What is Currency Costing?

Setting a budget rate is a part of currency costing, and each company may approach this process differently based on their unique needs and strategies. Here are some common methods:

Straightforward Approach

Some companies use a straightforward method to set their budget rate. They look at the exchange rate at the start of the year and then deduct a small amount to account for potential volatility. For example, if the prevailing rate at the start of the year is 1.27, they might set their budget rate at 1.25. This slight reduction helps them anticipate and buffer against a possible drop in the exchange rate over the year.

Advanced Approach

Other companies with a large currency exposure might employ a more sophisticated approach, using historical and expected volatility as well as economic data to set their budget rate. Here’s how they might do it:

• Historical Volatility Analysis: Companies can analyse the historical volatility of a currency pair by looking at its returns distribution or average true range (ATR). For example, if the GBP/USD exchange rate historically fluctuates by about 6% annually, they would consider this data in their calculations.
• Economic Data Assessment: In addition to historical data, companies might also evaluate current economic indicators and forecasts. Factors like interest rates, inflation, and economic growth projections can influence currency movements and should be considered when setting a budget rate.
• Setting the Rate: Based on the analysis, a company might decide to deduct a certain percentage from the highest observed rate over a recent period. For instance, if the highest rate observed is 1.30 and they expect a 6% fluctuation, they might set their budget rate at approximately 1.22 (1.30 – 6%).

Combining Methods

Some companies might combine both simple and sophisticated methods, using historical data to inform a straightforward adjustment. For example, they might look at the start-of-year rate and deduct a percentage based on historical volatility trends, ensuring they are both prepared for fluctuations and leveraging past performance data.

By setting a budget rate using these methods, companies can more effectively manage their pricing strategies and protect their profitability against unexpected currency fluctuations. This proactive approach to currency costing allows for more stable financial planning and better risk management.

Strategies for Managing Currency Costing

Hedging

Hedging involves using financial instruments such as forward contracts to fix exchange rates for future transactions, thereby mitigating the impact of unfavorable rate movements.

Example:

A UK-based importer of electronics purchasing from suppliers in China can use forward contracts to fix the exchange rate for USD to GBP in advance. By doing this, the importer ensures that the cost of future purchases remains predictable, regardless of how the pound performs against the dollar over time. This means that if the pound weakens against the dollar, the forward contract will protect the importer from increased costs, ensuring stable pricing for the electronics being imported.

Diversification

Diversifying market presence and sources of supply involves spreading business activities across multiple currencies and regions to reduce the risk associated with fluctuations in any single currency.

Example:

• Market Presence: A global beverage company like Coca-Cola diversifies its market presence by operating in multiple countries and regions. By earning revenues in various currencies (dollars, euros, yen, etc.), the company minimises the impact of fluctuations in any single currency.
• Supply Chain Diversification: A clothing retailer such as H&M sources products from different countries (e.g., Bangladesh, China, Vietnam). If the currency in one country becomes unfavorable, the retailer can shift production to another country with a more favorable exchange rate, thereby stabilising costs.

Currency Clauses

Including currency clauses in contracts allows businesses to adjust prices based on exchange rate changes, ensuring that they are not adversely affected by sudden currency movements.

Example:

• International Construction Contracts: A construction firm like Bechtel working on an international project may include a currency clause in the contract stating that if the local currency (e.g., Brazilian real) depreciates significantly against the dollar, the project costs will be adjusted accordingly. This protects the firm from losses due to exchange rate volatility.
• Supply Agreements: An electronics manufacturer such as Samsung might include a currency clause in supply agreements with component suppliers. If the Korean won weakens against the dollar, the clause would allow Samsung to adjust the payment amount to reflect the new exchange rate, ensuring stable costs.

Local Production

Establishing local production facilities in key markets reduces dependency on fluctuating exchange rates, as businesses can produce and sell in the same currency.

Examples:

• Automotive Industry: A car manufacturer like BMW sets up production plants in the US and China. By producing cars locally in these large markets, BMW avoids the risks associated with currency exchange when importing cars from Germany. The company can price its cars competitively in dollars and yuan, respectively.
• Consumer Goods: A company like Procter & Gamble establishes local manufacturing units in various countries to produce products like detergents and shampoos. This approach minimises the impact of currency fluctuations between the US dollar and local currencies, as the costs of production and revenue are in the same currency.

Natural Hedging

Natural hedging involves matching incoming currency sales with expenses in the same currency, which can be effective if your business is set up that way.

Example:

If a company earns revenue in euros and also has significant expenses in euros, it can offset the currency risk naturally. This means that if the euro weakens, the impact on revenues is balanced by a similar reduction in costs, thus protecting the company’s profit margins from exchange rate volatility.

By using these strategies, businesses can better manage the impact of exchange rate fluctuations, ensuring more stable financial planning and protecting their profitability.