NEWS for North Dakotans
Agriculture Communication, North Dakota State University
7 Morrill Hall, Fargo, ND 58105-5665

January 7, 1998

EDITORS: this is the fifth article in the series" "Assessing Your Business For Today's Markets and Beyond."

The Market Advisor: What Does It Cost You To Produce A Dollar Of Income?

Harlan Hughes, Extension Livestock Economist
NDSU Extension Service

Today, many farmers and ranchers are under considerable financial pressure and yet profit opportunities are being missed because of the lack of the time spent on the financial and marketing aspects of the business. In many cases, the family farmer or family rancher is simply too busy. Herein lies the dilemmatoo busy to manage but survival hinges on increased management power.

Let's take a look at some financial management power that you could immediately apply to your farm or ranch business.

Assess your current situation. Ask yourself a fundamental question: What does it cost to produce a dollar of income? This simple question gives considerable insight into the economic efficiency of your business, yet I seriously doubt that many of my readers can answer it.

I suggest that you break this question into two parts. First ask, what is the cash cost (only) of producing a dollar of cash gross income? This question addresses net cash flow and is used to determine if you can stay in farming or ranching.

Next ask, what is my economic cost (cash and noncash) of producing a dollar of accrual adjusted gross income? This question addresses the profitability of the farm or ranch business and is used to determine the economic side of whether you want to stay in farming. (Certainly, it takes more than just economics to completely answer this question.)

Let me demonstrate how one might go about answering these two question by going back to my demonstration farm's financial data presented in previous Market Advisors in this series.

First, let's work through the cash flow question. The cash flow question takes less detailed business records to answer. A review of the demonstration farm's income statement shows that during 1998 this farm generated $116,127 of livestock sales, $27,699 worth of crop sales, and $19,826 of other income for a total gross cash income of $163,652. Operating expenses, listed on the IRS form 1040F, totaled $109,500. Operating expenses totaled 67 percent of gross income with interest included. Interest will be included later so after excluding the $32,045 in interest payments, direct operating costs totaled $77,455. In other words, 47 cents of each dollar of income was paid for operating expenses (excluding interest). From a gross margin concept, it takes 47 cents of direct operating expenses to produce each dollar of cash income generated on this ranch.

But, there are additional costs beyond cash operating costs. Overhead cash costs need to be accounted for. To keep it simple, cash overhead will be defined here to include debt service payments (interest and principal) and family living draw. A check of the business records shows that the annual principal and interest payments on the $356,060 of beginning liabilities totaled $41,696 for the year. That's 25 cents for every dollar of gross cash income generated. If debt service costs and operating costs are added together, it cost this rancher 72 cents for every dollar of cash gross income generated.

Family living draw is the other overhead cost that needs to be included in answering the cost of generating each dollar of cash income. This ranch family withdrew $30,000 for family living during 1998. That's 18 cents per dollar of gross cash income generated. Added togetherdirect costs, debt service, and family living drawit cost this rancher 97 cents to generate each dollar of cash gross income. This leaves 3 cents on each dollar of gross cash income left over for income taxes, Social Security payments, capital purchases, savings, and/or retirement funding. There is some pressure on this family for someone to take off-farm employment.

Given this tough 1998 year, the fact that this ranch cash flowed before income taxes and Social Security payment is a real compliment to this manager. This ranch family probably can stay in ranching with some minor adjustments.

Next, let's work through the profitability question. This question needs to be based around the accrual adjusted income. Accrual adjusted income takes the gross cash income used before in the cash analysis ($163,652) and adjusts it for inventory adjustments. In this case, inventory went up $6,084 during the year. Total accrual adjusted gross income totaled $169,736 in 1998. While this ranch's inventory adjustment was positive, your inventory adjustment could be positive or negative.

The same direct operating expenses of ($109,500 with interest payment) $77,455 without interest is used. This implies that it cost 46 cents ($77,455/$169,736) of direct costs to generate each dollar of accrual adjusted gross income. Remember that gross cash income and gross accrual adjusted income are different.

Overhead costs under the economic profitability analysis are made up of depreciation and interest. Principal payments are not included in a profitability analysis. All principal payments do is determine who owns the assets. Principal payment have nothing to do with the earned returns to the assets. If land is cash rented, cash rent could also be included in the overhead costs. In this case, the producer did not rent any of the land.

If you have read the previous articles in this series, you might remember that this farm has a very high depreciation cost of $29,078. Depreciation on this farm is costing 17 cents per dollar of accrual adjusted gross income generated. The $32,045 of interest is equal to 19 cents per dollar of gross income generated. If depreciation and interest are added to the direct cash expenses, it cost this rancher 81 cents to produce each dollar of accrual adjusted gross income generated.

This ranch family contributes three resources to the ranch business: unpaid family and operator labor, management, and equity capital. This is all a farm or ranch family contributes. Rather than charge an opportunity cost for the family's contributed resources like ranch management text books do, let's measure what the family's resources collectively earned. I like this approach better.

After deducting the production cost of 81 cents for each gross dollar generated, this family's three resources earned a pre-tax return of 19 cents per dollar of gross income generated. Is this sufficient return so that the family wants to stay in ranching? Only this family can answer that. At least, they now have some hard economic data to answer the economic side of this question.

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Source: Harlan Hughes (701) 231-7380 hhughes@ndsuext.nodak.edu

Editor: Tom Jirik (701) 231-9629