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 and takes ownership of goods once the seller ships the goods. For accounting purposes, the supplier should record a sale at the point of departure from its shipping dock. "FOB origin" means the purchaser pays the shipping cost from the factory or warehouse and gains ownership of the goods as soon as it leaves its point of origin. "FOB destination" means the seller retains the risk of loss until the goods reach the buyer.
Free On Board
Free On Board (FOB) Explained
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 in the United States must also adhere to the Uniform Commercial Code (UCC). Since there is more than one set of rules, the parties to a contract must expressly indicate which governing laws they used for a shipment.
- Free On Board is a term used to indicate who is liable for goods damaged or destroyed during shipping.
- The terms of FOB affect the buyer's inventory cost; adding liability for shipped goods increases inventory costs and reduces net income.
- FOB contracts have become more sophisticated in response to the increasing complexities of international shipping.
How Free On Board Works
Assume, for example, that Acme Clothing manufactures jeans and sells them to retailers such as Old Navy. If Acme ships $100,000 in jeans to Old Navy using the term FOB shipping point, 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 FOB destination, Acme Clothing retains the risk and would insure the shipment against loss.
Factoring in Inventory Costs
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 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.
Examples of Inventory Cost Management
The more often a company orders inventory, the more shipping, and insurance costs it will incur. Also, a business may incur costs to place an order, hire labor to unload the goods and rent 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.
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 letter 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.