JD bwThis two part series we will explore the fundamentals of risk management, starting with what risk is and the ways we manage it. Following that will be our second post on industry trends, methods, and tools that are in place to mitigate that risk.

Risk

When we contemplate risk, we often think only about potential loss and tend to focus on the adverse consequences associated with it. But the word risk means “to dare”, which implies that we have choice to take it or leave it.

So why would we willingly take on risk? Because even though there is a possibility of loss there is also opportunity for reward! This reward is what attracts an entrepreneur to invest in a new business venture or an athlete to chance injury in pursuit of a championship. Success, however, often walks a fine line between being too conservative and taking on too much risk.

Just like the athlete or entrepreneur, a farmer is no stranger to the risk/reward conundrum. Year in and year out producers depend on an uncountable number of variables that determine how well their crops and livestock will produce. Some variables are uncontrollable by the producer, but some are within their control.

The most common risks that have the potential to affect the Ag industry can be classified as:

  1. Production risk (weather, insects, seed quality, disease)
  2. Price risk (input costs, sale prices)
  3. Casualty risk (hail or wind storms, fire)
  4. Technology risks (equipment failure)
  5. Uncertainty risk (lease or rent terms, borrowing costs, government programs)

With so much left to chance, savvy farmers look to remove risk from the aspects of their operation that are within the means of their control. Though we have not found ways to change the weather, there are ways for farmers to manage the amount of risk they take on, in almost every other aspect of their operation. When the goal is to maximize profit, and to minimize loss, some of the most common strategies include insurance, equipment warranty, regular inspections and service, and investing in high quality feed, seed, and spray,   There is no way to eliminate all risk, but there are plenty of ways to help manage it. The key is finding the balance that works for your operation.

 Risk Management

The first step in understanding how to manage risk starts with how to quantify it.  This is traditionally done by identifying the probability that the risk will occur and measuring the potential impact that the consequences would have on your operation. The level of risk will vary from farm to farm, and depends on the size of the operation and the level of reserves that are in place. Once the risk has been quantified, it can then be handled in one of three ways: it can be absorbed, avoided, or transferred.

Absorbing the risk can be very appropriate when times are good and there’s sufficient capital to withstand a catastrophic event without excessive impact to cash reserves.

Another option is to avoid risk. While we cannot avoid all risk, we can do our best to plan ahead. Examples of avoiding risk would be planting a crop for the current and predicted weather conditions, buying quality equipment with extended warranties, and having a preventative maintenance program.

The last method to manage risk is to transfer the risk to someone else. Some of the common methods of risk transfer include crop insurance, physical damage insurance, futures and options contracts, as well as equipment warranties. Transferring of risk comes with a known cost, so this method is a way to convert variable expenses into fixed.

Risk cannot be completely eliminated, nor would you want to as it can hurt your chance to make a profit. However, you want to reduce your risk to acceptable levels to help minimize loss. Walking the risk/reward tight rope is no easy task. Finding the right balance for your operation can mean the difference between success and failure.

Stay tuned for the follow up to this post where we will discuss industry trends and tools used to mitigate risks.