What Is Free on Board (FOB)?
Free on Board (FOB) is a shipment term used to indicate whether the seller or the buyer is liable for goods that are damaged or destroyed during shipping. "FOB shipping point" or "FOB origin" means the buyer is at risk once the seller ships the product. The purchaser pays the shipping cost from the factory and is responsible if the goods are damaged while in transit. "FOB destination" means the seller retains the risk of loss until the goods reach the buyer.
- Free on Board (FOB) is a term used to indicate who is liable for goods damaged or destroyed during shipping.
- "FOB origin" means the buyer is at risk once the seller ships the product.
- "FOB destination" means the seller retains the risk of loss until the goods reach the buyer.
- The terms of FOB affect the buyer's inventory cost—adding liability for shipped goods increases inventory costs and reduces net income.
- Legal definitions of FOB may differ between individual countries.
Free On Board
Understanding Free on Board (FOB)
Historically, FOB was used only to refer to goods transported by ship—in the U.S., the term has since been expanded to include all types of transportation. Contracts involving international transportation often contain abbreviated trade terms that describe matters such as the time and place of delivery, 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 the International Chamber of Commerce (ICC) publishes, but firms that ship goods within the U.S. must also adhere to the Uniform Commercial Code (UCC). Since there is more than one set of rules, and legal definitions of FOB may differ from one country to another, the parties to a contract must indicate which governing laws are being used for a shipment.
Any vendor-client transaction needs to make clear FOB terms in the purchase order as these terms determine which party will pay for shipping and insurance costs. However, it's worth noting that FOB status does not determine ownership—ownership is determined in the bill of sale or agreement between the buyer and seller.
If the terms include the phrase "FOB destination, freight collect," the seller is responsible for the goods until they are delivered, and the buyer is responsible for freight charges. If the terms include "FOB destination, freight prepaid," the seller is responsible for goods until delivered, provided there are no insurance claims. In this scenario, the seller is responsible for the freight charges. On the other hand, "FOB origin" or "FOB shipping point" indicates the opposite—that the buyer is responsible for goods soon as the vendor ships the goods.
Depending on the FOB terms, the more often a company orders inventory, the more shipping, and insurance costs it will incur. Companies can also incur costs when placing an inventory order through the price of hiring labor to unload the goods as well as the cost of leasing a warehouse to store the goods. A company can lower its inventory costs by ordering greater quantities and reducing the number of individual shipments it brings in.
Example of Free on Board (FOB)
Assume, for example, that Acme Clothing manufactures jeans and sells them to retailers such as Old Navy. If Acme ships $100,000 in jeans from their factory in Los Angeles to an Old Navy store in New York City using the term FOB shipping point (FOB Los Angeles), Old Navy is liable for any loss while the goods are in transit and would purchase insurance to protect the shipment.
On the other hand, if the goods are shipped to FOB destination (FOB New York), Acme Clothing retains the risk until the freight reaches Old Navy's offices and would insure the shipment against loss.
Shipping terms affect the buyer's inventory cost because inventory costs include all costs to prepare the inventory for sale. Using the same example, if the jeans were shipped using FOB shipping point terms, Old Navy’s inventory cost would have to include the $100,000 purchase price and the cost of insuring the goods against loss during shipment.
Similarly, when Old Navy incurs other costs related to inventory, such as renting a warehouse, paying for utilities, and securing the warehouse, those costs are also added to inventory. This accounting treatment is important because adding costs to inventory means the buyer does not immediately expense the costs and this delay in recognizing the cost as an expense affects net income.
Another reason companies should be acutely aware of free on board (FOB) terms is that FOB establishes when the goods become an asset on the buyer's balance sheet. This becomes especially important if a transaction occurs close to the transition from one accounting period to the next, such as the end of a calendar or fiscal year.
Accountants need to know whether to include the freight on the company's balance sheet when the goods are shipped or when they are delivered. FOB destination would mean the seller carries the inventory on their balance sheet until it's delivered. FOB shipping point means the buyer records merchandise when it's shipped.
Criticism of FOB
A 2018 study by Ki-Moon Han of the Korea Research Society for Customs looks at the complexities of FOB contracts and explains that they are often misunderstood. According to Han, more sophisticated contracts are increasingly used to meet the needs of international traders.
The author states that there is often confusion because the parties involved in the contracts misunderstand incoterms FOB, sales contracts, carriage contracts, and letters of credit. Han urges companies to use caution and to clarify which type of FOB they are entering into so that the risks and liabilities are clear.
The latest publication of Incoterms, Incoterms 2020, is available for purchase on the International Chamber of Commerce website.
Each party should have a firm understanding of free on board (FOB) to ensure a smooth transfer of goods from the vendor to the client. Regardless of whether that transfer occurs on the domestic or international level, FOB terms can have a big impact on inventory, shipping, and insurance costs.
How does FOB work?
FOB stands for "free on board" and indicates when liability goods are transferred from a seller to a buyer.
What is FOB pricing?
The costs associated with FOB include transportation of the goods to the port of shipment, loading the goods onto the shipping vessel, freight transport, insurance, and unloading and transporting the goods from the arrival port to the final destination.
Who pays freight on FOB origin?
If the terms include the phrase "FOB origin, freight collect," the buyer bears the responsibility of the goods being shipped and is responsible for freight charges. If the terms include "FOB origin, freight prepaid," the buyer of goods assumes the responsibility of goods at the point of origin, and the seller pays the cost of shipping.
What is the difference between FOB and CIF?
CIF (Cost, Insurance, and Freight) and FOB (Free on Board) are two widely used INCOTERM agreements. Although the definition of both terms can differ across countries and is ultimately determined by each vendor-client contract, historically, FOB transfers liability from seller to buyer when the shipment reaches the port or other facility designated as the point of origin. With a CIF agreement, the seller pays costs and assumes liability until the goods reach the port of destination chosen by the buyer.