Annie's Project is Expanding across Ohio in 2008

The mission of Annie’s Project is to empower farm women to be better business partners through networks and by managing and organizing critical information. Annie’s Project was developed by Ruth Hambleton, an Extension educator in Illinois . She based the program on her mother, Annie Fleck’s life as a farm wife. She was a small-town girl who grew up to be a teacher, marry a farmer and lived with her in-laws. Annie was responsible for keeping the farm records, which were used to make tough management decisions in times of financial hardship. She was responsible for holding together the family as well as the business.

The program is an agriculture business course in risk management. It was held for the first time in 2003 and has been very successful throughout the Midwest . Since that time, over 2,000 farm women in nine states have completed the six week course in risk management.

Annie’s Project brings women together to learn the financial skills and critical information needed to manage the complicated business of running a farm. Specific topics include financial record keeping, understanding basic financial statements, financial management tools, goal setting and mission statement writing, commodity marketing basics, crop insurance, family communication, retirement planning, and learning about individual personality types and characteristics through the Real Colors program.

Annie’s Project was held in Wood and Delaware counties during the winter of 2007. The classes were filled to capacity with 47 women completing the course. Everyone had positive comments to share on the final evaluations. One participant from Delaware County commented, “This class has opened my eyes to a new side of farming and encouraged me to take a bigger role.” Another Delaware participant, continued, “ This class will enable me to help the farm be more profitable now that I understand how to take care of the paperwork.” A Wood county participant said, “I believe these classes made us realize the importance of taking care of insurance, liability and working on marketing besides just concentrating on planting & harvesting.”

Women play an important role in the family farm business and Annie’s Project will help them improve their management and communication skills. It will also provide the opportunity for women to network with other women in similar situations and learn from one another.

The class meets one evening a week for six consecutive weeks. Annie’s Project will be offered in six Ohio counties in the winter of 2008 as a result of funding by a North Central Risk Management Education Center Grant. The host counties for 2008 include: Ashland , Ashtabula , Auglaize, Defiance , Erie , and Wood.

The registration fee is $60 and class space is limited. For registration information contact the host county or project coordinators: Doris Herringshaw at 419-354-9050 and JuliaWoodruff at 419-281-8242. You can also follow this link to download a brochure with specific county dates and registration information.

The registration flyer can be downloaded here:

http://ohioagmanager.osu.edu/resources/annieregflier.pdf

Crop Input Outlook 2008

Higher fuel and nitrogen prices in 2007 have signaled trends that will most likely hold throughout 2008. OSU Extension Budgets show projected variable (cash) costs for corn production to be 24-35% higher in ’08 than ’07 depending on seed trait selection. Soybean variable costs are projected to be 23% higher in ’08 than ’07. Higher commodity prices and profitability in 2007 and projected net profits in 2008 have already led to cash rental rate increases. Cash rents increased 5.8% in Ohio in 2007 and projections are for these rents to increase at a larger rate in 2008.

Higher commodity prices and higher costs lead us to a riskier production year as the cash investment in an acre of corn will top $300 and the cash investment in an acre of soybeans will top $150. Outlook information presented here was developed with data from AEDE research, Energy Information Administration, USDA, other Land Grant research, futures markets and retail sector surveys.

Fuel

As of November 6 th , the Energy Information Administration (EIA) pegged the average price for West Texas Intermediate Crude Oil at $79.92 per barrel for 2008. This is a 12% increase over the 2007 Crude price.

The EIA projects the Henry Hub Natural Gas price to average $8.01 per thousand cubic feet (mcf) in 2007. This is a 9.7% increase over the 2007 Henry Hub Natural Gas price. The Henry Hub in Louisiana is the nexus of 16 intra- and interstate natural gas pipeline systems that draw supplies from the region’s prolific gas deposits. The pipelines serve markets throughout the U.S. East Coast, the Gulf Coast , the Midwest , and up to the Canadian border. Natural Gas Futures quotes are available via the online New York Mercantile Exchange at: http://www.nymex.com/ Natural Gas Futures are traded as million British Thermal Unit (mmBtu). One contract equals 10,000 mmBtu. Natural Gas is sold wholesale per thousand cubic foot (mcf). Btus per cubic foot of natural gas do vary. One cubic foot of natural gas = 1000 to 1031 Btu. One thousand cubic feet (1 mcf) of natural gas = 1to 1.031 mmBtu.

