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Risk of net operating loss

As you study the ideas presented on this page, consider how these thoughts contribute to step 8 of the strategic planning process: "managing constraints."

In production agriculture, risk is often addressed as production concerns and price concerns. These two critical concerns have led to the development of risk management tools such as crop insurance and marketing strategies. Although these topics are important to production agriculture, risk needs to be thought about more broadly. For example, what risks do non-production ag businesses face? What risks do non-crop farmers face? What risks other than production and price do crop-producers face?

This page offers some thoughts on risk management. Although the discussion begins with a description of risk and risk management, it ends by addressing the question of "how does one prepare themselves to assume risk." The importance of being willing and able to assume risk will be explained as the discussion proceeds.

Challenge: begin this section by thinking beyond crop insurance.

Reference: Risk management; Kay et al; Chapter 15

A statement for your consideration: risk can be described as "Quantify the potential for losses in an investment and then take appropriate action or inaction given their investment objectives and risk tolerance."  

Alternatively, can risk and risk management be described as "identifying and quantifying the potential for loss resulting from pursuing a particular action, and then deciding on a practice or course of action in response to that loss potential"?

 

What is risk?

Risk can be described as the uncertainty or the unknown relating to an action or an activity. For example, the outcome of an action or event could be better than expected or less than expected.

"Being prepared for the unexpected" is an easy description of risk and risk management.

A point to ponder -- is risk always the risk of loss, or could risk and risk management also relate to unexpected opportunities?

 

Why think about risk?

Managers are concerned about the possibility that the outcome of an activity could be dramatically less than expected and that this one event could impact the business to such an extent that the business cannot recover or that it will take a substantial effort and considerable time to recover.

Often managers think about the downside of risk, that is, what could go wrong. But it also is appropriate to think about the upside of uncertainty, that is, when the result is better than expected or there is an unexpected outcome or opportunity. The purpose of managing upside risk is being prepared so an unexpected but short-lived opportunity is not lost.

A North Dakota producer several years ago described the time a neighbor called indicating a willingness to lease the land to the producer but that the neighbor wanted an answer before the end of the phone call. How do business managers prepare for such unexpected opportunities?

A willingness to assume a risk that your competitors do not assume may be the basis on which your buyers distinguish your product and service from those of your competitors, and thus provide an opportunity to "break out of perfect competition." For example, being willing to commit to weekly deliveries throughout the year may distinguish your business from those that are not willing to assume the risk of assuring weekly deliveries.

• Does having a strategic vision help one assume risk? Why?  This question is based on an experience from several years ago when I asked a group of North Dakota business leaders how one expands their willingness to assume risk.  Without pause, one business leader responded "develop a strategic plan".  This point is worth pondering.

 

Why begin this section with "Risk of net operating loss?"

Why would we want to specifically address the "risk of a net operating loss?"

Risk of net operating loss is the legal obligation to fulfill unpaid debts if a business incurs an operating loss. This legal obligation is usually borne by the business owners.

Does assuming this risk define business ownership?

The economic return for assuming the risk of a net operating loss is profit; alternatively, the economic return for assuming risk could be referred to as a premium.

Assuming risk of net operating loss defines business ownership; "I am considered the business owner because I bear the risk of a net operating loss"

• Business ownership is not the same as asset ownership. "Owning the land, labor, capital or information does not entitle me to the profit; I do not have to own the land, labor, capital or information to own the business."
• If these statements are true, it must be a person's willingness to assume the risk that the business may suffer a net operating loss that entitles that individual to receive the business profit, ultimately control the business, and claim ownership of the business.

Managing a business (making decisions) is not the same as assuming the risk (owning the business). A business manager may or may not be the business owner.

Bottom line -- if you want an opportunity to earn some profit, you need to assume the associated risk.

What risks does a business face?

What are some different types or examples of risk? How do these examples differ? What do these examples have in common?

• Sources of Risk (derived from Kay, et al)
  • Production/technical risk
  • Price/market risk
  • Financial risk
  • Legal risk
  • Personal risk

Additional examples of risk

• Availability of labor
• Availability of capital (this may not be a risk, but it can be an uncertainty)
• Equipment breakdown (is replacing equipment a strategy for managing the risk of equipment breakdown?)
• Health of the business owner (are health insurance and disability insurance strategies for managing the risk of the owner's health? is proper lifestyle practices a strategy for managing the risk of the owner's health?)
• Accidents that lead to personal injury of the business owner, manager, family member, employee, business associate/colleague, or friend

