May 24, 2024

Importance of Managing Strategic Risk

by Michael Langemeier, Brady Brewer, and James Mintert

Dig into strategic risk management for farm businesses with the Purdue University Center for Commercial Agriculture. Join James Mintert, Michael Langemeier, and Brady Brewer as they discuss what strategic risks are and how to start thinking about your farm’s ability to withstand shocks. The team of ag economists also discuss how important it can be to identify and capture the business opportunities that sometimes accompany a shock to the operating environment. This is the first episode in a series focused on helping ag producers learn to manage strategic risks.

Slides and the transcript from the discussion are available below.

Audio Transcript

James Mintert: Thanks for joining us for the Purdue Commercial AgCast, the Purdue University Center for Commercial Agriculture’s podcast featuring farm management news and information. I’m the host today, Jim Mintert, Director of the Center for Commercial Agriculture and Professor of Ag Economics here at Purdue. And joining me are my colleagues, Michael Langemeier who’s also Professor of Ag Economics and Associate Director of the Center for Commercial Agriculture, and Brady Brewer, who’s an Associate Professor here in the Department of Agricultural Economics. Thanks for joining us Michael and Brady.

We want to talk a little bit about strategic risk today. And that’s a topic that’s maybe not real familiar to a lot of producers, at least in the context of thinking about what they could do to manage strategic risk. So let’s talk a little bit, Michael, about what are strategic risk.


[00:00:47] What are Strategic Risks?

Michael Langemeier: When we think about strategic risk, the first thing to think about is, is all, all farms should have some kind of competitive position. Am I, am I a low cost producer? Am I a producer that’s going to, Going to receive more for my outputs like corn and soybeans and other producers and have, and have average costs.

And so, and so that’s the first thing is to think about what’s my, what’s my competitive position? What’s my competitive advantage? And then you think cause that competitive position to change. And so usually strategic risks are caused by something exogenous to the firm, some kind of market shock.

James Mintert: So there’s lots of examples of that, what that might be, and in fact, when we were at the Commodity Classic just a few weeks ago, we actually surveyed the producers at the Commodity Classic about what are some of the strategic risks that their farms face. And people talked about a variety of different things, but some of them were government policy changes. Geopolitical conflicts, lots of examples of that here in recent times. Disease, clearly for animal agriculture, but not only that, also for crop agriculture as well. Changes in consumer preferences, that’s kind of a longer term strategic risk, but it’s certainly one that many farms could be exposed to. Shifting long term weather patterns came up. And then technological uncertainties, right? With respect to what’s going to happen to technology and how’s that going to impact my farm in the future. So those are just some of the examples of strategic risk that that people are exposed to.


[00:02:10] What does it mean to "Manage" These?

James Mintert: Let’s talk a little bit about what it means to manage strategic risk, because there is a tendency, I think, for us to throw up our hands and just say that strategic risk or something we can’t manage, right? How can I manage a project? Uh, something like a geopolitical conflict or a trade war or a shift in long term weather.

The first thing to think about is that managing strategic risk does not require that you accurately forecast that a particular risk is going to occur, right? That’s impossible, right? In fact, the literature talks about something known as black swan events. Those are the unanticipated events that could have a big impact on your business or your farm operation. This isn’t about forecasting those particular risk. It’s really about managing risk in a way that it’s positioning your farm for success. In a way that it makes it possible for you to successfully manage through a variety of strategic risk that might occur. Uh, and so we’ll talk about a little bit more about that.

Brady, you might think a little bit about positioning your farm for long term success.

Brady Brewer: Yeah. So, you know, you just mentioned that this isn’t necessarily something that the farm responds to on a daily basis and something that farmers don’t necessarily actively manage.

So when we think about strategic risk, there’s really, two key concepts here that are related to strategic risk. That is a farm’s ability to withstand when these black swan events happen. And the first is a agility. So this is the farm’s ability to quickly identify and capture the business opportunities as they come up and agility is really correlated with strategic risk. Because if you think about the trade war, right, the first question that comes to mind is how do you manage around a trade war, right? This isn’t price risk that we can go out and actively hedge against. Um, you know, an example for the trade war as well, thinking through the potential options that a farm has available to them. If a trade war to happen, and one of them may be, you lose access to a market where you’re selling your farm product to. So, you know, one thing you can do is diversify the markets you send your products too. Well, agility is related to the concept of how quickly can we do this? How, how quickly can we, uh, respond to these exogenous shocks that you talk about?

