MODULE 2 PRICING, FINANCING, PAYMENT METHODS DRAFTED BY: MYCCI BULGARIA

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1 MODULE 2 PRICING, FINANCING, PAYMENT METHODS DRAFTED BY: MYCCI BULGARIA NOVEMBER 2012

2 Contents PRICING, FINANCING, PAYMENT METHODS...2 INTRODUCTORY NOTES:...2 ABSTRACT:...2 PRICING...3 Price, pricing & cost...3 Strategy of Pricing...3 FINANCING...7 Documentary credit (DC)...7 Factoring...7 Forfeiting...7 Credit insurance facilities...7 PAYMENT METHODS IN INTERNATIONAL TRADE...7 Currency of Payment...8 Buyer and Seller...8 Determining the Payment Method - Key Factors...9 Security of Payment Terms...9 Payment Risk Ladder...9 Open Account Bills for Collection Letters of Credit (L/Cs) Advance Payment MAIN TYPES OF MONEY TRANSFERS SWIFT Inter-Bank Transfer Buyer s Cheque Banker s Draft International Money Orders ANNEX I GLOSSARY ANNEX II DECUMENT TEMPLATES SAMPLE LETTER OF CREDIT (GENRAL) SAMPLE LETTER OF CREDIT (IRREVOCABLE) TEMPLATE PAYMENT ORDER FORM

3 PRICING, FINANCING, PAYMENT METHODS i INTRODUCTORY NOTES: This module provides guidelines to exporters on key financial issues related to successful international trade. The module covers three basic financial areas of exporting concerning the pricing of products and services, financing of international deals and the methods of payment. ABSTRACT: Price and cost are two different things, where the first is the amount that customers pay for products, and the latter is the amount that businesses spend for making the product. The first major issue for the exporting companies is to have a proper pricing strategy in place. In determining their pricing exporters should be clear about what they want to achieve, consider the key pricing factors for their products and services and be aware of their revenue targets as well as of the competitors. Financing is another key issue to all exporters. Therefore, the module emphasises on several common short-term finance options by explaining the pros and cons they are associated with. Ultimately, exporters are to become aware of the main payment methods in international trade. Firstly, it is essential to be aware of the currency of payment and the buyer-seller relations, as these significantly influence the ultimate profitability. And secondly, exporters should have enough knowledge on how to determine the methods of payment and what are the risks faced by exporters in international transactions. 2

4 PRICING Price, pricing & cost Price is one of the four major elements of the marketing mix (Figure 1). Pricing decisions generally include the following: Pricing strategy Suggested retail price Volume discounts and wholesale pricing Cash and early payment discounts Seasonal pricing Bundling Price flexibility Price discrimination It has to be made clear that price and cost are two different things. The price is the amount that customers pay for products. The cost is the amount that businesses spend for making the product. However, any company needs to take account of the production costs when setting the price to ensure that it makes a profit on the products it offers. The decisions on pricing are among the most essential ones taken by the company management. It should be taken into considerations that unlike the other elements of the marketing mix (i.e. product, place and promotion), decisions on pricing directly affect revenues rather than costs. Furthermore, pricing has to be consistent with the other elements of the marketing mix as well, since it contributes to the perception of a product or service by customers. Strategy of Pricing The strategy of pricing is about recognising that customers have different pricing needs and then making efforts to profit from these differences. Customers: 3

5 have unique individual needs - it is important to make series of slightly different versions of the products based on one core product. These versions of the products can meet unique customer needs and profit from customers with different valuations. value a product in a different way - it is generally known that customers value products differently. Therefore, it is essential to develop a strategy of charging different prices to different customers for the same product. need different pricing plans - Many customers do not like certain pricing plans. This requires the design of a strategy that involves offering new pricing plans to serve new customers. Pricing is an important strategic issue because it is related to product positioning. There are different ways to determine pricing. The steps described below are generally accepted sequence of actions that could be followed for setting out the pricing of a product: 1. Set out clear aims The first step is to get real clear about what you want to achieve with your pricing strategy (Figure 2). Clearly people own businesses because they want to make money. To make money means that the company should generate enough revenue from selling their products or services so that they can cover not only the costs, but also make a profit and possibly expand the business. Businesses should not make the mistake to think that it is only the price that drives sales. Sales are driven by the businesses abilities to sell which means employing the right sales staff and adopting the right sales strategy. On the other hand, businesses are to be aware of the risks related to poor decisions on pricing. There are two key threats a company can face: Under pricing. Pricing company s products for a very low cost can have an extremely negative impact on business s bottom line. The most prominent business consultants keep on reminding that consumers want to feel they are spending their money wisely and a lot of them are unwilling to buy from a seller they believe to have less value. 4

