Lessons · Lesson 3 of 6

Two currencies, one company: which one is your profit?

Decide which currency the factory's result is really measured in, and see why a devaluation gives back about half of what everybody expects and then takes it away again.

Lesson 3 of 6 · 20 min

The same order, two answers

Lesson 1 read LKM-9126 as a cost sheet in dollars. The margin fell from USD 1.4935 a unit to USD 1.1600. Lesson 2 read the same order as sela cash flows. The margin fell from 2,885,400 sela to 1,646,190.

Both are arithmetically correct. They are not the same size.

	Expected	Actual	Change
The cost sheet, re-read in dollars with the local cost translated at the settlement rate	USD 62,726	USD 48,719	minus USD 14,007, or 22.3%
The company's books, in sela	2,885,400 sela	1,646,190 sela	minus 1,239,210 sela, or 42.9%

One order, measured two ways

Convert the dollar answer at the settlement rate and you get about 604,000 sela of damage. The sela answer says 1,239,210. The cost-sheet reading misses roughly half of it.

The reason is one sentence, and it is worth memorising.

Measured in dollars, a dollar is always worth a dollar. So a dollar view of the world cannot see the dollar itself losing value. It can see the sela cost line getting more expensive. It cannot see that the dollars Ardessa is about to be paid have themselves become worth less at home. In that frame, they have not.

Functional currency is a decision, and it has already been made for you

The accounting standard here is IAS 21. It calls the currency of the main economic environment a business operates in its functional currency, and it requires the business to measure its results in that currency.

This is not a preference, and it is not a reporting convenience. It is a question of fact: where does the money the business runs on actually come from, and where does it go?

For Ardessa the answer is not close. Wages, rent, electricity, local trims, tax and the owner's dividend are all in sela. The dollar is simply what a customer happens to pay in. The sela number is the company's profit. The dollar number is a useful way to compare one quotation with another, and nothing more.

The practical consequence is uncomfortable. Every cost sheet, every margin conversation and every price negotiation in the garment trade runs in dollars. None of them measures the thing the owner is actually trying to maximise.

What a devaluation actually gives you

Two seasons before this order, the sela fell. The dollar went from 38.00 sela to 46.00 sela over about seven months.

Before going further, notice that the same event has two sizes, depending on which way you divide.

The dollar bought 21.1% more sela than before.
The sela was worth 17.4% less than before.

Both are right. Which one appears in the board pack decides how large the story sounds. Agree internally which one you use, before somebody quotes the bigger number at you.

Ardessa's sales director expected the fall to cut the factory's dollar cost by about a fifth, and to make Corvane the cheapest place in the region to make a chino. It did neither. The reason is in plain sight on the cost sheet in lesson 1.

	Sela	Share
Imported fabric, thread and trims, priced in dollars	10,432,800	52.1%
Cut, make, trim, overhead, wages, priced in sela	9,576,000	47.9%
Total cost base	20,008,800

Where the cost base actually sits, at the January rate

Just under half of Ardessa's cost base is in sela. A devaluation only reaches that half. The fabric is bought in dollars, from a mill that does not care what the sela does. So in sela terms the fabric got dearer at the exact moment everything else got cheaper.

Put a number on it. Take a clean 10% fall in the sela from the January rate. The local cost line drops from USD 4.9565 to USD 4.4609 a unit — exactly 10%, as expected. But the total cost drops only from USD 10.3565 to USD 9.8609. That is a fall of 4.79%, not 10%. Slightly less than half of what the meeting assumed.

That ratio is the most useful single number a factory in a soft-currency country can know about itself. It is one division: local cost over total cost. Work it out once a season.

And then it decays

The 4.79% is not permanent either. A falling currency raises the local price of everything imported, and a country's cost base is full of imported things: fuel, spare parts, chemicals, freight, and the fabric in the table above. Local prices follow. Wages follow the prices. The advantage bleeds away.

What is left after prices have caught up is what economists call the real exchange rate, as against the nominal one on the screen. The whole point of the distinction is that only the nominal one moves overnight.

So a devaluation hands a factory a windfall that is about half the size it looks, and that shrinks month by month. Which brings us to the part where nobody in this story did anything wrong.

The mistake nobody made

When the sela fell, Ardessa's sela margins rose sharply for two seasons. Every decision that followed was correct on its own. The board treated the improvement as performance and approved a wage rise, to hold skilled operators who were being poached. The plant bought a second automatic pocket-setter, which paid back on its own numbers. The sales director, competing hard, quoted keenly and won volume — which is what a sales director is for.

Then local prices caught up. The wage rise stayed. And at the next round Larkmoor — which could see Corvane's published inflation and its own landed costs — asked for USD 11.20 against the 11.85 it had been paying.

At the settlement rate of 43.10, Ardessa's cost on this style is USD 10.69. At 11.20 the margin is USD 0.51 a unit, or 4.6%. Nobody made an error. The factory spent a temporary currency gain on permanent costs, and then had the price reset around that gain before it had gone away.

The defence is not cleverness about currencies. It is bookkeeping. If the currency result had been on its own line from the start, the board would have been looking at an operating result that had not improved at all. The wage rise and the machine would then have been argued on their own merits, which is where they belonged.

Check yourselfA factory buys 70% of its cost base in imported dollar-priced materials and 30% locally. Its currency halves against the dollar. By roughly how much does its dollar cost per garment fall?Show the answer

By about 15%, not 50%. Only the 30% local share is touched. Halving the currency cuts the dollar value of that share in half, so the total falls by roughly 30% of 50%. The higher your imported content, the less a devaluation does for you. A factory that has just moved to imported fabric for quality reasons has quietly reduced the only currency cushion it had.

What to take away

Your profit is measured in the currency you spend, not the currency you invoice. Everything the trade does in dollars quietly assumes otherwise. Split every result into an operating line and a currency line, because a factory that cannot tell them apart will reward the wrong things. And know your local share of the cost base to one decimal place, because that is exactly the fraction of a devaluation that will ever reach you.