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I am Michael Langemeier from the Center for Commercial Agriculture.
Today I'm gonna talk about Diversification and
Diversification Potential, Diversification Strategy.
So there's several reasons for a farmer diversify, I'm gonna briefly talk about
these three reasons there's textbooks written on all of these topics.
And so we're just gonna briefly discuss each of these in turn.
The one that's the main focus today is managing production risk.
And so how can we use diversification to management production risk?
But also diversification is very useful to take advantage of cost synergies.
I'll get into an example of that.
But one of the examples is really simple.
When we grow corn and soybeans in rotation,
we do not need to use as much nitrogen fertilizer for that corn as we would have,
if we would have produced continuous corn.
That's an example of a cost synergy.
Also your soybean and
one of the reason why we don't have to use quite as much nitrogen is because we're
getting some of that nitrogen from soybeans the previous year.
And so that's just one example of cost synergies,
I'll get into more when I talk about that a little bit later here.
Also diversification can be a form growth strategy.
So one of the ways to expand our operation is to diversify into other enterprises.
Let's start with managing production risk.
In general, enterprise diversification reduces income variability, and
this is true even if two enterprises are very correlated.
So for example, rotation corns, rotation soybeans, they're highly
correlated meaning that the net returns follow each other over time very closely.
Yes, there's years where soybeans are a little bit better than corn and
vice versa, but they're very highly correlated.
Even in that situation, enterprise diversification diversify by using a corn,
soybean rotation compared to continuous corn, reduces income variability.
The extent to which diversification reduces income variability depends on
the correlation between the enterprises.
And so essentially, if you have enterprises that are less correlated with
one another, that encourages you to produce those enterprises together.
One example of that would be wheat net returns are not as
correlated with corn and soybeans as corn and soybeans are.
And so that might be one reason to put wheat into the rotation of course there's
other considerations when we're thinking about put weeding rotation, but
certainly that is the case.
There is lower correlation between wheat and corn, wheat and
soybeans than there is between corn and soybeans.
The classic example of managing production risk in agriculture is producing crops and
livestock on the same farm.
Many times the variability of the net return streams from those
two enterprises are not that similar and so
the diversification is pretty powerful in that case.
Examples.
I've already talked a little bit about this but let's get
into some more examples producing both GMO and non-GMO corn for different markets.
That the prices is not gonna be identical for
those two enterprises, and so that's an example.
Producing rotation corn and rotation soybeans instead of continuous corn,
crop and livestock production, spreading crop sales over time.
Many times we don't think of this as necessarily diversification, certainly not
necessarily managing production risk, but certainly managing risk.
If you sell all your crop at one time,
that's more risky than spreading those sales over several months.
And in using options and futures for example, also might might reduce risk.
And so that's a very important risk mitigation strategy.
Also something we also might not think about in terms of diversification.
This is more related to financial risk.
What I'm gonna talk about here, is holding a non-farm job.
You likely your wages from your non-farm job are not that correlated with your
net returns from agriculture, and so that's a way of diversify diversification.
Investing in non-farm activities, putting some money into an IRA, putting money into
a stock market, putting money into another small business, the returns from those
activities investment or other business activities are not necessarily correlated
with your farm returns, and so that's a form of diversification.
So I've made diversification sound like an extremely powerful tool in terms
of reducing risk and it is.
Don't get me wrong it is.
However, when we think about diversification, we also have to think
about the return associated with diversification versus specialization.
So that's the reason why, given the potential reduction risk in producing
multiple enterprises, we don't necessarily grow all these enterprises or
do all these things that would reduce risk.
And so in addition to risk is also extremely important to gauge the potential
return associated with diversification.
So when we diversify, what's the expected return of that strategy?
What's the risk of that strategy compared to our baseline strategy
where we did not pursue that diversification strategy?
And so always looking at both risk and
return is the way we want to make decisions regarding new enterprises.
Are shifting our enterprise mix.
The diversified farm very well may have a much lower return and specialised for
mitigating the benefits associated with reduction in risk.
I wanna talk about a couple cost elements right now,
before I move on to the next slide.
Why is that the case?
Why is sometimes that return for
a specialised farm higher than the return for diversified farm.
Well, a couple different reasons.
One those is economies scale, maybe to garner economies of scale and
crop production producing corn and soybeans.
We need to put all of our resources into corn and
soybeans rather than dividing our resources to the corn and soybeans and
contracts wind finishing, or putting up a laying bar, produce eggs things like that.
So we always have to compare the risk and returns,
from both specialize and diversification strategy..
Also, maybe the knowledge of our operators is a lot better or
a lot higher with corn production versus livestock production.
So it makes sense to specialize in crop production in that case.
This is an example of a trade off between expected return and variability.
This is actually a curve that was generated using three corn
storage strategies.
And so if we take a fairly low risk strategy,
it's a possibility of getting a dime increase,
a dime improving expected return over the base case just selling in the cash market.
But the standard deviation is relatively low,
at 0.2 as the standard deviation increases, we increase risk.
If we take a more risky strategy it's possible to get up to 30 cents per bushel
higher than just a straight selling in the cash market strategy but the risk
is three times what it was in the strategy where we were only getting a dime.
And so as we increase expected return we're increasing risk and different
individuals are gonna be different places on this risk return trade off.
If a person's relatively risk averse,
they're gonna be towards the lower end of this curve.
They're gonna be looking at that strategy where they might get additional dime over
the base case.
Someone that's a little bit less concerned about risk,
maybe interested in that strategy or strategies that could be a combination of
strategies where we get 30 cents per bushel over the base case.
