Incoterms Must Perish, Part 2: An in-depth Analysis

For example, “free on board” (FOB) in the 2020 Incoterms version is superficially identical to both the 1936 Incoterms version and the 1952 UCC code version found in article 2 section 319. In each case, the seller loads onto the buyer’s vehicle. However, the Incoterms rule was created as a water-only rule that delivers to the main carriage (ship) and for decades specified that risk passed to the buyer upon traversing the ship’s rail. Only in 2010 did this finally shift to risk passing once safely at rest on board the ship, matching the expectation set by the rule’s name, “free on board.” The UCC rule, by contrast, works for any kind of vehicle, can deliver anywhere (domestic to either the buyer or seller), at any point in the logistics movement, and no mention is made at all of risk passage. One might expect the ICC’s Incoterms to be clearer on these points, but it is not even clearly written as to whether “F” rules apply only to domestic moves or whether “D” rules are intended exclusively for delivery after export.² That partners in trade are entering into contracts with such incompatible understandings of what seem to be the same rules should give pause to us all.

It was surely an improvement to the FOB rule to remove the “ship’s rail” as a point of risk transfer. In a well-known court case regarding an FOB cargo transfer gone wrong, a judge remarked about this rule, “Only the most enthusiastic lawyer could watch with satisfaction the spectacle of liabilities shifting uneasily as the cargo sways at the end of a derrick across a notional perpendicular projecting from the ship’s rail.”³ But, though the change was significant, long-time practitioners had to adjust to a major shift in a rule that remained superficially identical to the old rule. The change to risk passage was not called out in any way except in the bowels of the ICC rulebook language, and it was up to users of the rulesets to make themselves aware of the enormously impactful details that changed their liability. Plus, this change had no impact on the expectations of those doggedly referring to the American UCC version of FOB.

And lest you think that, as of 2021, the UCC version of the FOB rule has been relegated to history, research shows persuasively that it has not, particularly in the U.S., of course, which remains the world’s largest economy.

As another example, the Incoterms ruleset has a long-standing and ubiquitous rule called “ex works” or “EXW” that requires the buyer to come onto the seller’s premises and load the (usually heavy) goods, typically using heavy equipment. Imagine in today’s world an unknown transporter, appointed by a company to which you sold goods, waltzing into your facility to load heavy goods onto their truck. Of course, to compound it, the transporter needs a forklift to move the pallets, so you must make one available for this unknown third party to use, or in any case allow them to use the one they brought on your premises, when you have no idea of the training or skill of the person to operate the equipment and the liability is clearly yours. It’s an insurance adjustor’s nightmare, and a tort attorney’s dream, and most sellers won’t allow it. So instead they typically load the cargo for the customer, since that’s the only insurance-friendly way to complete the trade. However, any damage that occurs during this post-delivery handling, caused by the seller, is rightfully charged to the buyer under ex works. Then ensues an argument over who will pay the damages.

Add to the list of EXW’s problems the next level of concern around international movements. The customs declaration is done by the buyer, but in terms of the customs regulations, your company remains responsible for the correct declaration unless the overseas company is also a registered entity in the domestic country. As this is rarely the case, your risk profile just went up exponentially. Should the goods be illegally exported, you may be on the hook, legally. The UCC version of FOB origin is equally problematic in this regard, besides having multiple other issues.

Despite all this complexity, the Incoterms cannot even adapt to every reasonable logistics scenario, forcing supply chain personnel to select a rule that doesn’t fit and then rely on countermanding contract language to warp the rule into an outcome that will suffice. For example, suppose you need a rule for a delivery to rail where risk passes once the cargo is loaded onto the railcar? It turns out that there is not an Incoterms rule for this. Free carrier (FCA) requires the buyer to do the unloading and loading onto the next vehicle along the route, as does free alongside ship (FAS), and both FAS and FOB are designated for water transport only. To handle this very plausible scenario, you are forced either to misuse FOB for ground transport or to use FCA but separately specify loading responsibilities and risk passage in the contract, hoping that this modification to the specified rule is noticed and honored in practice.

As another example, suppose you want cargo delivered domestically to a location where the seller will unload onto the ground whereupon risk passes. The buyer will then arrive, pick and load the cargo, and then export. Again, there is no appropriate Incoterms rule for this scenario. FCA doesn’t entail the unloading by the seller, nor does FAS. FOB does, assuming the modality is water, but the risk will remain the seller’s until such a time as the buyer comes along to collect and load the cargo. Any mishaps during that time are the seller’s responsibility, which may not be a burden the seller is willing to accept.

Furthermore, the Incoterms rules are stated and constructed inconsistently, which adds to the challenge of understanding, retention, and application by industry practitioners. Some rules’ three-letter descriptions refer to the point of risk and responsibility transfer, as with delivered at place (DAP), FOB, and FAS, to name a few. Other rules’ letters refer instead to the arrangement and payment obligations of the seller, as with the “C” rules (CIR, CIP, CFR, and CPT). Some refer to the responsibilities of materials handling, as does “delivered at place unloaded” (DPU), (or as implied by FAS and FOB), whereas other similar rules leave the practitioner to dig into the verbiage of the rule to discover these responsibilities, as with DAP; delivered duty paid (DDP); and, arguably, FCA, with its split application. There is no consistent structure to set and maintain expectations or to help those novices who must interact with the contractual consequences of Incoterms to understand more easily what they are agreeing to.

