Page 279 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes
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Caution In the most formal way, we must use the statistical concept of variance or standard
deviation to measure financial risk.

In the above example, the value of the item in the foreign currency was contractually fixed.

Example: A firm exports denim jeans to the US, selling a pair of jeans at USD 50. The
exchange rate is ` 44.00, its operating costs are ` 1600 per pair of jeans. Thus its operating margin
on export sales is ` 2200 – ` 1600 = ` 600 per pair. Over the next year, US inflation is expected at
5% p.a., Indian inflation is at 10% per annum and by the year end, the exchange rate depreciates
to ` 45/-. Assume that it raises its price in the US market by 5% (based on inflation rate of 5%) to
` 52.50 and its operating costs go up by 10%( the Indian rate of inflation) to ` 1760. Its operating
margin per unit is now (52.50  45) – 1760 = 2362.50 – 1760 = 602.50).
In real terms adjusted for inflation at 10%, the operating margin has shrunk from ` 600 to
(602.50/1.1) ` 547.72.

Thus, it will be observed that in the present case, the impact of exchange rate fluctuations in the
operating cash flow depends upon several factors:
1. Change in price

2. Quantity response to price change
3. Changes in unit costs and
4. Changes in exchange rate
Unlike the case of contractually fixed items like a foreign currency receivable or payable, we
cannot access the impact of exchange rate fluctuations on the firm’s future, cash flow and
profitability unless we know the structure of the market in which the firm sells, price sensitivity
of demand, currency composition of its operating cost and the structure of the market in which
it buys its inputs. These, in turn, will have a bearing on the firm’s competitive position in the
output markets.
In the above situation, precise assessment of exposure of future cash flow and profit is possible
by:
1. Constructing an alternative scenario in which the relevant risk factor e.g. exchange rate
takes specific values and alternate future cash flows for each scenario. This will give an
estimate as to how sensitive future cash flows are to fluctuations in the exchange rate. This
requires a thorough understanding of the firm’s business including its competition,
customers and cost structure.
2. Alternatively, one can adopt a statistical approach using past data to access the influence of
the relevant risk factor on a target performance variable such as, cash flow.
Classification of Currency Exposure

Figure 14.4 presents a schematic picture of currency exposure. The first group of exposures
known as accounting exposures relate to items that currently appear in the balance sheet and
income statement of the firm.

Within this group, we have two further categories, e.g. transaction exposure and translation
exposure.

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