• Natural disasters such as rain, drought, storms, floods, etc. (is irrigation a strategy for managing the risk of drought? is drainage a strategy for managing the risk of too much water?)
• Power outage following a storm or other natural disaster (is purchasing a stand-by generator a strategy for addressing this uncertainty?)
• Natural event that damages your product, such as e-coli entering the food system

• Availability of transportation (is buying a truck a strategy for managing the uncertainty of whether a trucking firm can be hired "on time"?)
• Changing government regulations, e.g., regulatory revisions by importing nations (again, may not be a risk, but it is an uncertainty)
• Business activity or event that violates an environmental regulation
• Availability of a market in which to sell our product or service

• Livestock disease (example of Minnesota producer who stated "I will annually spend the $1 per cow for the vaccine")
• Terrorist attack on food industry (how does this threat impact the sector in which you operate?)

Additional examples suggested by students

• Are the fields dry enough to plant?
• Is there enough moisture to raise a crop?
• Will land be available to lease?
• Will the crop be harvested in a timely manner?

Have you thought about:

• Do the recent food safety concerns help identify risks; e.g., wildlife tracking e-coli into vegetable fields, a leaking pipe dripping contaminants onto food processing equipment, or an input supplier adding unacceptable substance into an ingredient?
• Consider the Minnesota farmer whose dairy operation was intentionally contaminated by a disgruntled neighbor
  • The solution involved installing security cameras, and locking mechanisms on facilities and equipment.
• Also consider a farmer or agribusiness' risk of anhydrous theft
• Consider the agribusiness firm that processes corn into food components. To address the firm's concen that aflatoxin may be present in its final product, the firm established a test procedure using a commercially available test. However as part of establishing a testing procedure, the firm studied/researched which test kit provided the most reliable results. The firm also set its standard for aflatoxin at the most stringent level, even though FDA would allow less stringent standards for some uses. This effort was intended to address the concern (the risk) that aflatoxin might be present in the firm's final product.

What would you add to this list?

• Risk of error in applying chemical to own crop
• Risk of non-timely operation if relying on custom operator
• Risk of rising interest rates
• Risk of rising input costs (e.g., fertilizer cost rising after entering into a rental agreement that was based on an assumption of lower fertilizer cost)
• Risk of labor without the necessary skills
• Risk of whether there will be enough storage?
• Risk of whether there will be natural loss or spoilage during storage?
• Risk that inventory is being wasted or lost due to worker indifference?
Risk that consumers change their preferences?

Businesses face more than market and crop production, fire and tort liability risks.

 

What strategy or practice would you consider to address these uncertainties?

What factors influence how a manager addresses these uncertainties? How might a business manager analyze 1) the cost of addressing a risk, 2) the benefit of addressing a risk, and 3) the cost of not addressing the risk? How is "probablity" incorporated into this thought process?

Is applying fertilizer a risk management strategy or an event that creates risk?

• Understanding risk and risk management requires that we consider "ability" and "willingness" to bear risk.
  • Ability and willingness to assume risk -- ability and willingness are not the same but both are needed for risk to be assumed
    • Ability to assume risk means "having the economic resources to pay obligations that arise when the outcome of an action or activity is negative."
    • Willingness to assume risk means "having the personal fortitude to accept responsibility of paying for obligations that arise when the outcome of an action or activity is negative."
    • An individual needs both capacity/ability and willingness to assume risk.
• What ability or capacity does the business have to assume risk? Does the balance sheet provide an indication of this capacity? How do others (such as lenders or suppliers) perceive the business' capacity or ability to assume risk?
  • Assumption is that individuals often expand their capacity or ability to assume risk as they accumulate assets during a lifetime of work.
  • Is the ability to assume risk primarily a matter of having cash, capital, equity, or the assurance that one can generate income from another source?
• What is the individual's willingness to assume risk? Do they accept the uncertainty or are they concerned (worried) about uncertain outcomes? Are they willing to risk the resources they have accumulated?
  • Assumption is that as individuals grow older, they are less willing to assume risk.
  • Can we expand our willingness to assume risk by developing a long-term vision; that is, by developing a strategic plan?

• Note: the assumptions are based on the idea that one's capacity and willingness to assume risk changes based on the individual's circumstance.

 

• An individual needs both capacity and willingness to assume risk. Whichever one is limiting, defines the level of risk the person assumes. If the assumptions are correct, capacity to assume risk is the limiting factor for many younger persons, whereas willingness to assume risk is the limiting factor for older persons. This also suggests that there may be a time in life when an individual is positioned to assume more risk because the two factors align.
  • Example: An young adult unmarried son (about 21 years old) was entering into business with his parents when he died in an accident. The parents felt they suffered a loss but were uncertain as to how to describe their loss. They had not lost land or capital; they were paying their son for his labor, so the loss of his labor was offset by the salary savings. So what was their loss?

