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Business Planning --

Managing Constraints*

Farmers know that unexpected events will interrupt even the best developed plans. This step in the planning process is where owners identify and prepare for events that could interrupt or constrain implementing their farm business plan. These events are referred to as constraints; that is, events which significantly interfere with executing the plan. At this point in the planning process, farm owners can consider

• which constraints are likely to be encountered in implementing the business plan, and

• what steps can be taken in anticipation of these constraints.

Assessing and managing risk are major components of this step.

A constraint can be negative, such as adverse weather, higher than expected costs, or lower than expected yields or prices. Constraints also can be positive, such as a brief marketing opportunity, a chance to acquire an adjacent tract of land, or an unanticipated $20,000 revenue.

Negative Constraints

Negative constraints focus on what can go wrong in the business; what if production is below expectations, what if prices fall, what if disaster strikes, what if ... Being prepared to prevent a bad situation from becoming a disaster may be a determining factor in whether the owners' goals are met.

Positive Constraints

Positive constraints can be described as opportunities that arise. They pose the challenge of assessing whether the business is ready to take advantage of an unexpected break. Examples of opportunities include a chance to acquire an adjacent tract of land or to sell at a temporarily higher market price. In such situations, the business owners often need to act promptly before the opportunity is lost. Being prepared to quickly but adequately assess an opportunity and then to timely implement the decision is one method of managing positive constraints.

Positive constraints also pose the challenges of

• distinguishing a potentially profitable opportunity from one that is likely to fail;
• determining whether the opportunity aligns with the business' current mission statement; and
• deciding whether the opportunity warrants revising the direction of the business so to better fulfill the owner's goals.

Even though negative constraints often are emphasized, the importance of being prepared for opportunities cannot be overlooked.

Examples of Constraints

Business owners face a wide range of constraints. The following list is provided only to suggest possible constraints; farmers who develop such a list for their operations will likely find that their list is more extensive.

• Production uncertainty due to disease, weather, natural forces;
• Price fluctuations due to market forces of supply and demand, government policies, farm programs, trade policies, and other factors; although the emphasis often is on downward price movement, opportunities offered by increasing prices should be part of the plan;
• Costs fluctuations , especially increasing costs; for example, the owners thought input cost would rise between 3% and 4% this year (see step 3) but it went up 10%, what can they do; alternatively, does a price drop justify using more of the input; production costs may change due to market forces, regulations (such as changes in environmental or food safety rules), or production technology;
• Resource availability -- will tasks be completed in a timely manner; concerns often include
  • an illness, disability or death of a manager/owner,
  • equipment breakdown which prevents field work from being completed in a timely manner,
  • inadequate facilities for commodity storage, livestock housing, or equipment maintenance,
  • availability of unskilled, skilled and managerial labor;
• Availability of land also can be a concern;
• Inadequate cash reserves due to unfavorable price and cost movements, unexpected costs, taxes, or a need to increase cash withdrawal to meet living expenses;
• Incomplete information about changing production techniques, or market opportunities;
• Obsolescence of equipment or facilities; what was adequate last year may not be adequate today; obsolescence can prevent the business from being a competitive producer;
• Fluctuating interest rates due to market forces, fiscal policy, or monetary policy.

This list could include any event that would interfere with the owners reaching their goals for profit, cashflow, equity accumulation, time off, and other personal interests.

Questions farmers may want to pose to themselves as they develop the list might include

• whether the capacity of the equipment matches the farm's acreages, intended enterprises, and available labor or capital;
• whether available information is the type needed to operate the business; and
• whether actual prices, costs or yields will differ from expectations.

A review of previous steps in the planning process also may be helpful; for example, what resources does the business currently have available (step 1), what are the owners' expectations of the future (step 3), and what do the owners need to operate their farm in the future (steps 5, 6 and 7).

Assessing the Importance of the Constraint

Each constraint the owners identify is not of equal importance. Some constraints will be critical to the success of the business and the goals of the owners. Other constraints will be insubstantial. The level of importance of each constraint will be unique for each farm operation and its owners.

