What is driving my profitability

Author: | Date: 07 Sep 2016

Introduction

It is a common perception that if only I can expand the farm then I will be more profitable. Reviewing the data in the Victorian Wimmera and Mallee over the past 20 years shows that farms have grown in size and income has more than doubled. However costs have also more than doubled so that the hoped for gains in efficiencies does not appear to be all that apparent. A relatively simple analysis of the farm profit margin and understanding the impact of key profit drivers can identify what areas are impacting profitability. 

The top profit performers within a region consistently operate with a higher operation profit margin than the group average. How do they do this? Management capacity is a key variable and good business outcomes tend to result for those who manage things well. As farms are increasing in size and scale in the Wimmera Mallee with the hope of being more profitable, this also serves to impact the risk profile of the business and make managing the farm more complex and challenging.

Dedicating time to establish, implement and update an effective business management framework can help mitigate the challenges of a more complex and time-hungry farm operation and position the business for better financial and social outcomes. 

Farming trends in the Wimmera and Mallee (1996 – 2015)

From reviewing approximately 70 farm businesses in the Wimmera Mallee over the past 20 years, the following business performance trends can be observed (Figure 1 to Figure 4, Table 1):
Note: Each farm business must have a minimum of 14 years to be included in the sample

Bar graph showing farm income versus costs (Wimmera Mallee). N.b. Bottom to top: overheads, machinery & labour costs, input costs and farm finance costs. (Source: Ag Profit)

Figure 1: Farm income versus costs (Wimmera Mallee). N.b. Bottom to top: overheads, machinery & labour costs, input costs and farm finance costs. (Source: Ag Profit)

Table 1: Average farm costs as $/ha (Wimmera Mallee). (Source: Ag Profit)
Year Period Average Farm Costs ($/Ha Croppable Area)
1996-2000 260
2001-2005 290
2006-2010 340
2011-2015 470
Line graph showing farm liabilities (lowest line at 1996) versus farm income (middle line at 1996) versus equity ratio (top line at 1996) (Wimmera Mallee). (Source: Ag Profit)
Figure 2: Farm liabilities (lowest line at 1996) versus farm income (middle line at 1996) versus equity ratio (top line at 1996) (Wimmera Mallee). (Source: Ag Profit)

Line graph showing farm land area (top line) versus crop intensity (bottom line) (Wimmera Mallee). (Source: Ag Profit)

Figure 3: Farm land area (top line) versus crop intensity (bottom line) (Wimmera Mallee). (Source: Ag Profit)

Line graph showing machinery area efficiency (Wimmera Mallee). (Source: Ag Profit)

Figure 4: Machinery area efficiency (Wimmera Mallee). (Source: Ag Profit)

Key observations

  • The average farm business in the Wimmera and Mallee has doubled turnover and costs over the last 15 years.

  • There has not been any consistent increase in profit over this period as the business scale has increased.

  • Average farm debt has increased significantly however market value of equity (including capital gain of land value) has remained relatively consistent.

  • Average size of farm croppable land has increased by over 50 per cent over 20 years and cropping intensity has increased by 15 per cent.

  • The value of machinery working the farm croppable land area has more than doubled over the last 20 years.

Farm profit and cost classification

Profit is achieved from generating more assessable income than what you expend as assessable costs.

With farming, costs can be broken up into four key categories:
  1. Input costs (such as chemicals, fertiliser, seed, fodder, irrigation electricity).

  2. Machinery and labour costs (such as fuel, repairs, depreciation, contractor costs, wages, super and imputed family labour; to compensate for drawings paid to family members rather than receiving a wage).

  3. Overheads (such as professional fees, insurance, rates, utilities and depreciation of improvement assets).

  4. Finance costs (such as interest and land and machinery lease costs).

Info graph showing Farm profit and cost classifications.

Figure 5: Farm profit and cost classifications.

These costs can be analysed as a ratio to the farm income produced to determine the impact each key cost area has on the business profit margin.

Profit margin

The business profit margin measures how much of the income generated is retained as profit and is expressed as a percentage of the income. There can only be a 100 per cent of the income allocated to costs before a loss results. However we are hoping that we do not allocate a 100 per cent of the income to costs as we want to retain some as profit.

Ag Profit uses the following guidelines to provide an assessment as to how the cost areas are consuming profit and thus reducing available profit (Table 2).

Note the guidelines have been assessed by looking at data over a long period of time. They may be a bit out for certain years (i.e. really good or bad production years) or not quite matched for certain farming regions (i.e. a really good farming area should have a higher profitability capacity than a not so good farming area).