6 Furthermore, companies also need to be very careful that they are fully covering their costs when pricing products. Over pricing. Contrary to underpricing, overpricing a product can have equal negative impact since the buyer will always look at the pricing of the competitors. However, pricing above the customer's willingness to pay can also decrease sales. Following Toftoy s advice to take little surveys of customers with two or three questions whether they find the pricing fair seems to be the best solution. 2. Consider key pricing factors There are two key factors for setting the 'right' price: Customers Successful businesses are aware that the first key factor to consider is the customer. The more companies know about their customers, the better they would be able to provide what customers value. Small-scale, informal or extensive market research is a useful tool for getting to know the customers. Companies can focus the market research on designated customer groups selected on the grounds of different indicators (e.g. budget sensitive, convenience centered, etc.), then decide which group they would want to target and finally, price accordingly. Costs Basically, pricing is about covering company s costs and generating a profit. This means that any business should know exactly the cost of their product and be aware how many items need to sell to be profitable. It is essential to remember that the cost of a product also includes overhead costs. Overheads may include fixed costs like rent and variable costs like transport or storage fees. These costs must be included in company s estimate of the real cost of their product. Many businesses are threatened to go from one extreme end of not calculating all their costs and underpricing to the other extreme end of putting in all their costs and expect to make a profit by overpricing the product. A good path to follow is to make a spreadsheet of all the costs businesses need to cover on a monthly basis, which could include the following: actual product costs, incl. labour costs and the costs of marketing and selling operating costs for performing the business activities debt service costs A return on the capital invested by all shareholders Capital for future expansion and replacement of fixed assets Companies have to list the amount in their national currency for each of the above on their spreadsheet. The total should give a pretty good idea of the gross revenues that needs to be generated to ensure all those costs have been covered. 3. Know the Revenue Target Businesses should also have a revenue target for how much of a profit they want to make. That revenue target plus the costs for producing, marketing and selling make the final price per product. What a company should do is estimate the number of units of a product which they expect to sell over the next year. Then divide the revenue target by the number of units 5

7 expected to be sold and the company have the price at which they need to sell their product in order to achieve the revenue and profit targets. 4. Become Aware of the Competition It is always helpful to know whether company s competitors offer comparable products and be aware of their pricing. However, of a company puts an additional value to their products compared to the competitors, then they could come up with higher pricing. The following is essential to be considered: Offer additional service Provide higher quality Consider regional differences Consider the costs 5. Acquire Knowledge on Market trends and Developments Any company should continuously update their knowledge of outside factors that will impact the demand for the product in the future. These factors can vary from environmental and climate conditions through legislation to economic and financial crisis. Business need to be flexible and adaptable in order to respond to the market developments and new trends. They need to keep on testing new offers, new prices, new combinations of benefits, etc. It is a fact of fat of the business life that if a company do not raise their prices from time to time as part of the successful management, they will not remain in business to too long. However, prices and costs should be constantly monitored, so that the company stay both competitive on the market and make the profit against their targets. The best way for a company to be sure that the products are priced correctly is by the sales volumes after making a certain change. For example, this can involve keeping a sharp eye on the cash collections for several weeks after the change. If a price increase is too high, customers will react immediately. On the other hand, it always help to watch the reaction of the competitors, i.e. if the change in prices proofs to be positive, then the competitors are most likely to do the same. However, business should try to raise prices the right way. Rather than raising prices steeply and loose customers, it is better to have a strategic plan at hand for a period of two to five years for a gradual increase of prices with 5% to 10%. Ultimately, all businesses should be very careful when raising prices during recession times. Lowering of process is another process that should not be ignored. Provided that a company realize they have missed their target customer groups due to pricing their products too high, they can always make a discount or provide customers with something for free to get them to try or not to give up the product. Generally, lowering prices is not a good practice unless businesses are using this strategically, e.g. to gain market share, to have a price-sensitive products or in case the competitors lower their prices. 6