Diesel price is expected to increase 8.1% in 2008 with an expected average price of $3.09 per gallon for on-highway diesel.

Why Are Oil Prices So High?

•  Strong world economic growth driving growth in oil use,

•  Moderate non-Organization of the Petroleum Exporting Countries (OPEC) supply growth,

•  OPEC members’ production decisions,

•  Low OPEC spare production capacity,

•  Organization for Economic Cooperation and Development (OECD) inventory tightness,

•  Worldwide refining bottlenecks, and

•  Ongoing geopolitical risks and concerns about supply availability.

Fertilizer

Nitrogen (N)

Ten years ago the U.S.imported approximately 35% of our nitrogen needs for crop production. Today, the U.S. imports approximately 80% of our nitrogen. This highlights the importance of the world supply and demand as we try to evaluate price direction of nitrogen fertilizers.

Due to continued high natural gas prices and strong U.S. and World demand, the cost of all N sources remains very high. The retail price of N in November in Ohio was at $680/ton for anhydrous ammonia, $290/ton for UAN (28%), and $505/ton for urea.

Using anhydrous ammonia as a base for projections, N is averaging $0.415 per pound of actual N compared to $0.289 per pound of actual N in 2007. (NH3 price of $680/ton equals price per actual pound of N of $0.415 and $475/ton equals price per actual pound N of $0.289.) This is a 43% increase from 2007 to 2008.

If UAN (28%) is your N choice, the $290/ton price equals $0.518 per pound of actual N. Retail Urea price in November was $505/ton which equals $0.549 per pound of actual N.

Phosphorous (P 2 O 5 )

The average price of phosphorous fertilizers is expected to increase approximately 65% from 2007 to 2008. Increases in anhydrous ammonia price and transportation costs together with strong world demand continue to pressure phosphorous fertilizer prices. These pressures signal continued higher prices for the 2008 crop production year with the price for P 2 O 5 expected to average $0.5144 per pound. (This equates to a MAP price of around $535/ton).

Potassium (K 2 0)

Although world potash production continues to increase, demand has increased at a faster pace. Demand in growth areas such as Asia and South America have contributed heavily to price increases in farm-gate potash. Potash prices are expected to increase 40% from 2007 to 2008. Potash prices for the 2008 crop year are expected to remain at these high levels and average $0.283 per pound. (K 2 O price of $0.283 per pound equals Potash (White) at $340/ton.)

Fertilizer Buying Strategies

Buy-As-Needed Approach

This is easiest way to procure fertilizer but often the most expensive as we tend to buy when others are buying and prices are highest.

Price Target Approach

We can set price targets for these three fertility products but

if prices don’t move you may never hit your buying triggers.

Historical Price Pattern Approach

Pricing N product during fall (for application or storage) or early winter (pre-pay for early spring delivery where the pricing opportunities exist) may allow you to average lower prices than other buyers.

Storage Approach

To take advantage of “lows” in the market during seasonal lows or unforeseen dips in the market, building storage for your N, P and K needs may be an option to consider as prices for these three products remains volatile.

“Home-Run” Approach

Pricing all of your needs and storing the product or locking in a price on a pre-pay basis may result in a “home-run” as you may hit the low in the market. On the other hand you may see prices drop and you have priced product in the upper 1/3 of the market.

Price Averaging Approach

As fertilizer price remain high and volatile it may be wise for producers to spend more time on pricing these critical inputs. Spreading out your purchases and buying N, P, and K at several different times should result in a better price average over the long run as you average your high priced purchases with your low priced purchases. The only drawback to this option is the inability to take advantage of volume discounts if you are spreading your purchases over several different buying opportunities instead of buying product in one large volume at one time.

