AgDM newsletter article, November 1997

Developing a risk management plan

By Phil Hufferd

The level of risk facing the farm business has increased dramatically in recent years. So, the development of a sound risk management plan is critical to the success of your farm business.  Developing a risk management plan involves answering these four questions:

1.       What can cause a substantial income shortfall in my business?
2.       How much shortfall will it cause?
3.       How much shortfall am I willing and able to bear?
4.       How can I limit the shortfall to an acceptable level?

Below is a discussion of each of these questions.  They can be used as a process for developing a risk management plan.

Cause of the shortfall (question 1)

Answering this requires you to identify the risks that can severely disrupt your business.  In this article we will confine our discussion to identifying risks associated with loss of cash flow and net worth from producing and marketing crops.  However, this is just a small sample of the myriad of risks you face.

To help identify risks in your business you can classify them by type of risk.  One type of risks is outside (external) of your business.  The other type is internal to the business.

External risk factors
These are risk factors outside of the business.  Examples are market prices and weather risk.  You have little or no control over external risk factors.  All farm businesses face external risk.  However, these risks affect each farm business differently.  So it is important to develop a risk management plan specific for your business.

Internal risk factors
These are risk factors within the business.  Examples are high levels of financial and operating leverage, a high degree of specialization, and locking oneself into long-term decisions.  To identify internal risks you must know the physical and financial characteristics of your business.

Size of the shortfall (question 2) 

This requires knowledge of your business’ yield history and production costs.  You must know the yield history of your farm and estimate the probabilities of lessor yield and price outcomes.  A good set of production records for your farm is the best source for developing best case, worst case, and most likely yield scenarios. 

Similar scenarios can be developed for sale prices. These scenarios can be developed with the assistance of price outlook information.  The Iowa Outlook Letter from ISU Extension is a good example.  By combining your yield and price estimates with a good set of production cost information, you can calculate the income under different price and yield scenarios. 

Ability to bear the shortfall (question 3)

This requires identifying your ability and willingness to bear risk. It involves calculating the impact of the shortfalls identified above (questions 1 & 2) on your business.  Knowledge of your business’ liquidity and equity position is essential in determining your ability to bear risk. Cash flow requirements and equity positions can vary among producers. Identifying your willingness to bear risk is more of a personal decision.

How to limit the shortfall (question 4)

This involves developing strategies to limit the impact of an undesirable outcome on the business or improve the ability of the business to withstand an unfavorable outcome.  It requires gathering information about various risk management tools and techniques.

Ways of reducing price and income variability involve using strategies to shift risk to others by using tools such as crop insurance and pricing tools such as forward contracting, futures, and options.  Ways of reducing production variability include diversification strategies such as planting more than one corn hybrid or using a corn-soybean rotation as opposed to continuous corn.  Farm operations that are geographically dispersed may also experience reduced risk from localized weather, insect, and disease factors.

In addition to increasing profits, improving profits margins helps the business withstand an undesirable outcome.  Ways of reducing costs and increasing profit margins might include taking manure credits to reduce fertilizer costs, field scouting to reduce input costs, and spreading fixed costs through joint machinery ownership arrangements with neighbors to more fully utilize machinery capacity.  

Structuring the business to withstand an undesirable outcome involves managing debt to keep financial leverage and debt service requirements at an acceptable level, utilizing share or variable cash leases, and avoiding excessive levels of cash rent.

Risk management techniques
There are four general types of risk management techniques that can be used to limit a shortfall (question 4).  Choose the techniques that work best in your situation.

Conclusions

There is no single risk management formula for all farms.  Sound risk management plans need to be developed for each farm business.  You can use the procedures outlined above to help you identify and quantify the risks facing your business and select risk management techniques that fit your farm situation.

 

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