Table 2: Profit margin and profit driver guidelines. (Source: Ag Profit)

Key Performance Indicator Units Weak Medium Strong Guideline
Profitability
Farm Profit Margin as % Farm Income < 3.0% 3.0% - 17.0% > 17.0% 10.0%
Farm Operating Profit Margin as % Farm Income < 15.0% 15.0% - 25.0% > 25.0% 20.0%
Farm Profit Drivers
Input Costs as % Farm Income > 30.0% 30.0% - 22.0% < 22.0% 26.0%
Machinery & Labour Costs as % Farm Income > 50.0% 50.0% - 40.0% < 40.0% 45.0%
Overheads as % Farm Income > 11.0% 11.0% - 7.0% < 7.0% 9.0%
Finance Costs as % Farm Income > 14.0% 14.0% - 6.0% < 6.0% 10.0%
Looking at the profit margin for a business provides an insightful measure of how efficient the business is in managing costs in relation to income. For the many business industries, this is a key consideration as to how they structure their business model. For example, with retail industries goods are purchased at a price and then a margin is added to go towards covering the rest of the business costs based on expected volume of sales and providing for a profit component. Service industries are similar; they know what the cost is to provide the service, they then add a profit component and this determines the service rate they charge their customers.

As farmers work in the commodity industry; where in general we are price takers and not makers, profit margins are generally not commonly referred to. A relevant example of how analysing the profit margin can be insightful is if a farmer wants to expand the farm size in the belief that this will result in achieving an improvement in the business’s economies of scale; then an improved profit margin should result. If not, then you are working harder for a lower rate of return.

Profit drivers - top profit group versus average in the Wimmera (2010 – 2015)

For a comparison group of approx. 150 farmers in the Wimmera over the 2010 to 2015 financial year period, Figure 6 shows the relationship of costs and income for the group average and the Top 20% profit group.
Line and bar graph showing farm costs (as $) versus farm income. N.b. Group average:farm income is bottom line, Top profit:farm income is top line, Group average cost is left hand side column and Top profit cost is right hand side column. (Source: Ag Profit)
Figure 6: Farm costs (as $) versus farm income. N.b. Group average:farm income is bottom line, Top profit:farm income is top line, Group average cost is left hand side column and Top profit cost is right hand side column. (Source: Ag Profit)

Hence over this period the total amount expended on costs (as a ratio of the income) and hence the respective profit margins are shown in Figure 7.

info graphic showing Farm cost and profit margin (Wimmera 2010 – 2015). (Source: Ag Profit)
Figure 7: Farm cost and profit margin (Wimmera 2010 – 2015). (Source: Ag Profit)

Figure 8 shows the profit drivers over this period.
Info graphic showing Farm profit drivers (Wimmera 2010 – 2015). (Source: Ag Profit)
Figure 8: Farm profit drivers (Wimmera 2010 – 2015). (Source: Ag Profit)

This type of benchmarking shows what the trends are in how income is being consumed and thus reducing profit (i.e. what is driving profit) and how the profit driver performance compares with others in the region; both the average and Top 20% profit group.

The top profit group consistently deliver a more efficient performance of managing income generation and cost expenditure than the rest of the farms in the comparison group.

Framework characteristics of good business management

The 20 year trends of the Wimmera and Mallee show that farm scale has generally increased in farm land area and more substantially in terms of turnover and cost expenditure (Figure 2, Figure 3 and Figure 4). This expansion of business scale increases the complexity for managing the farm business as the risk profile changes due to the bigger dice being rolled each year. More pressure is placed on the management processes as there is a greater potential for reduced returns arising from limitations and errors.

For businesses to be in the Top 20% profit group, a key characteristic is management capacity. Time and time again we see neighbouring farms whose productive variables are similar, with a substantial difference in business performance.

Farm businesses are generally small businesses with relatively few people managing many or all areas of the business. This can result in a lack of attention to detail in a particular key area (which is easy to do as there are many areas to cover) which can lead to sub-optimal outcomes. In other industries, with larger businesses, detailed attention and focus is typically applied to the key areas of the business. Human resources (HR) is an example. Most non-farming businesses with say more than 10 - 15 staff have resources dedicated to HR. They realise the benefits in managing staff as well as possible; helping to achieve increased productivity outcomes and protecting the business by minimising the risk of adverse claims and damages.

Managing a farming business has challenges in addition to those common to most industries. Examples of their additional challenges are:
  1. Price takers and not price makers.

  2. Uncertainty regarding production yield; more especially for broadacre cropping.

  3. Large delay between when costs are expended and income received; again particularly for broadacre cropping.

  4. Farming work is away from population centres; smaller density of available workforce.


For a business management framework to be most effective it should provide a multi-dimensional approach (strategic, tactical and operational) for the key business areas.
  1. Strategic outcomes – perhaps the five year plan.

