Caterpillar Currency Issues - Case Study Example

? Case study: Caterpillar Currency Issues Introduction Currency exchange rates have always affected the operations of businesses, especially businesses whose operations and markets straddle international borders. This can be seen in Caterpillar case especially in the early years when the firms had not distributed its functions. Shifting currency rates are always a risk to a firm and can lead to the firm incurring many losses. However, by understanding the problem, the business is able to look at the way in which the market can be looked at and come up with solutions (Wihlborg, 2008). In Caterpillar’s case, the firm was able to reverse the adverse effects of a strong dollar by removing these processes, especially production and manufacturing functions to other countries thus neutralizing the transaction risks. This helped the firm to be able to able to overcome the shocks caused by currency exchange rates. This was achieved in two ways as follows; Hedging labour and production costs This can be understood by looking at the actual reason why high dollar values in the 1980s had affected the revenues and profits of Caterpillar. To begin with, since Caterpillar’s manufacturing units were located in the United States only, strong dollar meant that its manufacturing costs would be higher than the manufacturing costs of its competitors who were outside the United States. As a result, its products would have to be more expensive because when buyers in foreign countries would have to pay more once they converted their lowly valued currencies into American dollars. This meant that Caterpillar’s products could not be competitively priced as compared to those of the competitors. Hedging revenues Manufacturing costs were not the only issue affecting Caterpillar. By taking its manufacturing to other countries, the issues of high dollar value was solved. Not only did the manufacturing costs not get affected by the high US dollar values, but the firms would also be able to source raw materials locally and thus hedge the revenues. According to Delaney and Whittington (2010), this kind of hedging can be important where the firm needs to protect itself from unpredictable currency rates. By manufacturing in foreign countries and sourcing the raw materials in foreign countries, it meant that the profits margins would be stable because the sales and the profits would be measured by the same foreign currencies. As a result, it can be said that Caterpillar overcomes this issue by localizing its operations in foreign markets rather than having the operations centralised in the US. This, according to Madhuvij (2006) is what is called thinking globally and acting locally. Caterpillar looked at the market from a global perspective because its products have markets in the global arena, but to be effective, the firm had to look at each local market individually. The strategy As identified, Caterpillar used the think global, act local strategy. This is a strategy which is being used by so many global firms which have to contend with so many challenges caused by the very same opportunities caused by a global market. Globalisation has brought opportunities for many forms but has also brought with it challenges which firms must be able to overcome if they are to benefit from the opportunities brought about by globalisation. This is the situation which Caterpillar has found itself in. For firms to be able to benefit from the opportunities brought about by globalization, they have to create strategies which will turn challenges into opportunities. This is what Caterpillar realised and started working towards creating a way to help it overcome its challenges. The validity of the strategy As it is with any business strategy, this strategy may be seen to have both advantages and disadvantages. It is the balance between the advantages and the disadvantages which make a strategy to be either worth it or not. As per the Caterpillar strategy, the main advantage is the fact that distributing its operations around the globe has not only helped the Caterpillar to overcome the challenges brought about by unstable currency exchange rates, but also helped it to be able to meet the needs of the individual local customers. Being able to meet the individual needs of the customers is an important part of business strategy, especially in a modern world where customer service and customer satisfaction is everything. On the down side however, there may be issues which may arise from this strategy. The first one is the fact that although it solves the problem of currency exchange rates, it solves it partially rather than fully. For instance, it only solves the issues only in instances where the dollar value is high. It cannot be guaranteed that the dollar rates will always be high and if it comes to a point where the dollar is low, Caterpillar will have lost an opportunity. Apart from that, decentralisation of any business processes has its own issues. Caterpillar had to decentralise it business to a number of countries in order to protect its business from the shockwaves caused by the changes in the currencies of different countries. Distributing functions such as manufacturing may mean that the firm will not be able to take advantage of economies of scales for instance when buying raw materials. It also means duplications in the various costs such as administrations costs due to the fact that each country where the firm has established its manufacturing will need a set of management function to suit it (Birts, 2002). This will definitely cause redundancy which is a disadvantage to the business. However, on the overall, the strategy which Caterpillar has used can be seen as useful as it is helps it to deal with long term challenges which would otherwise cripple the business. This can be seen as an as a trade-off between the advantages of having a centralised management function and a decentralised one in which the advantages of the decentralised management function are seen to outweigh those of the centralised one. However, Caterpillar must be able to look at the various areas where the implementation of this strategy may affect its business in a negative way and therefore address these areas in order to make sure that its strategy is not working counter to its bottom-line. For instance, it will be necessary for Caterpillar to be able to streamline management functions in order to make sure that there are no unnecessary