    It was suggested that their loss was their "willingness to assume risk." For example, they were no longer interested in expanding their business (perhaps borrowing more capital or initiating new enterprises) because their son was no longer there to "take over" some time in the future. Without expanding their business, they lost the opportunity to enhance their profit. Accordingly, the parents' economic loss was diminished future profits due to a "diminished willingness to assume risk."

• Factors that influence capacity/ability to bear risk -- equity, income, credit history, availability of guarantees from others, including government, ???

• Factors that influence willingness to bear risk -- age, personal values, self-confidence, health, ???

• How would you describe your ability to assume risk?
• How would you describe your willingness to assume risk?

• Assessing risk

• How does a manager assess the risk associated with an activity?
• Does the manager consider the most likely outcome, the average outcome, or the outcome of an expert opinion?
• Does the manager consider the variability of outcome, range of possible outcomes, standard deviation among outcomes, and the coefficient of variation?

 

• Decision making under risk
  • Now that the risk has been assessed and the manager has considered both willingness and ability to assume risk, how does a manager make a decision about risk?
  • Begin by identifying the alternatives, such as assume the risk, assume but manage the risk, avoid the risk, etc.
  • Tools for making decisions involving risk: decision tree, payoff matrix, decision rules, most likely outcome, maximum expected outcome, risk and returns, safety first, break-even probability, etc

• Managing risk is not the same as reducing risk

• If you reduce risk, you may also be reducing ???

• Managing risk involves deciding which risks to accept, which to control, and which to avoid.
  • Consider 1) the likelihood or probability that an event will occur and 2) the magnitude of impact if the event occurs. 
    • Will the impact be financial?  Will the impact affect others, such as the decision maker's family?  Will the impact involve personal injury or illness?
  • What else does a manager consider in deciding which risks to assume?  For example, does a decision maker consider which uncertainties the manager can resolve should the event occur and which uncertainties the manager could not resolve should the event occur?  Does the manager then assume the risk of the events that the manager can resolve him- or herself, but try to devise a management strategy for the risks that the manager cannot resolve if the event occurs?
    • If an aspect of risk management is developing a strategic plan, and a step in strategic planning is self-assessment of one's skills, should the self-assessment process involve asking "what problems am I capable of resolving" and then assume the risk associated with actions where the person can resolve a problem should it arise, but alter exposure to risks where the manager cannot resolve a problem should it arise?
  • For agriculture producers, consider the government farm program
  • USDA Risk Management Agency
    • Yield and price
    • Crop Policies

• Insurance as a risk management tool
  • Types of insurance: health, disability, property, liability, life, professional (errors and omissions), business interruption/production, others??
  • Insurance is a contract
• Insurance policy or contract specifies which events or losses are covered and how much of the loss the insurer will pay or compensate ("policy limit")
• Considerations in deciding whether to purchase insurance: which events or losses are covered, what is the likelihood of the event, what is the impact or loss if the event occurs, how much of the loss would the insurer pay, what cost is the insurer charging to cover the loss

• Insurance "pools" risk -- who else is in the pool? How risky are their situations?
  • Their risks impact how much you will have to pay as a premium. Can you choose an insurance policy that places you in a pool with comparable risks?
• Someone is making money by offering insurance
• High risk usually means high premiums
• Use insurance to manage risk of losses you cannot afford; accept the risk of losses you can afford
• Use deductibles to reduce the insurer's risk and hopefully reduce your premiums but still protect yourself against large losses

• Insurer is not liable if insurer was not provided accurate information when the contract was created; do not mislead the insurer with wrong information when applying for insurance
• An insurer who has paid for a loss is entitled to pursue the client's claims against the person who caused the loss; insurance does not eliminate the question of who is liable for causing the loss.

 

• Paying an insurance premium directly reduces the insured's profit; that is, a portion of the insured's profit is transferred to the insurer in exchange for the insurer's assumption of some of the insured's risk. This observation further confirms the general statement that "the person who assumes the risk is entitled to the profit."

