This article was updated in March 2023 to reflect current trends and new industry information.
Foreign currency exchange rate fluctuations can have a huge influence on inventory management. If companies rely on imported materials to produce goods, changes in overseas currency can influence the overall cost to the firm.
Below, we summarise what you can do to manage the risk that foreign exchange rate fluctuations can have on your inventory.
8 foreign currency risk management strategies
While it’s not realistic (or sensible) for companies to try and predict currency fluctuations, most successful businesses will have a risk management strategy that includes a workable approach to foreign currency risks.
When it comes to inventory management, pragmatic risk analysis and strategizing is essential for long-term business success.
1. Gain clarity on foreign currency
It is essential that firms clarify the exchange rates and terms of an agreement with an overseas supplier from the outset.
Simply contracting in your own currency will not suffice, as suppliers can adjust price over time to account for currency risk. Making the terms and exchange rates explicit from the beginning of the agreement will prevent you from missing cost saving opportunities if currencies move in your favour.
It is also essential that you are aware of the extent to which your supplier is exposed to exchange rate risk. For many U.S. suppliers, exposure is minimal because the only exposure to a foreign currency may come in the form of paying a local labour force.
Often surprisingly, the materials U.S. companies buy are already priced in USD, keeping exposure low.
2. Allocate exchange rate risk
There are four essential factors that must be considered when allocating exchange rate risk. Firstly, the firm must consider both the local currency, which exposes them to risk, as well as the functional currency, used for the transaction.
Ensuring these details are explicit from the outset will help the firm to manage risk.
Next, the firm must clarify how much of the overall cost is denominated in the local currency. Again, this will help you to manage the risk brought by possible changes in exchange rates.
Relatedly, the firm must consider the baseline rate as well as the boundaries for fluctuation. It is equally important that the firm clarify the timeframe for the validity of the baseline rate and pricing.
Lastly, it is essential to understand that there is no “one size fits all” method for managing exchange rate risk. The firm must be aware that often, the customer, supplier and the supplier’s factory can all be operating in different currencies.
In this situation, you will need to manage pricing based on the volatility of the exchange rate in each region.
3. Communication and Coordination
It is crucial that there is good coordination between the supply chain manager and the company’s finance risk managers.
The supply chain manager must be aware of the exposure being created, so that they can work together with the finance risk specialists in order to manage it in the most effective way.
Managing foreign currency is especially important for small businesses, who might be more vulnerable to these risks.
4. Identify products with thin margins
One way that foreign currency fluctuations can greatly affect a small business is if they are selling products overseas with small profit margins.
During times of fluctuation, these margins can become damagingly reduced.
If a business in New Zealand is selling products in the United States, changes to the dollar value can distort the balance between costs and revenues. The business is generating revenue in U.S. dollars but incurring costs in NZ dollars.
During times of stability, this can be navigated with a fair amount of ease, but during times of fluctuation, the water starts to get muddy.
An important step for small businesses to take is to monitor both the margins of products being sold overseas and the value of the relevant currencies. In some cases, it may pay to increase the margin on certain products as a safeguard against significant changes.
When the margins are small, even a 3-5% fluctuation can effectively destroy the profitability of selling a product to overseas customers.
5. Avoid large overseas sales with delayed payment
A common trap that can cause problems for smaller businesses is selling an item in bulk with delayed payment options.
If your customer has agreed to pay in a months’ time, then any change in currency value will affect the true cost of the transaction. A good idea for small or start-up businesses is to avoid this situation as much as possible. If unavoidable, a forward exchange contract can be used.
6. Enter into a forward exchange contract with your bank
A common way to mitigate the risk of future currency fluctuations is to use forward exchange contracts. Put simply, this means ‘locking in’ the current currency value on a future transaction.
If you have an obligation to make or receive a payment from a foreign client at some point in the future, you can effectively buy the required dollars in advance.
This type of ‘hedging’ is one of the best ways that a business can guard against currency uncertainty.
7. Buy in bulk during favorable markets
Some businesses use targeted approaches to offset currency risk like buying products or parts in bulk.
While this isn’t always possible due to spoilage risk or lack of capital, it can be a good way to take advantage of favorable markets.
8. Transfer foreign currency risks to your overseas suppliers
Transferring risk to your overseas suppliers is an easy way to offset some of the burden on your business.
While not all suppliers may agree to do so, it’s worth requesting that all quotes are provided in the currency of the country where your business is based. This can help guard against distorted accounting and surprise fluctuations.
Negotiating a favourable forward contract
It is all very well to endeavor to have a forward contract in place, however how do you go about negotiating favorable pricing?
This comes from understanding the pricing of the product and the exchange rate between the two specific currencies. It is essential to understand the supplier pricing of the product being imported, as this will be made up of a variety of components, one of which will likely be accounting for fluctuations in exchange rates.
Once this is fully understood, sound negotiations can be made with the supplier. This may be that they charge a higher price but must maintain it for a certain period of time (where they are bearing the risk), or that the price may be slightly cheaper but could fluctuate under the influence of exchange markets.
It is absolutely essential to establish a few guidelines for a robust contract:
- Denote a reasonable functional currency and the ‘local’ currency.
- Determine how much of the cost is controlled by the ‘local’ currency. This is the exposure to the local currency.
- The baseline rate and the upper and lower limits of fluctuation. This provides a range in which the ‘real’ cost must fall to maintain the current price. If a fluctuation causes it to fall outside the range, then the price is adjusted.
- A validity period for the baseline rate and the fluctuation limits.
If these points are addressed when establishing a forward contract, then both parties can be satisfied with the risk they each bear going forward. It is important to remember that the risk is dynamic and must be owned by one or both of the parties.
If the supplier agrees to a forward contract with a lengthy fixed period and large fluctuation limits then they are bearing a significant increase in the risk (while protecting the importer), and as a result they will have likely factored this in and increased the pricing accordingly.
Likewise, if the importer accepts reduced fluctuation limits and a reduced fixed price period then they are assuming the majority of the risk, although they are benefitting from a cheaper price.
Therefore, in order to be in a good position to establish a sound forward contract, the importer also needs to understand their own exposure and subsequent ability to deal with risk.
Understanding exposure and going forward
Having a good understanding of the company’s exposure to exchange rate fluctuations with their nominated product requires investors or directors to understand the buying markets, selling markets and exchange rates affecting their product.
In addition, as exchange rates fluctuate over time, minimization of their affects could be achieved through intimate knowledge of the product, the supply chain, lead times, manufacture times and storage times.
This is where an inventory management product such as Unleashed Software comes in, as it is designed to keep track of all inventory that aids understanding and good purchasing and vending decisions.