Murmurs of the high profit margins of IT services firms coming down have been going around for some time now quite. Rising wages coupled with increasing costs of operation have been pointed out as reasons for downward pressure on margins. In reality, companies in the sector have sustained or actually improved margins and continued to generate shareholder returns through high growth and return on equity. Now with the sharp appreciation of rupee over the last nine months, t he debate has again gathered momentum.

For a typical IT services firm almost all the revenues are in US dollars, and to a lesser extent euros, while costs accounting for between 35 and 45 per cent of revenues are in rupees. These costs include salaries paid to staff, rental costs, administrative costs and the like. Thus, every 1 per cent appreciation in the rupee leads to a reduction in margins by 30-45 basis points (0.30-0.45 per cent), depending upon the currency diversification of revenues.

Previously, the rupee acted as a partial buffer against cost pressures, such as wages and rentals, due to its depreciation against other currencies. Now, not only is the buffer not available, the currency appreciation is actually adding to margin pressure. With a cumulative currency appreciation of 12 per cent since the beginning of the year, one would have expected margins to shrink by 3-5 per cent. However, an observation of last three quarters margins for top tier firms reveals they have managed to avoid the squeeze.

Increase in prices has been a major contributor to holding up the profits. For the first time, IT services firms have witnessed price increases over the last two years, which has coincidentally come at the same time as rupee appreciation and negated its impact. While existing customers have been hesitant to increase prices, new contracts have been won at higher rates. With differential of 3-4 times between onsite and offshore billing rates, there seems to ample scope to increase prices and yet retain attractiveness of offshore solutions.

Additionally, companies have begun to structure their contracts such that the risk of currency movement is shared with the customers. An example is stable prices within a certain price band of currency movement with resetting of rates if the rupee moves beyond the band.

Finally, the sector has been witness to maturing of processes and achievement of scale over the years. This has led to productivity improvements which buffer the impact of currency and other margin pressures to an extent. Many firms have also started scouting for acquisitions in Europe to diversify their currency exposure, but the exercise appears to be of limited benefit as their existing dollar revenue streams would continue to be exposed to the currency risk.

In summary there do exist levers with most firms to counter the impact of currency movement, at least to some extent. As with every measure however, the effectiveness will be determined by how well these steps are executed.