These examples and others show the fundamental rigidity and impenetrability of the current Incoterms ruleset. Mastery is difficult and comes only with many years of experience and pain. Too many traders negotiate deals under terms they are not prepared to understand, and the Incoterms rules, while aiding logistics and trade generally, also abet the exploitation of eager and unsavvy sales professionals. We’ll never know how many jubilant salespersons have closed a deal only to find out that the “CIP” (“carriage and insurance paid to”) terms they readily agreed to entail huge extra logistics expenses for their companies that they did not account for when negotiating the price. Or worse, they’ve agreed to sell on DDP (“delivered duty paid”) terms into a country where they lack import privileges, so the contract can’t even be executed. There are many such pitfalls.

Widespread misunderstanding and misuse 

There are no shortage of anecdotes about misuse or incorrect use of Incoterms. Indeed, recent research has hinted that Incoterms are commonly misunderstood and misused by professionals almost regardless of their expertise.⁴ In a 2021 survey of industry professionals who use Incoterms, we found zero respondents who managed to correctly assign the Incoterms rule to all of our five described scenarios, even though many of the respondents professed various degrees of expertise. Even the logistics scenario with the most correct responses was assigned the correct Incoterms rule by only 21% of procurement, sales, and logistics respondents. This result supports the conclusion of Thomas Schaefer makes that formal training is needed to reduce to prevalence of mistakes and misunderstandings on this topic.⁵ Indeed, when asked to express how helpful Incoterms training would be for personnel in these three areas of the supply chain, respondents to the 2021 survey overwhelmingly said either “very helpful” or “extremely helpful,” (see Figure 1) indicating that supply chain personnel understand fully how important Incoterms are and that there are deficiencies in knowledge and application that need to be addressed.

The same respondents, when asked what improvements in Incoterms they would like to see, overwhelmingly responded that simpler rules, fewer rules, and better documentation were in order. (See Figure 2.) Indeed, it hardly seems realistic to imagine that the best way forward is to demand that hundreds of thousands of industry professionals uniformly be trained so as to overcome the structural challenges of a ruleset they all must apply. While training is always a good goal, resources are limited and a broad impact across the economy would depend upon a degree of uptake (decision to take training, seriousness of intent and application) that is simply implausible.

For such an important cog in our economic machinery, there must surely be an economic cost to its practitioners wielding it with so tenuous a grasp. There are no available figures that estimate the cost to all of us for mistakes in Incoterms usage. Whatever that figure is, it is an invisible, pervasive, and persistent form of risk and cost that continues unaccounted for. Respondents were asked to report on the frequency of problems with choosing and executing Incoterms in the supply chain and, again, overwhelmingly reported that they see problems “sometimes,” “often,” or “routinely” in executing the logistics portion of trades.

To that point, it’s worth exploring who is doing the lion’s share of Incoterms selection. Is it logistics, as might be expected given the logistics function’s outsized role in delivering the result? Is it procurement, given that function’s direct involvement with deciding the terms of any contract of sale? Is it legal? Our survey respondents report that about 70% of purchase contracts use Incoterms that were determined by either procurement, sales, or legal, and that about 63% of sales contracts’ Incoterms choice is determined by sales, procurement, or legal. Only about 17% and 20% of purchase and sales contracts, respectively, use Incoterms chosen by the logistics people.

There is no clear data yet about the consequences of this reality, where the functions charged with performing the contract according to their capabilities have little say in the contract. However, the same survey respondents reported that problems originate from many places. (See Figure 4.)

Astonishingly, this suggests that the function performing the work is generally not a party to the decisions about who does what, how, and when. This is, at best, a recipe for poor performance, and the extent to which the research shows Incoterms are misused and misapplied means that a shocking amount of trade relies on goodwill alone to ensure delivery. Goodwill is clearly a powerful force, but it cannot be best practice to rely on it, and doing so introduces risks and inefficiencies, and places strain on supply chain relationships.

The unavoidable conclusion to these observations is that change is needed. Given that it is unlikely that training alone will make a substantial dent in the problem, it remains to decide how else we might forge a path. The next article will explore alternatives that address Incoterms’ complexity, incompleteness, and inscrutability.

Notes

1. “Incoterms,” or “International Commercial Terms,” is a legally registered trademark of the International Chamber of Commerce.

2. “F” rules deal with goods that are exchanged from the seller’s facility up to (and including) the port of international departure. “D” rules deal with the goods that are exchanged upon arrival in the buyer’s country.

3. Pyrene Co. Ltd. v. Scindia Navigation Co. Ltd, 2 QBD (1954).

4. See J. Vogt and J. Davis, “The State of Incoterm Research,” Transportation Journal (2020): 59(3): p. 304-324. J. Vogt, “The Use—and Misuse–of Incoterms,” SupplyChainBrain (2018).

5. T.J. Schaefer, Incoterms Use in Buyer-Seller Relationships: A Mixed Methods Study. 2017, University of Missouri – Saint Louis: Ann Arbor. p. 288.