Land and Rents

Cropland values in Ohio have increased 9.9% (’04 to’05), 9.6% (’05 to ’06) and 10.7% (’06 to ’07) the last three years. There is a mixed bag of evidence at this point suggesting on one hand land prices will increase at these high rates, and on the other hand that land markets may cool “a bit” from the rates of increase that we’ve seen the last 3 years. Higher commodity crop prices and good to excellent crops in many regions of Ohio signal continued strong increases in land values. A much cooler housing/development market signals a trend towards a slowdown in the rates of cropland value increases. Land values should continue to increase at a 8-10% rate from 2007 to 2008.

Cash rents in Ohio increased 5.8% in 2007 and Enterprise Budget analysis suggests larger increases for 2008. Landowners hesitant to negotiate for higher rental rates due to past poor crop years, low commodity crop prices and/or high fuel and fertilizer prices may now seek higher rates with the continued high commodity prices and positive returns for ’07 and positive returns projected for ’08 and ‘09. Areas hard hit by drought and late season flooding may see cash rents remain relatively more stable as producers struggle with very low or negative returns. Projections are for 2008 Ohio cash rental rates to increase 5-15 % depending local factors.

Landowners and farmers should both consider different price/yield/cost combinations when negotiating cash rental rates for 2008 and beyond.

Seed and Crop Protection Chemicals

Seed company data indicates price for 2008 to be 5-10% higher among similarly traited seed. This is a fairly nominal amount and one not out of the ordinary. However, the “real world” increase to the farmer’s seed bill may be much more than 5-10%. Whether producers choose to switch to “traited” seed or are “forced” to select “traited” seed to plant the latest genetics from a given seed company, the result is the same; much higher seed costs per acre. Farmers should carefully consider the need for these seed traits by evaluating University as well as company research. Increases in gross revenues for many Ohio row crops projected for 2008 will allow producers to absorb these seed cost increases, but farmers should still carefully consider the need for the traits. Increases of $25-35 per acre may not be uncommon as producers switch from a “non-traited” to a “traited” hybrid or variety.

Crop protection chemicals prices have remained fairly flat over the last 2 years and several products have seen price decreases due to the prevalence of generic products in the marketplace. Continued high prices of petroleum products (main ingredients in many crop protection chemicals) will pressure prices to move somewhat higher. Increases of 3-4% for the total basket of crop protection chemical are predicted for 2008.

Farm Labor

At first glance, farm wages may be expected to increase nominally at a 3% rate over 2007, but expected high margins for crop producers in 2008 may allow for (and employees may request) better compensation packages for farm employees. Livestock producers facing tighter margins may not have the same ability to offer cost-of-living (or possibly any) wage increases in 2008. Employers offering health insurance should continue to see health insurance premiums increase by 10% or more per year depending on the product and company.

Dairy Management Workshops Planned

Ohio ‘s dairy industry is growing. Just a few years ago, we couldn’t say that, but cow numbers are increasing and the majority of dairy farms had a very good year in 2007. This winter, dairy farms that plan to be profitable participants in Ohio ‘s dairy industry for the next fifteen to twenty years should plan to participate in the “Managing the Dairy of Tomorrow” workshop near them.

Many Ohio dairy managers participated in Dairy Excel’s Managing for Success Workshops in the 1990s. Since then, a whole new generating is taking on management responsibilities on Ohio ‘s dairy farms. This new generation, as well as others who want to brush up on their management skills, should plan to participate in these workshops.

The three workshop days will focus on:

-A changing dairy industry

-Management styles

– Mission and goals

-Developing and using your cost of production

-Budgeting for the dairy business

-Evaluating business alternatives

-Controlling feed costs

-Business planning

-Managing people

Following the workshop, a team will visit on-farm with each participant. Participants will have the opportunity to follow up their class work with an on-farm FINAN enterprise analysis or develop a business plan.

