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Adapting Budgets to Incorporate Risk

Gregory Ibendahl

Summary

Crop and livestock budgets are useful for showing profitability for a given set of conditions. However, budgets are less useful as a risk management tool as variability of prices and output quantities are not explicitly included. Sensitivity analysis can help but the comparisons analyzed may not include the entire range of variability and the problem of how likely each scenario is likely to occur still remains. To overcome these obstacles with risk when using budgets, we have developed a spreadsheet budget in Excel that uses Visual Basic to model variability in output quantities and output prices. Yield variability is incorporated by using a triangular distribution. A triangular distribution has the advantage of only needing three data points. Producers just enter a typical yield, a worst case yield and a best case yield. Price variability is incorporated by asking producers to enter the December futures price and the number of weeks to harvest. The price variability is modeled by taking the natural log of prices and then adding variability to this distribution. The variability is adjusted by the number of weeks to harvest. The longer till harvest, the more variability that is possible with prices. Using Visual Basic code, the yield and price variability is simulated using a Monte Carlo process that process a distribution of net returns. These net returns are then presented to farmers as both a CDF and also as a stop-light graph. The farmer can adjust the breakpoints of the stop-light graph by entering his or her own breakpoints. The result is a budget that is still easy to use but can now show risk.

Details

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