National Program for Integrated

Dairy Risk Management Risk, Uncertainty, and

Education & Research Management
Implications

by

Kevin J. Bernhardt
University of Wisconsin-Platteville

IDMR-100-2

1. Introduction
2. Risk and Uncertainty Defined
3. Management Response
4. Terminology
5. Bibliography

Risk Management Implications: An Introduction

In his popular book Seven Habits of Highly Effective People, Stephen Covey promotes a
principle of “beginning with the end in mind.” Applying that principle to this discussion
on uncertainty and risk, you might also ask what is the “end”, that is, why should I care?
The answer is that you want to improve your ability to pay your bills, bring a son or
daughter into the operation, and maintain the long-term viability of your farming
business. Thus, overall, the “end" is improving the manager’s ability to manage and
make decisions that take into account the potential negative impacts that can occur on
profits and other farm family and business goals. Understanding the distinction between
uncertainty and risk, the different management responses required by each, and the
different tools available to manage each, are steps towards that end. This discussion will
explore those steps, and how we can use that information to improve management of the
dairy business.

Impacts on the dairy farm business
resulting from uncertain and risky events
should not be taken lightly. The value of
the business at risk can be minor such as
a 10% increase in the towels used for
teat cleaning. On-the-other-hand, the
value at risk can be major where the
result is catastrophic, and radically
alters or ends family, personal, and/or
business life such as bankruptcy, death,
severe disability, or a significant herd
biosecurity attack. The paper by Wolf
titled “Risk Exposure on Dairy Farms”
provides some numerical examples of
the impact of risk and uncertainty.
Whether the value at risk being managed
is minor inconvenience, catastrophic, or
somewhere in between, understanding of
the distinction between uncertainty and
risk, the management responses required
by each, and the different tools available
to manage each is a beginning step
towards protection.
Some terminology has already been
used, or will be used, that you may not
be familiar with, such as event, outcome,
probability, and value-at-risk. A full
description of these terms is in appendix
A. In brief, an event is when something
happens or occurs such as rain,
movement in prices, or a decision to
treat a cow or cull a cow. Outcome is
the result or consequence of an event.
Probability is the likelihood that some
particular outcome will occur such as a
30% chance of rain. Value-at-risk is the
amount you will lose if the negative
event occurs, e.g., how much does the
business lose if the barn burns down.
Risk and Uncertainty Defined
When one hears the words risk or
uncertainty, it usually conjures up some
ideas about negative events that could
occur - reduced profits due to depressed
IDRM CL100-2
prices, losing the barn to fire, crop loss
due to hail damage, reduced milk
production, death loss due to a disease
outbreak, an employee making a
mistake, or an employee not showing up
for the morning milking to name a few.
In some cases, there is advanced
knowledge and information of the likely
occurrence of some negative event. For
example, as devastating as it was, the F5
tornado that struck Oklahoma in May,
1999 could have been a lot worse if
people had not been warned to take
shelter. That warning was possible
because there was enough knowledge
and information to predict this likely
tornado event.
Economists and others use the terms
“risk” and “uncertainty” to define the
level of knowledge and information
about an event or occurrence. The
importance of this knowledge is that it
affects how you, the manager, plan, what
decisions you make, and what tools are
at your disposal to use.
Specifically, uncertainty is defined as:
a situation when either you do not know
all the possible outcomes, the probability
of the outcomes are unknown, or both
the outcomes and the probabilities are
unknown.
The definition of risk is:
a situation where all possible outcomes
are known, and while you do not know
which outcome will occur for sure, you
do know the probability associated with
each possible outcome occurring.
Thus, as a manager, you have more
information and knowledge on what may
likely result from a risky event that you
would from an uncertain event. Let’s
illustrate further with a couple of
examples. Federal Order reform is an