Along with grant funding received from the North Central Risk Management Education Center , an excellent group of co-sponsors are supporting this educational program and encourage their clientele to participate in one of the workshops. Our co-sponsors include: Farm Credit Services, Ohio Dairy Producers, Dairy Farmers of America, Land O’Lakes Purina Feed and Affiliated Dealers and Co-ops, and the Ohio Dairy Veterinarians Association.

Workshops will be held at the following locations and dates:

Mercer County : February 13, 20, 27

Paulding County : February 19, 26, March 4

Ashtabula County: February 25, March 3 & 10

Mahoning County : March 12, 19, 26

Wayne County : March 13, 20, 27

Registration details will be available soon. If you have questions about the workshops, please contact Chris Zoller (330-339-2337) or Dianne Shoemaker (330-263-3799).

2007 Agricultural Census Coming Soon

The history of collecting data on U.S. agriculture dates back to President George Washington, who was known for keeping meticulous statistical records describing his and other farms. Such information was essential during this time when nine out of every ten Americans lived on a farm. They needed to know what crops they should produce to ensure a plentiful bounty for the people to eat.

While much has changed since then, the importance of accurate agricultural data to today’s farmers and ranchers is no different. As a highly technical industry, American agriculture relies heavily on statistical information to feed, fuel and clothe a growing world.

Farmers and ranchers will soon have the opportunity to make their voices heard and help shape the future of agriculture for years to come. That opportunity will come to their mailboxes in the form of the 2007 Census of Agriculture.

Conducted every five years by the U.S. Department of Agriculture, the Census is a complete count of the nation’s farms and ranches and the people who operate them. The Census looks at land use and ownership, operator characteristics, production practices, income and expenditures and other topics. It provides the only source of uniform, comprehensive agricultural data for every county in the nation.

The Census of Agriculture provides information that is not available anywhere else – information that benefits agricultural producers and their communities in myriad ways.

Policy-makers factor Census data into decisions concerning agricultural and rural programs. Community planners use Census to target needed services to rural residents. Companies rely on Census data when determining where to locate their operations. And farmers themselves can use Census data to help make critical decisions about their businesses.

The National Agricultural Statistics Service (NASS) will mail out Census forms on December 28, 2007 to collect data for the 2007 calendar year. Completed forms are due by February 4, 2008. Producers can return their forms by mail or, for the first time, they have the convenient option of filling out the Census online via a secure web site.

NASS is committed to making this Census the best count ever. Regardless of how large or small their operation is or what kinds of products they produce, farmers and ranchers will help themselves and their communities by filling out the Census of Agriculture and returning it promptly.

For more information about the 2007 Census of Agriculture, farmers and ranchers can visit www.agcensus.usda.gov online. This web site also contains many years of agricultural statistics for Ohio and all other states.

Work Opportunity Tax Credit

The work opportunity tax credit is available to employers hiring individuals from one or more of nine targeted groups. Generally, the credit limit is $2,400 per employee, based on 40% of the first $6,000 of qualified wages paid for services rendered by a member of a targeted group during the 1-year period beginning on the day the individual begins work for the employer. The employer’s deduction for wages is reduced by the credit. The 2007 Small Business and Work Opportunity Tax Act extended and changed the work opportunity credit for an additional 44 months, to cover qualified individuals who begin work for an employer before September 1, 2011. A designated community residents targeted group replaces the high-risk youth category, and the age limit is increased to include otherwise qualifying individuals who are at least age 18 but not yet age 40 on the hiring date. In addition, rural renewal counties are eligible communities for this group.

A rural renewal county is a county in a rural area that lost population during the 5-year periods 1990 through 1994 and 1995 through 1999. Rural renewal counties are located in 32 states. They include Ohio counties of: Crawford, Monroe, Paulding, Seneca, and Van Wert.

