination thereof. Choosing the correct term depends on the degree of responsibility each party is willing to accept.

Rules for Sea & Inland Waterway Transport

1. FAS (Free Alongside Ship): The seller delivers the goods alongside the ship at the designated port, after which the buyer assumes responsibility for loading, transportation, and all associated costs and risks.
2. FOB (Free On Board): After the items are loaded onto the ship, the seller bears the risk and the buyer bears the liability. The cost of sea freight is borne by the buyer. 
3. CFR (Cost and Freight): The seller pays for the sea freight to the destination port, but the risk transfers to the buyer once the goods are on board the ship.
4. CIF (Cost, Insurance, and Freight): The seller covers the cost of freight and insurance up to the destination port. 

These Incoterms are more specialized and typically used for bulk shipments, such as raw materials and commodities. Understanding the responsibilities outlined in each term is crucial to ensuring smooth transactions, particularly when dealing with maritime transportation, which carries higher risks of damage due to the nature of the shipping process.

What Do Incoterms Not Cover?

While Incoterms are comprehensive in defining responsibilities during shipping, there are certain aspects they do not cover:

1. Ownership Transfer: Incoterms specify when the risk is transferred from the seller to the buyer, but they do not address the change in ownership or title of the goods.
2. Contractual Obligations Beyond Shipping: They do not address the broader terms of the sales contract, such as payment terms, breach of contract, or dispute resolution.
3. Customs Regulations: Incoterms do not override local customs regulations or laws that may apply to the shipment.
4. Insurance Coverage: Except for terms like CIF and CIP, Incoterms do not mandate which party must arrange insurance, nor do they specify the level of coverage required.
5. Quality of Goods: The quality, inspection, or warranty of the goods is not covered under Incoterms; these must be separately negotiated and included in the sales contract.

Understanding these limitations is critical when using Incoterms. Businesses must supplement these terms with comprehensive sales contracts that address areas like payment methods, dispute resolution mechanisms, and legal jurisdiction.

Incoterms 2010 vs. Incoterms 2020

1. DAT (Delivered at Terminal) Replaced by DPU (Delivered at Place Unloaded): This change reflects the broader range of delivery locations beyond terminals.
2. FCA (Free Carrier): The 2020 rules introduced an option for buyers and sellers to agree that the buyer instructs the carrier to issue a bill of lading with an onboard notation, which is then passed on to the seller.
3. Insurance Coverage: Under CIP, the level of insurance required increased, reflecting a more comprehensive approach to risk management in international trade.
4. Enhanced User Guidance: Incoterms 2020 offers clearer and more detailed explanatory notes to help traders understand the obligations of each rule.

Businesses must clearly specify which edition of Incoterms they are using in their contracts to avoid misunderstandings. Both the 2010 and 2020 editions can be used, provided both parties agree.

Commonly Used Incoterms

Some Incoterms are more popular than others, depending on the nature of the goods and the transportation methods. 

1. EXW (Ex Works): Commonly used for domestic shipments, where the buyer assumes the bulk of the responsibility.
2. FOB (Free on Board): Popular in sea freight, particularly for shipping large quantities of goods internationally.
3. CIF (Cost, Insurance, and Freight): Favored by businesses who want to ensure insurance is included up to the destination port.
4. DAP (Delivered at Place): Frequently used in international shipping where the seller is responsible for transportation but not unloading.
5. DDP (Delivered Duty Paid): Ideal for buyers who want minimal involvement in the shipping process, as the seller handles all costs and risks.

Knowing when to use each Incoterm can save businesses both time and money while minimizing legal risks.

Advantages and Disadvantages

Advantages of Incoterms:

1. Standardization: They create a universal language, ensuring that all parties understand their obligations.
2. Risk Reduction: By clearly defining who is responsible for each stage of shipping, Incoterms reduce the likelihood of disputes and misunderstandings.
3. Flexibility: Businesses can choose the term that best suits their needs, allowing for greater control over cost and risk allocation.
4. Efficiency: They simplify negotiations by predefining roles, thus speeding up the contracting process.

Disadvantagesof Incoterms: 

1. Limited Scope: As discussed earlier, Incoterms do not cover issues like ownership transfer, customs regulations, or dispute resolution, requiring supplementary agreements or contracts.
2. Complexity: Some Incoterms may be confusing for inexperienced traders, leading to potential misinterpretation if not fully understood.
3. Obsolescence of Older Terms: While older editions of Incoterms like 2010 are still in use, confusion can arise when parties do not specify which version they are adhering to, leading to misunderstandings about responsibilities.

Conclusion

Incoterms play a critical role in international trade by clarifying the responsibilities of both buyers and sellers during the shipping process. They help streamline negotiations, reduce legal risks, and ensure smoother transactions, ultimately facilitating global commerce. However, businesses should be aware of their limitations and ensure that all aspects of their trade agreements are fully covered.