uncertain event (for more discussion on
Federal Orders see Cropp’s paper titled
“Risk Management and Milk Prices
Under Federal Milk Marketing Orders”).
As a dairy farm manager, or anyone else,
there is no real way of knowing what all
the possible outcomes for Federal Order
reform might be. Even if we did have an
idea of what the possible outcomes
might be, it would be very difficult to
attach a probability of occurrence to any
one particular reform outcome. Another
example is the changing tastes and
preferences of the consumer. How much
will the “Got Milk” campaign increase
demand (and thus price) for milk? Will
there be new health research published
either favorable or unfavorable to dairy
products that will impact demand and
price? These examples illustrate that
what the potential outcomes are is
unknown as well as the probability of
any particular outcome.
The textbook example of risk is a coin
toss. Given a fair coin and a fair toss,
we don’t know whether it will be heads
or tails, but we do know all the possible
outcomes that could occur (either heads
or tails). We also know ahead of time
what the probability of each outcome is -
50% for heads and 50% for tails.
FIGURE 1
Uncertainty
|----------------------|----------------------|----------------------|----------------------|
Probabilities Some Knowledge
[and Outcomes]
Unknown
IDRM CL100-2
Another example is weather forecasts.
Suppose you have hay to put up and you
are deciding whether to put it up today
or let it dry for one more day. All the
weather forecasters in your area agree
(perhaps a big assumption) that there is
an 85% chance for rain the next day.
The risk is whether it rains or not. It is a
risk, versus an uncertainty, because you
know what the potential outcomes are -
rain or no rain; and you know the
probability of each outcome - 85% rain
and 15% no rain. The prudent manager
would likely reduce risk by putting up
hay today.
To this point, one might conclude that
events are either uncertain or risky.
However, as Casavant, et al. point out
risk and uncertainty are polar extremes,
but in the real world many situations
have characteristics of both. Thus, it is
more realistic to view uncertainty and
risk as a continuum as figure 1 illustrates
below (source: Casavant, et al. pg 313).
Casavant et. al's illustration shows the
knowledge of probabilities, however, the
knowledge of outcomes is also a factor
in the continuum of uncertainty to risk
and is included in the brackets ([]) in
Figure 1.
Risk and
Uncertainty Risk
Probabilities
of Probabilities [and Outcomes]
[and Outcomes] Known

Kreitner also focuses on a continuum, but he
begins with “certainty” as one polar
extreme, “risk” in the middle, and
“uncertainty” at the other extreme.
“Certainty” exists when we know what
outcome will occur for sure. The probability
is 100 percent. Complete certainty does not
often happen in the dairy production
business, or any other business for that
matter. However, if we allow ourselves to
back off the rigid extreme, then Kreitner’s
point is well taken, i.e., there are many
occasions when the manager is fairly
confident of what the outcome will be as a
result of some decision. Kreitner presents
his continuum in the context of the
confidence a manager has in making and
implementing some decision. Figure 2
illustrates Kreitner’s thoughts that the more
one’s knowledge of an event moves towards
uncertainty, the more the manager’s
confidence in the outcome of a decision
dissipates.
Management Response and Tools for
Addressing Risk and Uncertainty
As seen in the definition, one key difference
as one moves from uncertainty to risk is the
knowledge of probabilities. This distinction
results in different management responses,
and different risk management tools that the
manager may be able to employ. As a
general rule, if it is a risk situation, i.e., the
probabilities of alternative outcomes are
known with some confidence, then there is
likely someone who is willing to insure
against the negative outcome given that they
are paid a fee to do so.
For example, we know with some
confidence what the alternative outcomes
and associated probabilities are for weather
over a production season - percent
probability of drought, normal, wet, etc. If
there is historical data, then we also know,
with some confidence, what the probability
IDRM CL100-2
is for yields in a certain area. Given good
information on the probability of yields,
weather, and the correlation between them,
it is possible to predict the chance for a loss
and how much that loss might be. Thus, if
someone wants to insure that you will
receive a certain yield, they have the
information to determine what losses are
likely to be on average and how much they
would have to pay out in any given year.
Once that is known, the insurer charges you
a little more than expected losses. The
insurer gains a profit for taking on your risk,
which is a cost to you, and you have the
benefit of being protected from a negative
outcome.
While an insurance contract is often a
possibility with a risky event, it is not the
only strategy that one could employ. For
example, while crop insurance could be used
to protect a growing crop from adverse
weather events, other strategies could also
be employed such as different maturing
varieties and diversification of crops. The
point is, insurance is often available when
we are dealing with a risk event, but this is
usually not the case for uncertain events
where probabilities are not known.
In addition to probabilities not being known,
with uncertain events, outcomes may not be
known either. The lack of information and
knowledge on outcomes and probabilities
generally makes it more difficult to shift the
risk to others via an insurance contract.
With uncertainty, the “protection” against
negative outcomes lies more with
management practices within the business,
such as decisions about what, where, and
how to produce. For example, uncertain
events such as a government led grain trade
embargo, elimination or change in dairy
marketing orders, economic recession in
Asia, or a divorce or disagreement between
principal owner operators does not have an

