There are two things that I hear farmers complain about all the time, other than the weather. It’s that they don’t have enough time or enough money. If this is you, I might have a solution for you.
Many years ago I was struggling to keep my farm afloat. I was working a full-time job, raising a young family and trying to make some money with cattle. I was good at all of the production practices involved with cows. I was bale grazing, feeding very low cost, calving rates were good, my pasture management was better than most but I was still broke all of the time. Why was I not making a profit? I was desperate to figure this out.
I attended the Ranching for Profit school in 2001 and this was where I was first introduced to the Gross Margin Analysis. I was surprised that I had never seen anything like it in school before, even though I did achieve two college diplomas in agriculture in my post-secondary education. I further pursued my private industry education and looked at the Gross Margin Analysis from a few different points of view. Holistic Management has a good model of it and I added a few more ideas from the TEPAP course out of Texas. My model has evolved over the years but it is still the same concept. You need a Big Number, and then subtract a Little Number from it! Then you make a profit. It’s that simple.
I will warn you, when you first dive into a gross margin, it can be overwhelming. It’s a lot of paper and a lot of numbers, but I like to keep it simple and it is really not that complicated once you get the hang of it. If we have a Big Number minus a Little Number, we have a positive answer. If it’s the other way around, we are in the negative. We just do this many, many times in the Gross Margin Analysis. I’ll try to give you a quick outline of my model. Follow along on the diagram if you will. It shows three separate profit centres that contribute to the business.
Our farms are made up of different profit centres. We might have a cow/calf profit centre, a hay profit centre, a silage profit centre, a grain profit centre, a feeder profit centre or a goat profit centre. As you can see, the list can go on and on. The key is to separate all of the revenues and costs, and then allocate them to each individual profit centre. Most farms have all of the costs lumped together and you cannot see the margins individually.
Our first step is to calculate the gross margin on each profit centre. This step involves using the gross product and subtracting all of the direct costs. Direct costs are costs that get used up and are usually on a per head basis or on a per acre basis. A couple of examples might be the hay that you feed or the seed that you plant. For every cow you own or for every acre you plant, you need one more unit of hay or one more unit of seed. In the end, they are gone. If your gross product is the Big Number, and all of your direct costs add up to be the Little Number, you have a positive margin. This is done for each profit centre.
We then look at each profit centre’s margin as the new Big Number and calculate its contribution margin. The small number will be the overhead costs that are specific to the profit centre, but are not used up. These are known as the profit centre overhead costs. Some equipment and labour costs are calculated here if they are specific only to the one profit centre. We also include the opportunity costs and depreciation costs here. If the gross margin is big and the profit centre overheads are small, we have a positive contribution margin.
We have now done these calculations on every profit centre which, on some farms, can be a lot of calculations. Now we can add up all of the contribution margins of all of the profit centres to get a total contribution margin. This is our new Big Number.
To find out if we made a profit or not, we still need to use the total contribution margin and subtract the business overheads. These overhead costs include all of the remaining costs not allocated to a profit centre. These might include utilities, labour, accounting, and/or equipment costs, just to name a few. We also include the opportunity costs and depreciation costs here. If your contribution margin is bigger than your business overhead costs, you have made a profit. If not, you better go back and replan and get it right. The advantage to this analysis is that it will show you exactly what you need to fix. Any place in the paperwork the Big Number is too small and/or the Little Number is too big creates a negative result. You need to change your plan.
In the end, in most cases, some profit centres will be positive while others might be negative. Now we have some good information which will help us make good economic decisions on the farm. In a lot of cases, we end up making financial decisions which can get us into trouble down the road. Once we see where our farms are losing money, we have a couple of options. We can fix it, or we can stop doing it.
To answer my first statement, if you do not have enough time or money, this analysis might get you more of both. If you stopped working at the profit centres that are losing money, you would not only have more money left over, but you will also have more time available to work on the profit centres that are making you money.
A lot of farmers think that if we just get bigger, we can make more profit. However, that is not usually true. Only if your margin is positive, will it make you more money. (Or in some cases, lose you less money). Only then, should you expand your profit centre.
This understanding of the Gross Margin Analysis was the biggest breakthrough that my business ever had. It allowed me to make better economic decisions instead of always making financial decisions. If you are looking for a breakthrough in your business, find somewhere that teaches this kind of analysis. It is a small investment in your business, with huge dividends in the long run.