Farm decision making - how does your risk profile affect your business decision making?

Author: | Date: 08 Sep 2015

Take home message

  • Managing risk is not about the middle or the average, it is the opposite. It is appreciating what happens at the extremes, the size or value of these extremes and how often they occur.

Introduction

Risk is a natural and accepted part of farming. Australian agricultural production (based on value of output) is the most volatile in the world and the most volatile sector of the Australian economy (Keogh, 2013). This volatility conveys a level of risk that needs to be managed. Given most farmers are still operating despite two centuries of volatility suggest they have developed long term strategies and operational tactics to cope with this ongoing challenge.

There are many strategies farmers use to manage production risk. Diversification in crop and pasture type, enterprise mix, targeting multiple markets and property location are common strategies. So is managing input costs, especially when production and prices can be highly variable.

Understanding risk

When we talk about risk most of us immediately think about the negative consequences if an action goes bad. Dictionary definitions re-inforce this thinking. However this is only one aspect of risk. The word risk is derived from Italian word risicare, which means 'to dare'. To manage risk effectively we need to understand both the downside, or the potential harm from taking a risk and also the opportunities that taking a risk can offer.

There is no reward without risk. In farming, risk is a necessary part of making returns. Managing risk is about making decisions that trade some level of acceptable risk for some level of acceptable return for an acceptable amount of effort. Decisions can be made to reduce risk, but it usually comes at a price, namely lower returns.

A common definition of risk is likelihood by consequence. In other words risk requires knowing how often an event happens (the frequency) and what is the impact (the value) when it does happen. A decision that increases risk will either increase the likelihood of an event happening and/or increase the consequence if it does occur. This increased consequence may be a greater return, not just a greater loss.

Average values are commonly used in agricultural extension. We present average yields, average prices and average costs. While these averages convey a value (and are convenient), they rarely present the frequency of this average occurring. This would be fine if we consistently got these average values, but in agriculture we rarely do. The key drivers of profit in agriculture, namely yield, prices and some costs have a range of values within and between production periods. If we use averages for analysis, it usually over estimates the profits and hides the volatility in those profits (Nicholson, 2013).

Managing risk is not about the middle or the average, it is the opposite. It is appreciating what happens at the extremes, the size or value of these extremes and how often they occur.

Decisions around risk

Firstly we need to understand there are three broad influences that shape a decision around risk. These are simply described as the head, the heart and the gut (Figure 1).

Figure 1: The head, heart and gut influence our decisions (Image courtesy of Alice Long, AgCommunicators).

Figure 1: The head, heart and gut influence our decisions (Image courtesy of Alice Long, AgCommunicators).

The relative influence of the head, the heart and the gut depends on:
  • The type of decision required (simple, complicated, complex),
  • the relevant information available (usually imperfect),
  • the personality of the decision maker, and;
  • the risk involved.

In my experience most farmers make decisions around risk by relying on their gut and their heart. Gut or intuitive decisions are informed through experience, both good and bad – although bad experiences are usually more influential than good experiences. The heart decisions reflect your personality (are you naturally a risk taker) and what you want to achieve from farming. This means everyone will have a different position on risk and this position can change rapidly, sometimes triggered by sudden events. Importantly no position is right or wrong, it is what you are comfortable living with.

The analysis I will show adds to the head part of a decision, by generating some numbers (usually profit) that we can combine with our intuition and goals. In combination the three influences lead to a more informed decision.

Choosing your level of risk

As described previously the derivation of risk is 'to dare'. This implies there is opportunity but it also implies a choice. As individuals we can influence how much risk we expose ourselves to by making choices.

Through the Grain and Graze program we have developed a relatively simple way to put some numbers around the level of risk in a farming business. The tool uses a combination of historic information and gut feel to ‘frame the odds’. Calculations and graphs are created that show the amount or value and how often this amount or value occurs. It includes extreme and average results. Note, the broader the range in values the greater the volatility or risk.

In this presentation I will explain:

  • Some key concepts around risk.
  • How risk can be analysed using ranges rather than single values.
  • Where to get historic information to ‘frame the odds’.
  • Which ‘risky variables’ are more important than others.
  • The effect on profit if we are able to change some of these ‘risky variables’.

Risk analysis conducted on a Victorian cropping and livestock farm will be used to demonstrate some of these concepts.

References

Keogh M 2013, 'Global and commercial realities facing Australian grain growers' in robust cropping systems - the next step. GRDC Grains Research Update for Advisers 2013. ORM Communications, Bendigo, Vic. pp 13-30.

Nicholson C 2013, 'Analysing and discussing risk in farming businesses’. Extension Farming Systems Journal. Vol. 9 (1) Australasia Pacific Extension Network. pp 178-182.

Contact details

Cam Nicholson
Nicon Rural Services
Grain and Graze
cam@niconrural.com.au