Free on Board (FOB)
Free on Board (FOB) is an international trade term used to indicate ownership and liability over goods that are lost, damaged or destroyed during shipment.
FOB has been standardized around the world to simplify small businesses’ participation in the global market. Whether you create a website to sell products online or sell in a store, you need to know how FOB guidelines affect shipments, costs, and liability for you and your buyers.
We’ll look at what FOB shipping is, how it works and why FOB matters so much for small businesses. We’ll also go over the differences between FOB shipping and other similar terms you might come across in sales contracts.
Understanding Free on Board (FOB)
FOB defines at which point during transportation a buyer or seller assumes responsibility for costs and potential damages. For example, the seller of goods pays a major port’s freight fees, while the buyer covers the transportation costs for the product from the port to its destination.
If shipment is listed as “FOB origin” or “FOB shipping point,” the buyer becomes responsible for all occurrences during transportation that once the seller ships the items.
If you’re looking to start a business and navigate through the eCommerce shipping work, it’s important to designate FOB shipping terms in advance to potential clients since it affects overall shipping costs and responsibility. Some vendors might prefer to designate goods as “FOB origin” to avoid as much liability as possible and reduce their costs.
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How does FOB shipping work?
Historically, trade was done entirely by ships. That’s why FOB refers to shipments via boats. Now that we have more transportation options, FOB applies to other modes of shipping, including planes and trucks.
As mentioned above, seller-buyer contracts stipulate the FOB shipping process. Therefore both parties know what to expect during transportation. Most shipping contracts also follow the International Commercial Term system, often abbreviated as incoterm, and includes FOB. Having standardized rules lets buyers and sellers create legally-binding contracts that can be used for multiple countries.
To better understand how FOB shipping works, let’s go over a hypothetical purchase and shipment process between a buyer and seller:
A buyer in the U.S makes a bulk purchase of $100,000 worth of clothes from a supplier in China.
In the purchase contract, the manufacturer stipulates FOB shipping.
The supplier loads the goods onto a truck from their warehouse and transports the order to the nearest port. At this stage, the supplier is still liable for the goods.
At the port, the goods are moved from the truck to a ship headed to the U.S. Until the goods board the ship, the supplier is still liable for them.
Once the goods are on the ship, the buyer is liable for them.
Upon arrival in the U.S, the goods are unloaded from the boat and handed over to the buyer, who is responsible for transporting the goods from the port to their final destination.
From the point where the goods are moved onto the boat, all liability lies with the buyer. However, if the supplier’s truck gets into an accident on the way to the port in China, the seller would assume responsibility for any damaged items.
Using our example above, let’s continue to look at different freight options for a delivery from Beijing to Los Angeles:
FOB Beijing, freight prepaid
FOB Beijing, freight collect
FOB Los Angeles, freight prepaid
FOB Los Angeles, freight collect
The location attached to the FOB indicates where the seller is liable for the goods. In this case, if the supplier is listed as “FOB Beijing,” they’re responsible for the goods until they reach the port. However, if the contract says “FOB Los Angeles,” then the supplier is liable for the goods until they reach the port in Los Angeles.
As for freight charges, they can either be prepaid or collected. If the FOB shipping in a contract says “freight prepaid,” then it means the supplier pays for the cost of freight charges. On the other hand, if it's stated as “freight collect,” the buyer is responsible to pay the freight charges.
Make sure you use the right wording as buyer or seller to reduce shipping and operational costs on your end. As a buyer, you’ll want vendors who offer “FOB (destination), freight prepaid,” signaling you’ll have less liability and fewer charges to pay. As a seller, “FOB (place of origin), freight collect,” will greatly reduce your operational costs.
FOB shipping vs FOB destination
Often, the difference between FOB shipping and FOB destination designations in a contract can confuse buyers. While the two terms are similar, they differ by who has liability and shipping costs.
As we’ve already covered, FOB shipping implies that the seller is liable for purchased goods as far as the port of origin. On the other hand, FOB destination means the seller is liable until the goods are delivered to their destination port, as we saw above with “FOB Los Angeles.” The FOB destination doesn’t have to be a port, it can be any destination that the buyer and seller have agreed upon, such as a specific city or warehouse where the buyer will store the goods.
This designation is also important to the seller since it’s likely where they’ll officially record the sale. If they’re responsible for the transportation of goods until the buyer’s loading dock, then they’ll want to ensure it arrives safely at the final destination and record the transaction as a completed sale. It’s also important to the buyer since it indicated at which point during the transaction they take ownership of the goods.
What’s the difference between FOB and CIF?
Another incoterm that businesses will often see on sales contracts is CIF, which stands for “cost, insurance and freight.” CIF is another term indicating liability for shipped goods in case of damages, as well as responsibility for certain delivery charges. Unlike FOB, CIF is clear-cut.
With a CIF contract agreement, the seller covers the delivery and insurance costs, assuming responsibility for any damages that might occur during the entire shipment process. Though a CIF agreement favors the buyer, these contracts are more expensive than FOB ones.
Why FOB matters for business
It may seem like the FOB terms are strictly an administrative concern, but as a business owner, the FOB can significantly affect your company’s finances. As business trends move towards eCommerce, you must know how international purchases that come through your website can impact your operational costs.
FOB terms make a difference in other areas of managing the cost of a business. For example, when looking at inventory turnover, businesses need to calculate the cost of goods sold (COGS) to understand the turnover ratio. To find that cost, you’ll factor in all the fees related to buying and producing the inventory. If the company that bought $100,000 worth of clothes from China also spent $5,000 in freight charges and transportation insurance, those extra fees need to be added to the COGS equation to get the actual inventory cost.
When considering FOB costs, it is also important to address sales tax implications. For example, some U.S. states charge sales tax and a business pays these taxes on top of freight charges. However, if the contract stipulates that the goods are transported “FOB freight prepaid,” the buyer is exempt from any applicable tax on the amount.