The years of 2008 and 2009 are still very vivid in the minds of the dairy farmers who weathered the huge drop in milk prices during those years. This period of time, known as the Great Recession, is also stuck in the minds of the rest of the world.
But let’s focus on dairy farmers, who are the pillars of their communities and local economies. Many of them were forced to sell their herds because, unlike machinery that can be stored away, cows had to be cared for – at a cost.
Fast-forward to late 2016 – milk prices experienced an uptick and as I write this article, and despite the frigid temperatures across the U.S., the milk price has hit a two-year high at $17.40 per hundredweight (cwt), according to the USDA.
That is $3 more than a year ago, yet farmers are still treading carefully, hoping this will continue into the year ahead. Now would be a good time for producers to position themselves before prices drop again.
In this article, we will begin by trying to understand the nature of risk and how to create a simple risk profile. Then we will discuss how to use that risk profile for financial planning and risk mitigation to ensure a successful operation.
What is risk?
Fundamentally speaking, risk is a possibility of something untoward happening with a certain level of probability. The key to risk management is the ability to predict (based on current and past information) an event happening (whatever the event may be).
Where are the risks?
Farmers need to begin by understanding what the key risks are to their operations. There is no standard that everyone can copy; each farm’s context is different since they operate in different environments.
Establishing a risk profile begins with understanding where the risks are hidden. This can be accomplished via a simple method called the SWOT analysis. It stands for:
- S: Strengths of the operation (good genetic herd, good-quality feed, etc.)
- W: Weaknesses (poor sanitation, small acreage, etc.)
- O: Opportunities (opening of new markets like China, new government)
- T: Threats (greater competition, more regulation)
A good way to think about the above is that strengths and weaknesses are internal to the farm while opportunities and threats emanate externally. As the name suggests, this is a simple exercise of listing these for the operation to try and understand structurally what lies in the future.
The next step is to understand what risk scenarios can happen. Once individual scenarios are enumerated and understood, we can understand the risks hidden in each of them.
For example, if a new government is taking charge and is less business-friendly, it could create a risk of suppressing demand for milk (for a host of reasons beyond the scope of this article). That risk can then be measured via a simple quantified approach described below.
Understanding, cataloging and quantifying risks
A good way to think about risk management is to make a list of all the possible things that can go wrong in the operation. This can be categorized into risks originating internally (breakout of a disease, cows with mastitis because of poor work practices) or externally (milk prices plummeting, government regulations).
Once you categorize risks, you can assign them a probability number from 1 to 10 (1 being low and 10 being high probability of happening). Then you can assign another number that assesses what the impact would be if that risk was realized (1 to 10, with 1 having no impact and 10 catastrophic).
If you multiply the two numbers, it will give you a number to quantify the risk and also compare with the other risks. This number is generally referred to as the risk index value.
The probability that the incoming government will changes regulations that will bring milk prices down by 10 percent = 4
The negative impact on the farm finances if milk prices drop by 10 percent is really high = 8
So the overall index number is 8 x 4 = 32.
If a producer does this for all the risks, they later can be arranged in a descending order. This is not a perfect method since it’s a little subjective; however, it is a good place to start by creating a consolidated risk profile (and above all is very simple to do).
This will provide a visual idea of where the producer stands and can help with his or her financial plan strategies, starting with the highest-ranking risks.
All of the farm’s financial key indicators (cash holding, reserves, etc.) should be based on a risk assessment and a producer’s risk appetite. The lower the appetite for risks, the higher the reserves.
Financial planning is imperative
Financial planning will help the farm manager determine the short- and long-term goals of his operation and how to meet them. This enables a manager to make easier financial decisions and stay on track to meet the dairy’s goals.
Being able to compare forecast numbers to actual results will provide valuable information of the overall financial health and efficiency of the farm (and of forecast accuracy for future decision-making).
Not only is this information important for the owner, and the spouse, but also the lender. The financial plan should include a balance sheet (solvency), income statement (profitability) and, most importantly, a cash-flow plan (liquidity).
The cash-flow plan is especially important for a farm. Many producers have an “asset rich but cash poor” status. This puts them in a difficult place to balance a budget between money coming in and bills being paid.
