Marginal thinking: We can’t move forward if we’re focused on the pastMarginal thinking: We can’t move forward if we’re focused on the past
May 14, 2015
Marginal thinking, while present in almost any business, is the dominant school of thought in agriculture. By marginal thinking, I mean focusing on managing the margins as we buy and sell the efforts of our hard work. It is emphasized at our universities and I spent my early career preaching it from the roof tops. When we bought our ranch, our entire business model was built on being low-cost producers and it is what enabled us to survive and grow through the start-up phase.
We focused on the “no iron” mantra, and we lived it. We were avid followers of the principle that is taught in every basic course in finance and economics: when evaluating alternative investments, we should ignore costs that have already been occurred (sunk and fixed costs), and base decisions on the marginal costs and marginal revenues that each alternative entails.
It has taken me 25+ years of application to discover the problems and potential pitfalls with this type of analysis. We’ve found that, almost without exception, this marginal analysis shows that the marginal costs are lower, and the marginal profits are higher, than the full cost. This is what makes this type of analysis so dangerous; it is naturally biased to encourage you to continue to leverage what you have put in place to succeed in the past, rather than encouraging you to create the capabilities that you’ll need to succeed in the future.
Marginal thinking, then, biases you toward what has been successful in the past, just doing it more efficiently. That approach is not without merit; it helps you eliminate things that did not work in the past, but it tends to assume the future will be exactly the same. The predominance of marginal thinking makes agriculture a tradition-bound industry that is slow to change, but it doesn’t stop the fact that the future continues to evolve. Thus, what was right for the past is almost always the wrong thing for the future.
It is ironic that past success becomes a significant problem. Evaluating new alternatives from the perspective or context of your existing business and marginal thinking tends to lead you in the direction of continuing what you are already doing. Those who are not burdened with the success of a current business model begin with a blank slate in evaluating new methods and models.
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Everyone’s work schedules are different. In our operation, since we do not farm or grow hay, August 15 to June 15 is extremely hectic and is focused on implementation rather than strategy. June 15 through August 15, however, is when we build our work plans, develop our strategies going forward and have time to work on projects.
We have learned that a key to the success of this process is not to focus on how we protect our existing business (marginal thinking), but rather how we would build a great business today (opportunity thinking). A good friend sent me a series of case studies of failed businesses that were once great, but all died because they followed the path of marginal thinking. Ultimately, in the end, you pay for the full cost of your decisions and not the marginal costs.
Looking at the flip side
I have a neighbor who unabashedly proclaims the value of marginal thinking. He embraces the philosophy that a rancher should be paid for the land base; charge the cows a lease rate and ignore opportunity costs or the true costs of production by focusing on out-of-pocket expenses.
This focus on out-of-pocket expenses and commodity prices justifies a silo approach where he focuses strictly on his costs, relying on the assumption that a commodity pricing system will continue to reward him for producing an inferior product for the rest of the production chain. This philosophy is historically solid, and has led to consistent margins.
However, it has also led him to lose his competitiveness with other entities that have continued to build cattle that will improve efficiency and profitability for the entire production system. The marketing system is changing as it moves toward a pricing system where the product is routinely differentiated upon quality and value. At that point, those who have followed the marginal line of thinking will find themselves out of business. Marginal thinking only works in the absence of competition. Where competition exists, you must measure the full cost of decisions but also your long-term competitiveness.
If you’re like me and have spent time at the altar of marginal and low-cost thinking, this discussion is unsettling. It has been a long, hard journey for our operation, and I still struggle with the allure that it offers – to do what you have always done, just do it more efficiently.
When we began our operation, cash and capital were our two most scarce resources. We had no option but to take the lowest-cost route in everything we did. We haven’t gotten to the point that it is abundant, but many of those options have become overwhelmed by another limitation, and that is simply time—especially time to invest in high return areas.
This changing dynamic, along with experience, has taught me the wisdom of Henry Ford, who once said, “If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.” I paid for some equipment 3-4 times before I actually purchased it.
That in a nutshell is what I have learned about the danger of marginal thinking. It is always easy to measure the immediate impacts of investing, but it is almost impossible to accurately assess the costs of not investing. It leads us to not invest in a new and better product, and justify that by saying the product we are currently producing is completely acceptable.
Unfortunately, someone else who isn’t making those same decisions ultimately will bring a new and improved product to market. The fundamental flaw in marginal thinking is that it keeps us from investing in our future, and encourages us to bet that current market conditions and competition will remain the same. They rarely, if ever, do.
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