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).

Lets 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 $ = .817.

Variable costs = $60

The local price in = 81.70 ($100 * .817 $/).

The per-unit contribution is $40 ($100 revenue - $60 variable cost).

What happens when the dollar depreciates (Euro appreciates)? Assume the $ appreciates 10% to .898

At 81.70, the price now converts to $90 (81.70 / .898).

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 .735 ?

At 81.70, the price now converts to $110 (81.70/.735).

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 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 Advantages Disadvantages

1. Maintain local price Maintain current volume levels Loss of per-unit contribution

2. Raise prices to offset currency depreciation under conditions of little consumer price sensitivity and minimal competition Maintains current per-unit contribution Small potential loss of some volume.

Small potential loss of total contribution.

3. Raise prices to offset currency depreciation under conditions of high consumer price sensitivity and significant local competition Maintains current per-unit contribution Greater potential loss of volume from competitive price gap and lower consumer demand.

Greater potential loss of total contribution.

Case Study: Small Appliance Market in Germany

A U.S. manufacturer is exporting small appliances to European markets. Until recently it sold all of its products through distributors. Each distributor set the prices in local currency for each market. To gain more control over their international operations, the company has recently established its own European sales and marketing subsidiary. One of the major challenges facing the new European marketing manager is how to manage local prices when exchange rate changes occur.

The marketing manager decides to focus first on the companys largest European market, Germany. Annual sales are expected to be 100,000 units. The prevailing exchange rate is $/ = .751. Units are sold in Germany for 75.10 . Variable costs per unit are $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.

The manager constructs the following spreadsheet to explore different pricing alternatives when the dollar rises versus the mark.

Current Situation

Calculations

1. Initial $US Price $100.00 Given

2. Starting Price in 75.10 Given

3. Starting Volume 100,000 Given

4. Exchange Rate 0.751 Current

5. Price 75.10 1 * 4

6. Price in $US $100.00 5 / 4

7. New Volume 100,000 Formula, depending on price elasticity

8. Variable Cost $70.00 Given

9. Unit Contribution $30.00 6 8

10. Total Contribution $3,000,000.00 9 * 7

Assignment

The marketing manager knows that while the dollar and are relatively stable currencies, the $/ 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 . 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 firms fiscal year, and stay at the same rate for the ensuing 12 months).

1. Assume the FX changes to $/ = .6759. If the manager maintains the local price, what will be the effect on total contribution?

2. Another alternative, assuming the Fx rate remains at $/ = .6759, 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 raising prices will lead to a drop 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) = 100,000 - (1750 * (current price starting price))

High price sensitivity: Demand (units) = 100,000 - (2750 * (current price starting 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?

3. Another alternative that the marketing manager considers if the Fx rate changes to $/ .6759 is to adjust prices just half of the amount as in the previous alternative (question 2). That is, rather than change prices to cover the full Fx change, prices will be changed to cover 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.

Pricing Contribution Analysis

Current

Situation

Initial $US Price $100

Starting Price in 75.10

Starting Volume 100,000

Exchange Rate 0.7510

Price 75.10

Price in $US $100.00

New Volume (a,b) 100,000

Variable Cost $70.00

Unit Contribution $30.00

Total Contribution $3,000,000.00

Gain/Loss n/a

(a) Low price sensitivity: Demand (units) = 100,000 - (1750 * (current price - starting price))

(b) High price sensitivity: Demand (units) = 100,000 - (2750 * (current price - starting price))