Even though the production components of your business are important, they don’t make or break it for you. The most important part of any business is in managing the business itself. The economics and finances behind the production practices are more important than the production practice itself.
Two producers can use the same production practice. One could be making a profit and the other losing money. It all comes down to the margin. The economics of a production practice has to show an adequate profit to cover opportunity costs, depreciation and inflation. I also have to be able to cash flow the practice in order for it to be financially viable.
Economics and finances are two different sets of numbers. A production practice could be profitable, but not financially feasible. Or you might be able to cash flow a venture but it is not profitable. We need to have both the economics and the finances in order to have a viable business.
I would like to look at the economics side of the business today by looking into the gross margin analysis.
I have taken numerous private industry education courses, Ranching for Profit, Holistic Management, Low Cost Cow/Calf, TEPAP, just to name a few. All of them have contributed to my business management system because they taught me an amazing tool that I had never even heard of before, the gross margin analysis.
It can show me where my business is failing and gave me the ability to make good choices. Sometimes it even shows you that the best decision is to stop doing something. As a farmer myself, I know that we complain all the time about three things. The weather, of course, is No. 1 but I can’t control that. After weather we complain that we don’t have enough time or enough money. I have found that by understanding how to run a gross margin, you can free up time and make more money by focusing on the profit centres that are making a positive margin and possibly even shutting down some profit centres that are producing negative margins.
By breaking my operation into profit centres, I am able to see which practices are working and which are not.
A gross margin analysis is quite simple. If you have a big number and you subtract a small number from it, you have a positive margin. We just do this many times for all the different profit centres.
Wait, let me back up. A profit centre is one component of your business. You may have many that make up your farm, such as a cow-calf profit centre, a land profit centre, a grain profit centre, a hay profit centre, a grazing profit centre or a feeder profit centre. Every farm is different. Hopefully, your gross product (the big number) minus your direct costs (the little number), for each profit centre gives you a positive gross margin. If not, you can see what needs to be fixed. Either the big number needs to be bigger or the small number needs to be smaller.
Each profit centre can be broken down to determine the margin it contributes to the total margin. This in turn then has to cover all of your business overhead costs. If it does, you are making a profit. Now this analysis has to cover all of the costs, even the non-cash costs.
After you have paid for all of your labour (I do not like the term unpaid labour) and all of your cash costs, you need to cover depreciation, opportunity cost and inflation.
Depreciation is the loss in value of an asset over time. It is calculated by subtracting the salvage value of an asset from the purchase value divided by the number of years owned. Most of our equipment does depreciate but our cows also depreciate. The longer she can stay in the herd, the lower her depreciation. In theory, every year, the depreciation value of an asset should be accounted for and saved for when that asset needs to be replaced. When that time comes, you use the money saved up plus the salvage value of the asset to replace it. Are you covering your depreciation each year?
Opportunity cost is a measure of your management. Most people have a hard time understanding opportunity cost. You don’t see it in your finances, but you need to account for it in your economic analysis. Look at it as an interest charge on that investment. The money that could be earning you a return somewhere else. Is it earning enough of a return as a cow or as a tractor? I like to use an opportunity cost of 10 per cent. Somewhere, my money invested should be able to return me 10 per cent. An easy way to determine your opportunity cost is to use your highest interest rate you are currently paying on borrowed money. An asset could be sold and its value could pay down the loan and save you the interest charges on that loan. If your loan interest was eight per cent, then the opportunity cost on your assets could be eight per cent.
Inflation can vary but let’s say an inflation rate of three per cent is average. Will the money you have today be worth the same tomorrow? Will you still pay the same for a litre of gasoline 10 years from now as you do now? Not likely, so we have to make sure our business will be ahead of where it is today 10 years from now by accounting for inflation.
Now include this all into your gross margin analysis and see if you are making a profit. It is a powerful tool. I can’t emphasize enough the importance of understanding the economics of a farm business. As fun as the production side of your operation is, it’s the economics that makes a profit.
You are the manager of your business and it is up to you to manage. If you haven’t done so already, I challenge you to find somewhere that teaches gross margin analysis and learn it. That was the biggest breakthrough I ever had in my business.