Question

Foreign exchange rates have an impact on the establishment of budgets and the tracking of actual performance. Of the various exchange rate combinations mentioned in Chapter 10, explain which you favor and why. Support your choice with academic references.

The five meaningful combinations of exchange rates differ as follows in the extent to which management is held responsible for fluctuations in exchange rates: 1. 2. 3. Translate the budget and actual results using the exchange rate that exists at the time the budget is prepared. Under this combination, the total budget variance is a function of sales volume and local currency (LC) price and quantity variances only. Exchange rates have no effect on evaluation. However, there is little incentive to incorporate anticipated exchange rate changes into operating decisions. This combination is equivalent to evaluating results in local currency. Translate the budget and actual results using the exchange rate that exists at the end of the budget period. The comments related to combination 1 apply equally to this combination. Translate the budget and actual results using a projected ending exchange rate (projected at the time the budget is prepared). Under this combination, the total budget variance also is a function of sales volume and local currency price and quantity variances only. However, unlike combinations 1 and 2, the use of a projected exchange rate provides managers an incentive to incorporate expected exchange rate changes into their operating plans, but they are not held responsible for actual exchange rate changes. For example, if the local currency is expected to decrease in value during the year, the foreign operation's ability to export should improve, and local managers should attempt to take advantage of this opportunity. On the other hand, the cost of imports will increase, and local managers should search for alternative domestic inputs. (This is discussed more fully later in this chapter in discussing how to incorporate economic exposure into the operating budget process.) Because of its potential for causing local managers to consider the impact that exchange rate changes will have on parent currency profit, this combination is generally favored in the literature. Translate the budget at the initial exchange rate and translate actual results using the ending exchange rate. In this case, the total budget variance is a function of sales volume, local currency price and page 426 quantity variances, and the change in

Answer 1

Because of the following reasons i would favour point no. 4 :

1. Translate the budget at the initial exchange rate and translate actual results using the ending exchange rate.

2. In this case the total budget variance is a function of sales volume , local currenct price , qty variances and change in exchage rate (whether anticipated or not).

3. local managers bear full responsibility for exchange rate changes

4.local managers will hedge if allowed to , even though natural hedge exists.  Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements.Hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss.

The aim of hedging is to reduce the losses from unexpected fluctuation arises in the market. .

When local managers plan to hedge that means they are trying to reduce the risk, they can not prevent the event to occur but they can reduce the impact of losses.