Weakening RMB = Time to ask your Chinese factory for a discount?

I was recently reminded by one of my clients that the Chinese currency (Yuan, CNY, renminbi or RMB) had been depreciating steeply against the dollar. “Is this a good time to ask for a discount on my factory prices?” she asked me.

exhangerates

 

If I were to choose one macroeconomic lever that has the most direct impact on a Chinese factory profits, it would be the exchange rate. The other economic statistics we see in the media (GDP growth, purchasing indexes, minimum wages, interest rates, etc.) are all important in their own right, but nothing impacts an export-driven factory’s profits more directly than exchange rates.

Why is this so?

Data and graph courtesy of xe.com, http://www.xe.com/currencycharts/?from=USD&to=CNY&view=10Y

I learned this lesson first-hand, while working for a Chinese golf bag manufacturer in Shanghai from 2006-2008.

A factory has three main costs: labor, materials and overhead. Our factory, like most, almost always pays for all three in local currency, RMB. However, like many successful Chinese factories, especially at the time, we were exporting and selling to foreign customers, mostly American. Therefore, almost all our income came in the form of foreign currency, mostly US dollars or USD.

Consider the microeconomic situation at our golf bag factory when I started working there in 2006. Let’s say at that time, for each golf bag we were paying about 20 RMB for labor, 100 RMB for materials and charging our customers 20 USD for a finished golf bag. After adding our OH costs and applying the prevailing exchange rate at the time (about 8:1) we were making a profit margin of roughly 15%.

Exchange rate

1 USD = ? RMB

8

FACTORY COST (for one golf bag)

1/1/2006

Labor, RMB

¥20.00

Materials, RMB

¥100.00

Overhead, RMB

¥15.00

TOTAL COST, RMB

¥135.00

TOTAL COST, USD equivalent

$16.88

SALES PRICE (INCOME), USD

$20.00

Profit margin, %

15.6%

Note: All these figures are roughly, but realistically, contrived for explanatory purposes.

Now, imagine the RMB strengthening against the dollar, which makes our factory’s materials, labor and overhead relatively more dear while making the USD from our customers less and less valuable.

In the two years from the beginning of 2006 to the end of 2007, the value of the RMB versus the Dollar increased roughly 12.5%, from 8:1 to 7:1. In RMB terms, our factory’s expenses had not changed, nor had our USD prices to our customers, yet our profit margin decreased by more than 75%. For those unfamiliar with a “cut & sew” factory, 15% margins are decent for a medium size bag maker, but 3% is unworkable. Below you can see the detailed figures that illustrate this example.

Exchange rate

1/1/2006

12/31/2007

% change

1 USD = ? RMB

8

7

-12.50%

FACTORY COST (for one golf bag)

1/1/2006

12/31/2007

% change

Labor, RMB

¥20.00

¥20.00

Materials, RMB

¥100.00

¥100.00

Overhead, RMB

¥15.00

¥15.00

TOTAL, RMB

¥135.00

¥135.00

TOTAL, USD equivalent

$16.88

$19.29

14.29%

Sales price, USD

$20.00

$20.00

Profit margin, %

15.6%

3.6%

-77.14%

Our story was shared by tens, if not hundreds, of thousands of factories across China in 2007-2008. You may have read about the massive swath of factory shutdowns at the time. Mine was one of those.

From the opposite (US government and media) perspective, anyone who’s read about China’s currency manipulations from a Western point of view will be very familiar with the story of China (and other export-driven economies) artificially depreciating their currency to boost their economy. Just apply the above exchange rate figures in reverse and you can see the opposite effect on profits. You’ve also probably read about the opposite situation as well, where manufacturing companies and economies are hurt by a strong local currency. (Japan has exemplified this problem in recent years.) Above is the microeconomic logic behind this.

So, let’s return to my client’s question. Should she ask for a discount based on the recent devaluation of the RMB vs the USD?

She currently pays about $5/piece for canvas bags. Last summer the exchange rate was about 6.2 RMB = 1 USD. When she approached me at the beginning of February the RMB was trading at about 6.6 to the dollar. This is the opposite effect that I described at my golf bag factory. The Chinese factory was profiting from the decreased value of local currency.

7/1/2015

2/1/2016

% change

Exchange rate, 1 USD = ? RMB

6.2

6.6

6.45%

FACTORY COST (per bag)

7/1/2015

2/1/2016

Labor, RMB

¥5.00

¥5.00

Materials, RMB

¥15.00

¥15.00

Overhead, RMB

¥5.00

¥5.00

TOTAL, RMB

¥25.00

¥25.00

TOTAL, USD equivalent

$4.03

$3.79

-6.06%

Sales price, USD

$5.00

$5.00

Profit margin, %

19.4%

24.2%

25.25%

Her factory would appear to be pocketing an extra 25% in profits versus six months earlier, so at first glance, you’d think she’d deserve a share of that windfall. However, my advice was to hold off on re-opening price negotiations with her factory.

Why?

  • Exchange rates can be a double edged sword: Will my client raise her prices when the RMB appreciates (as it already has in recent weeks)?

  • The recent devaluation is relatively minor: Six percent is a lot for a trader managing billions of RMB, but a relatively small change in the context of my client’s order volume.

In my client’s case, I suggested keeping this currency advantage as a bargaining chip when discussing other less sensitive costs like sample charges, minimums or payment terms in the coming months.

If you’re wondering how exchange rates might affect your factory or import/export business, please email joe@thayer-consulting.com.

Thank you!

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