Question

As a subsidiary manager, would you consider Regent’s use of the beginning-of-the-year exchange rate for budget setting and average-of-the-year rate for budget tracking appropriate? Why? What changes in the budgeting process can Regent make to prepare foreign subsidiary managers to better respond to the effects of inflation and exchange rate changes?

It was January 2016, and Lee Morgan, CEO of Regent, Inc., was getting ready to review the financial performance of Regent’s subsidiaries. In recent years, this exercise had become a challenge for Morgan because of rising complaints from several subsidiaries regarding the performance evaluation system (PES) at Regent. Morgan called in Tracy Kimball, Regent’s controller, and had the following conversation with her:
Morgan (CEO): Tracy, I guess it is time for us to take another look at our PES. Yoshi Takada [manager of Japanese subsidiary] has been complaining that it is unfair to evaluate all subsidiaries by the same yardstick.
Kimball (Controller): But fairness was perhaps the most important consideration when I designed the PES back in 1993. We hold each subsidiary manager, domestic and foreign, responsible for the budgeted U.S. dollars profit, allowing us to achieve corporate profitability goals.
Morgan (CEO): Takada feels that since his unit’s distinctive contribution comes from its low- cost production, we should treat his unit as a cost center. He contends that because he sells mostly to discounters and builder channels in the U.S., the price competition is severe, and profit margins are rather low.
Kimball (Controller): That’s true. But it’s a huge market, and Takada has exclusive rights from
Regent to cater to that segment of the U.S. market.
Morgan (CEO): Steve Bogage [manager of Danish subsidiary] has suggested that his is a marketing unit and should be treated as a revenue center. Also, he thinks that managers should be rewarded using ROI [return on investment] since it is a comprehensive measure incorporating
not only the profitability, but also the investments we make in the subsidiaries.
Kimball (Controller): We could consider that, but you know the many limitations of ROI as a performance metric. For example, ROI encourages managers to focus more on short-run profitability rather than on long-term success.
Morgan (CEO): What about the demand from several managers of our foreign subsidiaries that we should track the budgets using the same exchange rate that we use in setting them?
Kimball (Controller): In that case, who should assume the responsibility for changes in the exchange rate?
Morgan (CEO): That’s the point. They feel penalized by our holding them responsible for dollar profitability when they cannot control the exchange-rate fluctuations.
Kimball (Controller): That’s incorrect! Who else can determine the sourcing, supplying, and pricing strategies better than the subsidiary managers? We already manage the transactions and translation risks at the headquarters. Shouldn’t they manage the operating part of the foreign exchange risk?
Morgan (CEO): Yes, I guess. We’ve always asked foreign subsidiary managers to address the economic effects of the exchange-rate changes in making strategic and tactical decisions.
Kimball (Controller): Moreover, most of our stockholders are based in the U.S. Maximizing dollar returns to them should be our top priority!
Morgan (CEO): But Takada has complained that the strengthening yen hurts his margins.
Kimball (Controller): That’s been his alibi every year. Ever since he assumed the responsibility of Japanese operations in 2000, Takada has been clamoring for higher bonuses, despite his unit’s unsatisfactory performance.
Morgan (CEO): But why should exchange-rate changes matter? I recall from my college economics course that purchasing power parity takes care of exchange-rate changes. In other words, inflation and the foreign exchange rates offset each other, leaving managerial performance unaffected by the exchange-rate movements.
Kimball (Controller): True, but that happens only in the long run. In the short run, exchange-rate movements might not fully reflect the differences in the inflation rates between the two countries [see the Appendix].
Morgan (CEO): So what should we do about that, Tracy?
Kimball (Controller): Maybe we need to revise the budgets for performance evaluation purposes.
Morgan (CEO): Should we institute new measures, such as market share, that Bogage has suggested on numerous occasions?
Kimball (Controller): If we incorporate the wish of each subsidiary manager in the PES, then we will need a different system for each manager!
Global Appliance Industry
As a result of mergers and acquisitions in the past three decades, the home appliance industry in
2015 has fewer than ten companies that together control about 50 percent of the global market. Some of the global players in the industry include Electrolux (Sweden), General Electric (U.S.), Maytag (U.S.), Whirlpool (U.S.), Matsushita (Japan), and Bosch-Siemens (Germany). The remaining 50 percent of the market is in the hands of country focused competitors. The overall industry has grown at a very slow pace, making competition among players very fierce. Growth for a particular company has come mainly from acquisitions or from stealing a competitor’s market share.  There are significant economies of scale in the manufacturing of components, such as compressors and motors that form a critical part of home appliances. Improvements in component design are essential in enhancing the functionality of home appliances in areas such as energy efficiency, noise control, and water consumption. The three major segments in the
home appliance industry are the low-price segment (where several eastern European and Chinese companies, and private label suppliers, compete), a mid-price segment (where Electrolux competes), and a high-price segment (where Bosch-Siemens, Whirlpool’s KitchenAid
subsidiary, and Maytag have positioned several products). The distributors of home appliances in the U.S. consist of major retailers (Sears, JC Penney, etc.), appliance stores, discounters (Sam’s Club, Costco Wholesale, BJ’s Wholesale Club, etc.), and builder channels (Home Depot,
Lowe’s, etc.). The retailers’ large size enables them to exert tremendous influence over the suppliers of home appliances in terms of prices, delivery, and credit terms.
Regent and Its Subsidiaries in Denmark and Japan
Regent, a publicly held U.S. company, is a global player in the home appliance industry with a wide range of products, including refrigerators, kitchen appliances, and laundry machines (washers and dryers). Regent’s 2015 sales were $1.1 billion. Regent’s overall strategy has been to participate in all three (low-price, mid-price, and high-price) segments of the appliance industry.
Regent has several subsidiaries in the U.S. and abroad. The foreign subsidiaries resulted mainly from Regent’s acquiring a majority interest in appliance companies during the mid-
1990s. These acquisitions were made in countries where Regent expected a significant growth in disposable income and in the proportion of two-income families in the population. These subsidiaries design, produce, market, and distribute appliances in the respective countries.
They also incur all their costs and generate all their revenues in currencies of their respective countries. The Danish and Japanese subsidiaries are, however, different in the nature of their operations, as described below.
The Danish subsidiary was established in 1997 as a marketing unit and has exclusive rights to market Regent’s kitchen appliances in Denmark. Denmark had an attractive base of customers who could afford high-priced kitchen appliances, who desired feature-filled cooking ranges, and who preferred foreign-made products. Demand has not been great enough, however, for Regent to justify putting up a scale-efficient manufacturing operation in Denmark. Moreover, a U.S. subsidiary of Regent that holds a proprietary technology to produce high-quality kitchen appliances has been experiencing excess capacity. Regent’s corporate management seized the opportunity by asking the Danish subsidiary to source its products primarily from Regent’s U.S. subsidiary, as long as the latter is able to supply the quantities needed. The transfer price (inclusive of transportation costs) is denominated in U.S. dollars and is negotiated between the two subsidiary managers; the price for each quarter is to be decided at the beginning of the quarter. There are no local suppliers of comparable kitchen appliances in Denmark. Most other businesses in the kitchen appliances market in Denmark are small private companies, producing and selling their products in Denmark only. The high-end U.S. product gives the Danish subsidiary a distinct advantage over local competitors.

