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After the Highs: Why You Still Need that Margin Management Plan

Jun 17, 2013

Don’t let a "woulda, coulda, shoulda" mentality set in if you’ve missed a pricing opportunity. Here’s advice on avoiding that trap.

chip whalen thumbBy Chip Whalen, CIH

Forward dairy profit margins have been in retreat over the past several weeks as milk prices have come down from loftier levels back in April. Meanwhile, feed costs have largely held steady or even increased in some cases as with soybean meal.

In the bigger picture, forward margins still exist at relatively high levels from a historical perspective, although some producers may nonetheless be discouraged that current margin projections are not as strong as they once were. This can be problematic on a number of levels. A "woulda, coulda, shoulda" mentality may set in where one feels badly to have missed an opportunity. This is not only unproductive because there is nothing a producer can do about it in hindsight, but even worse it can begin to cloud future decision-making.

Many readers of this space probably identify with Katie Krupa’s recent post in discussing the emotions that come into play when making marketing decisions. To experience the feeling of having lost an opportunity stirs up emotion which can be very hazardous when facing important financial decisions for your business.

As an example, maybe you would look at the prior margin opportunity as the benchmark to now shoot for and opt to do nothing until that opportunity presents itself again. Should margins continue deteriorating and possibly go negative, you might panic and make a rash decision to stop the bleeding and contract at unfavorable levels. While some of you reading this might think they would never find themselves in that position, I can tell you that I have experienced this firsthand and it is more common than you might think.

How does one avoid this trap? Emotions can run very strong and are quite subjective – personal experiences that vary from individual to individual. One way to keep emotions in check and limit their impact on your marketing is to bring objectivity into the decision-making process. In reading through Katie’s post that I previously referenced, she mentioned making decisions based upon the financials of your business and the concept of establishing goals.

I think this is a key point that deserves more attention. We believe it is critical for a dairy to establish goals and objectives in helping to refine their decision making process, and this all starts with a clearly defined plan. What is an acceptable return for my operation? How much risk am I willing to accept in trying to achieve this return? How much capital do I have access to that can assist me with margin management strategies to protect forward profitability?

These are some of the questions that come up in drafting what we refer to as a margin management policy that clearly spells out what the goals and objectives are, and how we intend to achieve them. This does not have to be a complicated document, but serves as a roadmap for determining where we want to go and how we plan on getting there.

Just as you might plan a summer driving trip and consider all the possible roads or routes that can bring you to your destination, you might similarly lay out all of the different marketing tools at your disposal to protect both your forward feed expenses and milk revenue. This might include an array of cash market contracting alternatives such as forwards, hedge-to-arrives, basis contracts, min/max combinations, etc. It might also include derivative alternatives including exchange-traded futures and options.

What are the features of these various contracts? What are their costs and limitations? When might I choose to use one alternative over another? This is where some of those initial questions come back into play, such as how much risk I am willing to accept or how much access to capital I have to allocate to the process. A more refined approach to marketing starts to present itself when certain alternatives can be eliminated, which may not fit with my tolerance for risk or level of capitalization. What about my goals and objectives? Perhaps I can define forward profit margin levels that represent returns for my operation which are attractive based upon the investment that I have in the business. What if I could set targets that trigger alerts telling me when this level of projected profitability has been achieved in a forward time period?

I might consider in advance what types of strategies or positions I would elect to use in the market to protect my forward profitability should an opportunity present itself, such that I was ready to take action once that event occurred. What I am describing is the process of crafting this margin management policy so that the decision making becomes objective and clearly defined.

Katie also mentioned the idea of including an outside advisor in helping with these decisions. In addition to someone like herself or myself who might assist in navigating through the various contracting alternatives at your disposal, another key partner in this process is your lender. Despite what some people might think, your lender is a very important stakeholder in your business, and wants to see that your dairy is successful and profitable. Including them in the discussion of your goals and objectives and how you might use various contracting alternatives might lead to opportunities of incorporating certain tools you would not have otherwise considered.

While a margin management plan cannot promise that you will "hit the highs" on milk or "catch the lows" on feed, it can bring a lot more structure and objectivity to the decision making process. It can even become quite granular and sophisticated, spelling out what types of strategies to use on each piece of the margin, depending on what levels of historical profitability are on the table for instance, or under what circumstances those strategies may be adjusted over time.

Regardless of how simple or complex the plan is though, one major benefit of having it in place is to remove the natural emotion that comes into play when faced with making key financial decisions for your business. You put a lot of care and attention into how you care for your dairy herd and the quality of milk you produce. Similar attention should be paid to how you are securing forward profitability to continue dairying successfully into the future.

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com.

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