Whether you are a grain farmer, a rancher or a diversified grain farmer and rancher, I bet most of you will agree that 2016 was not a good business year. Now it is the time of year to analyze the past business year and then develop a game plan for the next business year — maybe even develop a five-year game plan.
The big picture. In 2016, my study rancher farmed 1,400 acres and ran a herd of 250 beef cows, normally selling calves at weaning time. He also raised 300 acres of grass hay, 150 acres of alfalfa hay and 700 acres of corn.
Overall, this ranch grossed $606,233 and had total expenses of $602,810, leaving an earned net return to operator and family labor, management and investment capital of only $3,423 for the year (see Figure 1). Not a good year!
Dissecting the business. Let’s start dissecting this business by first dividing the total business costs into operating costs and overhead costs. All ranch production costs have to fall into one or other of these two categories.
Overhead costs are those costs that are independent of the number of acres or cows run. Depreciation, taxes, utilities, shop, pickup costs and insurance are a big part of the overhead costs. Overhead costs totaled $145,186, amounting to 25 cents for each dollar of gross income.
Operating costs, on the other hand, are determined by the number of acres and cows run. Operating costs for this ranch totaled $457,624 and amounted to 74 cents for each dollar of gross income generated in 2016.
This leaves only 1% of gross income as the profit margin. In fact, it actually calculates out to 0.56% of gross income being the profit margin, or $3,423 earned net returns for the year.
Given these financial performance numbers, this rancher’s breakeven point, where earned profits would be zero, was at $563,133 gross income. This low profit margin is not sustainable. Something has to change.
The goal of this rancher is to generate $50,000 earned net return to operator and family labor, management and equity capital annually. This goal requires an 8.2% profit margin on 2016’s $606,233 gross income.
As a guide, the 10-year average profit margin (2002-2011) for 1,086 farms in North Dakota and Minnesota was 13.6%. The annual average was from 21.5% to 2.5%. I generally suggest a goal of 10% to 15% profit margin for ranchers. Sure, this varies from year to year, but I argue it should average in this range through time.
Conduct a “Back in the Black” analysis of the business. A picture is worth a thousand words. Let’s take a look at this same ranch’s total business analysis in graphical form (see Figure 2). Total overhead costs, calculated at $145,186, occur regardless of the production level of the ranch and are represented by the horizontal red line in Figure 2. Since overhead costs are constant for all gross income levels, the red line is horizontal at the $145,186 level.
Operating costs at 74 cents per dollar of gross income are accumulative as gross income increases and are represented by the tan line. Note the tan line is added to the red line to generate total costs for each gross income level. As gross income increases, so do operating costs.
Gross income is represented by the gray line. Note it starts at the 0,0 point on the graph. Note the gray line (gross income) crosses the tan line (operating costs plus overhead costs) at the $563,163 point on the graph. This is the breakeven gross income for the 2016 business year.
Profit is represented by the distance between the gray and tan line. Where the tan line is above the gray line, profits are negative. Where the gray line is above the tan line, profits are positive.
Management’s goal is to maximize the distance that the gray line is above the tan line. Drawing a vertical line at the ranch’s $606,233 gross income level (the yellow arrow) shows very little distance between the gray and tan line.
Three ways to increase profits. There are three ways, and only three ways, to increase profits. They are:
- Decrease overhead cost — lower the red line. Reducing direct costs has the biggest impact on profits. Each dollar of direct costs reduced increases profits by that same amount.
- Increase the profit per unit produced — reduce the slope of the tan line and/or increase the slope of the gray line.
Do this by increasing the price of product or quantity of products sold, e.g., higher calf prices. Or sell more pounds — maybe precondition calves for 45 days before marketing.
You can also decrease operating costs of production. For example, reduce feed costs by running cows on cornstalks part of the winter, instead of feeding hay all winter long.
- Increase scale of operation by producing more dollars such as backgrounding calves before marketing. Farm more land. Maybe adding more cows; but adding cow depreciation and maybe interest payment and principal payments will also increase the overhead costs (raise the red line) so more cows may or may not increase profits.
A more detailed analysis of this business. Let’s continue dissecting this ranch business. The beef cows were charged market value for hay consumed, and the hay enterprises were credited with the market value of hay produced. A more detailed economic summary of each enterprise is presented in Figure 3.
This rancher’s high-profit enterprises were grass hay and alfalfa hay. The corn enterprise was only slightly profitable. The beef cow herd generated a negative profit.
The Back in the Black concept introduced above for the total business also works just as well for analyzing each enterprise in the ranch business. For example, Figure 4 presents this Back in the Black analysis for the alfalfa hay enterprise. Fixed cost for this enterprise was $8,000, as illustrated by the horizontal red line. Operating costs are represented by the tan line. Gross income, based on market value of alfalfa hay at $85 per ton, is represented by the gray line.
The breakeven acreage was 61 acres. After that, you can see that profits got bigger and bigger as more acres were harvested. Given that the rancher harvested 150 acres of alfalfa, he generated profit of $11,257. You can immediately see the potential for expanding this profitable enterprise.
Figure 5 presents the Back in the Black analysis for the beef cow enterprise. Again, overhead costs are represented by the horizontal red line. The tan line represents the operating costs per cow such as feed costs, vet costs, etc. Again, note the operating costs are added to the overhead costs.
The gray line represents the gross income generated per cow in 2016. Unfortunately, the gray line does not cross the tan line until 981 cows. Given that the tan and gray lines do not cross before 250 cows, something needs to change for 2017. Again, there are only three possible actions:
- Decrease overhead costs.
- Raise profit per unit produced:
- Increase scale of operation.
Think about your suggestions for these three possible profit-increasing actions, and I will share mine with you next month. Let’s see what we can suggest for this rancher in 2017. Stay tuned.
Hughes is a North Dakota State University professor emeritus. He lives in Kuna, Idaho. Reach him at 701-238-9607 or [email protected]