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Impact of Exchange Rates on Profits | AQA Q2.3, Paper 2 2018
Last updated 27 Oct 2020
This suggested response is to the "open question" in Paper 2 in 2018 on whether managers of all businesses need to worry about the effects of changes in exchange rates on profits,
For many businesses, particularly those that have a high level of exports or rely on using supplies from overseas, profits are affected by changes in exchange rates. However, as I will explain, the relationship between profit and exchange rates isn’t always so important for managers to worry about.
In the case of Lego, the effect of changes in exchange rates on profit is complicated by the fact that it is a multinational with global business operations. With a high proportion of sales to Europe, Lego’s revenues and profits will be particularly sensitive to changes in the Krone / Euro exchange rate. The chart in the case study indicates that over the last five years the Krone has fallen sharply compared with the Euro from around 0.135 Krone to 1 Euro to 0.1 Krone (which is a fall of about 25%) and the data also suggests wide fluctuations over the period. This would mean that, over the longer-term, Lego products sold in Europe have become significantly cheaper as a consequence of the weaker Krone, which is likely to lead to higher sales and profits from Europe, although that would depend to some extent on the sensitivity of demand for Lego to changes in price. On the other hand, a weaker Krone might leave Lego managers worrying about increased costs of imported raw materials such as plastic, which will be more expensive if suppliers are charging using Euros. Of course, the Krone might start to strengthen against the Euro in the future, which would reverse the effects described above to some extent, creating different worries for Lego managers.
However, not all businesses are as closely exposed to changes in the exchange rates as Lego. Take the example of a domestic business that does not export to overseas customers or import from overseas suppliers. Here, profits are mainly determined by factors other than exchange rates since there is no impact of a change in exchange rates on the selling price charged or the costs of supplies. Many businesses are hardly affected at all by exchange rate changes except indirectly (e.g. their suppliers might push for price increases if they have been impacted by a weaker currency). Even for multinationals, it is possible for managers to organise their operations so that the effect of exchange rate changes on profits is minimised. For example, a multinational might choose to open a factory in a key export market so that it reduces the effect of exchange rates changes by producing in locally and then selling in the local currency. This is just one way that managers can reduce the risk of exchange rates affecting profits; another way would be to “fix” the exchange rate using forward contracts so that managers know what exchange rate they use to convert sales and profits.
Managers of all businesses should, therefore definitely consider the impact of exchange rate changes on their profits. However, the extent to which they need to worry will depend to a large extent on how complex their international operations are and, in particular, how reliant the business is on sales and profits from countries where the business has to trade in a different currency. In general, the relationship between profit and exchange rates is much more significant for multinational businesses, particularly those that operate increasingly in emerging markets whose exchange rates fluctuate more wildly. Managers would need to worry more if the exchange rate fluctuations were significant and sustained over a long period, rather than lose too much sleep over exchange rate changes day-to-day.