The definition of “risk” might be different for everyone. Whichever definition you choose to use, it frequently does not have a positive connotation. Dairy farmers are exposed to many forms of risk, from falling milk prices and rising feed prices to personal injury or the breakdown of a piece of farm equipment. Fortunately, there are many ways to mitigate these risks if managed properly.
There are several types and categories of risk. I like to place them into four main buckets: strategic risk, operational risk, compliance and regulatory risk, and financial risk.
1. Strategic risk
Strategic risks are those that affect your operation on more of a long-term basis. A good recent example of this is the change in the Class I price calculation from the “higher of” to “the average of Class III and IV plus 74 cents per hundredweight” made in May 2019. This change was implemented to make hedging easier and was meant to be revenue neutral to dairy farmers. In reality, the change caused significant monetary issues in early 2020 when the COVID-19 pandemic hit. Dairy farmers continued to feel the effects of this change through 2021 and 2022.
Other examples of strategic risks are the closing of a local milking equipment dealer or feed mill, or a housing development built next to the dairy.
2. Operational risk
Operational risk and strategic risk are similar, but operational risks have more to do with a dairy business’s short-term ability to operate. Chances are, you have already dealt with operational risk issues today. This type of risk can be as simple as someone leaving a gate open and letting a group of cows out or the tractor battery being dead when you tried to start it this morning.
These risks are somewhat easily managed by following standard operating procedures or keeping spare parts to fix common problems.
Of course, major problems you cannot fix yourself or that require days or weeks to fix may become a financial burden. A barn collapsed by snow or a fire would fall into operational risk that would be costly to the dairy business in the short term and could potentially develop into strategic risk if repairs are not financially feasible or cannot be completed in a timely manner.
3. Compliance or regulatory risk
Dairy farms have plenty of compliance and regulatory risks as well, from milk quality and animal welfare to nutrient management. Failure to address those risks can lead to lost markets, restrictions on growth plans or fines. Various tools are available to manage those risks, including the National Dairy Farmers Assuring Responsible Management (FARM) Program and a comprehensive nutrient management plan (CNMP).
4. Financial risk
The last bucket of risk is financial risk. The previous buckets may have financial consequences, but financial risk is often more market-driven. The easy ones to identify here are milk and feed price changes. Other examples include interest rate changes and credit availability.
Although you may not have much or any control over these, there are opportunities to help you mitigate the impact. With interest rates on the rise, maybe it is better to lock in a fixed rate on that next loan versus a variable interest rate.
Managing your milk price risk through programs such as Dairy Margin Coverage (DMC), Dairy Revenue Protection (DRP), Livestock Gross Margin for Dairy (LGM-Dairy), fixed contracts or other hedging programs will help protect you against an unexpected decline in milk prices.
The feed bill for a dairy operation may be as much as 60% of total expenses. Hedging feed commodities can help keep your feed costs down. Purchasing coverage through the Federal Crop Insurance program can help protect against increased feed cost by providing income to buy feed in the event of reduced yields due to drought or overly wet growing seasons.
Guarding against milk price drops and feed price increases can result in a much more positive or stable margin than living by the whims of the market.
Identify, cover costs
Managing financial risk is key to being able to navigate today’s volatile milk markets. What do you need to know about developing a risk management plan to minimize loss in income due to milk price decreases? The main purpose is to cover your cost of production, with an added benefit if you can lock in a profit.
If you know your cost of production is covered, you know you can pay yourself and your employees, stay current with your accounts payable and make your loan payments. If you do not know your cost of production, how can you know that your risk management plan will work?
The first step is to calculate your cost of production. If you do not know how to do this yourself, there are many ways to get help. Your lender, accountant or university extension may be able to help with the process. Once you know your cost of production, you will know what target milk price you need, and then you can develop strategies to make sure you are hitting your targets. The second step is to learn or work with someone who knows and understands the risk management opportunities available.
Once you know what programs or strategies you want to use and what they cost, determine what you are willing to spend on risk management. Make sure to include the cost of your risk management plan in your cost of production. That way, you know you will always be able to pay for your risk management plan even if it does not return a benefit.
One thing to remember is that risk management is like insurance. There is a cost to use risk management, and just like insurance, you will have a premium to pay regardless of whether you receive any benefit. I like to use the example of fire insurance to illustrate this point. I do not know anyone that buys fire insurance hoping their barn burns down. They buy insurance for the slight chance that it does.
Risk management is no different from that. If your risk management plan does not return a benefit, it means that markets remained positive enough that poor conditions did not trigger your risk management plan. This is a good thing. Once your risk management plan is developed, make sure it is in writing so you can refer to it as needed.
Flexibility and consistency
A risk management plan is not necessarily set in stone. If the plan is written, it can be reviewed periodically and updated as needed to meet the ever-changing needs of your operation.
Lastly, the most successful risk management plans are those that are used consistently. It is easy to be tempted to jump in and out of markets as you try to guess milk price directionality. However, trying to guess the market is not easy or very accurate. Using an effective risk management plan may mean that you occasionally give up the top side of milk price markets, but you will also miss the lows. This will give you a more stable milk price, making it easier to do financial planning and making you more capable of meeting your business goals.