  2. Tactical outcomes – achieving seasonal objectives.

  3. Operational outcomes – day to day/week to week needs and activities.

Staff productivity

For any business, adequate productivity of staff (both external employees and family members) is critical for business sustainability 
Strategic

Establish staff HR policies and procedures, including:

  • Recruitment and engagement

  • Staff induction/Work, health and safety (WHS) considerations

  • Dispute resolution

  • Role and salary review

  • Training opportunities

  • Staff meetings

  • Overtime/time in lieu options

Transition/succession strategy
Tactical Review policy annually
Undertake staff review
Find out what motivates each individual – how to keep them motivated and enthusiastic
Investigate, plan and discuss training options
Social activities
Operational Run staff meetings
Reward good performance – praise when deserved

Farm productivity

Managing farm productivity is typically what farmers do best; but some still do better than others. Timeliness can be critical:

Strategic Enterprise selection and risk strategy (more livestock less crop etc.)
Synergistic enterprise opportunities
Soil health
Weed, pest and disease management longer-term plans
Paddock size and structure
Grain logistics
Monitor and review – gross margins and whole of business benchmarking
Tactical Crop/livestock budget and inputs program planning
Soil sampling strategy
Machinery maintenance plan
Schedule contractor involvement
Operational
Timely implementation of crop/livestock plan activities
Effective weed/pest/disease monitoring and paddock assessments
Remove fences
Soil sampling
Complete data recording

Marketing/sale price

Profit can be increased without additional operational work and cost if higher prices are achieved:
Strategic Establish marketing policy, including:
  • Decision-making criteria

On-farm storage plan
Understand available hedging options
Tactical Review seasonal forecasts and markets on regular basis
Maximise buyer/seller networking relationships
Operational Make decisions using agreed criteria (avoid rushed decisions when tired)

Machinery

Due to the high costs involved managing machinery efficiency is critical for farm profitability:
Strategic Longer-term planning requirements – machinery/contractor mix
Alternative options for generating income (i.e. contracting)
Asset purchase business case justification
Operating procedures
Tactical Machinery maintenance plan
Staff training for machinery use (document)/review operating procedures
Spare parts inventory
Operational Thorough maintenance
Update operating procedures

Engaging contractors

Contractors can fulfil a key role; are they considered partners or just hired help?:
Strategic Longer-term planning requirements – machinery/contractor mix
Establish contractor engagement agreement, including:
  • Charge rates and conditions

  • Engagement commencement commitments

  • Supply of fuel

  • WHS considerations

Tactical Review/rate contractor criticality - what are the consequences if they are late?
  • Alternative options

  • Review current rates

Operational Implement contractor engagement agreement
Communicate with contractors as required to ensure optimum arrival
Other examples of management considerations for key business areas include:

Finance costs

  • What can I do to reduce my interest rate risk margin?

  • Review alternatives funding source options.

  • Negotiate with competitive tension to drive better outcomes.

  • Plan to pay off principal.

Overheads

  • Insurance review (life insurance, accident and trauma, multi-peril and crop).

  • Professional fee review.

  • Utility pricing review/alternatives.

Cash flow (the lifeblood of business activity)

  • Do I manage a detailed budget for cash flow planning throughout the season?

  • Do I monitor the budget with cashbook actuals?

  • Is access to working capital guaranteed?

Off-farm diversification

  • Am I able to afford to diversify off-farm?

  • Do I have an interest in other investment areas?

  • Need for business case justification.

  • How to best assess the risk when not that familiar with the asset class?

Management framework

  • Who are the participants in the management team?

  • What role can advisers play; can I use them more (in different ways) to help me manage the business?

  • When and how often should we meet?

  • Where should we meet?

  • Note taking and follow-up action management.


A good business management framework helps you manage the business variables which you have more control over so that the business will be in the best possible shape to deal with the outcomes of variables where you have less control over.

Beware the accumulation of incremental cost increases

If you feel as though you are managing the farm well and you are working hard, yet the profits are not as high as you expect and thus the margins are being squeezed; then be aware of costs which somewhat insidiously increase bit by bit, each year without drawing too much attention for review.

Figure 9 outlines an example for fertiliser expenditure for the years 2012 and 2013. In 2013 the fertiliser cost has increased to $85,000 up from $80,000 the previous year, an increase of 6.25 per cent. When viewing this increase on the profit and loss statement of the accountant’s financial statements, this will typically not raise any alarm bells, as in the broad scheme of running the farm, the $5,000 increase is not that large.
Bar graph showing Example of a two year fertiliser cost trend.
Figure 9: Example of a two year fertiliser cost trend.

However if you view the fertiliser expenditure over the past six years (Figure 10); each year has seen a similar increase that has most likely not been thought about all that much but the fertiliser cost has now gone from $64,000 in 2010 to $98,000 in 2015. This represents an increase of over 53 per cent over this period.
Bar graph showing  Example of a six year fertiliser cost trend.
Figure 10: Example of a six year fertiliser cost trend.

This extra $34,000 has to be provided for as additional income in order to maintain the profit margin.

Examples of other ever-increasing costs include:
  • Council rates,

  • insurance,

  • some professional fees,

  • inputs,

  • machinery servicing, and;

  • wage (and super) rises.

Other considerations

How profitable is the farm if market rate for land access is applied?

If land ownership and farming operations are separated out as separate business units and the operational unit is required to pay the land holding unit market rates for leasing the land, the impact this has on the profitability of the operational business unit needs to be considered. How much of the farm profit performance results from the effective subsidy from the land holding unit?

This scenario is becoming more and more a legitimate business structure and it provides a rationale for any potential farm expansion where presumably access to new land will come at a market rate cost.

Contact details

Matthew Bryant
Ag Profit
03 5444 2600, 0419 322554