Do you know your budget rate from your costed rate when managing your currency requirements?
Everyone from buyers to financial decision makers will be familiar with budget and costed levels. But can they distinguish one from the other? All too often these terms are used in an interchangeable manner, without much thought for what they mean or the impact they could have on a business. Their potential to affect profitability and accurate forecasting means initial decision makers should be mindful of the difference between the two.
The aim of this article is to highlight the importance of being able to identify the differences between these financial management tools when transacting foreign currency requirements.
Budget rate: An FX budget rate is an exchange rate used to convert projected non-GBP (or the accounting currency of an organisation) denominated revenues and expenses. These are normally used in a company’s financial forecasting for draft budgets and to establish business objectives.
Costed rate: An FX costed rate is an exchange rate that considers the costs associated with products, production and projects. It is used in commercial decision-making processes, to calculate, evaluate and monitor costs.
Thankfully the difference between the two can be articulated in simple terms: an FX budget rate is used for forecasting budgets, and therefore can be viewed as theoretical; while an FX costed rate takes variables during the transaction cycle into consideration.
Why is this important to businesses with FX requirements?
Some companies will maintain a costed level that’s the same as their budget level due to costs being fixed, and a variable change not being required. For example, this will be the case if they already hedged their FX requirements for the next 12-24 months at the time of forecasting their activity for that period, due to ongoing consistencies.
It is not uncommon for FX rates to shift by as much as 10% in a 12-month period. Institutional forecasts, on the other hand, typically have a 20% variance between the high and low estimates over this timeframe. This can impact end user pricing and the overall competitiveness of the business. Below are some common examples of the costed level impacting the end user and a variable factor that is at play.
|Variable priced good/service||Impacting factor on variable end user price|
|Price of petrol||Price of oil|
|Domestic energy bills||Price of oil and gas|
|Shrinkflation of consumer products||Value of sterling|
Basing the price of your goods/service off the budget rate during the forecasting period could have adverse effects. A basic example would be:
A company sets a budget rate of $1.30 on GBPUSD when planning their financial year forecasting. It is determined that this will secure a profit margin of 10%. The business operates by publishing a catalogue of prices that are fixed for the 12 months:
Scenario 1 – GBPUSD moves against the business
During the next three months GBPUSD is volatile, so the budget level is reduced to 1.20 to satisfy the accounts; however, this erodes the profit margin to 3%. Consequently, the forecasting of profit for the business is inaccurate and could have adverse effects in other areas.
Scenario 2 – GBPUSD moves in favour of the business
During the next three months GBPUSD is volatile and the budget level is held at 1.30, while the market moves to 1.45. This increases the profit market margin, but sales volumes are lower, as their competitor adjusts their pricing based off a costed level. This could result an excess of inventory and lower headline numbers at year end.
British businesses with exposure to currency risk are often impacted by the dynamic nature of exchange rates. Therefore, an FX costed level is likely to be more useful than an historic budget level, because it will help with decision-making, understanding the unit cost and establishing/maintaining profit margins. Relying on the historic FX budget rate set out in the financial year forecasting stage could hinder the ability to make effective commercial decisions.
It is not a case of one size fits all. Your approach will be dependent on your specific market sector and the end user sensitivity to price. However, in both cases there are strategies and instruments available that can help your business secure your FX rate for a period. Utilising these will mitigate currency risk and help you to make informed commercial decisions.
Speak to a commercial FX specialist to discuss your specific requirements and find out what strategies and options could be employed to best serve your objectives.