The rigorous business of budgeting for international operations: managing global risk is at the center of budgeting for overseas subsidiaries. But transfer pricing and inventory policy also weigh heavily on international budgeting

Management Accounting Quarterly, Wntr, 2004 by Ken Milani, Juan Rivera

Multinational companies contend with an array of external factors, internal considerations, and other forces that influence budget policies, composition, and control. Budgeting in a global business environment calls for an enhanced level of coordination and communication because of the variety of powerful components that impact organization performance. In this article, we examine and describe how international issues influence the budgeting process of multinational companies that are headquartered in the United States and that control foreign affiliates. (1)

EXTERNAL FACTORS

Foreign currency exchange rates, interest rates, and inflation are the three major external factors that affect multinationals and their markets. Although these variables are interrelated--for example, higher inflation in a specific country tends to drive the value of its currency down, which impacts the exchange rate--changes in currency exchange rates have the most effect on the budgeting process.

Example 1. In June 2001, the value of the U.S. dollar was at a 15-year high when compared to the British pound and other currencies of the major U.S. trading partners. This caused John T. Dillon, CEO of International Paper and head of the Business Roundtable, to complain to U.S. Treasury Secretary Paul O'Neill that the dollar's strength made it difficult for U.S. companies to compete with imports and penetrate foreign markets. (2)

Changes in these three external factors stem from several sources, including economic conditions, government policies, monetary systems, and political risks. Each factor is a significant external variable affecting areas such as policy decisions, strategic planning, profit planning, and budget control. To minimize the possible negative impact of these factors, multinational corporate management must establish and implement policies and practices that recognize and respond to them. Other external forces such as political turmoil, competition, labor quality, and cultural or religious orientation of the local populace exist, but they tend to be related specifically to one country or particular region of the world.

For example, the events of September 11, 2001, have been significant to U.S.-based multinational corporations. Since 9/11, many international entities have focused on security measures, employee counseling, and other special training that they had not paid much attention to in the past. All of these efforts must be addressed in budgeting for an international operation.

Foreign Currency Exchange Rates

But of all factors influencing international budgeting, foreign exchange rates have the most significant and pervasive effect.

Changes in foreign exchange rates are explained by different theories but essentially are based on the underlying demand for assets denominated in a particular currency. Foreign exchange rate fluctuations affect a multinational through translation exposure, transaction exposure, and economic exposure. Each of these exposures has a different effect on the entire budgeting process.

Translation Exposure

Translation exposure influences financial statements during the development of a budget and/or while the budget is being used for control purposes. Specific exchange rates, usually based on forecasted values, must be determined and applied when preparing the budgeted financial statements from the applicable operating budgets. (3) Throughout the budgetary period, the actual exchange rates will likely vary from the anticipated exchange rates. The differences can generate unpredictable--often uncontrollable--results during interim and final budget performance reviews. Because management cannot control shifting exchange rates, the effects of the fluctuations can be removed from the budgeting control process by setting aside the variations from the budget that are due to changes between the budgeted and actual exchange rates. After removing these effects, however, there still may be some variances between the forecasted and actual budget due--in part--to exchange rates.

Example 2. Translation exposure influences include: (1) pricing policies being modified to compete with either higher- or lower-priced goods that are not produced in the same country, usually price-sensitive goods such as consumer electronic items, table wines, and textiles; (2) positive or negative changes in sales volume resulting from lower- or higher-priced competing goods and services either in a domestic or foreign market; and (3) deviations from standard input efficiencies because of alternate domestic or foreign suppliers who become more price competitive as a result of changes in the foreign exchange rate. To remove all of the effects of foreign exchange rate fluctuations, a different exchange rate would be required for each revenue and expense category. Because this process would be cumbersome and time-consuming, it is not utilized.

Transaction Exposure

Transaction exposure results from international transactions such as unhedged contracted cash flows that characterize international trade, repatriation of profits, and acquisition or disposal of foreign assets. The principle of applying an expected future exchange rate can be employed when comparing the actual cash flows with the expected cash flows between foreign units of a multinational corporation. Because of transaction exposure, multinationals hedge their international cash flows. The hedging usually occurs in two basic modes: a "natural hedge" mechanism, such as pricing decisions, risk shifting, exposure netting, or currency risk sharing, and an "artificial hedge" that is created with foreign exchange contracts or derivative instruments such as options, swaps, and futures. (4)