A company manufacturing specialized electronic equipment has so far sold only inside the country where it is established. It has considerable surplus capacity and the Chairman has asked you, as his Finance Director, to prepare a draft memorandum for the board on his proposal to open up export business to a number of countries.
Required:
Draft this memorandum, setting out the main points that would need to be considered before arriving at a final decision, under the following headings:
i) Export pricing and profitability;
ii) Credit terms and methods of obtaining payment;
iii) Risks and methods of avoiding them;
iv) Forms of representation or local organization in export markets.
(Where appropriate, indicate advantages, disadvantages or your own recommendations). (10 marks)
View Solution
MEMORANDUM
To : Board of Directors
From : Finance Director
Date : August 14th 2017
Subject : Proposed Export Business
It has been proposed that the company should utilize its surplus capacity by opening up export business to a number of countries. The following are some of the main points which will need consideration before a final decision is made.
i) Export Pricing and Profitability
First, extensive market research will have to be carried out in the countries under consideration to ascertain:
* Whether there is a demand for our products;
* Whether we would have any direct competition for our goods;
* The quality and price of competitors’ products;
* Whether the price we could charge for our products in that country would achieve the profit margin the company requires.
Depending upon the outcome of these initial investigations, consideration would then have to be given to the pricing and invoicing of the products abroad.
The export price would obviously not only have to cover our normal costs, overheads and profit margin, but also take into consideration any further costs associated with selling goods abroad such as transport, distribution, shipping and insurance costs. However, as there exists some surplus capacity, the items for export may be priced on variable or marginal cost basis.
The potential effect of the variability of exchange rates on pricing policy must also be considered. These effects could be reduced or eliminated in the following ways:
By invoicing in our own currency. This would eliminate the possibility of loss due to exchange rate fluctuations as it transfers any exchange risk to the buyer. However, this could have a detrimental effect on sales and thereby, profit.
By invoicing in the buyer’s own currency but including an ‘extra’ profit in the invoiced price to cover possible exchange losses. However, this policy has the danger of possibly making our price uncompetitive.
By invoicing in dollars – Fluctuation of the dollar against other currencies would affect our exposure. (2.5 marks)
ii) Credit terms and methods of obtaining payment
When deciding upon credit terms to be offered to foreign customers, consideration must be made of the additional time lag involved in sales to foreign countries.
In addition to the period of trade credit granted there is also the time involved in the shipment of goods to the country and the time taken to transfer the funds back.
This brings us to the choice of the method of obtaining payment. There are several ways in which payment in foreign currency can be received:
* By cheque or bank transfer
* By a bill of exchange drawn on the customer by the company
* By a documentary credit facility (or letter of credit). The documentary credit system works as follows:
-The buyer and seller agree to a sales contract which provides for payment through a documentary credit;
-The buyer then requests a bank in his country to issue a letter of credit in favour of the exporter;
-This bank guarantees payment to the exporter provided that the exporter complies with the terms and conditions set out in the letter of credit such as presenting a transport document, copies of the invoice, certificate of insurance, etc. (2.5 marks)
iii) Risk Avoidance
The exchange risk can be avoided by one of three methods.
By selling the currency forward. By this means the exporter can be sure of the exact amount of cedis he will receive. However, as there will be presumably many sales, the numerous foreign currency sales will have to be negotiated.
By borrowing the currency now. By this method the exporter would borrow foreign currency and sell the currency for cedis and then repay the loan from the sale proceeds. In this way short-term assets and liabilities are being matched in the same currency so as to eliminate exchange exposure. By this method one loan can be arranged to cover numerous sales.
By invoicing and receiving payment in our currency. However, as already mentioned this could have a detrimental effect on sales. (2.5 marks)
iv) Forms of representation or local organization in export markets
If the company is to sell the goods in foreign countries then consideration must be given to how the goods will be sold. It will be necessary for the company to have some form of ground support in the countries concerned probably by selling through an overseas agent. Such agents might be found through an export organization such as the Ghanaian Export Promotion Board or with the help of a local bank. Consideration should also be given to the remuneration of such agents and the commission that they will be allowed. (2.5 marks)