8 FINANCING A key problem all exporters face is cashflow - companies need to offer credit to win customers but they also need cash to finance growth. However, banks, credit insurers and trading houses all compete to convert credit arrangements into cash. There are a number of common short-term finance options: Documentary credit (DC) DC is a fixed assurance from the buyer's bank in the buyer's country. It is issued on behalf of the buyer to say that payment will be made for the goods or services supplied by the seller, providing the seller comply with all terms and conditions established by the credit: If it is a cash contract, the DC terms will provide for payment immediately upon presentation of conforming documents. If sellers have offered credit, the DC terms will state when payment is due, reflecting any extended payment terms the seller has granted. Seller s bank may be prepared to provide a short-term loan, for a percentage of the DC, prior to shipment to cover the temporary shortfall. They will then collect from the proceeds of the subsequent presentation of the DC. Factoring A factor enables sellers to receive cash within a few days of invoicing by taking on the ongoing responsibility for collecting their short-term debt. In some cases the factor will also take on a percentage of the non-payment risk. This is called non-recourse factoring and means the factoring company will not come back to the seller if the payer defaults. Forfeiting This is for larger projects and involves a bank buying 100 per cent of the invoice value of an export transaction at a discount. The seller is then free from financial risk in the transaction and liable only for the quality and reliability of the goods or services provided. Credit insurance facilities Exporters can also raise finance by assigning their credit-insured invoices to banks. In return the bank will offer up to 100 per cent of the insured debt as a loan. PAYMENT METHODS IN INTERNATIONAL TRADE 7

9 There are several broad issues that affect what payment method will ultimately be used in an international transaction. Every participant in the transaction must consider these issues, though they will affect each differently and to a different degree. Payment methods in international trade are largely similar to those in domestic business. However, due to the added risks and complexities involved in cross-border transactions, certain terms are more often seen in international trade. In international trade, the means of payment are frequently known as the "terms of payment." There are four commonly used terms of payment, each of which offers different levels of risk and stability for buyers and sellers. Getting paid for providing goods or services is critical for any business. However, getting paid for an international transaction (also commonly known as "export receivables") can be a very different experience from securing payment on business with other national entities, due to the number of extra factors that can influence the process. Currency of Payment The currency specified for payment in a contract can have a significant effect upon the ultimate profitability of the transaction for either the buyer or seller. If the value of the specified currency appreciates between the contract date and payment date, it is a hardship for the buyer. If it depreciates, it is a benefit to the buyer. In most instances, the specified currency of the transaction within the EU is the Euro, however, certain transactions are still negotiated in US dollars. Buyer and Seller The buyer and the seller are at the heart of every business transaction. Both parties have one thing in common: to profit from the transaction and to expose themselves to the least risk possible. All transactions, no matter how innocent, expose buyers and sellers to risk. Fundamentally, the concerns of the buyer and the seller are the same in both domestic and international transactions, where the buyer wishes to get the goods ordered and paid for, and the seller wishes to get paid for the goods shipped. International transactions, however, add a layer of uncertainty and risk for the buyer and seller that does not exist in purely domestic transactions. In the international transactions the buyer and seller are separated by long distances, differences in culture and business tradition, different government and economic systems, different currencies, and different banking and legal systems to name but a few. The following table gives an overview of the key issues for the buyer and the seller in terms of international payments: 8

10 Table 1 Key Issues Concerning the Buyer and the Seller BUYER Certainty in secure delivery of goods purchased Quality of goods Condition of goods Timely receipt of goods Transaction financing Costs of transportation and insurance SELLER Certainty of getting paid Assurance in equal quantity of goods shipped and goods received Condition of goods Timely shipment of goods Assurance in getting paid Costs of transportation and insurance Determining the Payment Method - Key Factors The terms of payment used in an international transaction will depend on the relationship between the seller and the buyer, the nature of the goods, industry norms, the distance between the buyer and seller, the potential for currency fluctuation, and political and economic stability in either or both countries. All of these factors must be considered before deciding on a method of payment that is acceptable to both parties. The single most important factor, however, is the nature and length of the business relationship between the buyer and seller. Trust and confidence in the other party go a long way in both parties' willingness to accept payment terms bearing a higher degree of risk. Security of Payment Terms It is, of course, the desire of all parties for a transaction to have absolute security. The seller wants to make absolutely certain he gets paid, while the buyer wants to make absolutely certain he gets the goods as ordered. In fact, there cannot be absolutes of certainty for both parties to a transaction. If one has absolute security (seller gets prepayment or the buyer gets the goods before making payment) the other party correspondingly loses a degree of security. International transactions, therefore, often require a compromise on the part of the seller and the buyer that leads to relative security for both. Payment Risk Ladder It is often a good idea during or even before contract negotiations that exporters and importers consider where, on the diagram below, they will be comfortable in placing themselves. 9