And so where you're at on this curve really depends on your attitude
towards risk.
Now, let me shift gears and talk about economies of scope or cost synergies.
This occurs when the production of one good reduces the cost of producing another
related good.
So example, the classic example producing crop and livestock enterprises on the same
farm may increase the efficiency of labour utilization and capital utilization.
This is particularly true on a smaller crop farm, they can more effectively
utilize their labor, more effectively utilize their machinery tractors and
so on, by adding a livestock enterprise to that operation.
Also obviously, if we have manure with the livestock enterprise like we will,
we lower our fertilizer costs and so that's an example of a cost syenergy.
Diversification may utilize operator expertise that is currently being
underutilized.
That's another source of economies of scope.
Let's say we've got somebody on the farm that's really familiar with growing
non-GMO corn, waxy corn, why not take advantage of that knowledge and
maybe think about diversifying into the production of non-GMO corn,
waxy corn, white corn, seed corn things like that?
If we have someone in the business either that has some agribusiness
experience in those areas, or just born knowledgeable about those markets,
we can take advantage of that by diversifying into those activities.
Now I wanna go talk about the third farm strategy related diversification.
This is a strategy that there's a quite a bit written about, so
I'm just gonna briefly touch on this.
I'm calling this the diversification strategy related to farm growth.
From a marketing perspective, farm growth occurs in the following ways.
The last on the list is diversification, which I'm gonna talk about here.
This is creating new products to sell in new or different markets.
Let's look at these other examples before talking about diversification more fully.
Market penetration, selling more product in our existing markets.
And so if you're a corn soybean producer producing more corn soybeans for
our existing market, that's market penetration.
Market development, creating demand for existing products in a new market.
And so maybe continue to produce our corn and soybeans, but
let's explore different markets for those corn and soybeans.
Maybe we haven't been selling to an ethanol plant.
Maybe we could expand our market, by selling to an ethanol planners are looking
at prices in multiple ethanol plants.
Maybe we can truck our grain a little bit further and look at new markets.
And so that's market development.
Product development selling new products in an existing market,
that's probably closer to the non-GMO example where it's a very
similar product or producing GMO corn.
And it is a slightly different market, but it's a similar market.
And so that might be a good example of product development.
Whereas diversification as I indicated earlier,
we're creating an entirely new product.
Producing a different enterprise for a different market.
Do you think that diversification in this case is gonna account for less risk?
No, and so that's why I wanted to talk about this strategy
along with cost synergies and particularly managing production risk.
When we think about diversification in terms of managing production risk,
managing marketing risk, managing financial risk,
we typically think diversification is risk reducing.
Well, in this case, when we're looking at new products for
new markets, diversification is more risky than not doing these things.
So let's talk about this a little bit more.
This strategy is usually high risk due to the inherent risk associated with
developing new products and the farms lack of experience working in the new market.
And example a talk about the next slide little bit is,
producing organic corn and organic soybeans and organic wheat,
if we go back to our corn soybean farm, that's a new product.
There's different production practices for those organic enterprises.
We have to look at different markets that it's not the same market.
If it is, we're not gonna make any profit on that because organic crops
are typically higher price, if we can find the appropriate markets and so
that's more risky.
Then just not looking at that endeavor.
So a foreign pursuing a diversification strategy knowingly puts themselves in
a position of greater uncertainty.
Why would they want to do that if diversification is increasing?
Go back to my risk return trade off.
There's a potential for higher return.
I've done some work on this and it's on the Senate for
commercial agriculture website.
If you're willing to learn about organic crop production,
there is a potential for a higher return growing organic crops.
And so we're going after a higher return knowing that we're gonna take a little
bit more risk to do that.
Diversification also typically involves an expansion human and financial resources.
Let's go back to the organic corn and soybean and wheat example.
We have some knowledge gaps there.
If we haven't produced those crops before,
there also might be additional financial resources,
additional equipment that we need to purchase for those organic enterprises.
And so that's often the case with a diversification strategy.
And then a very important question here, the last point on this slide.
How will the new endeavor impact the farms current enterprises and resource use?
We are gonna lose focus, if we think about organic production.
Is that gonna a cost slippage in terms of our breakeven prices for our corn and
soybeans that are not growing organically?
Do we have the resources that, the human resources, then the knowledge,
the labor that we're gonna need to to engage in these organic enterprises?
So I've used organic enterprises to try to get Illustrate the content on this slide.
That is one of the examples I did wanna mention on a slide by itself.
Adding one or
more organic crop enterprises is a good example of a diversification strategy.
Another one that is common to the Corn Belt.
And also Indiana is adding a vegetable enterprise, maybe potatoes,
maybe tomatoes, something like that to the farm.
There is additional returns that could be garnered from adding that enterprise but
there's also additional risk and so always think about that risk return trade off.
Always ask the question.
When I'm doing something different, this case diversifying
into producing organic enterprise or vegetable enterprise.
Don't just look at the additional return also look at the additional risk and
do some what if scenarios.
What if the price for the organic or the vet organic enterprises as
vegetable crop is not as high, as what it has been historically?
Is this still a good idea to engage in these activities.
So just to summarize here, there's multiple reasons to for
a farm to diversify, in terms of managing production risk,
diversification typically reduces risk.
Also diversification is important to take advantage of cost synergies.
This is particularly important for small and middle sized farms,
many times diversifying you can more effectively utilize labor and capital.
And then finally,
diversification is a strategy if we're looking at new products for new markets.
It is a strategy related to farm growth and something you probably should take
a look at, if you're thinking about aggressively expanding your operation.
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