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3Farm management extension guideMANAGING RISKin farmingbyDavid KahanFOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONSRome 2008

First Printed: 2008Reprint: 2013The designations employed and the presentation of material in this informationproduct do not imply the expression of any opinion whatsoever on the part of theFood and Agriculture Organization of the United Nations (FAO) concerning thelegal or development status of any country, territory, city or area or of its authorities,or concerning the delimitation of its frontiers or boundaries. The mention ofspecific companies or products of manufacturers, whether or not these have beenpatented, does not imply that these have been endorsed or recommended by FAO inpreference to others of a similar nature that are not mentioned.The views expressed in this information product are those of the author(s) and donot necessarily reflect the views or policies of FAO.ISBN 978-92-5-107543-2 (print)E-ISBN 978-92-5-107544-9 (PDF) FAO 2013FAO encourages the use, reproduction and dissemination of material in thisinformation product. Except where otherwise indicated, material may be copied,downloaded and printed for private study, research and teaching purposes,or for use in non-commercial products or services, provided that appropriateacknowledgement of FAO as the source and copyright holder is given and thatFAO’s endorsement of users’ views, products or services is not implied in any way.All requests for translation and adaptation rights, and for resale and othercommercial use rights should be made via www.fao.org/contact-us/licence-requestor addressed to [email protected] information products are available on the FAO website (www.fao.org/publications) and can be purchased through [email protected]

iiiPrefaceFarmers in developing countries are frequently exposedto the uncertainties of weather, prices and disease.Many farmers live on the edge of extreme uncertainty,sometimes falling just below, and sometimes rising justabove the threshold of survival. Farmers do not knowwhether rainfall will be good or bad over a season; theydo not know the prices they will receive for producesold; and they do not know whether their crops will beinfected by disease. These risks are not under the controlof farmers but some farmers have developed ways ofcoping and managing themHow do you as an extension worker help farmersdeal with risk and reduce variability in productivity andprofitability? How can you assist farmers by advisingthem on good risk management?

vContentsPreface . iiiAcknowledgements . viChapter 1RISK, RISK MANAGEMENTAND INFORMATION REQUIREMENTS .1Chapter 2APPROACHESTO RISK MANAGEMENT . 29Chapter 3ASSISTING FARMERSIN MANAGING RISK . 87Further reading . 107

viAcknowledgementsThe author would like to acknowledge the assistance ofcolleagues and friends. Thanks are due to Steve Worthfor his review of the draft guide and to Andrew Shepherdwho reviewed and edited the final version, as well asto Tom Laughlin, who managed the production process,Michael Breece, for the design and final layout forpublication, and to Francesca Cabre-Aguilar and MartinHilmi for their contributions. Errors and omissions do, ofcourse, remain the responsibility of the author.David Kahan

Chapter 1Risk, risk managementand information requirements

2Managing risk in farmingMAIN POINTS IN CHAPTER 1The risks of farmingFarmers make decisions every day that affectfarming operations. Many of the factors thataffect the decisions they make cannot be predictedwith complete accuracy; this is risk. Farming hasbecome increasingly risky as farmers becomemore commercial. Farmers need to understandrisk and have risk management skills to betteranticipate problems and reduce consequences.Sources of riskRisk affects production such as changes in theweather and the incidence of pests and diseases.Equipment breakdown can be a risk as canmarket price fluctuations. Borrowing money canalso be risky with sudden changes in interestrates. Risk also occurs as a result of changesin government policies. Such risks often have amajor impact on farm income. Finally, there arerisks related to the health and wellbeing of thefarmer and his family and the supply of labourfor the farm.Risk managementDecision-making is the principal activity ofmanagement. All decisions have outcomes orconsequences. However, in most situations the