The Japanese subsidiary was established in 2000 as a production unit. Using the excellence of Japanese engineers in component design and low-cost manufacture, the subsidiary produces low- cost laundry machines (washers and dryers) in Japan and sells them in the U.S. with sales prices (inclusive of transportation costs) denominated in U.S. dollars. The Japanese subsidiary has exclusive rights from Regent to sell laundry machines to discounters and builder channels in the U.S. under ‘‘store’’ brands that cater to the low end of the market. Manufacture of laundry machines in Japan is largely in the hands of domestic manufacturers that produce energy- efficient and compact machines for sale in Japan. Other ‘‘private label’’ suppliers of laundry machines to U.S. discounters and builder channels consist of local (U.S.) companies known for producing domestically, using lean manufacturing techniques.
Budgeted and Actual Profitability of Regent’s Foreign Subsidiaries
In consultation with the subsidiary officers, and taking into account the expected changes in market conditions in the forthcoming year, Regent’s headquarters set budgets for subsidiaries at year-end. For the foreign subsidiaries, budgets are communicated in local currency (LC) as well as U.S. dollars, using the exchange rate at the end of the previous year. The 2015 budgets, using the December 2014 exchange rates, for the two subsidiaries are given below.
Regent’s investments in the Danish and Japanese subsidiaries at the beginning of 2015 were as follows. These investments did not change materially during 2015.
The actual number of units sold in the two countries, as well as the product mix, practically met the levels budgeted for 2015 (50,700 units and 249,000 units in Denmark and Japan, respectively). The actual inflation in the home appliance industry in both countries was almost identical to Regent’s expectations reflected in the budget above. The actual performance of the two subsidiaries for 2015 was as follows:

The average economy-wide inflation in 2015 was 4.30 percent in Denmark, 2.25 percent in Japan, and 2.30 percent in the U.S. The specific inflation in the home appliance industry in each country paralleled the economy-wide inflation in 2015.

Answer 1

Regents strategy for using beginning of year exchange rate mechanism and average if year for budget setting is inappropriate as exchange rate mechanism in long run is offset by inflation across various nations and its purchasing power parity.

Hence Regents and subsidiary managers must adopt weighted average model of budgeting where budget takes into factors like inflation, current performance, industry wide benchmarking, purchasing power parity, exchange rate and all of them being assigned equal weights. This minimises risks from all parameters and efficient allocation of resources is thus possible with streamlined operations and cost effectiveness in budgeting.