You need solid financial information to accurately predict margins
There has been a lot of discussion on managing risk on a dairy operation by focusing on margin management. While margin management sounds straightforward, producers must have solid financial and production information so their margin needs can be accurately predicted.
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The purpose of margin management is to systematically evaluate differentials between an output and an input to make profitable short-term and long-term decisions. Margin management is not focusing on a set price for milk or feed.
Margin management focuses on the differential that is necessary to cover all remaining expenses after feed expense, while still providing a return to the business.
Many producers develop an annual budget to use to help manage their business. Budgets are an excellent tool for producers to use to predict the profitability of their dairy. The problem with budgets is that the market is not stable, and with the huge swings seen in milk and feed prices over the past few years, making marketing decisions based on a budgeted price has not ensured profitability.
In the past three years, milk prices have varied by as much as $8 per cwt. within six months, corn by as much as $2 per bushel in a month, soybean meal as much $250 per ton in six months, and hay $120 per ton in three months. The milk and feed markets do not necessarily move together and sometimes move in opposite directions.
As a result of these dramatic variances, dairy managers have been on an emotional roller coaster as they try to make marketing decisions and often are second-guessing the decisions they have made.
Therefore, it is critical to know your cost beyond feed expense to effectively manage margins. These costs are usually much more stable. The budget is a great source for this information.
In addition to knowing these expenses, it is also important to understand what type of profit margin you would like to obtain for your business. Be realistic in establishing the profit margin. A good starting goal would be an 8%-10% return on assets. When non-feed expenses and the profit margin are added together and non-milk revenue is subtracted, the dairy is left with its desired margin over feed cost.
Once the desired margin over feed cost is known, it is divided by the projected milk production for that time period to determine the desired margin over feed cost per cwt.
The volatile part of margin management is taking the milk price per cwt. and subtracting from it your total feed cost per cwt. to determine if the remainder will cover your desired margin over feed cost per cwt. When subtracting feed costs, include the cost of both purchased and home-raised feeds.
Marketing does come into play with margin management. You need to ensure you have a balance between the amount of output (milk) you are marketing and the amount of input (feed) that you have marketed. If the percentage of your feed and milk that are forward-priced are not balanced, your dairy operation may be taking on more risk than it would have with no risk-management program.
There will be times when the markets will not provide you the desired margin over feed cost that you are looking for in your business. During these times, you will need to decide if the environment could present an opportunity down the road to obtain your desired margin over feed cost. Or, alternatively, or if the environment is such that for this time period, your business will need to settle for less than your desired return on assets. A critical number to know during these times is what the minimum margin over feed cost is necessary to maintain your net worth.
Each dairy business is unique, and it is key that you understand your leverage as you decide on your marketing decisions. When a dairy has more leverage, the amount of price risk that the business can handle is less. Then, this business could settle for a lower return on assets until it has improved its leverage position.
The focus of margin management is developing a system that helps ensure profitability of the business. It’s not a system to ensure the highest milk price or the lowest feed cost. Margin management helps take the emotion out of marketing and helps you feel confident in your business decisions.
Editor’s Note: Steve Bodart is a senior agribusiness consultant and dairy industry leader with Lookout Ridge Consulting. Contact him at (715) 308-9888 or firstname.lastname@example.org.