Risk, risk management and information requirementsRisk management, continuedoutcome of a decision cannot be predicted.The more complex the risk, the more difficultit becomes for farmers to make aninformed decision. For effective decisionsto be taken, farmers need information onmany aspects of the farming business. Farmershave to find ways of dealing with risk andprotecting themselves from the uncertainties ofthe future.Farmers’ attitudes toward riskFarmers differ in the degree to which theyaccept risk. Some farmers are willing to acceptmore risk than others. Attitudes to risk are oftenrelated to the financial ability of the farmer toaccept a small gain or loss. Farmers’ attitudesmay be classified as: risk-averse those who tryto avoid taking risks; risk-takers those who areopen to more risky business options; and riskneutral farmers who lie between the risk-averseand risk-taking position.Information for decision makingGood risk management decisions depend onaccurate information which requires reliabledata. Good information can help a farmermake rational risk management decisions. Thesources of information available include farmrecords, off-farm statistics, information frominput dealers, traders, extension workers andother farmers and market price data.3

4Managing risk in farmingINTRODUCTIONExtension workerscan help farmersto improve theirrisk managementskills . help them torecognize andunderstand theirproblems . and assist themin making betterfarm managementdecisions.Farming is risky. Farmers live with risk and make decisionsevery day that affect their farming operations. Many ofthe factors that affect the decisions that farmers makecannot be predicted with 100 percent accuracy: weatherconditions change; prices at the time of harvest coulddrop; hired labour may not be available at peak times;machinery and equipment could break down when mostneeded; draught animals might die; and governmentpolicy can change overnight. All of these changes areexamples of the risks that farmers face in managing theirfarm as a business. All of these risks affect their farmprofitability.While farmers have always faced risk, farming hasover the years, as a result of market liberalization andglobalization, become increasingly risky. Smallholderfarmers have become especially vulnerable. A casualapproach to farming, even if it is for household foodconsumption, is no longer viable. Farmers need to acquiremore professional skills, not only in basic production butalso in farm business management. Among these arerisk management skills.Skillful farmers and other business peoplegenerally do not become involved in risky situationsunless there is a chance of making money. Higher profitsare usually linked with higher risks. These risky butpotentially profitable situations need to be managed ascarefully as possible. Good risk management involvesanticipating potential problems and planning to reducetheir detrimental effects. Simply reacting to unfavourableevents after they occur is not good risk management.

Risk, risk management and information requirementsIn order to succeed, farmers need to generatemore profit and become competitive. They must havea good understanding of the farming environment andbe skilled at managing risk. By dealing with risk moreeffectively, better farming opportunities arise.Extension workers can help farmers improve theirrisk management skills. They can help farmers recognizeand understand their problems and assist them in makingbetter farm management decisions.At the start of a season, farmersdecide to grow different crops. Theydecide what to plant, how muchto plant and when to plant. Thesedecisions may appear simple, butfor each decision there are manypossible consequences. There willbe only one outcome; only oneresult. But at the time the decisionis made, the outcome is uncertain.When the chance or probability ofan outcome is known in advancethis is called risk. When the chanceof an outcome is not known inadvance this is called uncertainty.Note: For the purpose of this guide we will assume thatrisk and uncertainty refer to the same thing.5

6Managing risk in farmingSOURCE OF RISKThe most common sources of risk in farming can bedivided into five areas:production marketing financialinstitutional humanRisks includelow rainfall,drought, hailor heavy rains,pests and disease,breakdown orunavailabilityof equipmentand spare partsProduction and technical riskCrop and livestock performance depend on biologicalprocesses that are affected by the weather, and by pestsand diseases. Low rainfall or drought may lead to lowyields. Hail or heavy rains could damage or even wipeout crops. Outbreaks of pests or diseases could alsocause major yield losses in crops and livestock.When farmers plant seeds and fertilize their landthey do not know for certain how much rain will fall, orwhether there will be a hail storm. They do not know ifthere will be a problem with pests or diseases. But stillthey must decide whether they are going to plant theircrops or raise their livestock. The resources they spendto plough, plant and fertilize their crops or to care for theirlivestock may not be recovered. This is why there is risk.Farmers produce without complete certainty about whatwill happen to their production.Another source of production risk is equipment. Afarmer’s tractor may break down during the productionseason resulting in an inability to harvest in time, thusaffecting yields. Similarly, if the farmer uses shared orhired traction or other equipment, will it be available whenneeded? If the farmer is using a new technology, will itperform as expected? Will it actually reduce costs and/or increase yields? If seeds do not germinate and dayold chicks die what will be the impact on production andfarm family income? The farmer can never be completelycertain.

