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

March 4, 1999

EDITORS: this is the seventh article in the series "Assessing Your Business For Today's Market and Beyond." Including the accompanying graphic will make it much easier for producers to grasp the concepts outlined in the column.

The Market Advisor: Managing Your Farm or Ranch Back in the Black the EZ-Way

Harlan Hughes, Extension Livestock Economist
NDSU Extension Service

I've developed an easy way to analyze the economics of your farm or ranch business. This analysis, which I call the EZ-Way, requires only three numbers: total overhead costs, your variable cost per dollar of gross income produced and your total dollars of gross income generated this last year. These numbers can be obtained from your IRS income tax forms and associated farm business records.

With these three EZ-Way numbers you can determine your farm or ranch business profits, your break-even volume and average net profit margin. Once you know your net profit margin, you can calculate the gross income change needed to hit a target net farm income.

A graph is indeed worth a thousand words and this EZ-Way analysis lends itself to a graphical analysis of your farm and ranch business. You need to design the EZ-Way graph so that the horizontal axis represents dollars of total gross income while the vertical axis represents total dollar costs.

Step One
The first step in generating an EZ-Way analysis is to plot your total overhead by finding the point on the vertical axis that represents your overhead costs, and drawing a straight line to the right. Label this line "overhead costs." This line signifies that overhead costs do not change as gross income increases.

Step Two
Plot the variable costs on top of (added to) the overhead costs. In my example farm, variable operating costs were 64 cents per dollar of gross income generated. So, $100,000 of gross income cost $64,000 in variable costs. Since the cost is the same for each dollar of income generated, map a point in the field at $100,000 on the horizontal axis and $129,909 on the verticle axis (determined by adding the $64,000 direct costs to the $65,909 overhead costs). Then, draw a straight line from the field to the initial point of the overhead cost on the vertical axis ($65,909) out through that point in the field. Label this line "total costs."

Step Three
Add a gross income line to the graph. Do this by putting a point at $100,000 on the vertical axis and also $100,000 on the horizontal axis. Draw a line out of the origin through this point and label this line "gross income." You now have an EZ-Way graph of your farm or ranch business.

The break-even gross income in this business is immediately identifiable as the point where the gross income line crosses the total cost line. Now compare your actual gross income to see if it was above or below the break-even level of gross income. The difference between the total income line and the total cost line gives you the net income for this business. If you divide the net income by the gross income and multiply by 100 you can generate the profit margin for this business. This graphical analysis of your business was conducted with only three business numberstotal overhead, direct cost per dollar of gross income and total gross income.

Let's now apply this EZ-Way analysis to a study farm. This farm's total farm overhead is calculated at $65,909 for the total year. These overhead costs are for land, unpaid family and operator labor, and management. The overhead costs are plotted as a horizontal line corresponding to this $65,909 on the vertical axis.

The direct costs per dollar of income generated on this study farm was 64 cents per dollar. The point generated to plot the direct costs was $100,000 on the horizontal axis and $129,909 ($65,909 plus $64,000) on the vertical axis. This line is labeled total cost. The gross income line comes out of the origin (0,0) and goes through point (100,000; 100,000). Now that we have the three lines on this graph—overhead costs, total costs and gross income —we can now proceed to analyze this farm via this EZ-Way.

The breakeven gross income for this farm is where the gross income line crosses the total cost line. In this case, it is at $184,305 of gross income. The actual gross income for last year was $188,298, so gross income last year was only slightly above the break-even level. In fact, net income for the $188,298 gross income level was only $1,428 dollars or only 0.76 percent of gross income. This says that less than one penny out of every dollar grossed was generated as net income.

Clearly, adding more gross income with such a low profit margin is not a viable solution. The only viable solution for this business is to get better before betting bigger. My last Market Advisor went into detail on a recommended management process for getting better on your farm. It focused primarily on the process of reducing overhead and/or reducing direct costs.

My experience in helping beef farmers and ranchers cut costs through my Integrated Resource Management Program suggests that most producers can cut cost by increasing their management intensity. The more details monitored, the more intense the management. The more intense the management, the lower the costs of production. Let's, then, look at two increased management intensities proposed by the study farm's manager after many agonizing hours of analysis and pencil pushing.

One financial consultant suggests that the first thing that a farmer or ranchers needs to do in a financial emergency is eliminate any non-critical overhead. This may even mean selling some or all underutilized assets. This could be farm machinery, equipment or even land in a financial emergency.

This study farm family decided that it could reduce the non-family living $32,000 overhead costs by 15 percent. This $4,800 reduction would decreased total overhead down to $61,109. Now the break-even gross income, where the new total cost line crosses the total gross income line, is reduced to $171,340. This break-even gross income is down $16,958 from the initial analysis. Note that this $4,800 direct reduction in overhead costs reduced the breakeven gross income by $16,958. On the other hand, if this farm maintained the original $188,298 gross income, this reduction in overhead costs would increase net farm income to $6,064 and the profit margin to 3.2 percent of gross income. This increased management intensity is at least moving the farm's performance numbers in the right direction.

After considerably more agonizing analysis, this family arrived at a second conclusion, that increased management could reduce their direct cost of production by 6.25 percent or four cents per dollar of gross income without impacting gross sales. When this revised EZ-Way analysis was plotted, the projected break-even gross income was again reduced to $153,103. If the same $188,298 dollars of gross income is generated, net farm income projects at $13,596 with a 7.2 percent profit margin. A 6.25-percent decrease in direct costs increased net income by another $7,532. It may well be easier to intensify management and increase the efficiency of what is already being produced than to try to produce more. I've observed that it's generally more profitable for a farmer or rancher to get better than to get bigger.

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

Editor: Tom Jirik (701) 231-9629

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