During the past 12 months, we have seen near-record-level milk prices in most areas of the country and most recently low milk prices which rivaled the last 10 years.

Many questions need to be asked before an expansion is considered. Some of them include the following:

1. Why does the operation need to expand?

2. What will the new operation look like?

3. Where will the new operation be located?

4. How will the operation be different from a management perspective?

5. When is the best time to expand?

These questions are interrelated and need not be answered in any certain order. However, No. 1 is probably the most important and requires the most consideration before going forward.

Why the operation needs to expand
This question continues to be one of the most-discussed issues surrounding agricultural economics as it relates to production agriculture and family-owned and -operated agribusinesses. When a family member decides to join the operation, many times the first impulse is to expand. While this may be an acceptable decision, a thoughtful review of the situation should be done to determine if this is a logical choice.

For example, if the operation is currently profitable and operating at optimum size and scale, does it make sense to expand? It’s possible that there might be another way for an additional family member to enter the operation without expanding. Perhaps there is a new enterprise related to the dairy operation that could be added and/or expanded in some way to enhance overall profitability without changing an already efficient system. An operation needs to be examined very carefully when a new family member is joining in order to determine the proper strategic path to follow.

Other valid reasons to expand certainly may exist. There could be an opportunity to acquire another facility or additional land or other resources that are important to the overall well-being and potential growth of the operation. Another reason for expanding might be because management expertise is superior and capable of handling more size, scope and responsibility. All of these are valid reasons.

Historically, we have seen operations expand because they speculate that prices will go up and they are trying to “time the market.” We have also seen operations that are struggling to survive and falsely believe that being bigger will make them profitable. These are dangerous reasons for deciding to expand and should be weighed carefully. Again, it is important to examine the reasons why the operation needs to expand and confirm that they are legitimate.

The ‘what, where, how and when’ questions
The remaining questions on expansion need to be carefully thought out, discussed, researched and confirmed. Although finding the correct answer to each question is critical to the success of the expansion, the “when” question in particular needs careful consideration. A number of factors can influence this decision, and proper planning is necessary in order to avoid roadblocks. Volatility in prices of feed, cows, materials and milk can greatly influence the success of an expansion. As part of the “when” answer, forward contracting and/or hedging of these commodities may make sense as part of controlling costs after a completion date is calculated. This helps to enhance the integrity of financial projections and the business plan that is presented to a lender.

Financial projections are very important in the confirmation process. Bankers will want to see a business plan along with the economics of the expansion. Developing several versions that use different input cost levels and milk price assumptions can be helpful in understanding what drives solid margins and profits. It is also important to use historical production levels in order to project revenue, as it adds creditability to the numbers by taking current management history into account.

Project costs
Just as feed costs and cow prices can rise, so can the cost of construction. These other costs have gone up. This needs to be given careful consideration when projecting the cost of expanded facilities.

A common mistake during this process is to underestimate facility construction cost. Almost every project comes in over budget by 10 to 20 percent. With the price of material rising and the tendency to underestimate construction cost, the area of project cost can be a slippery slope to navigate.

A related problem is a delay in completion and, ultimately, a delay in cash flow from the expanded operation. More money is needed to finish the project, and it will take longer before the project begins to pay for itself. Farms and lenders should plan accordingly by budgeting and approving 20 percent more than the highest cost expectation and by assuming another 90 to 120 days to completion from the latest projected date.

Summary
An expansion to a dairy operation needs careful consideration and planning before it is initiated. This includes the why, what, when, where and how questions to be answered. The most critical of these is the question of why the operation is expanding. Once that is answered, the other questions need to be addressed as well. Timing is very important and cost considerations need to be taken into account.

Developing a business plan and creating financial projections are ways to demonstrate to a lender that expansion makes sense, and the debt can be paid back in a timely fashion. This will add integrity and creditability to the relationship as the expansion unfolds. PD

Larry Davis
Vice President
KeyBank Food and Agribusiness Team
Larry_W_Davis@KeyBank.com