The authors are with First Capitol Ag in Galena, Ill.

Here's dairy net margin de­­­fined: the result of all dairy revenue minus all dairy expenses . . . not solely the difference between milk price and feed cost.

Over the past several months, you probably have received a steady diet of presentations, magazine articles, and discussions focusing on dairy margins. As an owner or manager, you have been encouraged to "Know" your margins, "Model" your margins, "Own" your margins, "View" your margins, and "Manage" your margins forward in time. This attention to dairy margins is the product of the financially devastating impact of the combined milk and feed price volatility of the past three years.

Those who took a fixed price position in milk or feed without doing both clearly felt the financial pain associated with greater margin and price volatility. Managing milk price forward with a milk processor's cash contracts or futures and options, in itself, cannot guarantee an expected profit outcome.

When you fully appreciate your role as a commodity processor (processing a number of commodities [feed] into another commodity [milk]), you must recognize the financial management practices that are required for your success. Ethanol producers, cattle feedlots, hog finishers, and soybean processors have had to become commodity-margin focused in the current volatile price environment to avoid financial hardship. The commodity processors who have applied structured commodity-margin risk management have realized more sustainable earnings during extreme margin volatility periods. These businesses have employed models that project revenue and expenses forward eight to 18 months and roll all of their marketing and risk management positions into the model to generate a net margin view forward. Such a model is complete when all commodities and market positions involved are "marked to the market" every day with current live market prices. This dynamic view of the commodity processor's margin enables them to "know it," "own it," and "manage it." As a dairy owner or manager, you also should apply this financial approach to producing milk.

All dairy managers/commodity processors have been offered various tools for managing the margin of their processing enterprise. What follows is not an exhaustive list, but it does represent margin-management methods currently being employed by financially focused dairy managers.

Gross livestock margin - dairy insurance: This government-subsidized, gross margin insurance program, which may not be available again until October, enables producers to protect a minimum gross margin level for a specified deductible and forward period of time. The tool is not very flexible since it can't be adjusted after purchase and may not be well suited for capturing opportunity in high-margin environments. It can be useful for protection against dramatic declines in margin and should be thought of as a tool rather than an all-encompassing margin-management approach.

Gross income over feed cost: This strategy, which involves a broker, enables a dairy to view forward gross income over feed values generated by exchange traded milk, corn, and soy meal futures contract prices. You can compare current gross margins offered to the historical opportunities of the past to determine the current level of opportunity in the market. This approach is limited since it doesn't typically tightly match anyone's actual operation. Industry gross margins don't reflect the significant variation from dairy to dairy in basis, operating costs, operating efficiency, existing contracts, and homegrown feed versus market pricing.

Structured dairy net margin program: Under this approach, an individual dairy works with a broker to employ customized software to model all dairy revenue and expenses forward to derive a dairy's net margin for up to two years forward. You then take advantage of all available cash, futures, options, and insurance tools to capture opportunity and minimize risk. All commodities are valued, and all physical futures and options positions are marked to the market daily.

This comprehensive program can provide greater transparency to net margin opportunities through daily profit and loss and risk reports that take into account all operational, financial, and position details. This net margin-management approach is superior to the above simpler options because of its completeness and specific detail to the individual dairy's financials, operations, and positions.

The chart shows an example of the current net margin through February 2013 for a Midwest dairy that is nearly 100 percent self-sufficient for all forage and grain needs. The dairy has calculated its input costs to grow the 2011 crops that will be fed in the fall of 2011 through summer of 2012. It can look at futures prices for milk in terms of known costs for rent, fertilizer, seed, fuel, chemicals, and other anticipated variable and fixed costs.

Margin management will continue to be the "buzz" word in dairy management going forward as dairy earnings' volatility persists, and you are challenged or even required by lenders to know your margins. Progressive dairymen must embrace dairy-margin management as they continue to work toward combining a financial focus with their production emphasis.