Analyzing the variance in operating margin (OM) between plan and actual results is an important tool for finance professionals. This article will consider the potential OM variance related to fluctuating foreign exchange (FX) rates.
As companies have reported their results for the first quarter of 2015, the impact of FX on operating profitability has hit home and, in many cases, hit hard.
While it may be less expensive to travel to Europe this summer, the stronger U.S. dollar can create significant weakness in short-term OM. Naturally, there are times when circumstances work to a U.S. domestic company’s favor, typically when the dollar is weakening. The tricky part in late 2014 and early 2015 was the speed and magnitude of the dollar’s ascent against the euro and yen, which caught many companies by surprise.
To demonstrate the potential negative impact of a strong dollar, consider our first (hypothetical) graphic, which represents the OM variance of a European subsidiary of a U.S. company when euros are restated in dollars. We assume that the average rate of exchange was $1.20 in plan but $1.05 actual. The variance analysis (which we call a “variance walk”) presented during an operations review, is represented as follows:
In euros the European subsidiary would have shown a 10% increase in sales and 20.6% increase in operating margin relative to plan — probably a positive surprise in the face of a weak local economy. But in U.S. dollars, sales and OM would have respectively dropped 3.8% and increased only 5.5%.
Note that in this example, we are assuming that production is in Europe. With a purely export business doing production, the OM would have decreased by 8.3%, representing a classic example of FX risk: that FX fluctuations can be equivalent to losing price. The negative FX variance relative to plan would have cut the perceived growth by 75%, and presumably, being dollar-based and trading on the New York Stock Exchange, may have resulted in a lower stock price. [Contact the author for a full explanation of how he arrived at the numbers in this hypothetical example.]
Two real-world examples are seen in Toyota and Pentair. In the case of Toyota, all results are presented in yen. The stronger dollar and euro relative to the yen (noting Toyota’s significant operations in the United States and Europe), coupled with the recent foreign profitability, caused a very positive FX variance. In fact, approximately 80% of the overall operating income came from FX. This is not unusual for Toyota — there are frequent periods of positive and negative impact. In the past there have been negative impacts where more than 100% of the variance came from FX.
Pentair is a great example of the use of variance walks from a forward-looking, or proactive, perspective. In this case (see chart below), it is easy to see both the top-line and operating income impact of the stronger dollar. The productivity bucket, presumably under Pentair’s control, is not sufficient to offset the combined impact of negative volume, cost, and FX. Note that the company’s variance analysis is very similar to our hypothetical example. Management has certainly recognized the headwind to be faced when FX goes against the company.
Naturally, one can debate whether FX will equalize over time. But placing that bet can be very dangerous if long-term structural differences exist between the U.S. economy and other major customer regions around the globe. That can require thinking well beyond the quarter-to-quarter Myopia, getting right to the heart of business strategy and long-term planning.
Here are some strategic mitigants for dealing with FX risk:
The aforementioned should not be left solely to finance to solve. A cross-functional team with a total-value-chain mindset is essential for both the short and long term. That kind of creative thinking is required when dealing with the risks associated with FX.
Tom Conine, Ph.D., is president of TRI Corporation, which specializes in corporate education, experiential leadership, and simulation programs to help clients develop leaders, sharpen financial acuity, improve executive business acumen, and enhance shareholder value. He is also a professor of finance at Fairfield University in Connecticut.