• Kaushik kothari
• Finance
• September 30, 2010

Currency volatility: How fluctuations affect our Operating Margins

by Kaushik kothari

Unfavourable currency (Fx- Foreign Exchange) fluctuations eat into our margins while favourable Fx moves boost them. The long term pricing strategy of the company has to factor in these negative fluctuations to prevent non digestible margins squeezes and reduced profits.

What can we do to mitigate these Fx risks?

In any midsized or large company, the number of financial transactions taking place every day is vast. Each of these transactions can take place in any number of currencies, across borders and between countries. The value of currencies changes continuously and this causes both positive and negative effects on the operating margins. Mitigating the negative effects is a high priority and one which can be partly done through raising prices of products and services.

Generally, global companies buy and sell their products and services in a variety of different currencies. If goods and services are manufactured in an international framework and subsequently sold across borders, then exchange rates becomes an issue as they impact the operating margins. Depending on the various Fx moves, the competitive pricing of the company’s products to be sold changes over time.

As an example; XYZ company has a manufacturing plant in Europe and manufactures the product in this European plant and subsequently sells the products in the US market, and now if the USD weakens against the EUR, then it will negatively effect the company as the sales go down due to the weak USD and vice versa, if the EUR weakens against the USD, then the competitive pricing has improved the overall situation. Within such Fx- environment the sales guys should by no means transfer the Fx benefit to the customers by lowering the selling prices. The sales force should then simply resist and tell the customers that the price of the product is not going to change as over the time the Fx effect can also become a disadvantage.

The same mechanics apply with regards to Procurement / Purchasing. As soon as the price discussions for a longer term contract starts, the procurement team needs to consider potential Fx- movements over time and start thinking about mitigating the risks involved.

As an example; Company XYZ’s IT department (headquartered in Europe) was considering buying hardware on a mid to long term basis from Company ABC (headquartered in USA). They came up with a proposal and intended to source everything in Euro prices. However, during this period, the USD weakened against EUR and then it made more sense to do the purchase agreement in dollars rather then Euro. Company XYZ already had excess position in USD to report as a result of its daily transactions.  So by entering the purchase agreement in USD, the company made use of its USD balance and naturally hedged the currency position. This improved also the overall profitability of the company.

Sales managers need to be sensitized about the currency volatility situation. If we lose operating margins triggered by negative currency fluctuations, we do not get it back in our normal business results via successful hedging as the IFRS rules force to book every hedging action below the EBIT line. So it’s all the more important to aggressively increase prices wherever possible and also allow for some flexibility in terms of currency fluctuations.

A few things Sales managers can do to factor Exchange rate volatility

1. Carefully evaluate the optimal currency to buy or sell. “Natural hedge” is best and cheapest.
2. Factor in Currency fluctuations when setting the initial price of the product
3. Consider building in a “Currency Clause” into a contract especially when the timeline of a contract is mid to long term.
4. Do not lower selling prices when favourable Fx developments theoretically allow you to do so! As soon as the Fx bounces back you’re going to find yourself trapped and with absolutely no way out.

However, use unfavourable Fx developments to support selling price increase discussions.

Tags: currency fluctuations fx fluctuations