11 10

12 Open Account This is the least secure method of payment for the exporter, but the most attractive to buyers. Goods are shipped and documents are remitted directly to the buyer, with a request for payment at the appropriate time (immediately, or at an agreed future date). An exporter has little or no control over the process, except for imposing future trading terms and conditions on the buyer. Clearly, this payment method is the most advantageous for the buyer, in cash flow and cost terms. As a consequence, Open Account trading should only be considered when an exporter is sufficiently confident that payment will be received. It should be noted that in certain markets, such as Europe, buyers will expect Open Account terms. The financial risk can often be mitigated by obtaining a credit insurance policy to cover the potential insolvency of a customer, which provides reimbursement up to an agreed financial limit. There are a number of commercial insurers who specialise in this market. Bills for Collection More secure for an exporter than Open Account trading, as the exporter's documentation is sent from exporter s bank to the buyer's bank. This invariably occurs after shipment and contains specific instructions that must be obeyed. Should the buyer fail to comply, the exporter does, in certain circumstances, retain title to the goods, which may be recoverable. The buyer's bank will act on instructions provided by the exporter, via their own bank, and often provides a useful communication route through which disputes are resolved. The Bills for Collection process is governed by a set of rules, published by the International Chamber of Commerce (ICC) called "Uniform Rules for Collections" document number 522 (URC522). Over 90% of the world's banks adhere to this document. Any interested foreign trade company can pick up a copy from the ICC ( ) or from their bank and familiarise themselves with the contents. There are two types of Bills for Collection, which are usually determined by the payment terms agreed within a commercial contract. Each of them provides exporters with different benefits, as explained below in more details: 11

13 Documents against Payment (D/P) The Documents against Payment are used where payment is expected from the buyer immediately, otherwise known as "at sight". This process is often referred to as "Cash against Documents". The buyer's bank is instructed to release the exporter's goods only when payment has been made. Where goods have been shipped by sea freight, covered by a full set of Bills of Lading, title is retained by the exporter until these documents are properly released to the buyer. Unfortunately, for airfreight items, unless the goods are consigned to the buyer's bank, no such control is available under the Air Waybill, as this document is merely a "movement certificate" rather than a "document of title" (Under URC522 goods should not be consigned to a bank without prior approval.). Similarly, there is no such control available for road or rail transport. Documents against Acceptance (D/A) The Documents against Acceptance are used where a credit period (e.g. 30/60/90 days sight of document or from date of shipment ) has been agreed between the exporter and the buyer. The buyer is able to collect the documents against their undertaking to pay on an agreed date in the future, rather than immediate payment. The exporter's documents are usually accompanied by a "Draft" or "Bill of Exchange" which looks something like a cheque, but is payable by (drawn on) the buyer. When a buyer (drawee) agrees to pay on a certain date, they sign (accept) the draft. It is against this acceptance that documents are released to the buyer. Up until the point of acceptance, the exporter may retain control of the goods, as in the D/P scenario above. However, after acceptance, the exporter is financially exposed until the buyer actually initiates payment through their bank. Bills for Collection are used in certain markets (particularly Asian) to fulfil Exchange Control Regulations. They are a cost-effective method of evidencing a transaction for buyers, where documents are handled (and reported) via the banking system. Letters of Credit (L/Cs) A Letter of Credit (also known as a Documentary Credit ) is a bank-to-bank commitment of payment in favour of an exporter (the Beneficiary), guaranteeing that payment will be made against certain documents that, on presentation, are found to be in compliance with the terms set by the buyer (the Applicant). Like the Bills for Collections, Letters of Credit are governed by a set of rules from the ICC. In this case, the document is called Uniform Customs and Practice which latest version is 12

