Managing the Risk that Comes with Turbulent Times
A deeper look at the first two steps in handling uncertainty
The uncertainty of events in the environment that we find ourselves working in continues to increase. Major weather events, international trade and African swine fever are directly affecting U.S. agriculture and your feed and grain business.
Previously we reported on six steps to handling uncertainty adapted from “Strategic Response to Uncertainty” by Dr. Elizabeth Olmsted Teisberg.
In this article, we’ll delve deeper into some of her steps and provide examples for reference.
When formulating this list, be sure to distinguish between those things that are sources of uncertainty and those things that are direct results of your actions. We will get to the impacts of your actions in the next step.
In the book “Mastering Risk: Volume 1: Concepts,” by James Pickford, Dr. Lisa Meulbroek provides a useful framework to think about the risks or uncertainties that you face. She categorizes them by Product mix risk, Operational risk, Input risk, Tax risk, Regulatory risk, Legal risk and Financial risk. Many of these will overlap.
Let’s consider one source of risk in the Product mix risk area and one in the Input risk area.
Product mix risk: Trade wars with China are directly impacting your product mix and your associated profitability.
Consider two scenarios: one is a situation where a trade agreement is reached, and trade with China resumes to the levels before the trade wars started; and second, the trade war escalates with exports to China decreasing even further than they have already (for example, no export of soybeans to China in the next two years). Notice that we are suggesting something akin to “best” and “worst” case scenarios.
Input risk/regulatory risk: Labor is a key input for your business, so considering disruptive changes in the labor market is important. What would be the impact of a change in the minimum wage from $10 to $15/hour?
The bigger impact on your business may come with what you might think of as secondary impacts. Will you need to adjust the pay for other groups of employees when you pay the minimum wage employees a higher wage, so as to maintain relative wages within your business? Will a change in the minimum wage impact your ability to be competitive in the labor market?
For this change, let’s consider three scenarios: the minimum wage remains the same; the minimum wage increases to $10/hour; and the minimum wage increases to $15 per hour. For the remainder of this article, we will identify these as different “states of nature.”
First, consider the example of the minimum wage. Now identify two to three strategic responses that your feed and grain business can make. For purposes of this example, let’s consider these strategic choices: continue as you are doing and change nothing; upgrading your employee in-service/training program to ensure that your employees are the most efficient they can be; or substitute capital for labor.
In the second choice, you will be getting the best return from your employees — in fact, you may discover that you can increase wages, and with the increased efficiency, your returns may be steady or even increase.
In the third option — substitute capital for labor — you would evaluate all aspects of your operation and figure out where you might make the capital investment so that you are not as dependent upon people.
For the “Trade Wars with China” example, you might consider the business as usual approach. A second strategic option could be to diversity your business operations by developing new products/services so that you are not as dependent upon commodities that are directly influenced by Chinese trade wars.
Put numbers to the problem
For our discussion, we will assume profit is the variable you are focused on. You might, however, consider net present value, which would be very appropriate when looking at analysis for a multiple year time frame. For each different combination of a state of nature and a strategic choice — calculate the expected profit (or net present value) that you expect (or you might find it helpful to calculate the percent of the profit (compared to the “status quo” scenario) you expect from each scenario).
Work with your management team and use budgeting and planning processes where you can change key numbers and observe the impact on profit for different scenarios.
Create a table like the one shown in Figure 1. Each column of the table is a strategic choice, and each row of the table is a state of nature. Enter the profit levels in the corresponding cells. We have filled in some sample numbers solely to illustrate how to analyze your strategic choices in the face of risk. We used the minimum wage example for illustrative purposes.
The first thing to do is to consider all of the different profit levels. As you do this, consider the range of different profit levels that can occur when different states of nature arise and are combined with different strategic actions on your part.
How significant is the difference between the highest profit value and the lowest profit value? If this is a small number for your business, then you know that this is a source of uncertainty that you do not need to worry so much about — and you might move onto other risk sources. It this is a large value for your business, then you will want to give it the attention it deserves.
Now that you have your payoff matrix generated, there are alternative decision rules that you can consider as you analyze what strategic choice is best for your business. A key thing to keep in mind when evaluating a payoff matrix is to focus on the columns.
Compare one column with another. Remember the columns represent the different strategic choices, and you have control over what strategic choice to select. The rows represent the states of nature, which you do not control.
We have calculated the mean (simple average) at the bottom of each row. In this example, the average profit will be higher for the two strategic actions that are different from the business as usual action.
If, for example, you got this outcome — it should get you thinking about moving away from the status quo concerning the management of labor. One decision criteria is to select the strategy that results in the highest average payoff, which would be to select the “invest in capital to replace labor” strategy.
While the simple average values are interesting to consider, it is also important to note that it is just that — a “simple average” which assumes that all of the states of nature in the calculation have an equal chance of occurring. This may or may not be true.
You could calculate a probability adjusted or weighted expected value. To do this, you assign probability values (that add up to one) to each of the states of nature and calculate a weighted average.
If basing a decision solely on expected value, it would be better to use a probability-weighted average rather than a simple average.
While averages can be interesting, keep in mind that your business is going to experience one state of nature or another — not an average. ■
Dr. Joan Fulton is Professor and Associate Department Head, Department of Agricultural Economics and Center for Food and Agricultural Business.
Dr. John Foltz is Chair, Department of Animal Sciences, The Ohio State University, Columbus, OH, and Dean Emeritus, College of Agricultural and Life Sciences and Professor Emeritus, University of Idaho, Moscow, ID.