Pricing and Foreign Exchange Rates: Contribution Analysis Introduction Unlike a purely domestic business, where costs and prices are denominated in the same currency, international commerce typically entails two currencies. This is the case, for example, when a firm exports its product from the country of manufacture (or country-of-origin) to a target country (where the customer location is located - often referred to as the \"local\" market). In such cases, exchange rates and price elasticity (the degree to which consumer demand is sensitive to changes in price) can have profound effects on volume (product demand) and contribution margins (revenues less variable costs). Let's consider a U.S. firm exporting its product to Germany. The following are relevant cost and market data: Desired revenue per product = $100 (analogous to the price denominated in $US) Exchange rate (Fx) is $ = .703. Variable costs = $60 The local price in = 70.30 ($100 * .703 $/). The per-unit contribution is $40 ($100 revenue - $60 variable cost). What happens when the dollar appreciates (Euro depreciates)? Assume the $ appreciates 10% to .781 At 70.30, the price now converts to $90 (70.30 / .781). The per-unit contribution falls to $30. Thus when the dollar rises in value (Euro depreciates), the exporting firm gets lesser revenues and profits. Clearly this scenario does not bode well for the exporting firm. What happens when the dollar depreciates (Euro appreciates), for example, if the $ falls 10% from the original value to .0.639 ? At 70.30, the price now converts to $110 (70.30/0.639). The per-unit contribution rises to $50. This is the reason exporters in the US like to work with a weak $ value. Pricing Alternatives and Foreign Exchange Note that in both of these scenarios the price to German customers did not change. Maintaining constant local prices is referred to as pricing-to-market. The logic behind pricing-to-market is that customers in a local market should not be affected by changes in exchange rates. Rather, only \"local\" market conditions, such as competitive pricing or inflation in the local market should affect prices to end-users. As we see, this strategy is problematic when the home currency (dollar) rises relative to the local currency. The only way to maintain the same level of profitability under this condition is to lower costs in proportion to the 2 Fx change. The more costs can be reduced, the more flexibility management has in pricing-to-market without losing margin. On the other hand, managers can choose to alter local prices, or pass-through the Fx change to customers. This strategy is used to better maintain rates of return, such as contributions. In so doing, local prices are adjusted to some degree when exchange rates change. It is critical to remember that in most markets consumers exhibit some degree of price elasticity (sensitivity). Raising prices to address a rise in the dollar, therefore, typically yields some decline in demand, i.e., fewer units sold. At issue, then, is how to best trade-off per unit contribution and unit demand. In summary, assuming costs cannot be lowered, the following table lists the most common alternatives. Alternatives 1. Maintain local price 2. Raise prices to offset currency depreciation under conditions of little consumer price sensitivity and minimal competition 3. Raise prices to offset currency depreciation under conditions of high consumer price sensitivity and significant local competition Advantages Maintain current volume levels Maintains current per-unit contribution Disadvantages Loss of per-unit contribution Maintains current per-unit contribution Greater potential loss of volume from competitive price gap and lower consumer demand. Greater potential loss of total contribution. Small potential loss of some volume. Small potential loss of total contribution. Case Study: Small Appliance Market in New Zealand A U.S. manufacturer is exporting small appliances to New Zealand. Until recently it sold all of its products through distributors. Each distributor set the prices in local currency. To gain more control over their international operations, the company has recently established its own New Zealand sales and marketing subsidiary. One of the major challenges facing the new New Zealand marketing manager is how to manage local prices when exchange rate changes occur. Annual sales are expected to be 100,000 units. The prevailing exchange rate is USD/NZD = 1.25. Units are sold in New Zealand for 125.00 NZD. Variable costs per unit are USD 70. Since the subsidiary essentially buys finished goods from the parent company in the U.S., it has no control over variable costs or contribution. The parent company expects the subsidiary to return as much dollar profit (contribution) to the U.S. as possible. 3 The manager constructs the following spreadsheet to explore different pricing alternatives when the US dollar rises versus the NZ dollar. Current Situation Calculations 1. Initial $US Price 2. Starting Price in NZD 3. Starting Volume $100.00 125.00 100,000 Given Given Given 4. Exchange Rate 5. NZ$ Price 6. Price in $US 7. New Volume 1.250 125.00 $100.00 100,000 Current 1*4 5/4 Formula, depending on price elasticity 8. Variable Cost 9. Unit Contribution 10. Total Contribution $70.00 $30.00 $3,000,000.00 Given 6-8 9*7 Assignment The marketing manager knows that while the USD (US $) and NZD (NZ $) are relatively stable currencies, the USD/NZD Fx rate is forecast to fall in the coming year. The manager wants to determine how he should price the appliances if in fact the dollar falls relative to the NZD. Several alternatives are considered. To simplify the analysis, the manager estimates the effects of the various alternatives for the coming year (that is, the Fx changes can be assumed to take effect at the beginning of the firm's fiscal year, and stay at the same rate for the ensuing 12 months). 1. Assume the FX changes to USD/NZD = 1.15. If the manager maintains the local price, what will be the effect on total contribution? 