Managing business and production risk

Take home messages

• Managing risk involves dealing with the downside and the opportunites in the long-term nature of farming.
• There is no reward without taking some risk, but the level of risk is a personal choice by farmers.
• Advisers play an important role in quantifying and discussing how to manage the risk, but ultimately it is the farmer’s choice.

Introduction

There is a great deal of talk about risk in farming but little discussion about what it really is. The outside perception is that farming is a risky business. What does this mean? What are the risks and do we have any control?

Farming is a long term, highly variable low margin business that requires competent and skilled management for success. With appropriate management, farming is profitable over the long term.

The key to success is implementing a production system that is sustainably profitable and maintains the capacity to remain “in the game”. Access to working capital is a critical part by which a business has the capacity to remain “in the game”. Therefore, the inability to access sufficient working capital is a major risk to the long term success of a farming business. By managing a choice of enterprises that optimises risk, farmers have a much bigger chance of managing their risk and 'staying in the game'. But how do you determine the right mix for you?

Variation is a normal feature of farming and is often confused with risk. Over the long term, the variation of price and season is predictable. It is the decisions that are made within the farm business that create the risk from this variation. The main question is one of how we manage the farm production system and business within the normal year-to-year variation.

A few concepts related to risk

Defining risk

The most common definition is: risk = likelihood x consequence

In other words, risk is how often an event happens (the frequency) and what is the impact (the value) when it does happen. A decision that increases risk will have either increased the likelihood of an event happening and/or increased the consequence if it does occur. This increased consequence may be a greater return, not just a greater loss.

What is risk management?

Risk

Definition (Oxford dictionary):  

“Risk is a situation involving exposure to danger”.

“The possibility that something unpleasant or unwelcome will happen.”

Management:

Definition (Oxford dictionary):

“The process of dealing with or controlling things or people”.

Therefore risk management is: “The process of dealing with or controlling a situation involving exposure to danger or the possibility that something unpleasant or unwelcome will happen”.

There are two broad types of risk in farming that we need to consider; business risk (which includes a full range of production, weather, price and human risks) and financial risk (gearing, debt/equity). Financial risk can exacerbate business risk. The analysis presented in this paper is focussed on part of the business risk (price, yield and costs). The subsequent structured discussion deals with the human side and puts the business risk into perspective.

The tension between risk and reward

There is no reward without risk. Risk is a necessary part of making returns. You can make decisions to reduce risk, but it usually comes at a price, namely lower returns. Managing risk is about making decisions that trade some risk for some return. The challenge is that human beings usually want both high returns and low risk. This is not easy to achieve.

Risk, uncertainty and probability

Often risk and uncertainty are used interchangeably but I believe there is a useful distinction. Risk has knowable odds that something will happen, uncertainty is happenings with unknowable odds (‘we couldn’t have predicted this one was coming’). Because risk has odds or probabilities, we can use this knowledge to calculate the likelihood of certain events occurring. This approach is used in the Grain and Graze analysis.

A farmer's position towards risk

Everyone has a different position on risk and this position is constantly changing. Importantly no position is right or wrong, it is what the farmer is willing to live with. We can conduct activities that help farmers understand their position on risk that can be useful in helping to understand why certain choices are made, but ultimately you have to accept their position is right, and work to help them achieve this.

@RISK- the Grain and Graze analysis

One component of the Grain and Graze programs has been to support farmers, advisers and consultants in understanding the risk in the farming business. The various activities have been intended to help explore a farmer’s current level of risk and what impact changes to enterprise mix or improvements within an enterprise may have on this risk.

The analysis conducted is not intended to determine the optimum level of risk. This is an individual decision based on many things including soils and climatic conditions, a farmer’s skills, personal preference, stage in life, debt levels, succession and importantly the amount of risk a farmer wishes to take on. The discussions advisers can have with a client around the analysis can help to explore the level of risk but it does involve a lot more than just production and prices.

Nor is the analysis intended to simply minimise risk. What we do is understand the current risk profile of a business and explore the implications of major enterprise changes to help inform some big picture questions. The answer to these questions will be unique – different for every individual.

Quantifying the production and price risks

The first step in managing risk is to understand the risk in the business. Historically when we wanted to compared different options we would conduct analysis using average values, such as the average price of grain, the average expected yield and the average expected costs. So to work out our expected profit we would use the average yield by the average price less the average costs. This type of analysis is OK if we get the average values, but in agriculture we rarely do!

If we are uncertain of a value or a result we will test the calculation with a couple of values either higher or lower than the average (scenario analysis). The problem with most scenario analysis is the values do not have a frequency with them (how often this value happens) and when we change a value, we assume all other variables remain the same.

The key drivers in agriculture, namely yield, prices and some costs have a range of values over time. If we use the average method, it usually over estimates the profits and hides the volatility in those profits.

Managing risk is not about the middle or the expected, it is the opposite; it's what happens at the extremes that's important. This includes managing for the inevitable poor results but equally important is what we do when we get a good result.

The analysis in Grain and Graze uses ranges and probabilities for prices, yields and some costs to calculate the range in profits for a farm. It shows how big or small the profit is when the extremes in yields, prices and costs occur, how often it occurs and which of these variables is contributing the most to the volatility and the extremes

This makes the analysis more realistic because it combines a value (how big or small) with a likelihood (how often). This builds context and helps us understand exposure and risk. With this information we can then start the conversation.

Contact details

Ashley Herbert
ashley@agrarian.com.au

Danielle England
dannielle@aginnovate.com.au

David Watson
david@agasset.com.au