Over the years we have had a number of controversies around the costing of Imported goods. The tendency has been to cost imported goods at the spot rate of the day, even though the goods will be paid for somewhere in the future and can only be sold once received. This spot rate costing has even found its way into numerous long-term contracts, usually between government organizations and corporates. Now, there is a time and place for everything, but the spot rate is usually not the right rate to use for costing purposes.
Now, there is a time and place for everything, but the spot rate is usually not the right rate to use for costing purposes.
The reason for this is quite simply the Time Value of Money. This dictates that if you order goods that will be payable in the future, you will have to buy the currency at some point or another. If you buy the currency now and deposit the currency into a CFC account, you will be out of pocket as the ZAR interest rate is much higher than the interest rate you will receive on your CFC account, hence the spot rate is inappropriate for costing purposes here, unless you want to forego some of your profit margin.
If you cost the goods to your customer at the spot rate and you only have to pay in the future, you have no idea what the rate is going to do and where it will be when the payment is due. Again, using the spot rate to cost your goods will be inappropriate.
The only time a spot rate is appropriate for costing purposes is when your client pays you upfront for something you have to source from overseas and where the order is payable immediately. In this case any carry cost of the currency is being borne by your client and you will not be out of pocket.
What rate should then be used for costing purposes?
The best rate to use for costing purposes is the rate that can be achieved right now that is the closest match, in terms of timing, to the expected payment date. Therefore, if you have to cost goods now that will be shipped and be payable later, you should use the forward rate to the expected payment date as this is a rate that is achievable right now. If you then decide to buy the currency right now, you should be able to achieve a very similar rate and you will have protected your profit margin. If on the other hand you decide to wait, you will be taking a view as to where the currency is going. That is fine but at least you will have some fat to play with because the currency may not actually depreciate by the same amount as the forward points and you could end up making a currency gain. If the currency depreciates by more than the forward points, you would end up with a currency loss, not because you costed incorrectly but because you took a view which happened to have turned out wrong.
Just to recap: Forward Exchange Contracts, otherwise known as Forward Cover, is a product frequently used by business entities to secure an exchange rate today, for settlement sometime in the future and are typically used to 'hedge' a direct underlying foreign currency exposure, in respect of periods less than 12 months, or a firm and ascertained commitment for periods more than 12 months. By the way, a ‘hedging’ arrangement, basically means the implementation of a risk management strategy designed to limit losses which might occur because of price changes in future foreign exchange commitments and the likes.
The moral of the story, use a costing rate that is as close as possible to the rate you can achieve to the expected payment date, at the time you are quoting your customer.
Some companies have the luxury of ordering goods which they only have to pay for at a later date and where the goods will be taken into stock on arrival. In this case the costing rate should be the actual rate obtained.
Naturally, profit margins will be added to whatever costing rate is used.
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Author: Eddie Rall | Gauteng Franchise Owner