2. Another alternative, assuming the Fx rate changes to USD/NZD= 1.15, is to change the local price such that per unit contribution remains $30. The marketing manager knows that there is some degree of price sensitivity in the market, and lowering will lead to an increase in volume. Based on an analysis of historical records, the marketing manager develops a best case (low price sensitivity) and worst case (high price sensitivity) demand schedule: Low price sensitivity: Demand (units) = 150,000 - (4000 * (current NZD price - starting NZD price)) High price sensitivity: Demand (units) = 150,000 - (6000 * (current NZD price - starting NZD price)) The marketing manager decides to maintain the $30 per unit contribution. How many units will be sold and what is the resulting total contribution for (a) the low and (b) the high price sensitivity scenarios? 4 3. Another alternative that the marketing manager considers if the Fx rate changes to USD/NZD = 1.15 is to adjust prices just half of the amount as in the previous alternative (question 2). That is, rather than change prices to pass on the full Fx change, prices will be changed to pass on half of the Fx change. How many units will be sold and what is the resulting total contribution for (a) the low and (b) the high price sensitivity scenarios if local prices are changed in this manner? 4. Based on the three alternatives the marketing manager has considered, how should the marketing manager price the appliances if: a) Price sensitivity is low b) Price sensitivity is high All of the data shown in this case can be found in the \"appliance.xls\" Excel spreadsheet on the course web site. Answer the questions in a one page note. Attach no more than three pages of exhibits to your memo. This is an individual assignment and please post your memo to the dropbox on the course website. Mike Glezos Tuesday November 10, 2015 Re: Global Pricing Spreadsheet Exercise 1. Assume the FX changes to USD/NZD = 1.15. If the manager maintains the local price, what will be the effect on total contribution? Assuming volume does not change based on sensitivity, the total contribution increases $869,565. 2. How many units will be sold and what is the resulting total contribution for (a) the low and (b) the high price sensitivity scenarios? Low unit demand is 190,000 and contribution is $5,700,000. High unit demand is 210,000 and contribution is $6,300,000. Mike Glezos PG 1 3. How many units will be sold and what is the resulting total contribution for (a) the low and (b) the high price sensitivity scenarios if local prices are changed in this manner? If price changed to 120 (half) the low unit demand is 170,000 and contribution is $5,100,000. High unit demand is 180,000 and contribution is $5,400,000. 4. Based on the three alternatives the marketing manager has considered, how should the marketing manager price the appliances if: a) Price sensitivity is low The manager should change the local price such that per unit contribution remains $30 from $125 to $115 Mike Glezos PG 2 b) Price sensitivity is high Same as the low scenario. Change the local price. Mike Glezos PG 3 Pricing Contribution Analysis Question 1 Current Situation USD/NZD= 1.15 Initial $US Price Starting Price in NZD Starting Volume $100 125.00 100,000 $100 125.00 100,000 Exchange Rate NZD Price Price in $US New Volume (a,b) 1.2500 125.00 $100.00 100,000 1.1500 125.00 $108.70 100,000 $70.00 $30.00 $3,000,000.00 n/a $70.00 $38.70 $3,869,565.22 $869,565 Variable Cost Unit Contribution (Profit) Total Contribution (Profit Gain/Loss (a) Low price sensitivity: Demand (units) = 150,000 - (4000 * (current NZD price - starting NZD price)) (b) High price sensitivity: Demand (units) = 150,000 - (6000 * (current NZD price - starting NZD price)) Pricing Contribution Analysis Question 2 PRICE CHANGED Current Situation USD/NZD= 1.15 LOW HIGH Initial $US Price Starting Price in NZD Starting Volume $100 125.00 100,000 $100 125.00 100,000 $100 125.00 100,000 $100 125.00 100,000 Exchange Rate NZD Price Price in $US New Volume (a,b) 1.2500 125.00 $100.00 100,000 1.1500 115.00 $100.00 100,000 1.1500 115.00 $100.00 190,000 1.1500 115.00 $100.00 210,000 $70.00 $30.00 $3,000,000.00 n/a $70.00 $30.00 $3,000,000.00 $0 Variable Cost Unit Contribution (Profit) Total Contribution (Profit Gain/Loss $70.00 $70.00 $30.00 $30.00 $5,700,000.00 $6,300,000.00 $2,700,000 $3,300,000 LOW PRICE SENSITIVITY current NZD 115.00 starting NZD 125.00 Difference -10.00 4000 -40000 150,000 Demand (Units) 190,000 HIGH PRICE SENSITIVITY current NZD 115.00 starting NZD 125.00 Difference -10.00 6000 -60000 (a) Low price sensitivity: Demand (units) = 150,000 - (4000 * (current NZD price - starting NZD price)) 150,000 (b) High price sensitivity: Demand (units) = 150,000 - (6000 * (current NZD price - starting NZD price)) Demand (Units) 210,000 Pricing Contribution Analysis Question 3 1/2 Price Current Situation USD/NZD= 1.15 1/ 2 Price Change LOW HIGH Initial $US Price Starting Price in NZD Starting Volume $100 125.00 100,000 $100 125.00 100,000 $100 125.00 100,000 $100 125.00 100,000 $100 125.00 100,000 Exchange Rate NZD Price Price in $US New Volume (a,b) 1.2500 125.00 $100.00 100,000 1.1500 115.00 $100.00 100,000 1.1500 120.00 $104.35 100,000 1.1500 115.00 $100.00 170,000 1.1500 115.00 $100.00 180,000 $70.00 $30.00 $3,000,000.00 n/a $70.00 $30.00 $3,000,000.00 $0 $70.00 $34.35 $3,434,782.61 $434,783 Variable Cost Unit Contribution (Profit) Total Contribution (Profit Gain/Loss $70.00 $70.00 $30.00 $30.00 $5,100,000.00 $5,400,000.00 $2,100,000 $2,400,000 (a) Low price sensitivity: Demand (units) = 150,000 - (4000 * (current NZD price - starting NZD price)) (b) High price sensitivity: Demand (units) = 150,000 - (6000 * (current NZD price - starting NZD price)) LOW PRICE SENSITIVITY current NZD 120.00 starting NZD 125.00 Difference -5.00 4000 -20000 150,000 Demand (Units) 170,000 HIGH PRICE SENSITIVITY current NZD 120.00 starting NZD 125.00 Difference -5.00 6000 -30000 150,000 Demand (Units) 180,000