Five Principles for Creating a Supply Chain Foreign Exchange Risk Mitigation Strategy │ Supply Chain Quarterly, Q3
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BY GEORGE A. ZSIDISIN, BARBARA GAUDENZI, AND ROBERTA PELLEGRINO
Global political trends are making foreign exchange rates more vulnerable to fluctuations. These sudden changes can have a significant impact on global supply chain costs. The following principles can help companies create a plan to mitigate that risk.
FIRMS HAVE ENGAGED IN GLOBAL SUPPLY CHAINS for centuries. This is due to the many benefits organizations experience in trading globally, such as expanding their customer base, attaining lower purchasing costs, and obtaining higher quality products and services, among many other factors. Although firms have been enjoying the fruits of global supply chain management for many years, there are also inherent uncertainties and risks that exist which can quickly erode profitability.
One such form of risk prevalent in these supply chains is foreign exchange (FX) risk. Firms may suffer an increase in operating costs due to changes in exchange rates when purchasing components or materials from nondomestic suppliers, or they may lose margins when they sell products in markets with a lower exchange rate. For example, the price of a cup of coffee is the same every morning, and the price of the bakery product is the same on the shelf, but, if suppliers are paid in the supplier currency, the cost of the commodities—coffee beans and grain—can significantly increase due to the fluctuation in the country-of-origin’s currency.
FX risk can severely affect profitability, especially in industries characterized by tight product margins, low levels of stocks, and short lead times. A 2018 survey of 200 chief financial officers, for example, found that 70% of respondents had suffered reduced earnings in the prior two years due to avoidable, unhedged FX risk.**superscript{1} This finding shows the need to carefully consider FX risk. In addition, global political risk trends are increasing many firms’ exposure to FX risk. For example, the currency markets became particularly volatile after the British voted to leave the European Union.
Many firms have implemented financial hedging to manage FX risk. However, from an operational perspective, there are additional approaches firms can consider for mitigating this form of risk. In a recent research program, partly funded by the Council of Supply Chain Management Professionals (CSCMP), we uncovered five principles organizations should consider in creating a supply chain FX risk mitigation strategy. The primary focus of these principles is oriented more towards a supplier-facing perspective of the supply chain but takes into consideration internal and downstream FX risk exposure as well. These principles include 1) creating flexibility up front, 2) looking backwards and forward in the supply chain, 3) incorporating multiple sources of cost uncertainty, 4) using a range of risk mitigation approaches, and 5) considering relationships (see Figure 1).
Creating flexibility up front
Firms can mitigate a great amount of FX risk by considering a variety of sourcing strategies during the initial product development and supplier evaluation and selection stages. Sourcing a component or product from a sole supplier located in a foreign country leaves a firm vulnerable to changes in the exchange rate. When possible and feasible, firms should consider a multisourcing strategy, or at least establishing backup suppliers, by qualifying and selecting a domestic supplier or one from an alternate foreign country. Although identifying and qualifying alternate sources of supply can be costly, firms should see it as an investment in flexibility. It gives firms the opportunity to mitigate unfavorable fluctuations in FX rates by switching the purchasing quantity to another supplier.
We have seen organizations create backup, domestic sources of supply as well as qualify suppliers that use a third currency. For example, one Italian firm we studied purchases components from China, but it has also qualified a supplier in the U.K. and can source from another supplier in Italy. This example supports findings from a recent survey, which found that 80% of the companies studied invest in supplier relationships and flexibility to reduce risks.
However, companies need to be careful when creating these plans. They should make sure to consider additional expenses such as the costs of switching from one supplier to another, including the cost of changing manufacturing and distribution processes and any new transportation costs. Hence, before deciding whether or not to invest in flexibility by qualifying suppliers that use a different currency, it is crucial to carefully assess the expected benefits versus the cost for implementing the plan. One way to make this assessment is to use real options valuation (ROV) in combination with simulation tools. This avoids having firms build flexibility where it does not prove to be worthwhile.
Flexibility, in fact, has its limitations. It is very difficult to frequently change supply sources due to switching costs and process changes. Therefore, companies need to understand both the short- and long-term FX rate uncertainties and forecasts in order to determine if switching sources is really worthwhile, especially since it may take six months or more before another switch is viable. Longer time between switches may in fact dramatically erode the value created by the flexibility itself. At the extreme, if the next switch is viable several months later, the fluctuation of FX may make the switch financially unfavorable.
