Measuring sustained profitability, allocating resources more efficiently and reducing financial risk

Take home messages

• Victorian farmland 20 year investment return to 2016 was 9% per annum and includes a return on capital shown as land lease of 4% and capital growth of 5% as reported in Rural Banks Ag Answers May 2016. When compared to other investments this is very strong, suggesting farm land in Victoria has been a good investment option.
• Return on capital now averages 2-3% due to land values increasing faster than profits.
• Australian wheat cost of production five year average of $169 per tonne is 9% higher than overseas producers.
• The loss years now impact overall average profit more than the good years.
• Financial risk reduces when high cost paddocks are not cropped.
• Income volatility can be reduced by enterprise selection, seasonal carryover (water or $$) and timeliness of operation.
• Machinery investment has increased faster than income and has resulted in labour efficiency.

Australia competing in a global market

Results from an international benchmarking study, GRDC project AAM00001 titled ‘National and International Regional Crop Benchmarking Network’, referenced at GRDC Groundcover Issue 133 March-April 2018, which in summary can be interpreted as follows:

• Australian wheat yields are lower than other countries.
• Our farm gate prices for wheat are relatively good.
• We have higher seasonal variation in yield.
• Our wheat gross margin per tonne is comparable to our competitors.
• Our production cost per tonne averages about $169/tonne for wheat. The international average is $155/t with Argentina being the lowest at $109/t.

Victorian Wimmera/Mallee historical performance

AgProfit^TM long term data includes a 20 year continuous subset of North Western Victorian cropping businesses. Analysis of this subset is similar to results from other areas and indicates the following:

• Equity (Net Worth) for family farms has grown from $1.3 million in 1995 to $5 million in 2017.
• Land values have increased faster than farm profits, hence Return on Capital has reduced to an average of approximately 2% to 3%.
• Average business debt has increased to around $1.5 million in 2017.
• On average farm income has increased 2.6 times over the last 22 years to around $1 million, and is due to growth in land area and an increase in crop intensity.
• Cost of machinery, overheads and finance are rising faster than income.
• Cost of fertiliser, sprays and other inputs are now more efficient relative to income.
• Labour efficiency has resulted from extra machinery investment.
• The financial loss in low income years has tripled, and is the result of larger total expenditure when combined with seasonal volatility of income

Managing financial risk

A generation ago it was the profit in a good year that more than covered a loss in the poor year. Now the tripling of costs results in the size of a loss in the poor year being harder to manage and not recovered by the profit from a good year. As a result a large portion of these losses are converted into core debt, hence some of the debt increase is from trading losses.

Seasonal volatility impacts on yield hence income. If income reduces then costs are converted into losses which then becomes new debt. Farming systems that operate profitably in more years than not demonstrate lower income volatility and lower total costs per $ of income and their losses in ‘tough’ seasons are not as large hence debt from loss years is less.

The Top 20% for profit (before interest)

The Top 20% farms from the Victorian Wimmera/Mallee AgProfit^TM data subset make an extra $62 per hectare profit and achieve profits in most years compared with the average grower within this data subset. Hence for a 2,000 hectare farm there is $124,000 extra to spend on equity growth, debt reduction, capital replacement, land acquisition and lifestyle or family choices.

The profit drivers are a combination of attention to detail, timeliness of operation, cost control and efficient resource use. Extra profits can be the result of:

• Flexible management between seasons for crop area (intensity) and enterprise mix.
• Focusing the dollars where the return is best. For example, extra fertiliser and weed/pest control on best paddocks.
• Machinery costs is less per hectare both for operating and capital.
• Labour is doing more with less, i.e. machinery efficiency drives labour efficiency.

Less can be best

If profit is impacted by high costs and volatile income, then a farming system that achieves the same profit with lower costs and less fluctuation of income will be ‘best’.

Farm managers are dealing with a range of variables specific to each individual farm. These variables influence which is the best farming system for that business and include variables such as soil moisture holding capacity, soil fertility, problem weeds and pests, herbicide resistance, and climatic factors such as frost or heat. Profits are about managing these variables to achieve the best outcome.

It may be that a reduction in crop area (intensity) can achieve similar profits with a lower financial risk. This can be illustrated as follows:

• Reduce crop intensity to 75% to 80% by dropping out of crop in one in four paddocks. This is achieved by selecting the high cost per hectare paddocks and/or the high income variability paddocks and choosing not to crop them.
• Utilise the 20% to 25% non-crop area to control problem weeds and build fertility.
• Cropped paddocks will increase their yield by on average by 10% (through moisture carry over and/or less weed competition).
• Costs per hectare of crop will reduce by 15% on average.
• Livestock can be introduced to utilise the 25% non-crop area. Livestock profit will improve overall profits to be higher than the 100% cropping system.
• If there is surplus machinery and labour then income from contracting can be considered.
• Less crop hectares can reduce stress, improve timeliness and enhance lifestyle.

The financial risk is greatest in the high cost paddocks

The high costs paddocks are where the risk resides in a low-income year. The low-income event could be drought related or due to an unexpected event such as frost. Where production costs are high there is a limited ability to absorb reductions in output before you are ‘under water’ in terms of the cost of production. The better financial outcome would have been achieved from ‘doing nothing’. Costs of production relate only to the direct variable input costs, seed, fertiliser and herbicide, etc, it does not refer to the other fixed expenditure items which occur regardless of how much you produce.

So why is it important to avoid production that is loss making:

• It depletes the operating profit available to meet the fixed costs associated with operating the business.
• It accelerates the depletion of financial resources.
• Labour and equipment resources could be allocated to areas making better returns.

Summary

Making farm profits is influenced by:

• Management of volatile income due to seasons.
• Dollars spent per farming enterprise has tripled which equates to large losses in low income years.
• Debt which has tripled. The cost impact of this debt increase has been buffered by low interest rates.

Top 20% group make consistent profits (i.e. profit during most years), this is critical to maximising the long run operating returns from farm enterprises and the financial sustainability of their business.

Contact details

Phil O’Callaghan
ORM Pty Ltd,
46 Edward St, Bendigo
0354416176
www.orm.com.au
phil@orm.com.au
@Phil_OCallaghan