 

• Contracts as a risk management strategy

• A contract involves two parties agreeing to assume legally binding obligations to one another. A contract implies that the parties will perform or fulfill their contractual obligations regardless of what occurs in the future. Thus an agreement to perform implies the parties are assuming risks.
  • Many contracts are agreements to specify who bears which risks, as they are agreements to buy/sell, rent, or borrow
• Terms of the agreement -- anticipate what might happen and specify how the anticipated event will be resolved
  • This is the point at which the manager needs to know the businesses, understand the transaction, comprehend the business environment, and recognize alternatives for all negotiating parties
  • How does the idea that contracts address risk align with the idea that businesses pursue a strategy of collaboration?
• Futures market -- reduces price uncertainty.
• Does entering into a contract address one risk (e.g., price) while exposing the firm to another risk (e.g., must be able to deliver the agreed upon quantity)?  If this is the outcome of entering into a contract, what has the contract accomplished?  Has it eliminated risk?  Has it eliminated on risk but given rise to another risk?  If a contract replaces one risk exposure with another risk exposure, why enter into contract?  HINT -- is the manager possibly selecting which risk to accept?  If that is correct, how does a manager assess or decide which risks to accept?  Is part of the answer "a manager will accept the risk that the manager can resolve (or survive) if the uncertain event occurs"?

 

• Diversification as a risk management strategy
  • Do not be involved in just one activity
  • But does diversifying diminish the potential gain of specializing?
  • Does it make sense to specialize one's labor but diversify one's investments? Is this consistent with a professional who specializes but then invests their earnings in a variety of business through a mutual fund?
  • How does one share in the ownership of someone else's business? What business organizations or structures allow for shared business ownership?

• Are ongoing training, education, and gathering information part of managing risk?

• Managing production risk (based on Kay, et al)
  • Production risk -- uncertainty about the quantity and quality of product that will result from the production process.
  • Possible strategies: select stable enterprises, diversify (enterprises, locations, activities), purchase insurance, build extra capacity, hold inventory, negotiate lease terms, custom farming/feeding, input procurement
    • Example -- irrigation increases production but it also stabilizes production. Is a practice that stabilizes production a risk management strategy?
    • Example -- preventive maintenance on equipment, is that a strategy to manage the risk of an adverse impact of equipment breakdown?
  • Diversify the business enterprises, or specialize and diversify business investments?  How would farmers and ranchers diversify their farm business investments?

 

• Managing market risk (based on Kay, et al)
  • Market ris -- uncertainty as the price of an item, whether the item is being purchase or being sold.
  • Spreading sales, contract, hedge, options, flexibility
    • Example -- enter into a contract that assures that the buyer will purchase your production or that a supplier will provide the needed input?

 

• Managing financial risk (based on Kay, et al)
  • Financial risk -- the uncertainty associated with debt, including availability of cash in the future to repay the debt, future interest rates, the lender's willingness to continue lending in the future and the value of collateral securing the debt.
  • Fixed interest rates, self-liquidating loans, liquid reserve, credit reserve, owner equity

 

• Managing legal risk (based on Kay, et al)
  • Legal risk -- liability for damages that could result from the business operation, such as injury to another person or damage to another person's property; examples include accidents, an unsafe product, or environmental damages.
  • Business organization, estate planning, define your liabilities (insurance, contractual arrangements)

 

• Managing personal risk (based on Kay, et al)
  • Personal risk -- uncertainties about oneself, such as health, injury, illness or even death.
  • Health, life,
  • Insurance, prudent practices (exercise, rest, diet, carefulness), backup management

How does one learn to take risk?

• How does one learn how to assess a risk (e.g., able to identify a risk, estimate the probability of an adverse outcome, and estimate the magnitude of an adverse outcome)?
• How does one learn to manage a risk (e.g., what are the alternatives for addressing a risk)?
• How does one describe/assess their willingness to take risk? What prevents us from being willing to assume a risk? How does one alter their willingness to take risk?
• How does one measure their ability to take risk? How can one impact their ability to take risk?
• How does one combine their assessment of a risk with their assessments of their willingness and ability to take a risk to make a decision about which alternative to pursue in response to a risk?

• Does having a strategic vision help one assume risk? Why?

Closing thought for risk section:

• What are producers contributing if capital is borrowed; land is leased; technology (information) is purchased in the form of equipment, seed, pesticides, and other inputs; crop is insured; and field scouts and marketing strategies are hired?  Based on this contribution, what is the producer entitled to receive?
• What are taxpayers contributing if loans are guaranteed, crop insurance is subsidized, and income or prices are supported?  What do taxpayers expect in return for these contributions and how does that impact producers?
• Consider Walton, Gates, Buffet, Kroc and others; what did they "contribute?" To what extent were they contributing information and risk to their business?

• Has the discussion addressed risk analysis, risk taking, and risk management?

Closing thought for course:

• Review course objectives -- has the topics for each objective been addressed? Has the objectives been achieved? What can we expect for the future?

Last Updated December 7, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
Published by Agricusiness and Applied Economics
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