When importing or exporting in different currencies, businesses need to consider the impact of changing exchange rates on their profit margins. Accounting software will typically take the rate when an invoice is raised and then compare it to the rate that was transacted with the bank to obtain a realised gain / loss.
However, this accounting impact does not tell the full story.
Consider an example of Bob’s Bikes, an Australian business importing electric bikes from the US. Each month they bring in another shipment and distribute to retail bike stores.
The bikes cost USD 750 each and Bob’s Bikes sells them for AUD 1,300. In January, the rate is AUD/USD 0.75 and so the imported cost of the bikes is AUD 1,000 (USD 750 / 0.75), resulting in a gross profit margin of AUD 300.
In May, the rate suddenly drops to 0.68 and so the AUD invoice equivalent for the month is AUD 1,103 per bike. Bob’s Bikes may not show any accounting loss if they can still achieve 0.68 when the invoice is paid, but there is a clear economic loss with 33% gross profit erosion, unless the AUD sale price can be increased to compensate.
A better way to evaluate currency risk is to use a benchmark rate or budget rate.
This is a rate set by the firm to give more consistent gross profit margins and aid with cashflow planning. Instead of accepting a new accounting currency rate with each invoice, a constant rate is employed over a set period, and any realised difference is calculated as an FX gain / loss.
In the example above, if Bob’s Bikes accepted a benchmark rate of 0.73 for the first 6 months of the year, they would then budget for each electric bike to cost AUD 1,027.40 for a constant gross profit of $272.60. Now that we have a line in the sand, Bob’s Bikes can put in place a strategy to protect their costing rate, anything better is a bonus.
The challenge is to select a costing rate that is achievable but also ensures the business is competitive. If Bob’s Bikes sets it too high, they may need to adopt high risk currency strategies to achieve it. However, if they set it too low, their expected cost of goods sold (COGS) may suggest they have to increase their sale price to maintain margins, risking the business becoming uncompetitive.
Typically, the best process is to look at the current market rates and adopt a rate 2 – 4% away for a 6 month period and then review. If any forward exchange contracts are in place, they should also be incorporated into the costing rate.
This allows the business to stay aligned to the market conditions while also providing some pricing stability.