7Risk, risk management and information requirementsMarketing risk – prices and costsChanges in prices are beyond the control of any individualfarmer. The price of farm products is affected by thesupply of a product, demand for the product, and the costof production.* Supply of a product is affected by a combination ofproduction decisions made by farmers as a group andby the weather and other factors that influence yields. Demand for a product is affected by consumerpreference, consumers’ level of income, the strengthof the general economy, and the supply and price ofcompeting products. Cost of production of a unit of product dependson both input costs and yield. This makes it highlyvariable. Although input costs tend to be less variablethan output prices, when combined with yieldvariations the cost of production becomes a serioussource of risk.Sometimes price movements follow seasonalor cyclical trends that can be predicted. Many times,however, supply or demand will change unexpectedlyand, in turn, affect the market price. When farmers plantcrops or commit resources to raising livestock, they donot know for certain what prices they will obtain for theirproducts. In situations of low rainfall, production of cropsis often reduced and, as a result, prices rise.Financial riskFinancial risk occurs when money is borrowed to financethe farm business. This risk can be caused by uncertaintyabout future interest rates, a lender’s willingness andability to continue to provide funds when needed, and theability of the farmer to generate the income necessary forloan repayment. Smallholder farmers who borrow moneyat high interest rates may have particular difficulty makingdebt repayments. Lower than expected prices, combinedwith low yields, can make debt repayment difficult andeven lead to the sale of the farm.* See also Economics for MARKET-ORIENTED FARMING(Farm management extension guide 1).Factorsaffecting riskinclude supply,demandand cost ofproduction

8Managing risk in farmingInstitutional riskis caused byunpredictablechanges in theprovision ofservicesHuman andpersonal riskincludes illness,accidents, migrationand politicaland social unrestInstitutional riskInstitutional risk refers to unpredictable changes inthe provision of services from institutions that supportfarming. Such institutions can be both formal andinformal and include banks, cooperatives, marketingorganizations, input dealers and government extensionservices. Part of institutional risk is the uncertainty ofgovernment policy affecting farming, such as pricesupport and subsidies. The risks farmers face areoften a result of decisions taken by policy-makers andmanagers. Subsidies, food quality regulations for exportcrops, rules for animal waste disposal and the level ofprice or income support payments are examples ofdecisions taken by government that can have a majorimpact on the farm business.Human and personal riskHuman risk refers to the risks to the farm business causedby illness or death and the personal situation of the farmfamily. Accidents, illness and death can disrupt farmperformance. In many countries labour migration awayfrom rural areas is a common occurrence. Migration cancause labour shortages for the farm. Political and socialunrest can also limit labour availability. The spread ofHIV/AIDS has had a serious impact on labour availabilityand productivity in some areas. When farmers planttheir crop or commit resources to raise livestock theycannot be certain whether they will have enough labourto manage the farm enterprises.Interrelation of risksProduction, marketing, financial, institutional andhuman risks exist on most farms. They are frequentlyinterrelated. The ability to repay debts depends onlevels of production and the prices received for producesold. Financing of production depends on the ability toborrow capital and the ability of the lender to supplycapital in time. The different types of risk often need tobe considered together.