With all this information, the producer will be able to clearly identify the farm’s financial strengths, weaknesses and opportunities for investment. They will also have the opportunity to benchmark the cost of production against similar operations while continually analyzing the benefits and costs of decisions.
Maximizing assets in bad times and in good times
When margins are narrow or almost nonexistent, it is important to think out of the box and pay attention to the details. For example, let’s look at equipment; this can be an expensive item for the farm, yet the cost can be shared with neighboring farms over more acres if equipment is used collectively. Renting out equipment might also cut costs.
Reproduction is also another key area to focus on. Are your cows breeding back as quickly as they should? Are you monitoring compliance when using a synch program? Feed is an incredibly important component of this equation.
Managing forage inventory and quality is essential because of the significance it has in terms of economics and herd performance. This becomes critical especially during winter months where forage costs can spiral if herd nutrition needs are not met (in case the farm runs out of forage and it needs to be purchased on open market).
Feed costs represent a big portion of the total cost of producing milk. According to a publication from the Penn State Dairy Extension website, there are two measures utilized to monitor feed costs and milk prices: income over feed cost (IOFC) and milk margin.
These are two of many tools available to monitor milk prices and feed costs that affect farm profitability. IOFC measures gross profits on a per-cow, per-day basis and is ideal for assessing the impact of management and feeding decisions. Let’s review its formula:
IOFC = Price of milk ($ per cwt) x (daily average milk production [pounds per cow per day] / 100) – daily feed costs ($ per cow per day)
Both the IOFC and milk margin reflect the difference between milk price and cost of feed.
Milk producers can track their monthly IOFC measures and calculate averages, which will provide them with more information at the time of making a decision. As a side note, processors and futures contract brokers tend to focus more on the milk margin, which measures gross profitability on a per-cwt, per-day basis.
Utilizing IOFC monthly can help managers understand where the farm stands financially; this is especially useful when the price of feed is high and the price of milk is low, or both.
Progressive farms are monitoring feed costs and milk prices diligently in order to have some control over their profit margins. Because of its simplicity, the index can be calculated monthly and compared throughout the year.
The Penn State Extension Dairy Team developed a nifty app that can help you calculate your own income over feed costs. The app also has a feed price comparison section. IOFC is just another tool available that can be used with the futures market, helping producers lock milk and feed costs and giving them some degree of control over gross profits.
Proactively manage your risk
Knowing your numbers is key for creating a risk management plan and calculating cash flow, cost of production and breakeven costs, to name a few. This will allow you to understand and create a plan to mitigate price fluctuations in today’s dairy market.
The U.S. dairy farmer has multiple resources to help mitigate risk: the Chicago Mercantile Exchange for futures and options, forward contracting through a co-op or processor, the government-sponsored Margin Protection Program and over-the-counter trades.
It’s imperative to understand all the options available and which one best applies to a producer’s unique situation.
Always discuss your options with a financial professional who understands the business. There is no cookie-cutter strategy that will work for everyone since there are different financial needs for every farm and market that is in constant flux.
Like playing a game of chess, understand what strategies can be implemented beforehand if things dramatically change. Remember, you are buying your peace of mind, reducing risk and providing more stability.
Tighten your belt during good years and more during bad years
The temptation to purchase new things during a year of bonanza is almost inevitable. This is a sure way of making your farm vulnerable to cash deficits. It’s important to take advantage of the cash-cow year and pay off lines of credit, open accounts, short-term debts or credit cards.
This will make your lenders happy – and when you need them again, they might just be there for you. It’s also not a good idea to increase capital purchases as a tax management strategy.
Save, save and save some more. Cash is king – so when you need it for unexpected expenses, you will have it available. The amount you will put away will depend on the farm, but a ballpark number to have in mind is six to nine months’ worth of cash.
In conclusion, begin at the start by understanding what and where the key risks are to your operation. Based on that risk profile, having a financial plan in place and monitoring key performance indicators even when milk prices are doing well will help producers adjust in a timely manner.
References omitted but are available upon request. Click here to email an editor.
Ximena del Campo
- Dairy Consultant
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