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. Over the course of a supply agreement, it is essential to consider these risks at the outset.
Changes in overseas exchange rates may be beneficial or detrimental to the firm depending on the circumstances. Obviously, a higher exchange rate on your imported goods may require that you reassess strategies for inventory management. On the other hand, a low exchange rate may allow you to save money and reduce wastage. Below, we summarise what you can do to manage the risk that foreign exchange rate fluctuations can have on your inventory.
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.
Allocating 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.
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.