Short answer
Choosing a payment method in export is not a matter of price but of HOW RISK IS SHARED. With advance payment the risk sits entirely with the buyer: they send the money and wait for the goods. With open account it sits entirely with the seller: they send the goods and wait for the money. Documentary collection and the letter of credit sit between those two ends; both put a bank in the middle, but in a letter of credit the bank undertakes to pay, while in a documentary collection it only handles the release of documents. The less the two sides know each other, the further towards the middle, and towards a letter of credit, the method moves.
Four methods and who takes the risk
The choice between the four usually does not happen once but shifts gradually as the relationship develops: a letter of credit or advance payment on the first order, documentary collection once trust is built, open account in a long-standing relationship.
- Advance payment: the buyer pays before the goods are shipped. The safest method for the seller and the riskiest for the buyer. This is what makes a new buyer hesitate.
- Open account: the seller ships and the buyer pays after taking delivery. The most comfortable for the buyer and the riskiest for the seller. Generally used with long-standing, trusted buyers.
- Documentary collection: documents are sent through a bank; the buyer receives them and can clear the goods once payment is made or a draft accepted. The bank does not guarantee payment, it manages the flow of documents.
- Letter of credit: the buyer's bank undertakes to pay once the stated documents are presented in accordance with the terms. The highest in cost and paperwork, and the highest in security.
How a letter of credit works
In a letter of credit, the undertaking to pay comes not from the buyer but from the buyer's bank. That undertaking is not unconditional: the documents listed in the credit have to be presented in the stated form and within the stated time. Where the documents comply, the bank pays; where they do not, it does not.
For that reason the real work in a letter of credit is not the shipment but DOCUMENT COMPLIANCE. A typing error, a missing signature, a product description written differently from the credit, or a document presented late all come up as a discrepancy standing in front of the payment.
A discrepancy does not mean the payment is lost entirely; where the buyer accepts it, payment is made. But that puts the payment back at the buyer's discretion, which removes the reason the credit existed.
Read the credit before the goods are made
The most expensive mistake with a letter of credit is reading its text after the goods are ready. Where the credit asks for a document you cannot supply, a shipment date you cannot meet or a certification you cannot obtain, the right time to find out is before production starts. An amendment is always possible but costs time and money.
Do and don’t
Do
- Prefer the safer method on a first order with a new buyer.
- Read the credit from beginning to end before the goods are made.
- Write the product description on the documents exactly as it appears in the credit.
- Put the presentation period and the latest shipment date in the calendar.
- Have your bank and your customs broker see the text in advance.
Don't
- Do not treat the payment method as part of the price negotiation alone; it is how risk is shared.
- Do not pass over a clause in the credit as something to sort out later.
- Do not leave documents to the last day; the presentation period is short.
- Do not write the product description one way on the invoice and another in the credit.
- Do not ship on open account to a buyer you do not know.
What to weigh when choosing
- 1
How well do you know the buyer?
Is this a first order or a relationship of years. As trust grows you move to more flexible methods; flexibility on a first order can be expensive.
- 2
What is the country and bank risk?
Even where the buyer is sound, currency transfer restrictions in their country can delay payment. That risk is independent of the buyer's intention to pay.
- 3
How large is the order?
The bank charges and paperwork of a letter of credit are a fixed cost; on a small order that cost stays proportionally large. Advance payment or documentary collection is more practical on a small order.
- 4
Is the product custom or standard?
An attachment built for one buyer may not be sellable to another if payment fails. On custom production, an advance or staged structure is more reasonable than on a standard product.
- 5
How long is the lead time?
Long production and shipping times bring currency and cost risk into play. Splitting the payment into stages shares that risk between the two sides.