And the second is absorption capacity, which is a farm’s ability to withstand shocks from these strategic risks. So in other words, if one of these exogenous shocks happen, weather event, trade war. What’s the ability of your farm to withstand these shocks that happen to the agricultural economy?

James Mintert: You know Brady when I think about it I tend to think about absorption capacity first because that’s sort of the negative side, right? How could I withstand? Something bad that happens externally that has a impact on my farm operation. And Michael when I think about agility I start thinking a little bit more about opportunities, right? How I can respond in a positive way.

Michael Langemeier: Definitely. And usually when we’re thinking about strategic risk, we’re thinking in terms of scenarios. You mentioned that earlier. And when you do that, you might have three scenarios. This is what I encourage my students to think about strategic risk. One of those scenarios may be more of the same. So, kind of just trend, uh, what, what, you know, what, what is the, what is the trend line suggest, uh, prices might be, for example. Uh, the other, other scenario could be a worst case scenario. What happens if we have a trade war? What happens if a major, a major disruption in demand or, or something like that happens and our prices are relatively low? How would we respond to that? Finally, I encourage people to have a strategy that’s positive. What happens if the economic environment is very conducive to my farm growing? Uh, how am I gonna, how am I gonna respond to that? Uh, how am I gonna quickly try to rent some additional acres? Maybe, uh, be in position to bid on some ground, uh, to, to expand my business during, during good times.

James Mintert: One of the things I want to emphasize today with both of you is this idea that when we think about strategic risk, there’s this tendency to think about it in a very negative framework, but it can also be very positive, right?

And that’s why you want to have good absorption capacity so that you have the ability to respond. and be agile enough to respond to a positive situation. You know, I think back just over the last 20 years, there’s lots of examples where that could have happened, right? Think about the changing environment that happened when all of a sudden, uh, we saw a new source of demand for corn. That created an opportunity for people who spotted it and were agile enough to respond in a positive way, right? So we’ve seen other examples of that with respect to trade. So not everything in this context is negative. And I think if you’re really managing your farm for in positioning for long term success, that absorption capacity allows you to withstand the negative. But retaining agility is what allows you to respond in a positive way and see your farm be successful and grow over time.

Michael Langemeier: Another example that’s used quite often is labor. Let’s say we bring a younger family member into the business. And what that allows us to do is do some cross training. So if there’s an older family member, maybe, maybe they’ll have some health issues. Maybe they’re going to retire. We bring this younger person in, do some cross training. That’s the absorption capacity. So we can withstand shocks because we have a we have a younger person here that can take the place of an older person if they get ill, for example.

Also, from an agility standpoint, that works really well because you need it, you need you might need more of a larger labor force in order to rent additional acres or to buy additional land. And so I think this example also works really well, uh, when you’re looking at something like labor.

James Mintert: So, Michael, you decided, along with one of your graduate students, Margaret Lippsmeyer, to do some research on this topic, so I’m going to let you explain that a little bit.


[00:07:51] What the research says

Michael Langemeier: Yeah, we did some research specifically looking at strategic risk and looking at some of the variables that are related to strategic risk. Today, we’re going to talk about some of the questions we used to measure strategic risk, as well as managerial ability. Uh, there is a relationship between those that are, those that are, are worried, or in pretty good position to handle strategic risk. We call that resilient, uh, and, and managerial ability. And we’ll talk more about that.

So let’s start with agility. Let’s start with the positive. Uh, so a couple examples of questions. Our farm looks for opportunities that new enterprises may provide. Let’s say there’s a chance to grow some non GMO soybeans. Do we look for that opportunity? Do we try to figure out if that opportunity fits our operation? Because we know there’s probably not everybody’s going to be able to do it in a region. So you want to be one of those that looks at those early. Another question. We regularly assess our advantages and disadvantages compared to other farms. This can go back to labor. For example, maybe, maybe there’s a certain areas that that your current, uh, labor, operators and hired labor, are not very good at. Do we need to do some professional development to improve that? Or did we need to hire a consultant to help us in that area? And so that’s that’s the idea with agility. And again, that’s from a positive side.

