Using Total Margin to Assess and Manage Profitability
By Chip Whalen, Commodity & Ingredient Hedging LLC
The concept of a margin is not new. Simply put, revenues minus expenses equal the operating margin of a business. But many hog operations do not look at their enterprise in margin terms. Following a margin approach can significantly improve your profitability and help your business through the inevitable lean times that are part of any cyclical industry.
So how do you calculate your operation’s profit margin? From the revenue side of the equation, value of hog sales is the principal determinant for most operations. The expense side of the ledger is predominantly corn and meal. Fortunately, the futures market allows us to discover forward values for both feed costs as well as hog sales, and this provides the basis around which we can identify a hog operation’s profit margin.
In simple terms, the value of hogs minus the cost of feed and other expenses equals the operating margin. The futures exchange allows us to discover the best market-based estimate of what forward values will be for both hogs based on the Lean Hog contract that trades at the Chicago Mercantile Exchange as well as corn and soybean meal based on those corresponding futures contracts that trade at the Chicago Board of Trade.
Futures contracts are traded up to a year in advance or even beyond which allow us to identify a forward profit margin well ahead of when it will actually be physically produced.
Why is this important? Because the projected forward profit margin that you can identify in the market may change over time and your final physically-realized return might be different than what you identify today.
This can be either good or bad for you. A margin that improves over time will benefit your operation while a margin that deteriorates will hurt you. Identifying the profit margin is valuable for two reasons:
1. Anticipating seasonal tendencies. Changes in the margin as well as the components that make up the margin have tendencies that can be anticipated from one period to the next. This provides you clues as to whether the margin will improve or worsen over time. This is a key concept to grasp because it is often the case that the best profit margin opportunities for your operation may occur well ahead of the periods they will actually be realized in.
2. It allows you to use the market to manage this margin to the benefit of your operation.
Understanding these seasonal tendencies around the components of a hog operation’s profit margin and using them to anticipate how that profit margin may change over time from one period to the next is a powerful tool in assisting with the management of that profit margin. It is impossible to know exactly how strong or weak the profit margin will be in any given future period. However, it is possible to know what that indicated forward margin is ahead of time as well as identify how relatively strong or weak the margin is within a historical context for that period.
In addition, it is also possible to observe where the profit margin is from a seasonal standpoint. This allows you to anticipate whether you can reasonably expect it to improve or deteriorate from current levels as you move forward in time.
Here’s why this is important: it may be that a forward margin is strong by historical standards, yet coincides with a seasonal time when margins tend to decline. Identifying these situations allows you to manage or protect the margin from an adverse change that would reduce your operation’s profitability over time.
To illustrate, let’s look at the fourth quarter of a calendar year, often a time frame associated with poor margins as hog prices are under pressure during a seasonal period where the number of hogs as well as their market weight is increasing. Moreover, feed prices tend to increase into November and December following fall harvest lows. With relatively low hog prices and relatively high feed costs, fourth quarter is often a poor margin period for hog operations.
The chart above shows the months when 4Q margin tends to be strong (between 90%-100%) versus weak (between 10%-0%). We recommend that you look at fourth-quarter margin in the beginning of the first quarter. You will notice that there are two lines. The red line displays the seasonal tendency for all years between 1998-2007, while the blue line shows the seasonal tendency for those years excluding 2004 and 2005. Excluding 2004 and 2005, 4Q margin tends to seasonally peak in January, and is at its low in October and November (when you would actually be realizing much of that margin in the open market). Although there is a spike in margin in December, it still pales in comparison to several other periods.
We excluded 2004 and 2005 as these were years in which the hog price itself as one component of the margin was extremely strong in 3Q and 4Q. However, as the next graphs illustrate, there is a tendency in January for hog prices to be weak and for corn and soybean meal to show strength.
The graphs above introduce the topic of margin management. Identifying the indicated margin out in a deferred period in time based upon corn, soybean meal and hog futures prices is the first step in the process. The next step is to determine seasonally beneficial times to be expecting an overall favorable margin – often at times other than the period of physical contracting.
Once seasonally favorable times have been identified, it becomes valuable to look at the individual components that are driving the overall profit margin. This ensures that a comprehensive plan to address the overall margin is met with particular controls for each component.
Because there is a strong correlation between the cash prices of your hog, corn and soybean meal and the futures contracts that trade in Chicago, futures contracts can be used as substitute purchases and sales for the physical commodities. Holding other expenses constant and not factoring in basis considerations, if you sell Lean Hog futures against your projected hog sales and simultaneously buy corn and soybean meal futures against your projected feed purchases, you have effectively locked in a profit margin for your operation.
While expenses other than feed or feed expenses not associated with corn and soybean meal will ultimately cause the actual profit margin to deviate from what you can identify using futures prices, you have nonetheless offset a major source of the variation in your hog operation’s forward profit margin.
The futures market also provides other alternatives. Option contracts can be used instead of futures that will enable you to protect the profit margin that the futures prices identify, with added flexibility to allow for improvements that may occur with the margin becoming more profitable to your benefit over time. For example, you can lock in a minimum price for your hog sales as well as a maximum price for your corn and soybean meal purchases that effectively will provide you with a minimum margin in a forward time period. This added flexibility that option contracts provide present the hog operation with numerous contracting choices that can protect the unrealized profit margin.
Chip Whalen is Senior Risk Manager for Commodity & Ingredient Hedging (CIH) and the Hog Margin Management Service (HMMS). CIH is a consulting firm based in Chicago advising agricultural-based businesses on their price management needs. Contact: 800-241-5498, www.cihedging.com
|
