How to budget for foreign exchange in your business?
14 November 2019

Now that you have an understanding for how foreign exchange can affect a business, the next step is budgeting to ensure that you factor in foreign exchange risk into your forecasts and plan for fluctuations in the exchange rate.

An example of a business that is importing would be pricing up an invoice from a local supplier in a foreign country. The business would need to consider the local exchange for suppliers and factor this into their pricing. This is called a budget rate or costed level.

The same logic would apply to a business exporting goods. The costs of production, sales and transportation need to be calculated when invoicing customers overseas in a foreign currency.

What is a Budget Rate?

The budget rate or costed level is the exchange rate that a company’s financial management uses to draft budgets and establish business objectives.  When a budget involves calculations in a different currency to the company’s functional currency, financial managers use their budget rate to forecast key aspects involving foreign currency transactions including costs, turnover and cash flow.

For example:

  • A UK company forecasts a spend of £2m on imports in EURO and sets a budget rate of 1.15.
  • On face value, this means that the £2m worth of goods imports will cost a total of 1,793,130 at the budgeted rate.
  • If the GBP-EUR rate drops below this for a period of the year the product price will increase and profit margins will be squeezed
  • If the GBP-EUR rate drops to 1.10 the total cost of the £2m worth will increase to €1,818,182 increasing the cost of the imported goods by 4.5 percent.
  • If the profit margin of a product is 10 percent this small change in currency rates would lead to an eight percent impact profit margins, enough to undermine the viability of moving overseas.

Approaches to setting a budget rate

When calculating a foreign exchange budget rate for a business there are two common approaches:

  1. Spot Rate – In order to set a budget rate using the current spot rate, a business applies a margin to account for any potential FX losses. This allows for businesses to factor currency fluctuations in their forecasts. However, businesses must ensure that the margin applied still makes the company competitive to ensure the model to venture into overseas markets is viable.
  2. Forward rate – budget forecasting can also be achieved utilising a forward rate. This rate of exchange agreed in advance for a certain date. Essentially this is a spot rate adjusted for interest rate differentials depending on how far forward you buy/sell. Again businesses should apply a buffer to this but if executed correctly the forward contract should remove all FX risk and volatility.

Two other approaches to setting FX budget rates – despite having serious flaws –. continue to be used by a surprisingly large number of companies:

  1. Prior Period Average Rate – This approach simply takes an average over the previous correlation period and using that median as a budget rate forecast.
  2. Institutional forecasts – This uses institutional forecasts to estimate the budget rate for forecasting purposes.

All of these approaches demonstrate the importance of selecting the right foreign exchange provider in setting a budget rate that ensures businesses will effectively mitigate FX risk exposure. These strategies are unsuitable for setting the correct budget rate. The ongoing political uncertainty over Brexit has had a dramatic impact on the performance of the GBP. Using a prior period average or institutional forecasts to set a budget rate over the past few months would have left businesses exposed to a large amount of FX risk due to the heavy fluctuations in the currency, thus rendering both options ineffective.

Applying a budget rate to your business

When applying an FX budget rate to your business, the rate will vary according to its position in the corporate life cycle.

Companies that are in the early stages of the corporate life cycle generally use budget rates on an ad-hoc basis.

  • Example: Budget rates are used to price and negotiate overseas sales contracts or one-off projects in GBP terms, to estimate the GBP required to pay suppliers or overseas contractors
  • Budget rates are then typically set for the month as there is not an accurate forecasting or budget rate.

Companies at the later-stage of the corporate life cycle will have more holistic and strategic objectives so the need for accurate budget rates are even more integral.

  • Example: Budget rates are vital in determining forecasts and viability of business decisions. They are used for:
    • Key inputs for financial planning, analysis and profit margins
    • Establishing overseas sales office targets and identifying new markets
    • Communicating corporate performance to investors
    • The choice of budget rate incorporates input from all major stakeholders (management, treasury, business units, etc.) Accountability for avoiding shortfalls to the budget rates is shared across the organisation.

Setting a budget rate is the first step to achieving the appropriate FX strategy in mitigating currency risk and the impact of currency fluctuations.