To be eligible for the credit, the employer is required to have the employee complete and sign IRS Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, and federal Department of Labor (DOL) Employment and Training Administration (ETA) Form 9061, Individual Characteristics Form. The employer then is required to complete his part of the forms and submit both forms to the state Department of Workforce Development no later than August 2, 2007. (A certification letter is returned by the state agency, and it should be maintained in the employer’s files along with copies of the completed Forms 8850 and ETA- 9061, as substantiation of eligibility for the credit.) To claim the credit, Form 5884, Work Opportunity Credit, is filed with the employer’s income tax return. The employer’s deduction for the employee’s wages is reduced by the amount of the credit, even if some of the credit must be carried over to another tax year. More information may be obtained at: www.IRS.GOV .

This information is available in the National Income Tax Workbook 2007, Land Grant University Tax Education Foundation, Inc. The workbook is available by attending one of the OSU Income Tax Schools, sponsored by OSU Extension and the AEDE Department at OSU. Tax practitioners wanting to attend a school should contact the following web address: http://aede.osu.edu/Programs/TaxSchool/.

Weather Related Income Tax Issues

Tax payers selling livestock due to feed shortages caused by drought, floods or other weather related problems have two options for postponing the income from the sales. The first applies to draft, breeding, or dairy animals that will be replaced within a 2-year period. The second applies to all livestock and allows a 1-year postponement of reporting the sales proceeds as taxable income. Sales in excess of the number ordinarily sold in the producer’s usual or normal business practice is treated as the involuntary conversion.

Gains for breeding or dairy livestock will not need to be recognized if the proceeds are used to purchase replacement livestock within 2 years from the end of the tax year in which the sale takes place. The 2-year replacement period is extended to 4 years if the weather condition that caused the excess sales also caused an area to be eligible for assistance by the federal government. It can be further extended by the Secretary of Treasury if the weather condition continues for more than 3 years. Generally, the new livestock purchased must be used for the same purpose as those sold because of weather-related conditions. Breeding stock must be replaced with breeding stock, and dairy cows with dairy cows. However, if the condition that caused the involuntary conversion also makes it infeasible to replace the livestock with similar livestock, then the livestock can be replaced with any property, including real property, used in the farming business.

The election for a 1-year deferral of income is available for any sales of livestock, sold in excess of what is normally sold, due to weather conditions. This election is available for both breeding and market livestock.

Generally, farmers who use cash accounting must report payments in the year they receive the payments. An exception to this rule applies to crop insurance and disaster payments allowing these to be postponed by one year. A farmer must be able to show that, under the taxpayer’s normal business practice, the income from the crop would have been reported in a year following the year of the receipt of the payment. The election covers all crops from a farm. Crop insurance proceeds and the disaster payments must be aggregated in determining whether to defer the income reporting or to include the payments in current year income. If a farmer has more than one farming business, a separate election must be made for each farming business. For purposes of this provision, separate businesses are defined as those for which the taxpayer keeps separate books and is allowed to use different methods of accounting. In general, that requires the businesses to be separate and distinct.

Some farmers received compensation for Crop Revenue Coverage (CRC) policies they purchased from the Federal Crop Insurance Corporation. These payments are based on the price, as well as the quantity and quality, of the commodity produced. Only the payment for destruction or damage is eligible for the deferral. Therefore, a farmer who receives compensation from a CRC policy must determine the portion of the payment that is due to crop destruction or damage rather than due to a reduced market price.

2008 Enterprise Budgets for Field Crops, Forages, Dairy & Sheep On-Line

Budgeting helps guide you through your decision making process as you attempt to commit resources to the most profitable enterprises on the farm. Crops or Livestock? Corn or Soybeans? Or Wheat? We can begin to answer these questions with well thought out budgets that include all revenue and costs. Without some form of budgeting and some method to track your enterprises’ progress you’ll have difficulty determining your most profitable enterprise(s) and if you’ve met your goals for the farm.

Budgeting is often described as “penciling it out” before committing resources to a plan. Ohio State University Extension has had a long history of developing “Enterprise Budgets” that can be used as a starting point for producers in their budgeting process.

