Department of Rural Economy, 5-31 General Services Building,
University of Alberta,Edmonton, AB, T6G 2H1, Canada
Take Home Messages
The world surrounding dairy production in western Canada is in a state of transition. The political, technological, and economic environments are changing and dairy producers are feeling pressure to change with them. One type of change that is being considered by many producers is "expansion". The trend in the dairy sector over time has been towards more cows and fewer farms, which is indicative of larger dairy operations. While at the sector level this trend has been gradual, the changes at the individual farm level are more dramatic; that is, many operations are ceasing to produce milk while others are increasing significantly in size through expansion.
In examining expansion of the dairy enterprise at the individual farm level there are several questions that may be asked. First, should expansion be undertaken; that is, is expansion consistent with the goals of the farm manager? Secondly, can expansion be undertaken, or is it feasible to consider expanding the dairy operation? Finally, if the answers to the first two questions are "Yes", how should expansion be undertaken and to what degree? Dairy expansion can be carried out in any number of ways, from expansion of the total farm operation including both dairy and crop production enterprises, to expansion combined with specialization whereby the farm focuses its capital on dairy production only.
This paper addresses the questions and issues surrounding dairy expansion in western Canada. The primary objective of the paper is to outline a process by which producers may consider whether or not to expand their dairy operation. Specifically, expansion is considered within the context of strategic planning. A second objective is to identify and discuss some of the key factors that will undoubtedly influence the answers to the three expansion questions noted above. A third objective is to identify some alternative expansion strategies that may be considered by western Canadian dairy producers.
Strategic Planning - Examining the "Big Picture"
One way to consider expansion decisions is within the context of a strategic planning process. Strategic planning is one type of planning used by business managers. As the name would suggest, it involves identification of "strategies". Strategic planning may be defined as "the process of developing a broad long-term plan for how a business is going to compete in its industry, what its goals should be, and what policies will be needed to achieve these goals" (9). The purpose of this type of planning is to identify a strategy or strategies that will allow the business to be successful or achieve its objectives. Strategic planning is characterized by three features; it is long-term in nature, it encompasses much of the business (i.e., has a wide scope), and is directional. The term directional refers to the fact that the output from strategic planning is not an exact course of action (i.e., a recipe) to be followed by the firm. Instead, the "plan" points the business in the right direction. For these reasons, strategic planning may be referred to as "big picture planning".
While not typically considered within traditional farm management activities, strategic planning is an integral part of business management in that it helps to provide direction for managers. The process of strategic planning may be broken down into several steps (7). The process begins by establishing or reviewing overall business goals and objectives. The next step is to conduct an environmental analysis. In the context of strategic planning, the environment refers to anything that affects the management of the firm, but is beyond its control. In standard business analysis, the environment includes individuals, institutions, and other entities that affect the business, such as competitors, customers, government, etc. The third step in the planning process is to undertake an organizational analysis. This involves assessing the business itself; that is, strengths, weaknesses, available resources, products produced, etc.
The purpose of the environmental and organizational analyses is to identify relevant factors that may potentially influence the choice of the best strategy for the firm to undertake. This is done by combining and analyzing the results of these two steps in a fourth step; identification of opportunities and threats. Following this, alternative strategies are identified and evaluated in terms of their suitability for the business. Finally, the best strategy is chosen. This is the strategy that is actually implemented. At this point, the manager switches from strategic to operational issues as the "nuts and bolts" planning associated with this optimal strategy begins in earnest.
The strategic planning process as outlined above provides one model that may be followed in examining the questions surrounding dairy enterprise expansion. It is the model used in this paper. The remaining sections of the paper deal with the various steps of strategic planning. Within each section, the relevant issues and questions are identified and discussed. The result of this discussion is not a yes or no answer to the question "Should dairy farmers expand their operations?", but rather a template that may be used by individual producers in making their own decisions with respect to expansion.
Goals and Objectives
In every day usage, the terms goal and objective are typically considered to be synonymous. However, within business management they have distinct meanings. Goals are what an organization or business hopes to achieve within a certain period of time. Objectives, on the other hand, are specific results that must be achieved if the organization or business is to meet its overall goals. Given these two definitions, the focus of this discussion is on goals rather than objectives.
One goal often attributed to most (if not all) business managers is that of profit and wealth maximization. In fact, most economic analyses of agricultural operations assume that this is the overriding objective for farmers. It is probably safe to say that most agricultural producers are concerned with profits and wealth and that this drives many business decisions, including expansion decisions. However, it may not be the only relevant objective to consider within strategic planning.