On the absorption capacity. These are a little easier, I think, to understand. These are things like do we have a strong balance sheet? Do we have a good current ratio that’s measuring our liquidity that would allow us to respond very quickly to to an opportunity? Do we have a debt to asset ratio that’s low enough? That we could borrow money if we needed to, uh, to, to buy additional ground. Uh, but, but also, uh, when you’re looking at debt to asset, if we have several years in a row that are fairly low return, fairly low net returns, maybe we’re entering an environment here where net returns are going to be lower for two or three years. That current ratio will get you through those bad times. It’ll ensure that you’re able to make your principal payments on machinery and land, for example. And so, and so that’s why we call that more of a, uh, responding to the downside. Another question is do we have low per, per unit fixed costs? Uh, again, that would be something that you’d have to, you’d have to measure, uh, to make sure you have that. But that also puts you in a position, uh, to withstand some downside risk, which, uh, usually I, I, I indicate that’s lower, lower prices, uh, from, uh, whatever reason, lower prices. Another question that you’re not necessarily going to ask affirmative here. We need to discuss this one some more. Our farm enterprise is more diversified today than it was five years ago.

And so I’ll start this and maybe turn it over to Brady here for some more discussion. Cause this one’s rather difficult. Diversification is a very good response to risk. Given that, why is not everybody, not every farm really diversified. Why do we move away from farms that had corn, soybeans, wheat and and cattle and hogs and on and on and on? You know our the farm that I’m from in Nebraska, at one time we had six enterprises I I think. You know, why did they move from six enterprises to the to the two they have today? You know that we know that if we had six enterprises we would reduce risk. Well, it has to do with economies of scale. If you specialize, you’re able to garner the economies of scale. And so you have to look at that trade off between diversification and specialization. Diversification is a good strategy against risk, but there is other strategies that can protect you from downside risk, specifically a strong balance sheet, low per unit cost. You want to elaborate on that, Brady?

Brady Brewer: Yeah, I mean, resiliency of any business, Is at odds with the efficiency of that business. And that’s because of the economy is a scale that you mentioned. If we want to be the most resilient operation ever, we would produce a hundred different crops, uh, cause we know the population has to eat. So not all 100 are going to be down in terms of price, and that’s a very resilient operation. But can you imagine switching? You know, I’m giving an extreme example right now to prove a point. Can you imagine managing that type of operation? It just wouldn’t be very efficient or cost effective at all. So there is a point here, and this is going to be up to each individual farm and operation to decide, how much resiliency do we want to put into our operation, right? And what does that diversification strategy look for us? And it’s going to be dependent on the area of the U. S. you’re in, the crops that you’re trying to grow, um, and that mix, right? It may be adding in a livestock operation that complements something that you’re already growing. So there’s some, there’s some diversification you can build in that probably doesn’t reduce the efficiency too much, and you know, that’s where you look at kind of the long term strategy of what you’re going towards. But there is trade off. Efficiency is at the cost of diversification.

Michael Langemeier: I wanted to also briefly talk talk about managerial ability, because we also have some questions related to this. We had a series of six questions on managerial ability. I’m just going to give you a feel for some of the questions that we asked, uh, in this research. One of them was, does your farm have written succession plans in place? And this would be true even if you have nobody coming back to the farm, you still need a plan. You know, how am I going to exit this business? How is that going to work? If you have someone coming back to the farm, how are they going to fit into this operation? How are we going to make that work? Other questions were, does your farm use financial ratios to make decisions? Do you have written lease agreements. Do you use standard operating procedures documented for repetitive and routine tasks?

And one of the things we found, and maybe I shouldn’t have been too surprised at this, but some of the people that were pretty good at one dimension of manager ability, We’re good at the other dimensions of managerial ability. And so I think we really did a nice job of gauging whether you are above average managerial ability, average or below average. And it wasn’t perfectly correlated resilience, but there was a relationship there between being a good manager and also being resilient.

James Mintert: So, Michael, we need to back up for just a second. So you did a national survey, a telephone survey. How many people responded to the survey?

Michael Langemeier: 403.

James Mintert: Okay. And that was using the same kind of demographic constraints that we use for the Ag Economy Barometer in terms of being a representative sample, right? And when was the survey conducted?

Michael Langemeier: This was done in April of 2023, so about a year ago.

James Mintert: Okay. So, let’s talk about some of those takeaways and, you know, Michael, you’ve said a little already, but one of the things you mentioned when we were discussing this earlier was more aggressively seeking out professional development opportunities.