Risk, risk management and information requirementsRisk and variabilityRegardless of the source of risk, the degree of riskinessof an action depends, in part, on the ability to predictwhat will happen in the future.Risk occurs becauseof unexpected changesIf farmers are able to understand and predictthe patterns and trends throughout the year,the changes that occur may not be so risky.ExampleA vegetable farmer in Zambia studied the changes invegetable prices over several years. She observed thatthe prices follow a pattern of being high before the harvest,dropping at harvest time and rising again towards the endof the season. With this information, she could plan whento plant and harvest her vegetable crops. As a result shewas able to have vegetables ready to sell when priceswere good.However, changes that cannot be predictedand are more sudden are likely to be moresevere in their impact on the farm.ExampleA group of fruit farmers in Thailand growing under rainfed conditions and relying on the export market foundthat fruit prices varied greatly. This made it hard for themto predict future prices. As a result there was always therisk of having their fruit ready for sale when prices werelow.9

10Managing risk in farmingThe relative importance of the different sourcesof risk depends on the nature and circumstances of theindividual farmer and the farm household. This includesthe resource base of the farm, its physical location, theenterprise combinations chosen, the specific productionprocesses practiced by the farm family and the attitudeof the farmer towards risk.Farmers producing under rain-fed conditions maysee drought as the greatest risk. Farmers producinghigh-value produce may find price fluctuations to betheir greatest risk. Whatever the risk, farmers need totake it into account when making decisions about whatto plant, when to plant, where to plant, how to plant, howmuch to plant, and the resources to allocate. These arethe main management decisions that farmers make.The time between when a decision is made andwhen the outcome or consequence of that decisionis experienced also affects risk. The farmer oftenneeds to integrate what are called “short-term tacticaldecisions” with “longer-term strategic decisions”. Timealso influences the usefulness of information used indecision-making. The ability of the farmer to respond toevents is also affected by time. These aspects of timemake assessing risk more complex.

11Risk, risk management and information requirementsRISK MANAGEMENTDecision-making is the principal activity of management.Early in the cropping season farmers must make decisionsabout what crops to plant, and what seeding rates andfertilizer levels to use. The yield and prices obtainedwill not be known with certainty for several months, oreven several years in the case of perennial crops andlivestock.In only a few cases are farmers certain of theoutcome of their decisions. This usually occurs whenthe decision is easy and there is only a single outcome.For example, if farmers decide to take short-term loans,they know what will occur; banks will charge theminterest at a specific rate. In this case, farmers knowexactly the consequences of their decisions.In most situations, however, the outcome of adecision cannot be predicted, as there is more than asingle possible outcome. Farmers often find that theirdecisions turn out to be less than perfect because ofchanges that take place between the time the decisionis made and the time the outcome of that decision isfinalized. It may be that the outcomes themselves dependon the decisions of others and on future events that liebeyond the control of the farmer.For effective decisions to be taken, farmersmust have all the necessary information regardinginput prices, output prices and yields, as well as othertechnical data.Making gooddecisions is thehardest part offarming . one can neverbe absolutelycertain howthings willturn out.

12Managing risk in farmingAn example of rainfed cropsFarmers who produce rainfed crops are likely to have goodyields if the rainfall is adequate. But it is not certain whetherit will rain, how much rain will fall or whether that rain willfall at the right time. These farmers are uncertain of thecrop yield because of the risks of weather. If farmers planttheir crop and an average amount of rainfall occurs, yieldscould be high and the crop could generate a satisfactoryprofit for the farmer.* * *But if rainfall is not adequate, farmers may suffer lowyields and low or non-existent profit. The pattern andamount of rainfall directly affect yields and the level ofproduction of these crops. High rainfall results in goodyields but runs the risk of increasing production amongall farmers, resulting in price decreases. The combinedeffect of changes in production and price impact on thelevel of profit that can be earned.The risks associated with rainfed farming are usuallymore complex than those encountered under irrigation.Farmers often have a basic understanding ofhow their crops will perform under dry, average and wetconditions. Some may have a formal record of the annualrainfall in the vicinity of their farm, while others may justremember the pattern over the years. Some farmersmay have a feeling about the likelihood of a dry or wetyear occurring before they decide on a cropping patternfor the season. Often, farmers think about the possibleconsequences of a decision to plant a

2 Managing risk in farming MAIN POINTS IN CHAPTER 1 The risks of farming Farmers make decisions every day that affect farming operations. Many of the factors that affect the decisions they make cannot be predicted with complete accuracy; this is risk. Farming has become increasingly risky as farmers become more commercial. Farmers need to ...