A related, but different goal is that of ensuring adequate consumption by the farm family. This refers to the ability to generate enough cash from the operation to ensure that the consumption needs of the farm family are met. These needs include food, clothing, entertainment, education, etc. In the long run, this objective is likely consistent with profit maximization. However, in the shorter term strategies that eventually lead to greater profit accumulation may adversely affect the ability to meet these consumption needs.
Besides financial objectives, there may be other non-quantifiable goals that are of equal importance to the farm operator. The farmer may have the goal of leaving a "legacy" for his/her children; that is, a farm operation that is not only viable now, but also in the future when the next generation will be managing it. The farmer may also have a goal related to productivity and innovation. This could involve setting objectives with respect to milk production levels, butterfat test, adopting new technologies, etc. These types of goals may also be consistent in some cases with profit or wealth considerations, but this is not necessarily the case.
One final general goal for the farmer may be with respect to life style. It has often been hypothesized that a major reason that farmers farm is that they enjoy the lifestyle. To the extent that this is true, lifestyle considerations may have a significant influence on management decisions made by the producer, including decisions relating to expansion.
There are no "right" or "wrong" objectives for dairy farmers. However, it is important for dairy producers to be able to recognize what is important to them in order to make the "right" decision as to the optimal expansion strategy.
Within business management, the term environment refers to issues, institutions, etc., that affect management decisions for a business, yet are beyond its control. Given the question of dairy enterprise expansion there are several environmental factors that need to be considered. Some of these belong to the general environment; that is, factors that affect agriculture in general. Others belong to the specific environment facing dairy producers; that is, factors that are directly related to dairy production in western Canada.
Within the general environment, there are several megatrends affecting producer decision making in western Canadian agriculture (2). One of the most significant of these for dairy producers is the globalization of agriculture. This is not a new development, but recent events (e.g., GATT negotiations, NAFTA) have accentuated and accelerated the trend. In the short term, this has not had a significant effect on dairy production in western Canada. However, to the extent that the trend affects markets for dairy inputs (e.g., feedgrains) and related outputs (e.g., beef), it is of concern to dairy producers. Also, in the long run it is likely that western Canadian dairy producers will be less insulated from global market factors. This increases the importance of having dairy operations that are competitive in terms of milk production costs.
A related trend is changing attitudes towards government involvement in agriculture (i.e., a reduced presence). These changes have been driven partly by international trade considerations (i.e., globalization), but also partly by fiscal issues. This trend has manifested itself in several ways, including elimination of programs that involve pure subsidization and introduction of programs that place more emphasis on income stabilization rather than support. Net Income Stabilization Account is an example of this type of program.
A very visible and increasingly significant trend is the importance being given to the environmental sustainability of agriculture practices. Policymakers, consumers, and producers are increasingly interested in the interaction between agriculture and the environment, and the implications of agricultural practices for the quality of air, earth, and water resources. From the perspective of dairy expansion, waste management and soil/water quality interactions may become more important as larger dairy operations are concentrated on smaller land bases.
One other significant issue for agriculture relates to alternative sources of financial capital. This has significant implications for dairy expansion strategies as expansion typically requires significant amounts of financial capital for cows, dairy facilities and equipment, quota, related investments in cropping land and machinery, etc. The traditional sources of capital for financing agricultural operations are retained earnings (i.e., savings) and debt in the form of term loans. However, these are only two of several potential sources of financial capital utilized in general business. As well, the amount of capital available from these sources is often limited. Some alternative sources of capital are beginning to be used in financing agricultural businesses. For example, equity financing in the form of share capital, partnership capital or venture capital is being used increasingly to finance large scale agricultural operations. As well, alternative forms of ownership for farm assets (e.g., leasing) are being considered in order to reduce the costs of financing.
One other major trend in agriculture is the change in attitude towards agricultural production; that is, treating agriculture as any other type of business in which inputs are converted into outputs using a production process. This is referred to as a manufacturing mentality towards agriculture (3). Traditionally, agriculture has been considered somewhat unique in terms of production. Some of this uniqueness has been due to the relatively small scale of individual production units as well as the degree of uncertainty or lack of control over production. Both of these characteristics have changed over time. Given technological advances in nutrition, reproduction, genetics, etc., producers have been gaining more control over the relevant processes.