Two factors should be considered in attaching importance to a constraint: 1) the probability that the constraining event will occur, and 2) the impact the event would have on whether the owners' goals are fulfilled. For example, constraints that are most likely to occur and that have the greatest impact on the business are the most important ones to consider. The least important constraints are those with the lowest probability and would have the least impact on fulfilling the owners goals. Information about probability and impact can be based on the farmers' data/experiences, or the experience of others.

It may be helpful to think about the importance of a constraint as the product from multiplying the probability of the constraining event by its impact. The smaller the product, the less important is the constraint. Therefore, if either the probability or the impact is low, the need to address the constraint is not critical.

Few business owners know the probability and impact of a constraint with statistical accuracy, but they almost always have a perception as to whether they think the probability and impact are high, moderate, or low. By relying on their experiences, farm owners should be able to identify which constraints are most critical to their operation.

Business owners also can utilize sensitivity analysis to assess the impact of a constraint. This technique involves

• preparing the farm's budgets again but using various prices, costs, and production levels, and
• comparing the results to what was projected using expected or average prices, costs and yields.

For example, sensitivity analysis might reveal that a 8% drop in the expected market price will result in a 30% decrease in profit and eliminate 75% of the farm's cash reserve.

Businesses with more extensive data can use additional analytical techniques such as 1) statistical procedures to compute a coefficient of variation or 2) the construction of a decision tree .

Risk Management

After having identified possible constraints and assessed their importance, the owners are ready to decide how they will manage their constraints. Several general observations can be made.

First, the owners will want to manage the constraints, but not eliminate them. Negative constraints are the risks associated with operating a farm, and experience has demonstrated that eliminating risk also diminishes the opportunity to earn a profit. Therefore, owners who have a goal of earning a profit from their farm operation will not want to eliminate all their risks; but instead, manage them.

Second, there are three basic management strategies with respect to risk/constraints:

• avoid the risk by not engaging in the activity that leads to the risk exposure (this assumes the risk can be avoided),
• do nothing because the probability and impact of the risk are so low that it does not warrant any management effort (or the cost of managing the risk exceeds the cost of doing nothing), and
• manage the constraint.

Managing constraints is discussed further in the next section.

Third, deciding which strategy to use will reflect 1) the business' capacity to assume risk, 2) the owners' willingness to assume risk, and 3) the trade-off between the outcome of the current risk exposure and the outcome of a reduced risk exposure. The business' capacity to assume risk is considered in completing step 1, whereas the owners' willingness to assume risk is part of step 2. Assessing the trade-off among various risk management strategies is part of this step.

Fourth, in managing the constraint, the objective will be to 1) alter the probability of the event, 2) alter the impact of the event, or 3) both (before the event occurs), or 4) have a contingency plan to implement after the event arises. An example of each strategy would be

• preventive equipment maintenance to change the probability of the event of equipment breakdown,
• purchase of insurance to alter the impact of a hailstorm on the profitability of the business,
• diversification to alter both the probability and impact of a crop failure, and
• having a cash reserve as a contingency plan to take advantage of an opportunity when it arises.

Additional Examples of Strategies to Manage Constraints

It would be futile to attempt developing a list of all possible strategies for managing constraints (just as it would be futile in a preceding section to list all possible constraints). The following list of possible strategies is provided in the hope of stimulating ideas.