duplications and redundancies in its management structure. This will help in curbing managerial costs. Transaction exposure A transaction exposure is the risk which a firm runs as a result of the currency exchange rates after a transaction or a deal has been reached between business partners of different countries. For instance, if a business agrees to supply a certain product to another business in another country and the transaction is done in US dollars, the firm may run a risk if the US dollars fall in value because it would have to get less money (Apte, 2008). If for instance, a firm in US agrees to sell computers to a firm in UK and the value of the dollar gets stronger, the firm in US may lose because it have to get fewer UK pounds from the firm in UK. This kind of risk can be clearly seen in the case for Caterpillar where the changes in the currency rates were affecting the profits. Before Caterpillar was able to distribute its manufacturing to other countries, the firm was facing issues whenever the dollar gained weight against the foreign currencies. Caterpillar would enter into deals to supply equipment to foreign customers and the profits would be affected by the changing dollar rates. For instance, if Caterpillar was to supply goods in a different country such as Kenya and the customer is paying in Kenyan currency, the amount of money would be less than expected if the dollar rate goes up. For instance, if the Kenyan buyer agreed to pay twenty million shillings for a truck and the rate of dollar per shillings changes from the current one of Kenyan shillings 85 to 110 per dollar, Caterpillar would get less money. The problem is that once a company like Caterpillar agrees on a certain business arrangement which goes onto the future, it cannot change its stand. For instance, in the example above, even if the value of the dollar goes up thus making the amount paid in Kenyan shillings much less than the sum Caterpillar intended, Caterpillar cannot go back and would have to still supply the goods even in cases where the firm will make a loss. This as Madura (2011), says, is why it is increasingly important for organizations to be able to deal with this kind of a situation in order to prevent them from having to incur such big losses. In a global market, business want to be assured that changes in currency rates will not affect their business and that they will be stable, regardless of the changes in the foreign exchange markets. Translation exposure Translation risk exposure is very much like transaction exposure because it is a risk which is caused by unexpected changes in the currency rates in the foreign exchange (Wang, 2011). However, unlike the transaction risk exposure which basically deals with just daily business transactions thus affecting the profit or loss margins, translation risk exposure has to do with the assets of a firm and comes in when the firms wants to convert its assets from one currency to another. Translation exposure does not have a direct impact on the firm’s cash flow because it is usually an accounting reporting issue. Firms operating across the international borders are usually required to prepare consolidated accounts for reporting (Delaney & Whittington, 2010). In this regard, such a firm will have to include all the assets in the international markets and these assets are valued based on the local currencies where they are. To be able to have these assets in one accounting report, these assets have to be translated into the local currency where the firm is headquartered and where the consolidated accounts have to be done. This is where the firm is always affected by the changing currency rates. In many cases, if the changing rates lead to the assets being devalued, the firm’s reports will not look good and this may lead to the firm having poor performance in the stock market. Poor performance in the stock market will definitely lead to the firm losing a lot of money because it leads to the firm’s stock being devalued (Cool & Goddard, 2006). Firms like Caterpillar always face this kind of risk and must be able to know how to deal with these kinds of challenges. In Caterpillar’s case, this is something that it’s going to be a big issue epically with regard to the fact that it now has distributed its manufacturing functions across the globe which means that it has numerous assets located in other countries. This is an indication that Caterpillar will have many issues as the time goes on and as they prepare their consolidated accounts. In this regard, it means that even as Caterpillar has solved the issue of transaction risk exposure, it has gained more translation risk exposure. There are a number of issues which must therefore be looked in this in order for the firm to be able to deal with this kind of a challenge. Hedging Although translation risk exposure cannot be hedged, transaction risks can be hedged in a number of ways. One way to hedge these risks is by doing what Caterpillar has done, that is, to distribute the manufacturing across the globe. However, there are other ways such as forward and futures contracts, options etc. Forwards and futures are agreements which predetermine the currency exchange rates which will be used regardless of the market rates at any particular time (Birts, 2002). Business partners across two different countries can agree on the currency rates which will be used in their future transactions in order to make sure that any dramatic changes in the currency rates will not be an issue. Reference list: Apte, P. (2008). International Finance. New York City, NY: Tata McGraw-Hill Education. Birts, N. (2002). Balance Sheet Structures Association of Corporate Treasurers Series International treasury management series. New York City, NY: Woodhead Publishing. Cool, K. & Goddard, J.G. (2006). International Business: Theory and Practice. New York, NY: M.E. Sharpe. Delaney, P.R. & Whittington, R. (2010). Wiley CPA Examination Review, Outlines and Study Guides. Hoboken, NJ: John Wiley & Sons. Madhuvij, M. (2006). International Financial Management. New Delhi, IN: Excel Books India. Madura, J. (2011). International Financial Management, 11th ed. London: Cengage Learning. Wang, P. (2011). The Economics of Foreign Exchange and Global Finance. New York, NY: Springer. Wihlborg, C. (2008). Corporate Decision-Making with Macroeconomic Uncertainty : Performance and Risk Management: Performance and Risk Management. Oxford, UK: Oxford University Press. Read More