Stay tuned for the third instalment of our content series; What to consider when trading overseas

How to budget for foreign exchange in your business?
14 November 2019

Now that you have an understanding for how foreign exchange can affect a business, the next step is budgeting to ensure that you factor in foreign exchange risk into your forecasts and plan for fluctuations in the exchange rate.

An example of a business that is importing would be pricing up an invoice from a local supplier in a foreign country. The business would need to consider the local exchange for suppliers and factor this into their pricing. This is called a budget rate or costed level.

The same logic would apply to a business exporting goods. The costs of production, sales and transportation need to be calculated when invoicing customers overseas in a foreign currency.

What is a Budget Rate?

The budget rate or costed level is the exchange rate that a company’s financial management uses to draft budgets and establish business objectives.  When a budget involves calculations in a different currency to the company’s functional currency, financial managers use their budget rate to forecast key aspects involving foreign currency transactions including costs, turnover and cash flow.

For example:

  • A UK company forecasts a spend of £2m on imports in EURO and sets a budget rate of 1.15.
  • On face value, this means that the £2m worth of goods imports will cost a total of 1,793,130 at the budgeted rate.
  • If the GBP-EUR rate drops below this for a period of the year the product price will increase and profit margins will be squeezed
  • If the GBP-EUR rate drops to 1.10 the total cost of the £2m worth will increase to €1,818,182 increasing the cost of the imported goods by 4.5 percent.
  • If the profit margin of a product is 10 percent this small change in currency rates would lead to an eight percent impact profit margins, enough to undermine the viability of moving overseas.

Approaches to setting a budget rate

When calculating a foreign exchange budget rate for a business there are two common approaches:

  1. Spot Rate – In order to set a budget rate using the current spot rate, a business applies a margin to account for any potential FX losses. This allows for businesses to factor currency fluctuations in their forecasts. However, businesses must ensure that the margin applied still makes the company competitive to ensure the model to venture into overseas markets is viable.
  2. Forward rate – budget forecasting can also be achieved utilising a forward rate. This rate of exchange agreed in advance for a certain date. Essentially this is a spot rate adjusted for interest rate differentials depending on how far forward you buy/sell. Again businesses should apply a buffer to this but if executed correctly the forward contract should remove all FX risk and volatility.

Two other approaches to setting FX budget rates – despite having serious flaws –. continue to be used by a surprisingly large number of companies:

  1. Prior Period Average Rate – This approach simply takes an average over the previous correlation period and using that median as a budget rate forecast.
  2. Institutional forecasts – This uses institutional forecasts to estimate the budget rate for forecasting purposes.

All of these approaches demonstrate the importance of selecting the right foreign exchange provider in setting a budget rate that ensures businesses will effectively mitigate FX risk exposure. These strategies are unsuitable for setting the correct budget rate. The ongoing political uncertainty over Brexit has had a dramatic impact on the performance of the GBP. Using a prior period average or institutional forecasts to set a budget rate over the past few months would have left businesses exposed to a large amount of FX risk due to the heavy fluctuations in the currency, thus rendering both options ineffective.

Applying a budget rate to your business

When applying an FX budget rate to your business, the rate will vary according to its position in the corporate life cycle.

Companies that are in the early stages of the corporate life cycle generally use budget rates on an ad-hoc basis.

  • Example: Budget rates are used to price and negotiate overseas sales contracts or one-off projects in GBP terms, to estimate the GBP required to pay suppliers or overseas contractors
  • Budget rates are then typically set for the month as there is not an accurate forecasting or budget rate.

Companies at the later-stage of the corporate life cycle will have more holistic and strategic objectives so the need for accurate budget rates are even more integral.

  • Example: Budget rates are vital in determining forecasts and viability of business decisions. They are used for:
    • Key inputs for financial planning, analysis and profit margins
    • Establishing overseas sales office targets and identifying new markets
    • Communicating corporate performance to investors
    • The choice of budget rate incorporates input from all major stakeholders (management, treasury, business units, etc.) Accountability for avoiding shortfalls to the budget rates is shared across the organisation.

Setting a budget rate is the first step to achieving the appropriate FX strategy in mitigating currency risk and the impact of currency fluctuations.

Stay tuned for the third instalment of our content series; What to consider when trading overseas

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