Constraint and Possible Strategies

Production uncertainty:  acquire crop insurance; diversify** commodities being produced; diversify the business geographically; adopt technology that counters the impact of nature such as irrigation, drainage, fertilizer, and pesticides; use a share-crop lease

Price fluctuations:  contract to sell commodities; enhance the farm's marketing efforts; improve the owners' marketing skills; use the futures market such as hedging and options; produce for a niche market

Costs fluctuations: purchase or contract for services and inputs during the off-season; identify alternative inputs that can be used if price of normally used inputs increases dramatically; adopt production practices that do not use some inputs

Resource availability:  buy more of the resource that is in short supply; dispose of excess resources through sale or lease; improve storage facilities; practice preventive maintenance on equipment; buy larger equipment; be ready to hire additional help; acquire health, disability, and life insurance; alter production techniques or produce a different commodity to make better use of available resources

Availability of land:  buy the land or enter into a long-term lease

Inadequate cash reserves:  maintain a line of credit; maintain cash reserves; borrow more cash; seek outside investors; invest non-farm assets in the business; reduce owners' cash withdrawal; postpone capital investments

Excess cash reserves:  have an idea about investing in either farm or non-farm assets; set cash aside for future business expansion or expected increases in living costs like education, home improvements, or retirement; prepay loans

Incomplete information:  seek training; buy information; hire consultants

Obsolescence:  upgrade or replace equipment and facilities; buy up-to-date technology

Fluctuating interest rates:  consider both fixed and variable interest rate loans; shorten or lengthen the duration of the loan or investment; consider the use of equity and debt arrangements

The list of constraints and strategies is not all inclusive; most farm owners will probably add to both categories. However in all cases, farm owners will weigh the benefits of reducing or eliminating a constraint against the cost of that action. A strategy to manage a constraint should be adopted only if the benefits exceed the costs, and it moves the owners closer to fulfilling their goals.

Again, some strategies will reduce the probability of an event (such as preventive maintenance reduces equipment breakdown, or a healthy lifestyle reduces illness). Other strategies will reduce the impact if an event occurs (for example, insurance). Contingency plans, on the other hand, are strategies that can be implemented quickly if an opportunity or constraint arises (such as maintaining a cash reserve).

Some constraints cannot be overcome regardless of the owners' efforts and perseverance; for example, the climate of most of North America prevents the production of bananas. In such a situation, the constraint is not price or yield, but instead, a lack of comparative advantage, soil fertility, rainfall, or some other limitation. Hopefully, this type of limitation will have been identified and addressed in steps 5, 6 and 7 of the planning process.

Another question farmers consider when identifying strategies to manage constraints is "how and why is this factor constraining or limiting the farm operation." The answer may identify how the resource is being used and suggest a strategy to improve the situation.

As stated above, the strategy that the farm owners adopt reflects both their business' ability and their individual willingness to bear risk (as described in previous steps), but they are intertwined. For example, the capacity to assume additional production risks is influenced by the availability of insurance, production and management skills, and diversity of enterprises. Accordingly, proper management of risk exposure will extend the business' capacity to assume risk, and thereby, allow the owners to engage in additional activities. Likewise, storage capacity, perishability of the product, marketing skills, and willingness to use marketing tools (such as forward contracts and hedging) affect the capacity of a farm to assume price risks.

A final question in devising and implementing a management strategy or contingency plan is whether the strategy needs to be followed only this production season or whether there has been a fundamental change in the business, industry, or operating environment that requires a permanent change. Although the answer to this question may not always be obvious, successful farm owners recognize its importance.

Rationale for the Selected Strategy

This activity involves explaining the rationale for selecting a particular risk management strategy. The general reason may be that it helps the owners fulfill their goals. However, specific reasons for adopting a particular strategy will vary. It may be that the strategy best fits the business' capacity to assume risk, or the owners' willingness to assume risk.

Specifying the reason for adopting a strategy can be helpful in revealing assumptions, expectations, and the thought-process of the owners. In some cases, being able to quantify the trade-off among various strategies may be desirable, but most owners will not have the data necessary for such calculations (maybe they will in the future). More likely however, owners will continue to rely on their expectations and experiences to make decisions. Thus the reason for the decision may be a explanation of their thoughts, rather than extensive calculations.

Example: I believe that the risk of drought is moderate and that its impact on my business would be high; therefore, I want to manage this risk by purchasing crop insurance. This strategy imposes the cost of the premium; but I prefer that over exposing my business to a loss of all revenue.

