If your company manufacturers product in China, it is inevitable that you are feeling the pressure of decreasing profit margins. With appreciating currencies, specifically between China and the U.S., the margin is shrinking daily. The cost savings once enjoyed are being lost.
Many still view supply chain as a manufacturing term, but in reality the supply chain also importantly involves financial flows. Without taking into account currency exchange risk, profits can quickly erode by the increasing cost of material inputs, finished product and inefficiencies. This is a triple whammy -- a true game of Press Your Luck if the only consideration is the direct purchasing cost.
With this reality, there are three ways a company can protect itself from currency movements. The first is to hedge against risk through common financial tools or by generating monetary assets in China. Secondly, the downstream supply chain must be considered. How can profit margins be protected by reducing unnecessary costs in downstream operations? Lastly, moving to a new low cost source can provide protection. The key is building this competency. Let's first consider the challenge.
Considering the Problem
Take for example, a U.S. company purchasing from a Chinese supplier. The U.S .buyer focuses only on direct product cost. The company buys product at $100 and sells it for $150, a 50% margin. We should all be so lucky.
In one year, the company chooses to make no changes. They are happy with the margin, so why change? The answer is the currency risk absorbed. From November 1, 2006 to November 1, 2007 the Chinese Renminbi appreciated by 5.5% against the U.S. dollar. What once cost $100 would now cost $105.50 in 2007. This means 11% of the margin has been lost. If we include reductions in Chinese tax deductions, increasing raw material and transportation prices passed on to the buyer, this may increase to 15% or higher.
Currency Hedging in the Supply Chain
Financial hedging tools such as options, forwards and swaps are used to protect against currency exchange risk. This is not commonly however included in the discussion of supply chains. Finance and supply chain functions rarely interact, however communication is critical.
As the cost of a product is directly related to the monetary currency of exchange, especially for a company sourcing in a foreign location, hedging becomes a potential option to protect supply chain profits. This can be effective if utilized at the contract signing date. By taking into account pre-negotiated future values for a particular currency, the risk of appreciation can be managed to reduce future negative effects. The only cost is the transaction cost incurred.
Another potential solution is to establish a business unit acting in China. By having a transactional point, which uses the Renminbi (RMB) as the functional currency, cash in RMB can be accrued to reduce the currency exchange risk. This allows for faster payment to capture the spot rate, and lowers the exposure a company faces when exchanging between currencies over a period of time.
Downstream Supply Chain
Considering the downstream supply chain in China is another solution. By lowering the cost of production, potential currency appreciations are offset, whereby protecting profit margins. If a currency doesn't appreciate, the margin is widened. The question is; where should we look?
There are a number of factors, which will reduce costs. These areas could be lowering inventory, downstream supplier management policies, lowering both production and in-transit batch size, reduced lead times, improved packaging utilization and increased quality control to reduce returns.
In China today, companies expose themselves to currency risk by reducing supply chain thinking to simply the direct purchasing cost. Take packaging for example. One U.S. retailer recently realized that roughly 40% of their in-transit shipment was underutilized because of poor packaging procedures. By focusing on how product was prepared for shipping, the company increased container usage by 17%. This increased in-transit levels, lowered per unit shipping cost and reduced the exposure risk by 5%.
Another example is manufacturing batch size. Many companies order in volume based on economies of scale. The reality is these same companies commonly overlook the output level to achieve profit maximization. This means considering the optimal batch size taking into account potential currency fluctuations through sensitivity analysis. Here, the currency exposure is reduced by the combination of supply chain and financial knowledge.
Low Cost Hopping
Low cost "hopping" is another method of reducing currency risk by actively seeking the lowest cost production. Within China alone, large cost reductions can be achieved up to 20%, depending on the product, simply by moving inland. The key however is supply chain management.
In order to effectively "hop" from one low cost manufacturer to another, a company must look beyond simply the purchasing cost. What on the surface may seem like an immediate cost savings, can in fact cost more if factors such as inventory, lead times, throughput and service level are not taken into account. To effectively operate a "hoping" model, supplier identification is critical to ensure material flows maximize profit during the period of manufacturing.
Supply chains are too commonly today associated with only material and increasingly information flows. Financial flows play a critical role especially as supply chains become more global. Just as information flows became an important topic related to visibility and lead time, financial flows also build an advantage through efficiencies in exchange risk management and increased cash fluidity. In order to maximize profits and create a sustainable advantage, all three factors must be synchronized.
Each of these three potential solutions offers a glimpse of how a company can better prepare itself for the impacts of currency exchange risk. Without taking into account these critical factors, the supply chain is susceptible to less obvious added costs and profits will undoubtedly diminish. Facing these realities will separate the industry leaders from those who worry daily about increasing costs.
Bradley A. Feuling is the CEO of Kong and Allan, LLC, based in Shanghai, China. Kong and Allan is a consulting firm specializing in supply chain operations and global expansion. Yi Kong is vice president, Supply Chain Operations. http://www.kongandallan.com
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