Pricing and Foreign Exchange Rates:
Contribution Analysis Introduction
Unlike a purely domestic business, where costs and prices are denominated in the same currency,
international commerce typically entails two currencies. This is the case, for example, when a firm
exports its product from the country of manufacture (or country-of-origin) to a target country (where the
customer location is located – often referred to as the “local” market). In such cases, exchange rates and
price elasticity (the degree to which consumer demand is sensitive to changes in price) can have profound
effects on volume (product demand) and contribution margins (revenues less variable costs).
Let’s consider a U.S. firm exporting its product to Germany. The following are relevant cost and market
data: Desired revenue per product = $100 (analogous to the price denominated in $US)
Exchange rate (Fx) is $ = .703€.
Variable costs = $60 The local price in € = 70.30 ($100 * .703 $/€).
The per-unit contribution is $40 ($100 revenue – $60 variable cost).
What happens when the dollar appreciates (Euro depreciates)? Assume the $ appreciates 10% to .781
At € 70.30, the price now converts to $90 (70.30 € / .781).
The per-unit contribution falls to $30.
Thus when the dollar rises in value (Euro depreciates), the exporting firm gets lesser revenues and
profits. Clearly this scenario does not bode well for the exporting firm.
What happens when the dollar depreciates (Euro appreciates), for example, if the $ falls 10% from the
original value to .0.639 €?
At € 70.30, the price now converts to $110 (70.30/0.639).
The per-unit contribution rises to $50.
This is the reason exporters in the US like to work with a weak $ value.
Pricing Alternatives and Foreign Exchange
Note that in both of these scenarios the price to German customers did not change. Maintaining constant
local prices is referred to as pricing-to-market. The logic behind pricing-to-market is that customers in a
local market should not be affected by changes in exchange rates. Rather, only “local” market conditions,
such as competitive pricing or inflation in the local market should affect prices to end-users. As we see,
this strategy is problematic when the home currency (dollar) rises relative to the local currency. The only
way to maintain the same level of profitability under this condition is to lower costs in proportion to the 2
Fx change. The more costs can be reduced, the more flexibility management has in pricing-to-market
without losing margin.
On the other hand, managers can choose to alter local prices, or pass-through the Fx change to customers.
This strategy is used to better maintain rates of return, such as contributions. In so doing, local prices are
adjusted to some degree when exchange rates change. It is critical to remember that in most markets
consumers exhibit some degree of price elasticity (sensitivity). Raising prices to address a rise in the
dollar, therefore, typically yields some decline in demand, i.e., fewer units sold. At issue, then, is how to
best trade-off per unit contribution and unit demand.
In summary, assuming costs cannot be lowered, the following table lists the most common alternatives. Alternatives
1. Maintain local price
2. Raise prices to offset
currency depreciation
under conditions of little
consumer price sensitivity
and minimal competition
3. Raise prices to offset
currency depreciation
under conditions of high
consumer price sensitivity
and significant local
competition Advantages
Maintain current volume
levels
Maintains current per-unit
contribution Disadvantages
Loss of per-unit contribution Maintains current per-unit
contribution Greater potential loss of
volume from competitive
price gap and lower consumer
demand.
Greater potential loss of total
contribution. Small potential loss of some
volume.
Small potential loss of total
contribution. Case Study: Small Appliance Market in New Zealand
A U.S. manufacturer is exporting small appliances to New Zealand. Until recently it sold all of its
products through distributors. Each distributor set the prices in local currency. To gain more control over
their international operations, the company has recently established its own New Zealand sales and
marketing subsidiary. One of the major challenges facing the new New Zealand marketing manager is
how to manage local prices when exchange rate changes occur.
Annual sales are expected to be 100,000 units. The prevailing exchange rate is USD/NZD = 1.25. Units
are sold in New Zealand for 125.00 NZD. Variable costs per unit are USD 70. Since the subsidiary
essentially buys finished goods from the parent company in the U.S., it has no control over variable costs
or contribution. The parent company expects the subsidiary to return as much dollar profit (contribution)
to the U.S. as possible. 3
The manager constructs the following spreadsheet to explore different pricing alternatives when the US
dollar rises versus the NZ dollar.
Current
Situation Calculations 1. Initial $US Price
2. Starting Price in NZD
3. Starting Volume $100.00
125.00
100,000 Given
Given
Given 4. Exchange Rate
5. NZ$ Price
6. Price in $US
7. New Volume 1.250
125.00
$100.00
100,000 Current
1*4
5/4
Formula, depending on price elasticity 8. Variable Cost
9. Unit Contribution
10. Total Contribution $70.00
$30.00
$3,000,000.00 Given
6–8
9*7 Assignment
The marketing manager knows that while the USD (US $) and NZD (NZ $) are relatively stable
currencies, the USD/NZD Fx rate is forecast to fall in the coming year. The manager wants to determine
how he should price the appliances if in fact the dollar falls relative to the NZD. Several alternatives are
considered. To simplify the analysis, the manager estimates the effects of the various alternatives for the
coming year (that is, the Fx changes can be assumed to take effect at the beginning of the firm’s fiscal
year, and stay at the same rate for the ensuing 12 months).
1. Assume the FX changes to USD/NZD = 1.15. If the manager maintains the local price, what will be
the effect on total contribution?
2. Another alternative, assuming the Fx rate changes to USD/NZD= 1.15, is to change the local price
such that per unit contribution remains $30. The marketing manager knows that there is some degree
of price sensitivity in the market, and lowering will lead to an increase in volume. Based on an
analysis of historical records, the marketing manager develops a best case (low price sensitivity) and
worst case (high price sensitivity) demand schedule:
Low price sensitivity: Demand (units) = 150,000 – (4000 * (current NZD price – starting NZD price))
High price sensitivity: Demand (units) = 150,000 – (6000 * (current NZD price – starting NZD price))
The marketing manager decides to maintain the $30 per unit contribution. How many units will be
sold and what is the resulting total contribution for (a) the low and (b) the high price sensitivity
scenarios? 4
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