Developing the reasons also may lead to a reassessment of the situation and a different decision. Finally, recording the thought process can reduce the problem of forgetfulness or selective recall.

Goal for Selected Strategy

The next activity in managing risk would be to set a goal or performance benchmark for the selected strategy (performance benchmarks are addressed in more detail in step 9). By setting a benchmark, the owners are specifying what they expect to accomplish by adopting the strategy. If the benchmark is not reached, a different strategy could be considered in the future.

Example: By paying this insurance premium, I expect to reduce my personal stress as well as in case of a drought, receive enough benefits to pay my cash operating expenses. With these goals in mind, the owner, at a later time, can assess whether the cost of the premium provided the desired outcome, or whether a different strategy should be used in the future.

Example: By spending $_____ on additional equipment, I expect to reduce the time necessary to complete this task by ____ days. Again, with this goal in place, the owner, at a later time, can assess whether the equipment purchase resulted in making available additional time for other activities, or if the equipment is not the only constraint in completing the task more quickly.

 

Risk Associated with Selected Strategy

Some constraints can be easily addressed (such as leasing out excess acreage), some can be addressed only with expenditure of substantial assets (such as inadequate livestock housing to overcome disease or rate of gain problems), and other constraints cannot be altered by the farmer (such as changes in government farm program, market prices, and weather). Each management strategy, however, exposes the operation to other risks.

Example: Entering into a contract to sell a commodity before it is produced not only exposes the sellers to the risk of their individual production, but also to the risk that the commodity's overall production is less than normal; that is, having to pay a higher market price to acquire substitute commodity to fulfill the contract.

Example: Using the futures market to hedge against price movement but then being prevented from experiencing a favorable price shift (that is partial reason why options have arisen to complement future contracts).

Example: Seeking outside investor as a means to generate cash, but encounter a legal restriction.

Example: Borrowing more to increase available cash, but this increases the level of fixed cash commitment in the future when the loan matures.

Example: Acquiring a resource that is in short supply, but depleting cash or credit reserves.

Example: Buying up-to-date technology, but committing the resources to a use with little or no alternatives (e.g., specialized equipment or facilities).

Example: Acquiring additional land to generate more cash, but increasing the risk of expanding the business and requiring more management time and skills.

 

Each of these examples illustrate that strategies to manage risk also expose the business and its owners to different risks. A question owners sometimes end up addressing themselves is "which risk should we accept."

Worksheet

The attached worksheet suggests activities business owners may want to consider in deciding how to manage the constraints that may impact implementing their business plan. These activities include

1.   Identifying both negative and positive constraints.

2.   Assessing the importance of each constraint, based on the owners' perception of probability and magnitude of impact.

3.   Selecting a strategy of avoiding the risk, doing nothing, or managing the risk; the criteria for selecting a strategy will reflect the business' capacity to assume risk, the owners' willingness to assume risk, and the trade-off between the benefits and costs of each strategy; strategies for managing risk will likely alter the probability or impact of the constraint, or result in the development of a contingency plan.

4.   Specifying the rationale for selecting that strategy.

5.   Setting a goal for the strategy so the owners have some idea as to how they will assess whether the strategy was effective and should be continued, or if it should be modified in the future.

6.   Identifying and considering risks associated with the selected strategy.

Conclusion

Identifying and assessing factors that may substantially interfere with implementing the business plan allows farm owners to prepare for uncertainties and opportunities. Planning for unexpected events can reduce the amount of time spent in identifying and implementing an alternative when time may be most critical or when tension is at its highest. Being prepared for uncertainties is one step in the owners' efforts to reach their goals.

* Prepared by David M. Saxowsky, Dr. Cole R. Gustafson, Dr. Laurence M. Crane, and Joe C. Samson, agricultural economists, Department of Agricultural Economics, North Dakota State University. August 1995.

** Diversification is most meaningful as a management strategy if the risks of the various activities are negatively correlated.

Last Updated May 30, 2007

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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