Implementing margin management

By Steve Bodart, senior dairy consultant, Compeer Financial

There has been a lot of discussion on managing risk on a dairy farm by focusing in on margin management. While margin management sounds straightforward, farmers need to have solid financial and production information so that their margin needs can be accurately predicted.

The purpose of margin management is to systematically evaluate the differential between an output and an input in order to make profitable short-term and long-term decisions. Margin management is not focusing on a set price for milk or feed. Rather, margin management focuses in on the differential that is necessary to cover all remaining expenses after feed expenses while still providing a return to the business.

Many farmers develop an annual budget to use to help manage their business. Budgets are an excellent tool to predict the profitability of a dairy farm. The problem with budgets is 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 between the Class III price and basis have varied by more than $5.00/cwt within six months. Corn, soybean meal and hay prices have varied by as much as $25, $75, and $100/ton respectively, within six months. The milk and feed markets do not necessarily always move together and sometimes move in opposite directions. As a result of these dramatic variances, dairy managers have often been on an emotional roller coaster as they try to make marketing decisions and often are second-guessing the decisions they have made.

With margin management it is critical to know your cost beyond feed expense. These costs are generally much more stable, and your 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 a 6-8 percent 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. 

The volatile part of margin management is taking the milk price/cwt and subtracting from it your total feed cost/cwt to determine if the remainder will cover your desired margin over feed cost/cwt. When subtracting feed costs, include the cost of both purchased and home-raised feeds.

The marketing part of margin management ensures that 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 business 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 may present an opportunity down the road to obtain your desired margin over feed cost, or if your business will need to settle for less than your desired return on assets for this time period. A critical number to know during these times is what the minimum margin over feed cost necessary to maintain your net worth.

Each dairy business is unique, and it is key that you understand your leverage and working capital position as you decide on your marketing decisions. When a dairy has more leverage and/or limited working capital, the amount of price risk that the business can handle is less and the business may need to settle for a lower return on assets until it has improved its financial position.  

The focus of margin management is developing a system that helps ensure profitability of the business and not a system to ensure the highest milk price or the lowest feed cost. Margin management helps take the emotion out of marketing and allows you to feel confident in the decisions that your business makes.