The Department of Commerce recently introduced the Assess Costs Everywhere tool, which outlines the costs and risks firms need to weigh when considering location of manufacturing operations and supply chains. Trade financing and associated costs are especially relevant to manufacturers with overseas suppliers. These firms must consider more than just the selling prices of the items they plan to purchase. Purchasing goods and supplies from foreign countries requires different payment methods from buying domestically. In international trade, letters of credit are usually the preferred instruments of payment because they involved well-established procedures among banks and greatly reduce the risk of non-payment.
A letter of credit is a formal document that an importer obtains from his or her bank to pay for imported goods. The importer pays for the letter of credit with existing funds or through a bank loan. The issuing bank then pays the beneficiary (exporter in this case) a contracted amount through the exporter’s bank when certain conditions are met (such as the required shipping documents being provided to the importer’s bank). Payment is usually made while the goods are in transit, rather than after they have been delivered to the U.S. facility. This arrangement has a direct costs associated with issuing the letter of credit, possible financing costs, and also the risk associated with having to pay for a good before it has been delivered. Sourcing from abroad generally means that it would take the buyers longer to receive the goods than it would if their supplies come from domestic sources, leading some firms to keep a larger inventory. Extra expenses, paying for goods sooner, and keeping a larger inventory reduce a company’s cash flow.
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, it would pay the seller an amount covering the cost of the goods, insurance, and freight. ACE Hyperwidgets, Inc. plans to pay the seller with a letter of credit funded by a bank loan and the goods are to be transported to the U.S. by ship. Here is how the costs of a typical transaction could stack up:
The $45,283 estimate represents the direct trade financing and associated costs ACE Hyperwidgets, Inc. would have to pay to import from abroad. On the other hand, if ACE Hyperwidgets, Inc. had chosen to use suppliers based in the United States, that money would have been available for other purposes.
When firms take financing costs into account – particularly when considered in addition to labor, travel, shipping, and inventory costs -- they may well realize that U.S. suppliers are the best and cheapest option.
Fenwick Yu, Economist