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Steps for building a high-functioning risk management team

Mark Ludtke and Dan Wenzel Published on 29 October 2012

A common managerial theme in the dairy industry is “surround yourself with good people.” When it comes to risk and opportunity management for your dairy, how do you build the team? We teamed up to write this column and share the best practices we see among today’s well-run dairies.

Here’s what we – a dairy business consultant and a commodity marketing consultant – see as essential steps to creating a high-functioning team that gets results for the dairy business:

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Establish the team
In today’s world, commodity price fluctuations impact the farm every day on both sides of the balance sheet. As a result, on well-run dairies, the risk management function has been elevated from an occasional call to a broker to an integrated aspect of financial management. The team, at minimum, should include the producer, the market adviser, the business consultant and the lender.

First, be sure to understand the various types of market advisers you could add to your team and how they get paid for their expertise. There are brokers who will provide advice and conduct your trades – and traditionally these brokers get paid by the transaction.

There are also fee-based consulting programs with advisers who provide overall strategy, ongoing recommendations (including cash or forward contract recommendations) and market transactions if necessary. Select the adviser or service that best fits the needs of your operation.

Whoever you choose, make sure the adviser is a good educator and can help the team understand its playbook, which is the next practical step.

L’eggo my ego
There are many tools available to protect and build a milk price over time, as well as many ways to secure and manage the inventory of feed. The producer must have a basic understanding of how futures, options and forward contracts work. Admitting what you don’t know is tough. Rise above the temptation. You can’t avoid the tough stuff.

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When the team meets, all egos must be checked at the door and everyone must commit to creating a basic working knowledge of how the available tools can work, together or in combination, for the dairy.

Then, the team should evaluate all choices, such as, “Should we use forward contracts from the dairy or should we use the futures market?” If the dairy owner is not very experienced with marketing and finds the markets stressful, admit that.

You may then decide that forward contracts with the milk plant is the way to start. Your market adviser should be able to show you how managing market positions through a futures account performs versus contracting with your milk plant. The farm’s risk tolerance is a big factor in this decision, as well as the team’s knowledge level of how the tools work.

One more comment about checking egos at the door: The team should recognize that job No. 1 is to prepare the dairy operation for whatever the market may do, not to “guess right” about what the market will do. The market doesn’t care what you think about it, and a wrong guess without having discussed a “Plan B” will send the team scrambling.

It’s your team’s job to evaluate how various tools and strategies can protect and enhance the operation in various market scenarios. So establish a strategic culture on the team from the get-go.

Take down the silos
Early in the team-building process, bring the key players into the same room and begin sharing the farm’s financial position. If information does not flow freely between team members, the market adviser will not have a true picture of the farm’s risk tolerance and cannot make the best recommendations.

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It is the business consultant’s role to calculate the impact various pricing decisions have on the farm’s profitability. The business consultant will especially weigh the strategy choices against the farm’s equity and its working capital. If the business has the staying power of equity, or if it has adequate working capital, the market strategies can involve a little more risk with the eye on greater reward in the end.

Without that staying power, the lender will advocate for less risky positions. Sharing information allows the team to find the “sweet spot” of protection while building the best possible price for the business.

Most high-functioning teams meet either in person or by teleconference multiple times in a year to share information about what has been working and strategy choices going forward. In our experience, with this team approach, everyone has more confidence to choose and then stick with the marketing strategies over time.

Understand your weighted-average price
Lack of communication and confidence is what dooms many farm marketers to failure. To maintain confidence, it’s important to keep the team focused on moving the ball forward. In marketing, the ball you want to move forward is your weighted-average price.

Weighted-average price is the net average price received over time for all of your milk production (or paid out for feedstuffs). Your price at any given point in time might be higher or lower than the current market price. However, in the long term, it should be your goal to make strategic and incremental sales or purchases that build the best possible weighted-average price for all your long-term production.

Understanding the concept of weighted-average price helps the team evaluate the progress of their marketing decisions. If at any point in time one of the team members feels (emotionally) like the strategies are not performing, the weighted-average price provides empirical evaluation of how your decisions have performed against the market price for the past quarter, past year or past three years, for example.

Chuck the shoebox
Many of today’s well-managed dairies are setting up and using their accounting records not only for tax purposes but also to aid decision-making. One important and often overlooked step is to enter the activities of the brokerage account into the accounting system on a month-by-month basis.

With this information regularly entered, the team will be able to look back over time, see trends and understand the costs of risk management and the benefits it provided to the business.

This is particularly helpful when it comes to understanding margin calls. A margin call, from an accounting standpoint, is simply a transfer of dollars from one account to another to hold a market position. If a producer does not view a margin call from an accounting perspective, he may emotionally feel like his marketing strategies are costing him money.

At tax time, when he hands his stack of brokerage statements to the tax preparer, he may never fully understand how that margin money was put to work over the course of the year.

There are not many shoebox-record dairies out there any more; however, there are a lot of shoebox-record brokerage accounts. Dairies that do not integrate their marketing activities into the financial management of the dairy are more likely to abandon their marketing without clearly understanding its costs and benefits.

Separate the hedge line of credit
Another practical tip – and this is why the lender’s participation is so important – is to establish a hedge line of credit separate from the farm’s operating line of credit.

Doing so does two important things: It prevents the team from making market strategy decisions based on available operating capital, so that the best decision can be made, and it provides a clearer picture, from an accounting perspective, of how the hedge line is balanced with the marketing positions, because the hedge line liability needs to stay in balance with the hedge asset on the balance sheet. With your lender on the team, you can gain confidence for taking this important step.

Producer takes ownership
All this team talk does not mean the producer is no longer in the driver’s seat. It’s actually the opposite. The producer takes ownership of decisions and asks his team to provide perspective, recommendations and empirical evidence to back up those recommendations.

Yes, it takes time to establish your team and to educate yourself so you can ask the right questions. However, the risks associated with today’s commodity price fluctuations demand that as much attention be paid to financial management as to facilities and production.

In the end, building a risk management team is similar to other improvements you make on your dairy. When a new facility is planned, the owner does not simply approve the blueprint and tell others to build it without any supervision, questions or walk-throughs during the construction process.

When it comes to market risks and opportunities, there is no real “fix it and forget it” solution. Managing market risks and opportunities requires constant monitoring to stay above the market average and be among today’s high-performing dairies. PD

Dan Wenzel is a business and financial consultant for Wenzel Dairy Business Consulting LLC .

Disclaimer: Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results.

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Mark Ludtke
Business Development
Stewart-Peterson Inc.

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