Michael Langemeier: One of the things, when you, when you start looking at your managerial ability, you start looking at the skills of the different people that are in the business, one of the questions you should naturally ask is where are the gaps? Do I have someone that’s calculating financial ratios, for example, doing a good job of keeping the balance sheet up to date, making sure our cash flow is up to date, so we know exactly where we’re at, so we can respond to opportunities, uh, very quickly. And not just one example, uh, it could be, it could be marketing, it could be something else. Take a look at your operation, and if, it looks like, uh, there’s a gap in knowledge there, ask the question, do I need to hire a consultant? Do I need more help in this area? Um, marketing advice is, is, is one that’s very typical. But also, uh, have an agronomist. Uh, you know, help with, with the production plans. And so those, those are examples, uh, you know of seeking outside help, uh, getting professional development yourself.

James Mintert: So that’s one aspect of thinking about it, Michael. The other one, of course, is with respect to filling gaps in your management team, so to speak. But the other one is, we’re engaged in an industry that’s changing very, very rapidly. And if you’re not engaged in professional development over time, you’re going to fall behind relatively quickly. Even if you’re state of the art today.

Michael Langemeier: That’s definitely the case. Sometimes if it doesn’t look like someone’s coming back to the business, you might not think that that’s important. But if you have a 10, 15 year horizon in the business, uh, and you never know, maybe someone that you think is not coming back today wants to come back in 10 years because there’s a more opportunity to come back today. You need to, you didn’t make sure you need to make sure there’s not big gaps in the management.

James Mintert: So, Brady, one of the things that came out of this research, which I think is relevant to some of the other research you’ve done over the years, is if people were using one key management practice, they tend to be doing more than one good thing, right?

Brady Brewer: Yeah. What was found in Dr. Langemeier’s survey was that if people used one management practice, they tended to use them all. And this just makes sense when you think about the managing of any type of business, not just a farm, right? And that’s because they’re all related, right? If you make a change on your balance sheet, that’s probably going to impact what type of revenue you’re getting. Hopefully, you’re buying an asset that increases the productivity of your farm and increases revenue in some way. If you buy an asset, that’s probably going to change the labor requirements on your farm, right? So they’re all interconnected. So it’s very hard to just move one piece of the puzzle and not expect the whole thing to change.

Um, so yeah, not surprising that it was found that the good managers don’t just do one practice. It’s the full suite of tools that they look at and constantly are changing for their farm. I do want to bring up, Jim, one key point here that we kind of touched on earlier, but I just want to say it explicitly, you know, so we’ve painted agility in a very positive. There’s some positive outcomes to dealing with these strategic risk, but there’s also cost, right? We talked about diversification is at odds with efficiency. Really, the whole goal here is to minimize your downside risk of your farm to some of these exogenous shocks. But you don’t want to limit the upside.

And that’s why you’ve got to look at all of these management tools and figure out how each thing is interconnected. So you don’t limit the upside potential of your farm, not just if one of these exogenous shocks happen, but day to day basis.

James Mintert: Yeah, good point.

Michael Langemeier: And this is particularly important if you’re expanding because when you’re expanding, it’s a tendency to think on the financial marketing perhaps, but it changes everything. It changes. It changes labor. It changes how you think about professional development. So there’s going to be quite a few holes in your, in your, in your management, uh, perhaps, uh, because you’re expanding. And so you need, you need to take a look at that. And one of the tools we have on the Center for Commercial Agriculture website, uh, it’s a really easy tool to call it a tool, stretching it a bit, is we have these skill set lists.

And so you can take a look at finance, you can take a look at marketing, you can take a look at purchasing input, you can take a look at personnel management, you can do checklists. Where do I, where do I stand with each of the items on these checklists? Needs improvement. Uh, I, we do a good job and so on. And that’s a way to, to identify the management gaps.

James Mintert: Yeah, good point. So, Michael, make, let’s make this a little more concrete when we talk about these management practices. Uh, if a farm on the survey said that they had a written succession plan, what are some other good management practices that tended to follow right along with that? Because I found that to be a pretty interesting aspect of the survey.

Michael Langemeier: And these things were not things that are necessarily that complicated, you just have to make a, make a concerted effort to make sure that you do those. Written lease agreements. Um, there’s a lot of lease agreements that are not, are not written. Using financial ratios would be, be another example. If you have quite a few hired workers, even if you don’t, uh, do you have standard operating procedures? I mean, and just, just some, just some things that are just good management practices.

James Mintert: And so the tendency was, if you were doing one thing well, you tended to do maybe not everything well, but you did a variety of different management practices pretty darn well and that made your farm more successful.