Newly updated Enterprise Budgets for 2008 have been completed and posted to the Farm Management Website of the Department of Agricultural, Environmental and Development Economics. Updated Enterprise Budgets can be downloaded from the following website:

http://aede.osu.edu/Programs/FarmManagement/Budgets/

Enterprise Budgets updated for 2008 include: Corn-Conservation Tillage; Soybeans-No-Till (Roundup Ready); Wheat-Conservation Tillage, (Grain & Straw); Alfalfa Hay–Spring Seeding; Grass Hay-Large Bale System; Dairy Cow & Replacement-Large Breed; Ewe & Lamb Budget–Winter Lambing.

Our enterprise budgets are compiled on downloadable Excel Spreadsheets that contain macros for ease of use. Users can input their own production and price levels to calculate their own numbers. These Enterprise Budgets have a new look with color coded cells that will enable users to plug in numbers to easily calculate bottoms lines for different scenarios. Detailed footnotes are included to help explain methodologies used to obtain the budget numbers. Starting this year we will be updating these Enterprise Budgets periodically during the year is large changes occur in price or costs. Budgets will include a date in the upper right hand corner of the front page indicating when the last update occurred.

Highlights (or lowlights) of this years Crop Enterprise Budgets include increased prices for diesel and nitrogen. Three different Corn Production Budgets were developed with different Nitrogen sources; Anhydrous Ammonia (NH3), Urea-Ammonia Nitrate Solution (UAN or 28% N), and Urea. Price assumptions per lb. of actual N included in these three budgets are $0.415 per lb. for NH3 ($680/ton), $0.518 per lb. for UAN ($290/ton), and $0.549 per lb. for Urea ($505/ton). Off-Road Diesel is pegged at $3.00 per gallon.

Landlords and tenants should proceed with caution when negotiating cash rents based on 2008 field crop budgets. Commodity prices and input costs may change dramatically resulting in much lower or negative returns. Different price and cost combinations should be evaluated when budgeting for long term decision making such as long term cash rental agreements.

The entire set of Enterprise Budgets can be accessed at:

Conducting Successful Family Business Transition Meetings

There are countless excuses people give for not conducting regular family business meetings. For some, the need has not yet been recognized, in other cases present management isn’t ready to give up control and for others, the thought of discussing the future of the business upon the death of the present management team is not something they want to think about. However,future management of the business will happen by design or default. Conducting regular family business transition meetings can help families discuss the long-term operation and management of the business and minimize future problems. Specifically, these meetings can help develop a stronger family, develop a stronger business, plan for future ownership, and recognize and resolve conflict.

For more information on this topic, please refer to the OSU Extension Fact Sheet Conducting Successful Family Business Transition Meetings” available at http://ohioagmanager.osu.edu/resources/index.php and click on “Transition Farm Planning Factsheet Series.” Should you have questions, please contact Chris Zoller ( zoller.1@osu.edu ).

Some Basic Lessons in Risk Management

All businesses face a number of risks including production risk, price risk, input price risk, uncertainty in government policy and regulation, and labor risk. Social scientists, particularly agricultural and business economists, have produced a wealth of research on how to identify, analyze, and manage risk. How can this research be useful to farmers and agribusiness managers? This article highlights some key lessons.


Basic Concepts


Before highlighting the key lessons, a few important concepts need to be introduced.

First, economists use the term risk preferences to describe someone’s tolerance for risk. A firm or person who is completely indifferent to risk and only cares about maximizing profits is said to be risk neutral. A person who dislikes risk and is willing to pay money (i.e. sacrifice some profits) to avoid it is said to be risk averse. For example, a large farm that is diversified across several different commodities may be less risk averse than a small farm that produces only one commodity.

Second, it is important to be able to put a financial value on risk and economists often use the term risk premium to describe the financial cost of bearing risk. Risk premiums are common in everyday life. For example, the reason why people are willing to hold risky stocks rather than settle for simple savings accounts is because the expected payoffs of stocks over the long term is higher than the expected payoffs from a savings account. The difference in expected payoffs represents the “risk premium” that an investor gets for holding the riskier investment. Sometimes, rather than receive a risk premium, risk averse people may pay a risk premium to reduce their financial risk. This is called buying insurance.