This manufacturing mentality is manifested in livestock production through increased specialization in individual production units and separation of production stages. For example, traditional dairy operations encompass all activities related to dairy production, including feed production. Increasingly, these activities are being carried out by separate managers and in many cases separate firms. Dairy operations may specialize in milk production only, while other firms produce replacement heifers and produce the feed required by the dairy herd. An increased emphasis on partnerships and alliances between specialized firms is a necessary consequence of this adjustment.
Within the specific environment for the dairy sector, three factors are particularly significant for producers considering expansion; changes in dairy policy, the processing sector, and increased competition. General changes in government policy have been noted already, but changes are also occurring in specific dairy policies. An ongoing adjustment has been the gradual decline in the degree of government subsidy going to the dairy industry. This has direct implications for returns generated by the dairy enterprise, making cost efficiency more important.
Changes are also occurring at the interprovincial level with regional pools being created for milk revenues. This pooling may eventually extend to quota transfers as well. Finally, while major changes to the supply management system are unlikely to occur in the near future, adjustments at the international level may eventually force regulators to change the domestic supply management system for the dairy sector in Canada.
The processing sector represents the direct market for milk coming from dairy producers. As such this sector is an important part of the environment for western Canadian dairy producers. Changes are occurring in this sector, with regional rationalization being an ongoing trend. With future changes in interprovincial and international trade regulations, this trend is likely to continue. These changes have a direct impact on the ability of milk producers in different regions to ship their product in a profitable manner. Processors may also be considered as an intermediary between producers and consumers. As such, they are responsive to consumer tastes and preferences and provide feedback to producers in terms of the type of product demanded by consumers.
Finally, as a result of some of the changes and trends noted above, western Canadian dairy producers are likely to experience increasing competition over time. Some of this competition may come from producers in other countries (i.e., international in nature). However, any developments in this area are likely to occur in the long run. Of more immediate concern, however, is competition from producers in other regions (i.e., interprovincial in nature). As interprovincial barriers for milk and dairy products are gradually reduced, there may be shifts in the pattern of milk production and processing. Producers in some regions will likely be "winners", while other producers will likely be "losers". Comparative advantage in terms of costs of production is likely to be an important factor in determining where the winners and losers are located. All of these changes may have a significant influence on producers' expansion decisions.
This step in strategic planning involves an assessment of internal considerations. What is the business doing, how well is it doing these things, and what is the business capable of doing? What are the strengths and weaknesses of the operation? What resources are available and what resources are potentially limiting? If a dairy producer is considering expansion, good management is a necessity. The advantages associated with larger herd sizes are only achieved if good management practices are maintained in the larger operation.
Part of this analysis should focus on dairy production management. This includes the management of nutrition, health, reproduction, genetics, and milking. These are all key elements of production for a dairy operation with significant implications for costs and revenues. Any weaknesses in these areas will be magnified in a larger, expanded operation. Previously hidden problems may also appear as a result of dairy expansion.
Other aspects of management will also be important to consider in this analysis. Many dairy operations include on-farm production of some or most feed requirements for the dairy enterprise. A rigorous assessment of feed production management will be in order. One of the decisions that may need to be made as part of an expansion strategy is whether to maintain feed production as part of the dairy operation. An assessment of crop management capabilities may provide key information to be used in making this decision.
Besides production management skills, dairy operators also need skills and abilities in the areas of financial management and personnel management. Financial management involves financial planning and accounting. As the scale of production increases with expansion, so does the scale of the financial capital investment. Many agricultural businesses have been unable to survive not due to a lack of production management skills, but because of a lack of financial management skills. Successful dairy expansion requires an ability to choose the best sources of financial capital and invest that capital in an efficient and profitable manner.
As the size of the dairy operation increases, there is an increased need to be able to manage people. At some point, a dairy operation goes beyond the ability of a single person or couple to manage efficiently. Hired labour brings with it certain costs, both in terms of cash (i.e., wages or salary) and time. People management requires talents that the dairy farm operator may not have developed previously, including the ability to delegate authority and responsibility, and skills related to leadership and motivation.
Besides strengths and weaknesses, an assessment of resource availability is also part of organizational analysis. For a dairy farmer considering expansion, key resources include financial capital and management time. The importance of financial capital has already been noted, along with considerations of alternative sources of capital. The management time issue is not so clear. With expansion, there will be more demands on the farm manager in terms of managing the dairy enterprise, managing increased feed production, managing hired labour, etc. In some cases, this particular resource may be more important than financial capital in terms of limiting the degree of expansion that is viable and practical.
