Margin management is a comprehensive approach to managing the net profit margins of agriculture operations by addressing the risks of variability in both input costs and output prices. In contrast to traditional risk management, margin management aims to address both sides of the margin equation as distinct but related variables.
Why manage margins?
The goal of margin management is to maximize net margins in any market environment, including when both input and revenue prices are universally high – or low. In that way, producers can gain greater control of their long-term profitability.
How does it work?
Using the futures market as a price discovery mechanism, agriculture producers can calculate a range of possible forward profit margins that might result as input and output markets move. They can then using and combining various contracting tools – including cash, futures and options contracts – to effectively narrow the band of possible margin outcomes. Then, as those markets moves over time, producers can adjust their positions to incrementally improve margins or address increased risk.
In this way, margin management allows producers to establish and maintain the precise risk/return balance that matches their operations’ financial situation, pricing objectives, risk tolerance and market bias.
Where do I start?
The first step of effective margin management is to create a plan that will serve as an objective and reliable decision-making framework. A plan will clearly define your organization’s margin goals, which may take the form of a desired level of profitability, stated as a return on investment rate, a dollar amount, or percentile of historical profitability.
A plan will also spell out the fraction of production that will be contracted, and when. Generally, triggers for coverage are based on levels of historical profitability. For example, you may want to initiate a position on 25% of production when margins reach the 75th percentile and increase coverage as margins hit the 80th, 85th and 90th percentile. In addition, a comprehensive plan should also provide guidance for minimum levels of protection in case those trigger levels are never reached. (Read more about protection when margins are low or negative.)
To be most effective, a plan should also spell out a variety of other details related to achieving the stated goals, including the methods that will be used to contract for purchases and sales, the time periods that will be actively managed, as well as the roles and responsibilities of those charged with carrying out the plan.
If you have questions or would like help creating a margin management plan for your operation, please contact CIH at 1.866.299.9333.
There is a risk of loss in futures and options trading. Past performance is not indicative of future results.
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