Third, as a general rule, firms or individuals that are risk neutral tend to have very small risk premiums. They are less likely purchase insurance and are willing to bear more market risk in order to increase expected profits. Speculators tend to be risk neutral. On the other hand, firms or individuals who are risk averse are willing to sacrifice some expected profits to avoid risk. They tend to buy insurance and gravitate toward less risky investments and business opportunities.


Lesson 1: Don’t bear someone else’s risk for free and don’t expect others to bear your risk for free


Most people understand this lesson within the insurance context. People are willing to pay insurance premiums in order for others to bear their risks. People are also willing to buy risky assets such as stocks in order to earn a risk premium over a savings account. However, this lesson is often missed when dealing with business partners and employees so that people might fail to adequately account for risk premiums. An important point to keep in mind is that, regardless of the context, there is always a trade off between risk and return.

For instance, when a manager puts an employee on a pay-for-performance plan and performance is not entirely under the control of the employee (e.g. sales), then the manager may have to pay a higher average salary in order to get the employee to buy into the plan. Essentially, the manager is reducing her performance risk exposure while increasing the employee’s. Naturally, it would be appropriate to increase the employee’s average salary. If the manager fails to make this risk versus returns adjustment, employees may become disgruntled and some may quit.

Similarly, if a farmer is producing or selling under a production contract, the farmer should accept more risk only when he is compensated for it. If contract A contains a payment schedule that is contingent on many factors (e.g. death loss, feed conversion, fruit color, etc) whereas contract B offers a flat payment, then your next question should be: does contract A have a higher expected payoff? If not, then always accept contract B. This is how you would assess a stock or mutual fund and this is how you should assess your contracts.


Lesson 2: Minimize risk bearing costs by allocating risk to those who are most able to bear them.


The “cost” of risk bearing – the risk premium – varies across individuals. Thus, a rough estimate of risk preferences is needed in order to devise a strategy for dealing with risk. As a general rule, the more risk averse a person is, the larger is the risk premium required to get him to accept more risk. For example, an employee who is a single parent who is cash constrained and has no alternative sources of income is likely to be more risk averse then a young part-time employee who has alternative sources of income (e.g. parents). Thus, you would have to pay the single parent more than you would have to pay the young part-time employee to bear the same level of risk. A large corporate agribusiness that is well diversified across numerous product lines is likely less risk averse than a small farmer who sells only a single commodity. Why does all of this matter? Because it is very expensive to shift risk from risk neutral parties to risk averse parties. What implications does this have for managers?

First, this knowledge will enable you to optimize your labor management strategy. For example, if you are considering implementing a pay-for-performance plan to increase worker productivity, you must think carefully about the risk tolerances of your employees. If your employees are highly risk averse because they depend on a stable income, then you may have to pay a large risk premium to get employee buy in. The gain in productivity from the pay-for-performance plan might not offset the increase in risk premiums required to maintain employee morale and loyalty. If this case, it may be cheaper to forgo pay-for-performance and look for alternative ways of motivating performance. One caveat is that if performance incentives are absolutely necessary, then the employee may have to bear some risk. Then the manager must carefully balance risk versus incentives. See http://ohioagmanager.osu.edu/resources/wu_part4.pdf for a detailed discussion.

Second, risk neutral individuals or firms can make money by bearing risk for others. For example, one aspect of agricultural contracts is that contracts can allocate financial and production risks between contractor and farmer. If the contractor is a large, well-diversified company and the supplier is a small grower that produces only one or two commodities, then the optimal allocation of risk would be for the contractor to bear most of the risk and the supplier to bear a small portion of total risk. Why? Because the risk premium of the contractor is low relative to the risk premium of the farmer. Therefore, the “cost” of risk bearing is lower for the contractor than farmer. By bearing more of the risk, the contractor can avoid having to pay a relatively expensive risk premium to the farmer. This increases profits for the contractor. Essentially, the risk neutral contractor is providing insurance to the farmer in exchange for the farmer’s risk premium.


