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

February 18, 1999

[EDITORS: This is sixth article in the series "Assessing Your Business for Today's Market and Beyond." It is also extremely important that the illustration is included as part of this article.]

The Market Advisor: Putting Your Farm or Ranch Back in the Black

Harlan Hughes, Extension Livestock Economist
NDSU Extension Service

Managing a farm or ranch has never been easy, especially when commodities prices are as low as they are today. Changing production technologies, improved communications and an information explosion, coupled with changing federal, state and local regulations, are causing farmers and ranchers to ask, "How do I ever get a handle on it all?"

My recommendation for putting your farm or ranch back in the black under today's market prices is to conduct an integrated business analysis of your farm or ranch business. Integrated business planning is a method of planning and managing the farm or ranch as a whole, rather than by separate unrelated enterprises. Some are referring to this type of management system as holistic management. Integrated business planning provides a step-by-step method for working through the overload of information that managers must deal with when analyzing a farm or ranch business for today's markets and beyond.

The following discussion centers around a paper, "Diagnosing Problems & Opportunities," written by Dave Pratt of the University of California. I think Dave's approach to integrated business planning is one of the more effective ways to handle the big picture for increasing profits. It is straightforward, simple and effective.

Dave's integrated business analysis suggests that a business is a chain of three economic linksoverhead, gross margin and turnover (business size). There are three ways to increase profits in any business: decrease overhead costs, increase gross margin per unit or increase turnover (business size). If fact, these three ways are the only ways to increase profit in any farm or ranch business.

Let's take a more detailed look at these three business links. Overhead costs are defined as costs that do not change as livestock numbers or crop acres change. There are three kinds of overhead costs: land, labor, and management. For this analysis, we'll use family living draw as a proxy for labor and management wage, reducing overhead costs to two itemsland and labor. While economists call these fixed costs that are independent of number of animals and crop acres, these costs can indeed be changed and reducing overhead is certainly one of the three effective ways to increase profits.

If you want to know where you are making your profits in your farm or ranch business, break your farm or ranch business into its profit centers and treat each profit center as a stand alone business. Gross margin is a measure of the economic efficiency in your livestock and cropping profit centers. Gross margin is calculated for each profit center by subtracting the direct costs of production in that profit center from the gross income of that profit center. Gross profit is the sum of all profit centers' gross margins added together. Profit or loss is determined by subtracting overhead costs from gross profit.

Instead of calculating gross margin for each enterprise, let's calculate a gross margin for the total business and express it in terms of profit per dollar of gross income generated. The fifth article in this series went into detail on this per-dollar analysis. In the study farm presented in that article, gross margin per dollar of income was 36 cents ($1 minus operating costs of 64 cents). Overhead costs on the study farm consisted of depreciation and family living draw as a proxy for labor and management wage. In the study farm, depreciation cost was 17 cents per $1 gross income and family living draw was 18 cents per $1 gross income. In planning for today's markets and beyond, I strongly encourage you to calculate what your gross margin is for each dollar of gross income generated on your farm or ranch.

Turnover is a term being used to measure the size of the farm business. The higher the turnover, the larger the business. If gross margin per $1 is positive, then increasing turnover (size) will increase profit—provided that the increased size does not also increase overhead costs.

Now for the decision-making process. The key to Dave Pratt's technique for increasing profit is to study the accompanying illustration. Starting on the left-hand side, profit is calculated by subtracting overhead from gross margin. So if profit is low, it is due to two possible reasonseither gross margin is too low or overhead is too high.

Gross margin is calculated by subtracting direct costs form gross income. If gross income is too low, it is either because of low production or low price. If market price was not high enough it was due a down market or poor marketing techniques. If gross product is low but price is reasonable, then production is too low. If production is low it is either because of a low reproduction rate (for cattle), or we did not produce enough gain per animal.

If gross margin is low but gross product is not the problem, then the focus should turn to direct costs. There are only two major direct costs in beef cows feed costs and health costs. If direct costs are too high, it is either due to high feed costs or high health costs. If feed costs are too high, it is due to feeding unbalanced rations or high waste. If health costs are too high, it is due to high treatment costs or to the high use of preventive medicines.

If gross margins are healthy and the business still is not profitable, the problem must lie in the overhead cost category. There are only two kinds of overheads in this example—and costs and labor costs (family living draw is considered a labor cost). If overhead costs are too high, either land costs or labor costs are too high. If land costs are too high, it is because we are acquiring new land that is over priced compared to its productivity or the cost of maintaining the existing land is too high. If labor cost is too high it is either do to the family living draw is too high or the equipment costs associated with labor are too high. An example is having a pickup for each employee or having more tractors than drivers.

If gross margins are healthy and there is no room left to cut overheads, then turnover is the most promising way to increase profits.

It is my assessment that most farmers and ranchers spend most of their management time focusing on fine-tuning items on the far-right hand side of Figure 1 and that most extension educational programs are also focused on these items. It is my professional judgement that changing these far-right items will not save a farm or ranch business in today's tough times.

Today's tough times call for tough actions. If you are serious about putting your farm or ranch back in the black, you need to work on the big itemsthose on the left side of the illustration. In these troubled times, I suggest that the big payoff is in changing gross margin, reducing overhead and evaluating turnover (size). A well-known national financial consultant suggests that his clients generally have 15 percent of their overhead that is not really needed. Cutting overhead is where I would start for coping with today's markets and beyond.

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

Editor: Tom Jirik (701) 231-9629

Click here for a pdf version of this graphic.