What does 'Free On Board - FOB' mean
Free on board (FOB) is a trade term that indicates whether the seller or the buyer has liability for goods that are damaged or destroyed during shipment between the two parties. "FOB shipping point" (or origin) means that the buyer is at risk while the goods are shipped, and "FOB destination" states that the seller retains the risk of loss until the goods reach the buyer.
!--break--Contracts involving international transportation often contain abbreviated trade terms that describe matters such as the time and place of delivery and payment; when the risk of loss shifts from the seller to the buyer; and who pays the costs of freight and insurance. The most common international trade terms are Incoterms, which are published by the International Chamber of Commerce, but firms that ship goods in the United States must adhere to the Uniform Commercial Code. Since there is more than one set of rules, the parties to a contract must expressly indicate the governing law used for a shipment.
How FOB Works
Assume, for example, that Acme Clothing manufactures jeans and sells the jeans to retailers, including Old Navy. If Acme ships $100,000 in jeans to Old Navy using the term "FOB shipping point," Old Navy (the buyer) has liability for any potential loss while the goods are in transit, and this means that the buyer must purchase insurance to protect the shipment. On the other hand, if the goods are shipped "FOB destination," Acme Clothing retains the risk and must insure the shipment against loss.
Factoring in Inventory Costs
Shipping terms affect the inventory cost for a buyer, because the cost of inventory includes all of the costs to prepare the inventory for sale. Using the same example, Old Navy’s inventory cost includes the $100,000 purchase price, as well as any costs to insure the goods against loss during shipment. When Old Navy incurs costs to store the inventory, such as the cost to rent a warehouse and pay for utilities and warehouse security, those costs are also added to inventory. This accounting treatment is important, since adding costs to inventory means that the costs are not immediately expensed, and the delay in recognizing the cost as an expense affects net income.
Examples of Inventory Cost Management
The more often a company orders inventory, the more costs it incurs to pay a third party to ship the goods, along with the potential cost to insure goods during shipment. In addition, a business may incur costs to place an order, to hire labor for unloading the goods, and to store the goods in a warehouse. If a company can minimize the number of shipments, the inventory costs are lower.