Looking upstream and downstream in the supply chain
It is important for firms to know where in their supply chains they could be exposed to foreign exchange rate risk. To uncover these points of weakness, they need to look both up and down their supply chain and realize that FX risk is prevalent throughout both their internal and external supply chains. External upstream sources of risk include having suppliers located in countries using a different currency and having suppliers whose own suppliers receive payments in various currencies. Downstream FX risk exposure can come from customers in foreign countries who pay in their respective currencies as well as from making payments to providers of transportation and other supply chain services in a foreign currency.
It is important as well to understand how FX risk affects your supply chains. How will fluctuations in foreign exchange rates affect your cash-to-cash cycle and your firm’s profitability? Are there opportunities for natural hedging where sales and purchases are done using the same foreign currency? The mitigation of FX risk might be particularly crucial for firms located in countries where raw materials are scarce or the share of imported material from abroad (spend in other countries) is significant and experiences currency volatility. This can especially occur in developing countries, such as with BRIC countries (Brazil, Russia, India, and China). In such cases, experiencing a devaluation of the local currencies (the currency of the selling product) may produce a significant loss for a firm.
Incorporating multiple sources of cost/price uncertainty
Firms are exposed to uncertainty from many different sources. These sources of uncertainty can include, but are not limited to: global political dynamics, demand volume volatility, commodity price fluctuations, tariffs, and transportation costs. Further, many of these sources of uncertainty influence other sources. For example, the price of oil (a commodity) has an influence on transportation rates. Likewise, the uncertainty around the recent COVID-19 pandemic is dramatically affecting global demand, changing its volumes and affecting the equilibrium between off-shored and domestic manufacturing needed to meet that demand. Some of these sources of uncertainty can offset the effects of FX risk, while others can amplify unfavorable FX rates.
For example, the COVID-19 pandemic severely affected the global oil market as demand for oil from China (which accounts for 20% of total consumption) dropped by about 3 million barrels a day. As a result, global oil prices, such as the Brent crude oil price, dropped to their lowest level in more than a year. This drop also affected shipping prices and generated high volatility in commodity prices, which in turn affected foreign exchange rates. Commodity price shocks, higher prices due to disruptions to global supply chains, and the shortage of demand from the tourism industry all resulted in severe fluctuations in foreign exchange rates.
As recent events show, FX risk cannot be considered in a vacuum. Instead, we have found it is important for firms to create total cost models that holistically assess their entire financial risk exposure. These models would include FX risk as one of several factors. Similarly, when companies create a FX risk mitigation strategy, they should take into consider other cost drivers and how they influence FX risk.
Using a range of risk mitigation approaches
There is no one “silver bullet” for mitigating FX risk. Larger firms for many years have employed financial hedging instruments, such as derivatives and currency swaps, for reducing their exposure to FX risk. Although financial hedging remains an important tool and approach in creating a supply chain FX risk mitigation strategy, other approaches, especially at the operational level, can likewise be employed for actively addressing this form of financial risk and creating supply chain flexibility in the case of unfavorable FX valuation rates.
One common approach that supply chain professionals utilize for reducing the effects of significant FX valuation shifts is negotiation. Many suppliers want to ensure that they keep their customers’ business. From the purchasing firm’s perspective, we have found it beneficial for organizations to simply communicate how FX rate shifts affect the purchasing firm’s cost structure with the supplier. This tactic gives suppliers the opportunity to adjust their sales prices to counter the currency value shift and remain price competitive. Further, these negotiations, especially when they are done during the contracting stage, can include escalation and de-escalation clauses, where this form of risk is shared between the companies. For example, if future changes of FX valuation shift by more than 5% above or below an established rate, the risk of the price increase or decrease due to currency differences would be shared between the buyer and supplier. Other mitigation techniques can include suppliers switching or reallocating volume for reducing the effects of FX risk, financial hedging, and natural hedging.
Considering relationships
The success of many of the multiple approaches to FX risk mentioned above is dependent upon a firm’s current and future relationships with its customers and suppliers. Further, the power balance in the relationship will also partly determine how FX risk is mitigated.