14 document No 600. In a nutshell, it is known as UCP600 and, again, over 90% of the world's banks adhere to this document. The L/Cs can be of the following types: Irrevocable The terms and conditions within a L/C cannot be changed without the express agreement of the Beneficiary. Under UCP600, revocable L/Cs are no longer acceptable under any circumstances. Unconfirmed The payment commitment within the L/C is provided by the Applicant's issuing bank. Confirmed If an exporter has any concerns about the circumstances which may prevent payment being made from either the Issuing Bank or buyer's Country, the adding of "Confirmation" moves the bank/country risk issues to the bank which adds its confirmation (the confirming or advising bank) and notifies the Documentary Credit (DC) to the exporter. The price of such a confirmation will obviously depend upon the level of perceived risks to be covered. Banks can often provide indicative pricing for confirmations prior to the arrival of the DC, so that costs can be estimated. The above means that the exporter and buyer can agree detailed terms, as part of the commercial contract. This can include exactly what documents need to be produced and precisely what detail such documents should quote. Letters of Credit also offer benefits in terms of finance. Trading companies should speak to their banks to see how they can help. Additionally, commercial insurers now offer an insurance-backed product that covers the same basic risks as confirmations. Details should be discussed the relevant insurer. Standby Letters of Credit (SBLCs) or Bank Guarantees SBLCs are similar to Bank Guarantees in that they sit behind a transaction and are only called upon if the buyer fails to pay in the normal course of business (which is often Open Account). They can be particularly useful to cover an underlying financial risk where multiple payments are to be made, possibly as part of an agreed schedule. However, they do not offer the documentary control of Letters of Credit to buyers and, as such they are an unconditional guarantee. 13

15 Advance Payment The most secure method of trading for exporters and, consequently the least attractive for buyers. Payment is expected by the exporter, in full, prior to goods being shipped. As one might imagine, having covered the two extremes on the Payment Risk Ladder, commercial decisions have to be made and this usually results in selecting one of the middle rungs of the ladder. This is where banking products such as Bills for Collection and Letters of Credit come in to play. MAIN TYPES OF MONEY TRANSFERS SWIFT Inter-Bank Transfer This type of payment is now firmly established as standard practice in the major trading nations. The buyer instructs his bank to make payment to any bank account specified by the exporter. It is good practice, therefore, for the exporter to include his account details on the invoice heads. Buyer s Cheque This is an unsatisfactory method of settlement for the exporter, as it carries the risk of dishonour upon presentation as well as the added inconvenience of being slow to clear. There is also the very real danger of the cheque being lost in transit as well. A cheque is also unsatisfactory if it is in the currency of the buyer, as this will take longer to clear and will involve additional bank charges. Exporters should only use this method if they have an established trading history with their customer or in cases where the profit margin has been increased to offset cash flow problems anticipated by the delay in receiving payment. Banker s Draft This is arranged by the buyer who asks their bank to raise a draft on its corresponding bank in the exporter's country. The Banker s Drafts provide additional security to a buyer's cheque, but they can be costly to arrange and they do run the risk of getting lost in transit. International Money Orders These are similar in nature to postal orders. They are pre-printed therefore cheaper to obtain than a Banker's Draft, although again there is the risk of loss in transit. 14

16 ANNEX I GLOSSARY TERM Advance payment Banker s draft Buyer Buyer s cheque Currency Documentary credit (DC) Letter of Credit (L/C) Money order Payment method Pricing Seller SWIFT Inter-Bank Transfer Description Paying ahead of the agreed schedule for goods or services before their receipt. A draft drawn by a bank against funds deposited in another bank An entity that acquires ownership or usage of goods or services in exchange for money A payment document in writing containing an unconditional order addressed to a banker, signed by the person who has deposited money with the banker, requiring him to pay on demand a certain amount of money only to the bearer of the document. Money that is in circulation used as a means of exchange and falling within the monetary system of a country. A fixed assurance from the buyer's bank in the buyer's country. It is issued on behalf of the buyer to say that payment will be made for the goods or services supplied by the seller, providing the seller comply with all terms and conditions established by the credit A binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be transferred to the seller. A document drawn by one person or bank on another ordering the payment of money Means of payment adopted by a customer, such as cash, money order or credit card upon invoicing. Reflection of product and/or service quality level. It considers the customers, competition, costs and the long term outlook as well as short term gains before the adoption of pricing decisions, policies and procedures. An entity that offers or sales to a buyer. A type of payment where the buyer instructs his bank to make payment to any bank account specified by the exporter. 15

17 ANNEX II DECUMENT TEMPLATES SAMPLE LETTER OF CREDIT (GENRAL) 16

18 SAMPLE LETTER OF CREDIT (IRREVOCABLE) 17

19 TEMPLATE PAYMENT ORDER FORM 18

20 i Sources: 1. (Author: Jim Riley, October 2012)

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