At the time when businesses shift their focus onto next year’s budget, companies that are importing and exporting abroad have to contend with the added issue of currency fluctuations. In order to address this a budget rate needs to be applied.
What is a budget rate?
A budget rate is an internal costed rate that is applied to any foreign exchange transactions undertaken by the business.
For example, a UK company importing tiles from Europe who is required to pay their supplier in euros will need to know the cost in pounds so they can calculate at what price to sell within the UK.
Conversely, a UK company exporting cars to the US that receives profits in dollars will need to know the equivalent amount in pounds in order to know how much to value the sale of the car in the US.
Failure to apply some form of budget rate makes it impossible to accurately predict costs, can lead to companies becoming uncompetitive on pricing and in some instances results in unexpected losses.
Simply setting a budget rate far from guarantees that a business is out of harms way. Currency markets, especially in the UK, have become increasingly volatile and unpredictable in recent times which has meant the value of the pound has varied significantly throughout the course of this year. Ensuring your budget rate is able to reflect and incorporate these changes is the single most important aspect of managing the impact that foreign exchange can have on a business. Yet despite this, very few companies have much in the way of a strategy to help combat these risks.
Don’t take our word for it… fact check
To date in 2019 sterling has fluctuated a massive 10% against both the US dollar and euro
As recently as October the pound saw its biggest monthly move in a decade
In September GBPUSD fell to its lowest level in 34 years
How not to set a budget rate
Sticking to last year’s rate: Companies tend to do this because by luck the exchange rate happened to move in their favour the previous financial year. A year is a long time and no two are the same so there would appear to be little logic is this approach.
Spot rate on the day: The internet has plenty of websites providing live market rates for a whole host of different currencies. Plucking the required rate around the time that a budget is being agreed upon is both easy and hugely risky. As hopefully has been made apparent already, currencies move annually, monthly, weekly, daily and by the second. A budget rate selected in this way can become redundant within a very short period of time especially if a business has done nothing to ensure they can actually achieve it.
Forward buying your annual exposure: A forward contract is whereby a company can purchase their currency requirements at a fixed rate today to be utilised at a future period of time. Whilst this is certainly a step in the right direction and in some instances the correct one, a majority of small and medium size businesses have too many variables to afford them the luxury of this approach. Fixing all currency requirements on a forward reduces flexibility and ties a business to a single exchange rate.
What to consider before agreeing a budget rate
As has already been established, setting a budget rate is no easy task. Obviously every business is different and there is not a one size fits all model that can be rolled out to the whole SME industry however there are a number of key areas that a company should consider.
Profit margins: The tighter the profit margins the more rate sensitive a business is to changes in the exchange rate. Therefore whilst it may be tempting to budget at a very competitive rate, close to that seen on the internet, incremental percentage movements can easily wipe out all potential profit.
Payment terms: The type of payment terms offered to either suppliers or customers will determine how best to cover longer dated requirements. A company operating on staged payments with an initial deposit due upon order and the final balance six months later will budget differently to a company working on fixed thirty day terms.
Flexibility to change price: Some suppliers will fix their prices at the start of the year meaning costs will not change regardless of exchange rate fluctuations. Others may amend prices on a monthly basis and therefore allowing currency movements to be more easily absorbed. On the flip-side for exporters, the ability to change prices will be often be determined by a customer’s willingness to accept the impact of foreign exchange.
Ability to forecast: Predicting entire sales forecasts for the year and therefore potential currency requirements is almost impossible. However, every business will have the ability to do so albeit with varying degrees of confidence. The greater the degree of certainty the more accurate a company can be in setting a budget rate.
Points to consider
Each year corporates throw away needless profits because budget rates are not set correctly or remain largely unprotected and 2019 was no exception. Our three key messages are as follows.
- Currency purchases and budgets are focused on the short-term and not the long term.
- When to buy currency often coincides with what is perceived as a “good rate” at the time, only for this to not end up being the case. Decisions on hedging currency risk should be driven on forecasts and company data and not solely a rate. A good rate today may be a bad rate tomorrow.
- Forwards are wrongly considered as speculative instruments with a win or lose outcome depending on if they outperform the spot market.
These three points led many to clients being underhedged and overexposed to exchange rate fluctuations along with an entirely ineffective budget rate.
Still not convinced?
Nobody can predict exchange rate movements: Correct so why leave your annual currency exposure to chance?
We are unable to forecast future sales: This may be partly true but without any sales in the second half of the year there will likely be no business either.
We booked forwards before and got stung: How much you book and for how long is instrumental to successful foreign exchange budgeting. Having a simple and robust budgeting strategy ensures this never happens.
How to budget
Without knowing all the answers to some of what has been described above makes it impossible to offer up a single solution. No two companies are the same and each will approach budgeting differently as a result. At Central FX we are fully aware of this and would therefore be more than happy to undertake a free and in depth review of your currency exposures to provide the business with a budgeting strategy for 2020. Book your Currency Risk Assesment with one of our currency risk strategists today and receive a free Bespoke Hedging Strategy document today.
Should this be of interest please contact us.