Exchange rate pitfalls can sink offshore operations

There are many matters to consider when setting up an offshore outsourcing  deal-scope, location, roles and responsibilities, service levels, governance plans and price, just to name a few.

The effect of foreign exchange rates on the transaction tends to fall pretty far down the priority list at the negotiating table, if the outsourcing customer considers the issue at all.

But ignoring the currency exchange considerations associated with offshore outsourcing transactions can be a multi-million dollar mistake, say analysts. Unanticipated swings in currency valuation can increase a company’s exposure to financial risk and drastically minimize savings.

Offshoring’s changing landscape

“Many clients do not spend adequate time building a financial hypothesis of what [problems] currency fluctuations could cause in the short and long term,” explains Sandeep Karoor, managing director of offshore outsourcing consultancy neoIT. “At best, loose terms and conditions get agreed upon.”

Most U.S. companies think in terms of U.S. dollars. That’s understandable; everything from budgets to their day-to-day business is doled out in greenbacks. And during the golden age of offshore outsourcing, the savings reaped from labor arbitrage alone were significant enough that any additional money left on the table from a lack of currency arbitrage was pocket change by comparison.

But that scenario is changing. “Today, with many companies entering into second- and third-generation offshore deals, the low-hanging fruit is already gone,” explains David Rutchik, a partner with outsourcing consultancy Pace Harmon. “Companies need to look at currency implications as a way to drive down costs.”

How Offshore Outsourcing Providers Profit from Falling Exchange Rates

Typically, an outsourcing buyer pays in its own currency to the offshore vendor-in the case of an American customer, the almighty dollar. Meanwhile, the provider pays for its offshore resources in its local currency. As the value of that local (offshore) currency drops, the providers’ costs go down and the customer ends up paying more in dollars for the services provided than the services actually cost in the foreign currency.

For example, during 2008, the Indian rupee fell 23.3 percent against the U.S. dollar. A company with a $10 million IT services contract that would normally cost the offshore provider $8 million to provide (pocketing a 20 percent profit margin) would have actually cost the vendor less than $6 million, landing the provider a windfall of an extra $2 million.

9 ways to save on your next outsourcing contract

“We have seen these margins translate into literally millions of dollars annually,” Rutchik explains.

That’s no mere pocket change in today’s economic climate.

Offshore outsourcing providers-and multinational vendors with offshore subsidiaries-understand the impact that the complexity and unpredictability of currency markets can have on their business. Smart vendors have hedging strategies in place to deal with currency fluctuations that may prove unfavorable to them.

“In most contracts that have language around currency fluctuations, the terms tend to be service provider friendly, not client-friendly,” explains neoIT’s Karoor.

But a savvy offshore outsourcing client can negotiate terms that provide some protection for their half of the deal.

Next: Strategies for Mitigating Currency Risk

Methods for Mitigating the Risk of Currency Fluctuations

1. Ask the provider to bear the brunt of the risk of currency fluctuations.
Clients can negotiate to have the provider absorb the majority of exchange rate risk because the vendor generally has better capabilities for absorbing currency shifts, according to Forrester principal analyst Dr. Paul Roehrig.

In such an arrangement, the outsourcer bears the risk of currency fluctuations up to an agreed upon percent above or below a baseline exchange rate. This is usually referred to as “banding.” If the exchange rate rises above the “band,” the client pays more. If it sinks below the “band,” the client pays less. To make this work, customer and provider must agree on the indices for tracking the currency, the frequency of monitoring fluctuations and the process for handling variances, says Karoor.

2. Pay in dollars tied to foreign currencies.
In this kind of deal, the customer pays in dollars, but the amount of the payment varies based on the movement of the currency where services are being provided. If that local currency tends to devalue against the dollar, the customer will wind up paying less and that savings may help to cover other financial risks like inflation, says Pace Harmon’s Rutchik. The approach also tends to stabilize profit margins for the provider, so when the outsourcer is on the wrong side of the exchange rate, it isn’t scrambling to cover those losses by cutting service.

3. Hedge against fluctuations in exchange rates.
Offshore outsourcing customers can, in theory, use the same hedging strategies that their IT service providers do. However, creating a dedicated team of financial analysts to develop and execute a hedging strategy would be a costly option for the casual outsourcing client-and extraordinarily risky if the analysts bet the wrong way on the future movement of the currency markets.

4. Pay for services in the provider’s local currency.
Some customers, especially those with longer-term deals, prefer to pay in the local currency of the offshore provider-the Mexican peso or the Chinese yuan or the Estonian kroon. After all, the U.S. dollar trends higher against emerging market currencies over the long term.

But short term, the movements of the currency markets are more sporadic. There are periods where the dollar loses value against these currencies, so simply paying in local legal tender can end up costing during these phases. However, paying in the local currency can be cumbersome for clients who don’t already do other business in the market, notes Rutchik.

5. Apply a “look-back” average to future payments going forward.
With this approach, the customer pays in dollars tied to local currency fluctuations but not in real time. Customer and vendor take the average currency fluctuation “looking back” over a certain period-say, the last six months. They then apply that average fluctuation against the dollar to a forward looking period of payments-say, the next year. This is repeated each year over the course of the contract term. This provides some stability for both parties each year, except in cases where the “look back” period involves some wild fluctuation in exchange rates, which is certainly possible.

Some offshore outsourcing customers ultimately may decide it’s simpler to pay for IT services in fixed U.S. dollars even if that means some loss of savings.

But it’s important to at least consider the options for mitigating currency risk, even for customers well into their offshoring contracts.

Says Rutchik, “Service providers are willing to renegotiate because they often have experienced significant margin expansion due to the currency benefits they have gained at the expense of the customer.”

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