Very simply, your profit margin is your revenue minus your expenses. In order to figure out what this is in a future time period, you will need to estimate your input costs and your sales value. In some cases, this will be pretty straightforward.
For example, if you have locked in a cost or can determine an expense with reasonable accuracy such as for land, this will be known. Other costs however or the sale value of your product will be more a function of market dynamics in a deferred time period which are largely unknown.
The futures market is referred to as a price discovery mechanism in that buyers and sellers from all over the world actively place bids and make offers to buy or sell contracts on underlying commodities such as corn, soybeans, wheat, hogs, milk and cattle in future time periods. While the price discovered today on these commodities for delivery or settlement in a future time period may change, the futures market provides a means for these buyers and sellers to discover the value of these commodities daily.
Also, because a wide range of buyers and sellers are participating in this open auction process, the market is said to be an unbiased estimator of the forward price expectation.If you are buying or selling agricultural commodities tied to these futures contracts such as corn for example to feed hogs or cattle, the futures price can serve as a proxy for the anticipated cost or revenue for your operation.
It does not matter whether or not the futures price is correct about the eventual value that will prevail in the spot market. What matters more is the price can serve as a reference for your anticipated costs or revenues in that these prices are unbiased and coming from an active, dynamic market. How the prices the futures market discovers relates to the prices you pay or receive for the commodities you buy and sell in your local market is a function of how these values correlate to one another.
The Power of Strong Correlations
Correlation is a degree of association between two or more factors – in this case, a cash price in your local market to a futures price on an organized exchange. If you can determine that there is a strong correlation for prices you pay and receive in your local market to futures prices on the exchange, then the futures market can be used to model your revenues and expenses. In this way, the price discovery role of the futures market becomes a margin discovery tool by extension, and allows you to effectively model your profitability in a forward time period.
While other considerations need to be built into a profit margin model that accurately reflect your unique operation and local cash market dynamics, the futures market will be a central part of modeling forward profitability.