Michael Langemeier: Yeah, I’ll just give an example for succession plans. We had, we did a managerial ability score based on all six questions. And if you had, if you had succession plans, uh, 41 percent of those people were above average in managerial ability. If you had no succession plans, 6 percent. And so it wasn’t impossible to score wellness managerial ability if you didn’t do one of them, but it was harder.

James Mintert: Yeah, good point. So one of the things we did at the Top Farmer Conference back in January, was ask people some questions about their interest in strategic risk management. And Michael You might share a little of that those results.

Michael Langemeier: Yeah, first of all our survey results I think they provide a benchmark of resilience , for commercial producers in U. S. agriculture, and it was a U. S. survey, so I think that’s very important. But we did ask this question about whether people would be interested in learning more about strategic risk, and of course, we were very pleased with these results. 61 percent had high interest, and another 37 percent had moderate interest. And so this is one of the areas that we’re going to spend more time on, doing additional research, but also developing more outreach materials.

James Mintert: Yeah, so Brady, we talk about risk. People tend to focus on things like price risk, right?

Brady Brewer: Yep.

James Mintert: Lots of training available over the years, both from extension services like Purdue Extension, but also private firms, etc. Not that much information and not that much training in terms of availability of strategic risk management, right?

Brady Brewer: Yeah. And again, that’s, to me, it’s not surprising. We’ve talked about some of these exogenous events, right? Right. Uh, the example we used at the very beginning was the, was a trade war, a political conflict. And as a farmer, you may be sitting there going, well, how in the world do I respond to a political conflict on the other side of the globe?

And part of it’s just identifying what are the potential outcomes, right? So, uh, responding to some of these strategic risk can be a little bit nebulous, but it goes back to the core principles of the agility and absorption capacity. So no matter what that exogenous event is, your farm can withstand the shock and then make the strategic decisions after it to potentially be on a better footing on the other side.

You know, it doesn’t surprise me that a vast majority of the farmers are interested in this. We see a lot more of these exogenous shocks happening and impacting what farmers do on a day to day basis. So to your question about, you know, maybe the price risk, normally when you think about risk, it’s what you have to manage on a day to day basis, right?

Price goes up, price goes down, thinking about hedging, uh, maybe some short term weather risk, whether it’s drought or something flooding. Uh, that’s what farmers have to manage on a day to day basis, so that’s just naturally what they think about.

The strategic risk just isn’t something that come up on a day to day basis, so we tend not to, we kind of, well, I’ll deal with that when it comes, and when it does, we’re not prepared. So that’s what we’re really advocating for here is. No, these can have really serious consequences when they do happen. And quite frankly, your farm can be better off based on some of the survey results. Uh, from a managerial perspective of preparing for them.

Michael Langemeier: Analogy I, I want to use here, and hopefully it fits, you guys will tell me if it doesn’t, is think about the difference between crop insurance and Farm Bill. You know, Farm Bill, our county PLC program. I think this example fits. Crop insurance is more of a short term price risk. It’s within the season. So you’re looking at a drop in price within the season, from the spring to the fall. So that’s more short term. We can think of shorter term than that. But that’s more short term.

The farm bills looking at a low price over a long period of time. That’s where strategic risk fits in. Let’s say we’re entering a new period right now where we think corn price is going to stay 4 to 4.50. What are you going to do in that environment? What are you going to do if all of a sudden, for whatever reason, whatever shock comes out there. That all of a sudden we see 6 corn a year from now. How are you going to respond differently to the, to the different corn prices? And thinking ahead about that, let’s say if corn prices increase where you can buy machinery, that, that would be a good time to buy machinery. If prices are real low, uh, it’s, it’s not whether I can buy machinery because I probably can’t. There the question is, how am I going to make my, my principal payments? It’s going to be short on cash to make my principal payments. And so that’s how I think about it is think about long run prices rather than short.


[00:24:10] Conclusion

James Mintert: Yeah. So the key point there is to have some management plans in place for as you mentioned earlier, these different scenarios. And be ready for them going forward.

So that concludes our podcast today on strategic risk. But this is really just the first in a series. We’ll have more on this later on the Purdue Commercial AgCast. And of course, that’s available not only from all the major podcast providers, but also on our website, if you just want to listen there. And that of course, is purdue.edu/commercialag. So on behalf of my colleagues, Brady and Michael, and the Center for Commercial Agriculture. I’m Jim Mintert. Thanks for joining us.

TEAM LINKS:

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