associated probability. Thus, there is no
means to actuarially determine expected
losses. This being the case, it is difficult for
an insurer to provide protection against an
uncertain event, and if someone did offer
insurance the premium would likely be very
large.
Due to the lack of direct insurability and
before-hand knowledge of uncertain events,
they are often the “surprise” ones that can be
very dangerous to a business. While
uncertain events are often less common,
they also are often more costly when they do
occur. Thus, the manager is put in the
unenviable position of preparing for
potentially costly events that he or she has
little if any knowledge of what the events
and outcomes will be, when they will occur,
and what the impact will be. The on-farm
management practices one might use to
protect against uncertain events are often
broad-based and guard against a host of
potential uncertain events. Some of those
practices include enterprise and species
diversification, credit and financial reserves,
or cross-functional training programs to
name a few. Managing for uncertain events
often requires management creativity and
ingenuity, and can be unique to a situation.
Consider a Nebraska farm family who was
concerned about the uncertainty of urban
encroachment. As a means to manage this
uncertainty, they have put forth many efforts
IDRM CL100-2
to be “good neighbors” including devoting a
few acres to raising pumpkins and other
garden crops free for the neighbors use, an
annual farm festival and neighborhood party
complete with hay rides, and tours of the
farm.
It is useful to note, that risky and uncertain
events can also be described as being
externally or internally induced, i.e., the
origin or cause of the event can be external
or internal to the farm business. External
events are those that the manager has no
control over such as weather and price. In
these cases, the management challenge is
protecting the outcome, or consequence, of
the event. Internal events are those that
result from a manager’s decision such as
when to sell, when to buy, when to treat
cows, how much instruction and training to
give hired help, etc. The management
challenge now includes what decision to
make in the beginning as well as protecting
against negative consequences.
The following table provides some
examples of uncertain or risk events that
could occur (both internal and external), the
potential impacts on the farm business, and
potential risk management tools and
strategies that could be employed. Note: the
table is just a partial listing of events,
impacts, and strategies.
 IDRM CL100-2

UNCERTAIN IMPACT ON POTENTIAL RISK

OR RISK FARM MANAGEMENT
EVENT BUSINESS STRATEGY

Crop insurance
1
“Normal ” Crop diversity
Weather Minor crop loss Excess machinery capacity
(Risk) Herd health Facilities
Health maintenance/prevention programs
Production flexibility

Catastrophic Loss of facilities Crop insurance

Weather Major crop loss Property insurance
(Risk) Major herd health problems/death Life and Health Insurance
Loss of human life Off-farm income
Financial reserves

Employee handbook
Employee training period
Crop loss Employee continuous education
Mistake by Herd health Employee meetings
Hired Help Human injury/death Periodic farm safety checks
(uncertain) Facility/equipment damage Property insurance
Life insurance
Employee health insurance
Liability insurance

Sudden Loss of Decreased herd production Incentive programs

Hired Help Crop loss Cross functional training
(uncertain) Loss of manager's time Excess labor
Shared labor

1
“Normal” does not mean ideal weather, it means the normal cycle of dry, wet, and ideal seasons.
 IDRM CL100-2

UNCERTAIN IMPACT ON POTENTIAL RISK

OR RISK FARM MANAGEMENT
EVENT BUSINESS STRATEGY

Hedging
Options
Increase in Forward contracts
Global Reduced prices Revenue Insurance
Production Inability to meet cash flow Production diversification
(risk) Financial and credit reserve
Retained ownership flexibility
Storage (for crops)

Reduced
Consumer
Purchases
Due To New Financial and credit reserve
Research Reduced Prices Production diversification
Showing Inability to meet cash flow Off-farm income source
Negative Health Revenue insurance
Impacts From
Dairy Products
(uncertain)

Crop protection chemicals

Tillage systems
Pest/Disease Crop Loss Crop rotations
Outbreak Decreased herd production Biosecurity Protocols
(uncertain) Death Health maintenance programs
Employee training programs
Crop scouting consultants

Change
In Dairy Changes in price Financial reserves
Policy, or Banned/Limited Production Keep up with current public
Environmental Change in production practices policy debate
Regulations and costs
(uncertain)

Changing Fixed interest rates

Interest Cost of debt financing Financial reserve
Rates Ability to meet cash flow Credit reserve
(uncertain) requirements Off-farm income
Ability to get credit
 IDRM CL100-2

Whether it is uncertainty, risk, or ability to manage and make decisions that

somewhere in-between there is one strategy
that always improves the manager’s ability
to make sound management decisions and
that is information. The more information a
manager has on the potential uncertainties
and risks that they face, then the more they
can establish probabilities of likely
outcomes, evaluate the impact on the
business, and evaluate risk management
strategies accordingly. Given this level of
analysis information, it then follows that the
manager will have more confidence in his or
her ability to make the appropriate decisions
that will maintain the long run viability of
the farming operation. Thus, the “end” has
been achieved of improving the manager’s
take into account the potential negative
impacts that can occur on profits and other
farm family and business goals.
Understanding risk and risk management is
a multi-faceted challenge for the dairy farm
manager. Understanding the distinction
between risk and uncertainty, the
management response to each, and the
appropriate risk management strategy for
each is a small part of that challenge. Many
other pieces of the puzzle are provided
throughout this curriculum including a more
in-depth description of the risks that dairy
managers face in the 200 level such as:

Probability and Statistical Distributions; Definitions and Examples for Dairy Farms (by Wolf),
Milk and Feed Price Variability: An Introduction of Dairy Producers (by Thraen and McNew)
Managing Financial Risk (by Frank and Knoblauch),
Risks in Farm Transfers and Business Arrangements (by Ambrosius), and
The Role of Human Resource Management in Dairy Farm Risk Management (by Erven).