Opportunities and Threats
This step in the strategic planning process involves taking the results of the environmental and organizational analyses and putting them in perspective for the question at hand; that is, dairy expansion. Opportunities are those elements that can potentially be exploited by the business in order to achieve its goals. Threats are those elements that can potentially cause significant problems for the business.
In terms of dairy expansion, the single most important opportunity that exists for western Canadian dairy producers is the ability to exploit economies of size in the dairy enterprise. Previous studies have shown that significant economies of size exist in dairy production; that is, as herd size and total milk production increases, there is a tendency for average variable and total costs of production to decrease on a per unit of production basis (1, 6, 10, 11). This is often given as a contributing factor in regional differences in costs of production (4). While the focus is often on the cost structure for extremely large herd sizes (i.e., in the thousands) when discussing the existence of these economies, significant size economies may also be achieved through expansion to herds sizes in the 100 to 500 cow range. These economies arise through efficiency in production management, which contributes to lower average variable costs, and reduced investment requirements per cow, which contributes to lower average fixed costs.
A related opportunity that may exist for western Canadian dairy producers considering expansion is the potential for increasing the degree of specialization in the dairy operation. Studies in the U.S. have shown that expansion combined with specialization in the dairy enterprise may provide superior performance relative to "traditional" expansion which involves increasing both the dairy enterprise as well as related enterprises such as feed production (5, 8). This specialization may involve reducing or eliminating enterprises related to crop production and/or replacement heifer production. The advantage of doing this is that it allows the farm manager to focus his/her capital, management time, etc. on the dairy enterprise.
Just as expansion provides potential opportunities, it also may create some potential threats to the well-being of the producer and the operation. As noted in the discussion of organizational considerations, efficient management of the dairy enterprise (e.g., nutrition, health, genetics) is essential for a successful operation. Given the limits on management time and ability, expansion may expose previously hidden weaknesses, or may simply create constraints for the manager in terms of maintaining a high level of productivity in these areas. Expansion creates more demands on the farm manager's time, for production, finance, personnel management. There may simply not be enough time to go around. Any of these factors may jeopardize the ability of expansion strategies to allow the firm to achieve its goals.
Expansion of the dairy operation may also expose the manager to more risk than he/she is willing to bear. This risk may come from a number of sources. Price variability and uncertainty has never been a major concern for dairy producers in Canada. With the regional pooling of revenues and potential changes in demand for dairy products, however, this may change somewhat. As well, changes in the policy environment may have implications for quota values, guaranteed market access, etc. for individual producers. Larger dairy operations have larger investments in quota, larger revenues, and therefore more potential risk.
Related to these is the issue of financial risk. The use of debt financing entails a certain amount of risk as debt payments are fixed while revenues are not. Given the capital requirements of expansion, many dairy producers are forced to use at least some debt financing. In some cases, the impact on firm leverage is significant. As long as the cost of debt is not as great as the rate of return generated by the additional dairy assets, the added leverage works to the producer's advantage. However, there is no guarantee that this is always the case (e.g., high interest rates in the early 1980's).
One final threat that may be significant is the potential change in lifestyle. As noted earlier, many producers may have as a goal the desire to maintain a certain lifestyle. Expansion decisions may result in changes to the dairy operation that make it difficult to maintain this lifestyle. For example, managing a large scale specialized dairy operation with significant hired labour may be inconsistent with the producer's lifestyle goals in that the producer may become less of a farmer and more of a manager. To the extent that this is true, expansion may pose a threat to the well-being of the producer and his/her family.
Once all of the relevant opportunities and threats have been identified, alternative strategies may be introduced and evaluated. One possible strategy is to "stay the course"; that is, not to expand. It may be decided that given the trade-offs involved in expansion the optimal decision is to maintain the dairy operation in its current form. Even if alternative expansion strategies are considered, the default option is always to maintain the operation in its current size and structure.
One alternative strategy is to undertake a "traditional" expansion strategy. This involves expanding all aspects of the dairy operation while maintaining the current organizational structure. Given that most dairy farms include at least some crop production for the purposes of providing feed, this strategy would require expansion of the dairy enterprise as well as cropping enterprises. This has the advantage of allowing the farm manager to maintain control of all aspects of the dairy production process, including feed production, replacement heifer production, etc. However, the disadvantages associated with this type of strategy have been noted already; the capital requirements to finance this type of expansion are significant, as are the requirements in terms of management time (i.e., the manager must manage the dairy enterprise, crop enterprises, hired labour personnel, etc.).
