- Financing costs must be considered when a firm's supply chain extends to other countries.
- Special financing can be needed, such as letters of credit.
- Payment is usually required before the goods are delivered, tying up precious cash.
- Other costs include taxes, surety bond premiums, customs broker fees and storage expenses.
Sourcing goods from overseas may require a U.S. company to commit a greater portion of its cash flow to financing costs and inventory than when sourcing within the United States. Special financing arrangements generally are needed to purchase goods across borders. These arrangements will tie up cash. They often require the buyer to pay while the goods are in transit, rather than after they have been delivered to the U.S. facility. In this case, the U.S. buyer pays before inspecting the goods. Finally, longer shipping times combined with uncertainty about product quality force many companies to carry more inventory than they would when using U.S. suppliers. Special financing arrangements, paying for goods sooner and keeping a larger inventory reduce a company's cash flow.
Special Financing Arrangements
Purchasing imported goods or supplies requires different payment methods than purchasing supplies domestically. When exporters and importers trust each other, they might opt for less expensive arrangements such as an open account in which the goods are paid for after delivery. However, when there are risks that payments for the purchased supplies may not be made, letters of credit are usually preferred because they involve well-established procedures among banks and greatly reduce the risk of non-payment. In a letter of credit transaction, the importer's bank guarantees payment to the exporter (through the exporter's bank) once the required shipping documents are provided to the importer's bank. Payment is usually made while the goods are in transit.
Letters of credit are distinct from the sales contract that governs the other terms of the purchase. Payment from the importer's bank to the exporter's bank is solely based on the terms of the letter of credit and not the sales contract. Therefore, the importer's bank only examines the documents specified on the letter of credit for discrepancies before making payments to the exporters. Banks do not inspect the goods nor do banks take responsibility for the condition of the goods.
Let's use a hypothetical case to illustrate the trade financing costs associated with sourcing products from overseas. ACE Hyperwidgets, Inc. is importing goods valued at $1 million on a cost, insurance and freight (CIF) basis. Under this arrangement, ACE Hyperwidgets would pay the seller an amount covering the cost of the goods, insurance, and freight. It plans to pay the seller with a letter of credit funded by a bank loan and the goods are to be transported to the United States by ship. Here is how the costs of a typical transaction could stack up:
Trade Financing and Associated Costs
|Letter of Credit (LC) Fees||$3,750|
|$1 million LC x 0.375%|
|LC Issuance & Remittance Fees||$200|
|Interest on Loan - 2 Months||$7,083|
|$1 million x 4.25% x 2/12|
|$1 million x 3.0%|
|Surety Bond Premium||$500|
|Customs Broker Fee||$300|
This $43,568 estimate represents the direct trade financing and associated costs a U.S. company would have to pay to import from overseas. This is $43,568 that would not be available for other purposes, so it also has a substantial opportunity cost component. Further, the company might have to increase warehouse expenditures because of the need for larger inventory, or it might also lose parts of the increased inventory to obsolescence or waste.
Special financing arrangements needed to obtain sources of supply from overseas can tie up a company’s cash. Before committing to purchasing supplies from another country, companies should be sure to consider the full costs – including any special costs needed to finance the purchase and the additional time needed to convert shipments into cash receipts.
[i] In this hypothetical case, the import duty is assumed to be 3 percent, which is the average of applied tariff rates for manufactured goods.
[ii] The Harbor Maintenance Fee is 0.125% of the value of the cargo, and the Merchandise Processing Fee is 0.3464% of the value of the cargo (to a maximum of $485).