Lesson 3: Take advantages of differences in risk premiums to recruit and retain workers and suppliers.


Because different people have different risk preferences, their willingness to accept certain types of employment also differs. Thus, an employer can carefully design a compensation strategy to induce certain types of people to self select themselves into a job.

Ed Lazear, an economist at Stanford University , studied a change in compensation method at Safelite Glass Corporation in Columbus , Ohio . In 1994-95, Safelite changed the compensation method from pure hourly wages to piece rate variable pay, where glass installers’ pay depended on the number of glass units installed. Thus, while take-home pay became more variable and therefore riskier, the expected pay for strong performers was higher than what they would have earned under the old hourly pay plan. Lazear examined over 3,000 workers at all Safelite locations over a 19-month period and found that a switch to a pay-for-performance piece rate system resulted in about a 44% increase in productivity per worker. The output gain can be split into two components: a selection component and an incentive component. The “selection effect” refers to the gain that came from worker turnover where workers either were attracted to the piece rate or left the company because they did not like the piece rate. This selection effect, which is strictly due to a change in composition of workers resulted in a 22% increase in productivity. Presumably, the individuals that were attracted to the piece rate were willing to tolerate more risk in exchange for higher average payoff. The simple lesson here is that your compensation plan can actually attract certain types of workers. A highly variable compensation scheme that promises high payoffs for good performance is attractive to risk neutral types who do not mind risk. A fixed pay plan is attractive to risk averse types who are willing to accept lower average pay to avoid risk. The best plan for you depends on the nature of the job and the amount of risk taking you require of your employees.


Lesson 4: There are three major types of risk management strategies: diversification, hedging and insurance.


Diversification simply means to not put all your eggs in one basket. Most people are familiar with this concept because it is drilled into their heads by financial advisors. Thus, conventional wisdom would say that firms should diversify across product lines and farmers should diversify across crops. However, when diversifying, it is important to recognize that diversification is most effective when the various product lines or crops are not highly correlated with each other. For example, if the price of crop A and crop B rise or fall together, then diversification has little impact on risk exposure. Another point to keep in mind is that when evaluating risk exposure, it is important to consider the firm or farm as a whole and not focus only on individual sources of risk. It is possible that the various risks are uncorrelated or even negatively correlated so that the farm may be exposed to less total risk than it appears. For example, farmers are exposed to both price risk and production risk for their crops. If one focuses on price risk and production risk separately, it would appear that farmers are exposed to a lot of risk. But suppose crop failures cause a supply shortage which increases prices. Then it is possible for revenue (price × quantity) to remain constant so that farmers face relatively little risk. Note here that price and quantity move in opposite directions, which is why revenue risk is minimized.

Hedging means that you take an action that reduces your exposure to downside risk while sacrificing your opportunity for gain. You can achieve this by making forward purchases or sales to lock in on a price. By locking in on a price now, you eliminate your exposure to future prices swings. Futures contracts can be used to serve this purpose. Futures contracts are only one of many derivative instruments that are available for managing risk exposure. A complete coverage of derivatives is beyond the scope of this article. However, there has been a proliferation of good books on derivatives available in the business section of any good bookstore or library.

One can also purchase insurance to cover potential losses. With insurance, you are essentially willing to accept a sure loss that is small (you pay a premium) to avoid the possibility of a large loss in the future. Farmers can purchase crop insurance and there are many forms of business insurance available. In addition, some financial derivatives such as options , which gives the holder the right (but not the obligation) to purchase or sell something at a specified price in the future, can serve as a form of insurance.

Note that with both insurance and hedging, you must give up something to eliminate your risk exposure. What you give up with hedging is the potential for future gain. With insurance, you do not give up the opportunity to gain in the future; instead, you pay an insurance premium upfront. The method you choose should be the method that minimizes your costs of achieving the risk management level you desire.