A less traditional form of expansion strategy is expansion combined with increased specialization. This type of strategy can involve varying degrees of specialization. One version would involve expansion of the dairy enterprise, including calf and replacement heifer production as well as maintaining some elements of feed production (probably forages). In contrast, this type of strategy could involve elimination of all activities except those directly related to milk production. All feed would be purchased as would replacement heifers. This is the model used by many very large dairy operations in the southern U.S. It is less common in the more traditional dairy regions, although economic research suggests that there are advantages in moving towards more specialized dairy operations in the U.S. midwest region (5).
The advantages of combining expansion and specialization relate to capital and management requirements. This approach to expansion can reduce the overall capital requirements to finance the process, by allowing the producer to "shift" capital from crop production, for example, to milk production. As well, this strategy allows the producer to focus his/her capital and managerial abilities in the dairy enterprise. This is consistent with the principle of division of labour and specialization in job tasks that is often followed in the general business community. The major disadvantages relate to increased risk due to specialization and loss of control in some elements of dairy production (e.g., feed production).
Along with the type of expansion, the dairy producer must also consider the degree of expansion; that is, by how much the dairy enterprise is to be expanded. Should a producer with a current herd size of 65 cows consider an expansion strategy that involves doubling the herd size to 130, or should even larger herd sizes be considered (e.g., 200 or 250 cows)? In terms of the opportunity to exploit size economies, any increase combined with good management should result in average production cost savings. There may be constraints that limit the ability of producers to expand their operation. Availability of resources, both financial and managerial, will likely be a key constraint. As well, environmental factors may limit the degree of expansion. Given the regulatory environment in Canada, quota availability may be limited at least in the immediate future. As well, climate may limit the size of operation that is viable from a practical perspective. Examples of very large herd sizes are typically found in regions with a warmer climate than is present in western Canada. This may mean that the dairy facility investment requirements would be prohibitive for operations of this size in western Canada.
Evaluation of Strategies
The evaluation process involves comparing the alternative expansion strategies using one or more tools or methods of analysis. Evaluation is not the primary focus of this paper, so less emphasis is placed on the discussion in this section.
The choice of evaluation method(s) should depend on the goals to be achieved through expansion of the dairy enterprise. If the goals are primarily profit and/or wealth oriented, a number of quantitative tools are available. These include budgeting tools such as partial budgeting, or present value tools such as net present value or cost/benefit analysis. These types of tools allow the manager to compare alternatives in terms of their profitability; that is, the question of whether a particular expansion strategy should be undertaken. A related question is that of feasibility; is the manager able to undertake a particular strategy. The analysis surrounding feasibility considerations includes investigating the effects of the particular strategy on liquidity and solvency, requiring tools such as cash flow budgets and projected balance sheets.
A full discussion of these tools is beyond the scope of this paper. More details concerning these tools are available in any number of extension-oriented publications as well as short courses and university courses in farm and financial management.
While quantitative financial analysis is essential in evaluating alternative expansion strategies, it may not be sufficient. This is particularly true for cases where other, non-quantifiable objectives are relevant (e.g., choice of lifestyle). There are no decision making "models" that can be used to systematically incorporate these types of objectives into the analysis. However, ignoring these considerations when choosing an expansion strategy may lead to unfortunate consequences with respect to being able to achieve certain goals. The end result may be a combination of quantitative analysis and more subjective appraisals of the alternative strategies.
It may be noted that the final step in the strategic planning process is not discussed here. There is no statement provided in this paper concerning which type of expansion or what herd size represents the best strategy for western Canadian dairy producers. The stated objective of this paper was to introduce a process by which producers may determine the best strategy for their purposes, and to discuss relevant factors to be considered when making those decisions.
There are many incentives for dairy producers to expand, including improved cost efficiency and long-term viability. There are many ways in which expansion may be undertaken, including various degrees of specialization combined with herd expansion. Finally, there are many tradeoffs to be considered when making decisions concerning expansion; benefits of specialization vs. maintaining a diversified operation, lifestyle choices vs. wealth accumulation, size economies vs. the ability to maintain good control over production management. The bottom line is that there is no single right answer for dairy producers in western Canada. The best strategy depends on business goals and objectives, available resources, and managerial capabilities. If all of these factors are considered in conjunction with the appropriate environmental elements using a systematic planning process, the producer can be reasonably sure of making the right decision.