Further, the 300 and 400 level discussions
describe the use of various tools and
strategies for addressing these different
types of risk.
Finally, as Benson describes in "Risk
Management Planning: What you can do to
Enhance Your Chances of Success"
the management of risk and all its parts is
best accomplished as part of a whole-farm
strategic plan. Profitability is certainly a
significant goal in that plan, but for many
dairy farm managers the impact of risk and
uncertainty on other business and family
goals are also very important considerations.

Terminology
An event is an occurrence or incident while
an outcome is a natural result or
consequence (American Heritage
Dictionary). For example, there is always
weather, price, or production events, and
each of these events can have a range of
positive and negative outcomes that impact
the dairy farm business. Events can also be
a manager’s decision such as when to sell,
when to buy, when to treat cows, how much
instruction and training to give hired help,
etc. In these cases, the outcome is more
appropriately defined as the consequence
resulting from the implemented decision.
Any time a decision is made there is usually
more than one potential outcome. For
example, from 1988-98 the historical BFP
price for May was $11.53. If you made a
management decision to forward contract at
that average price, then there are a variety of
outcomes that could result - your forward
contract price could be the high price, low
price, or any variation in between. Actual
May BFP prices have been $13.65, $10.75,
and $10.80 in 1996, 97, and 98 respectively.
So, the outcome of your decision to forward
contract May production at $11.53 would
have had the outcome of being below the
market price in 1996, and above the market
price in 1997 and 1998.
Probability is defined as the proportion of
times that some outcome will occur over the
long run if the action is repeated many times
under uniform conditions (Mansfield, 1987).
For example, a 30% probability of rain
means that if similar atmospheric and other
physical conditions are repeated a large
number of times then rain will occur 30
times out of 100. Another example is the
May BFP milk price. Analysis of prices
from 1988-98 show that the average May
BFP price has been $11.53. Further analysis
also shows that 68% of the time the May
IDRM CL100-2
BFP price has been between $10.43 and
$12.62, and that only 16% of the time has it
been greater than $12.62 or less than $10.43.
It is often near impossible to define a “true”
or “objective” probability. To do so would
require collecting huge amounts of data or
testing under constant conditions which is
usually unrealistic or impossible. However,
past experience and more information often
allows one to “get close” to the true
probability. This “getting close” is called
“subjective” probability. An important point
to keep in mind is that the more experience
and information a manager has, the more
accurate the subjective probabilities will be,
and thus the more ability the manager has to
make appropriate risk management
decisions.
Probability is very important in the
distinction between uncertainty and risk and
strongly influences what tools the manager
may have at his or her disposal for
addressing various events that impact farm
profits and goals. In brief, the more
knowledge there is of the probability of
alternative outcomes occurring, the more
tools there often is for addressing the event
and the more confidence there is in
management decisions.
Value-at-risk is defined as how much the
business will lose if a negative outcome
occurs. Assuming the probabilities of two
different outcomes are the same, then the
one that carries a higher expected cost of the
negative outcomes, i.e. higher value-at-risk,
is clearly of more concern to the manager.
For example, the share of production costs
from feedgrains in the ration is much higher
than from trace minerals. Thus, the value-
at-risk from a 10% increase in feedgrain
prices is clearly of more concern to the
 IDRM CL100-2

manager than a 10% increase in trace
minerals. Implementing risk management
strategies reduces the value-at-risk. Another
example is insuring the farm buildings. If
you have a milking facility that is worth
$150,000 and you do not insure it, then you
have $150,000 worth of your business at risk
If you insure against 100% loss then you
have reduced your value-at-risk by
$150,000. If you insure 75% of the asset,
then you have reduced your value-at-risk by
$112,500.

Bibliography
Casavant, Kenneth L., Craig L. Infanger, and Deborah E. Bridges. Agricultural Economics and
Management, Upper Saddle River, NJ: Prentice Hall, 1998.

Kreitner, Robert. Management, 6th ed. Boston, MA: Houghton Mifflin Company, 1995.

Mansfield, Edwin. Statistics for Business and Economics - Methods and Applications, 3rd ed. New
York, NY: W.W. Norton & Company, 1987.

The American Heritage Dictionary of the English Language. Boston, MA: Houghton Mifflin
Company, 1978

Partial funding support has been provided by the Risk Management Education Agency,
The United States Department of Agriculture.
Issued in furtherance of Cooperative Extension work, Acts of May 8 and June 30, 1914
in cooperation with the U.S. Department of Agriculture.
 IDRM CL100-2

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F igure 2

H igh

Confidence
in Decision

Low

Condition Condition Condition

of Certainty of Risk of Uncertainty

Degree of Uncertainty