For example, building in flexibility by switching suppliers or reallocating volume may be a viable strategy when there are no production capacity constraints and the relationship with the supplier is more transactional. However, it may be the incorrect decision if the supplier is considered strategic to your success. Also, a multisourcing approach may strengthen a firm’s purchasing power by providing information that can be used to improve current relationships or negotiations with new suppliers. Therefore, investing in flexibility may be seen as a “strategic tool” to adopt from a longer-term perspective, based on the FX rate forecasts.
Understanding the relationship between yourself and a supplier is also key to successfully using negotiation as an approach to mitigating FX risk. By establishing rules at the very beginning of the negotiation, you may create efficiency and limit opportunistic behaviors of suppliers. In this sense, negotiation may be a “tactical tool” to manage with specific suppliers for shorter-term periodic FX rate fluctuations. Having strong, established relationships and rapport with suppliers is an important requisite for negotiating contractual terms in response to FX risk.
When determining what approach to take in mitigating FX risk, companies should ask themselves what is the true value of the supplier or customer? Is FX risk considered a win-lose game, where one organization gains temporary financial benefits from currency valuation shifts at the expense of the other? Or is it an opportunity to mutually discover opportunities for financial success?
Supply chain relationships are not just external. Internal supply chain relationships with other business functions (such as production, finance, and marketing) should be taken into consideration. Is finance/treasury considered the primary entity responsible for this form of risk? How can we work with them in mitigating FX risk? Are there opportunities for creating a natural hedging strategy with marketing and sales? How do our decisions affect production? Creating a supply chain FX risk mitigation strategy cannot be done in isolation, and needs to incorporate both external and internal supply chain partners and functions.
There is no question about it—firms are subject to a myriad of uncertainties that can detrimentally affect their profitability. FX currency fluctuations and its inherent risk is one such uncertainty supply chain professionals need to be aware of and incorporate for better managing their supply chains and contributing to corporate profitability. The five principles provided in this article shed some insight into what factors you may want to consider in creating a strategy for mitigating FX in your firm and supply chain.
The authors would like to thank the companies participating in this research and CSCMP for a grant helping to support this study.
GEORGE A. ZSIDISIN (GZSIDISIN@UMSL.EDU) IS THE JOHN W. BARRIGER III PROFESSOR AND DIRECTOR OF THE SUPPLY CHAIN RISK AND RESILIENCE RESEARCH (SCR3) INSTITUTE AT THE UNIVERSITY OF MISSOURI—ST. LOUIS. BARBARA GAUDENZI (BARBARA.GAUDENZI@UNIVR.IT) IS ASSOCIATE PROFESSOR IN SUPPLY CHAIN MANAGEMENT & RISK MANAGEMENT AT THE DEPARTMENT OF BUSINESS ADMINISTRATION OF THE UNIVERSITY OF VERONA (ITALY). ROBERTA PELLEGRINO (ROBERTA.PELLEGRINO@POLIBA.IT) IS ASSISTANT PROFESSOR AT POLITECNICO DI BARI (ITALY) IN MANAGEMENT ENGINEERING.
Notes:
1. Rethinking Treasury, HSBC and FT Remark, 2018: https://www.gbm.hsbc.com/the-new-future/treasury-thought-leadership/risk-management-survey.
2. M. Brown. “Procurement Improvements begins with process,” Supply Chain Management Review, July 7, 2019: https://www.scmr.com/article/procurement_improvement_begins_with_process
3. Real option valuation (ROV) methods are based on the concept of real options, which are defined as “the right but not the obligation” to choose a course of action and obtain an associated pay-off. Compared to traditional techniques, such as net present value, (NPV) or cost-benefit analysis, ROV methods have been widely used on project/asset valuations when further options, whose exercise is not certain and depends on the evolution of uncertainty, but which come at a certain initial cost. Examples are managerial flexibility (that is, having the option) to expand, abandon, or contract a project, based on different states realized during the process of the project in future.
4. Stephen Harris and Marcus Baker, How Volatility in Oil Prices Caused by Coronavirus Could Affect Shipping and Insurance, Marsh JLT Specialty, February 2020: https://www.marsh.com/it/it/insights/research-briefings/volatility-oil-prices-following-coronavirus-affect-shipping-insurance.html).
