Penny Wise and Pound Foolish

October 1, 2013 World Trade 100 0 Comments

By Perry Trunick

October 1, 2013

To one degree or another, every global manufacturer confronts certain challenges and risks from the financial and operations sides. They are thinking of their global financial risk, asking, “How can we better forecast, or better manage, or even sustain the value and cost of raw materials and inputs?” That includes the components made in foreign countries and even those assembled there as well, says Chris Morris, Cambridge Mercantile Group.

Morris, who advises Midwest-manufacturers on currency issues and hedging, points out that this also applies, on a higher level, to infrastructure or plants. There is going to be volatility in the actual financial measurement of these assets, due to the fluctuations in the currency markets, he says. Even if the company doesn’t own or operate the assets themselves, the overseas third party logistics supplier (3PL) that does is trying to determine how to price the use of those assets for their U.S.-based client.

Those assets, owned, leased or under contract, are carried on company balance sheets and are reportable to shareholders. The question becomes, how are we forecasting for those inputs and assets in view of currency fluctuations?

The eventual finished product is also going to be sold in a global market, Morris adds. That means more exposure to currency volatility across multiple markets at different points in the supply chain — the distribution channel, infrastructure and then pure revenue.

If you are selling something in China or Russia or Brazil, you are experiencing volatility and you will eventually have to report those earnings back to the U.S. Whether that reporting is for tax purposes or purely for shareholders, the currency fluctuations affect the values.

For instance, the value of an asset in Europe will rise and fall with the appreciation or depreciation of the U.S. dollar against the Euro. So, a hard asset like a warehouse or manufacturing plant will see its relative value change on the balance sheet when the currency exchange rate moves.

Morris offers the example of a Midwest business he met with — a 100-year-old company that has a sophisticated European operation in Switzerland. He points out that 55 percent of their total sales are in a currency other than U.S. dollars. They may also have physical assets that are owned or leased in Switzerland, in Swiss Francs. Their concerns are the remeasurement of these proceeds that are in foreign currencies back into the United States.

Some organizations are concerned about growing their top-line sales, but what happens if that currency remeasures and eats into the profit margin, he asks. Even with strong sales, the profit margin can still be eroded by currency.

Dollar-Denominated Contracts

The way finance managers and procurement managers tend to operate is that they want to know the dollar value of a contract, but they also want to know the value in the foreign currency, continues Morris.

See, the supplier in the foreign country has its expenses in the local currency and is trying to convert those into U.S. dollar terms, to make it easier for the U.S. buyers doing business with them. But the risk is then shifted onto the foreign seller because they need to buffer for currency fluctuation, he explains. If that seller has a U.S. dollar contract on its books, it must bring the U.S. dollars in and convert those dollars back into the local currency.

There are then opportunities for rate-of-exchange profits for the bank. And, more importantly, currency fluctuations come into play because they are pricing the contract “today,” but the funds are not being delivered for another 30, 60, 90 days or more. That means they are trying to buffer for any adverse currency movement. Depending on how large the contracts are, and how long before the funds are transferred, that can mean the contract is 5 percent to as much as 10 percent higher, notes Morris.

Morris asks clients if there is a material reason why the contract should be in U.S. dollars. Usually the answer is “certainty.” If the client and the seller are open to the idea, Morris usually advises drafting the contract in both currencies.

Then, at “today’s” rate, clients can see what the buffer is, continues Morris. Six months later, they can ask, “Would it be more economical for me to pay in U.S. dollars or the seller’s local currency?” One may be able to find some savings based on the buffer built into the contract and the exchange rate at the time payment is due.

The concepts apply whether the issue is a purchase contract for goods or services, and they can be extended to the value of other supply chain assets. One of the goals is to have a better idea of how to forecast the effects of currency shifts and avoid unpleasant surprises.

Extended supply chains are complex, with many parts that touch and interact with each other, observes Morris. Currency issues thread through the whole supply chain, affecting many of the moving parts.