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Expansion considerations in a volatile price period

Larry Davis Published on 29 October 2010

Since mid-2008, we have seen milk prices as low as $10 and as high as $22. Corn, corn silage, soybean meal and other feedstuffs have also experienced significant price volatility. Day-to-day operation management in these times becomes a challenge, let alone planning for an expansion.

Many questions need to be evaluated before an expansion is considered. Some of them include the following:
1. Why does the operation need to expand?
2. What will the new operation look like?
3. Where will the new operation be located?
4. How will the operation be different from a management perspective?
5. When is the best time to expand?

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These basic questions are naturally interrelated and need not be answered in any particular order. However, No. 1 is probably the most important and requires the closest consideration before moving forward.

Why the operation needs to expand
This question has been written about many times and continues to be one of the most-discussed issues surrounding agricultural economics as it relates to production agriculture and family-owned and operated operations. When a family member decides to join the operation, many times the first impulse is to expand the operation. While this may be an acceptable decision, thought and study is needed to determine if this is a logical solution for the operation.

For example, if the operation is profitable and operating at optimum size and scale currently, does it make sense to expand? If the reason for expanding is to bring another family member into the operation, there might be a different way to go about it without expanding. Perhaps there is another enterprise related to the dairy operation that could be added and/or expanded that would enhance the overall profitability of the operation without affecting an already efficient system. An operation needs to examine itself carefully when another family member is joining in order to determine the proper strategic path to follow.

Other valid reasons to expand certainly may exist. There could be an opportunity to acquire another facility or to acquire additional land or other resources that are important to overall well-being and potential growth of the operation. Another reason for expanding might be because management expertise is superior and capable of handling more size, scope and responsibility. All of these are valid reasons.

Historically, we have seen operations expand because they speculate that prices will go up and they are trying to “time the market.” We also have seen operations struggling to survive that falsely believe being bigger will make them profitable. These are dangerous reasons for deciding to expand and should be discouraged. Again, it is important to examine the reasons why the operation needs to expand and confirm that they are legitimate.

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The ‘what, where, how and when’ questions
The remaining questions on expansion need to be carefully thought out, discussed, researched and confirmed. Although each of these is critical to the success of the expansion, No. 5, the “when” question, should get careful consideration. A number of factors can influence this decision, and proper planning is necessary in order to avoid roadblocks. Volatility in prices of feed, cows, materials and milk can greatly influence the success of an expansion. As part of the “when” answer, forward contracting and/or hedging of these commodities may make sense as part of controlling costs after a completion date is calculated. This helps to enhance the integrity of financial projections and the business plan that is presented to a lender.

Certainly financial projections are important in the confirming process. Bankers will want to see a business plan along with the economics. Developing several different versions using various input cost levels and milk price assumptions can be helpful in understanding what drives solid margins and profits going forward. It is important to use historical production levels in order to project revenue. This adds more creditability to the numbers because it takes current management history into account.

Project costs
Just as feed costs and cow prices can rise, so can the cost of construction. Concrete, steel and other costs have gone up and are higher than ever. This should be given careful consideration when projecting the cost of expanded facilities.

A common mistake is to underestimate facility construction cost. Almost every project comes in over budget by 10 to 20 percent. With the price of materials rising and the tendency to underestimate construction costs, the area of project cost can be a slippery slope to navigate.

A related problem is a delay in completion and, ultimately, a delay in cash flow from the expanded operation. If more money is needed to finish the project, it will take longer before it begins to pay for itself. Farms and lenders should plan accordingly by budgeting and approving 20 percent more than the highest cost expectation and by assuming another 90 to 120 days to completion from the latest projected date.

Summary
During 2009, the dairy industry suffered the worst price decline in more than a generation. Although prices have partially recovered, the volatility and price cycles will continue in the future just as they have in the past.

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An expansion to a dairy operation needs careful consideration and planning before it is initiated. This includes answering the why, what, when, where and how questions. The most critical of these is why the operation is expanding. Once that question is answered, the other questions need to be addressed. Timing is important and cost considerations must be taken into account.

A business plan and financial projections should be used to demonstrate to a lender that expansion makes sense and that the debt can be paid back in a timely fashion. This will add integrity and creditability to the relationship as the expansion unfolds. PD

Larry Davis

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