A Guide On How To Increase Farm’s Profitability In Detail

Increasing your farm’s profitability involves a combination of sound financial management, efficient farming practices, and strategic decision-making. It is an increasingly competitive and volatile environment, farmers need to have a deep understanding of their profit drivers and tactical management plans in place. For many, price will have the largest impact on profit, but small changes made across the business is often more achievable and can have a larger overall profit impact.

• assess the flexibility of their farm’s in different production scenarios
• know the profit implications of pricing decisions
• evaluate expenditure on inputs
• plan more effectively for the future.

Debt can either constrain or support the profitability of a farm. Knowing the financial capacity of the agribusiness to repay debt is therefore critical when considering increasing debt levels. This means understanding the volatility and reliability of pre-tax profit and how this influences debt repayment.

Profit should be the focus as it is profit that will service and repay the debt, not the value of land. The land value is simply security for the bank to liquidate in the event insufficient profit is generated. When considering debt to fund an investment farm managers should ensure the investment generates a greater return than the cost of the debt and ideally the return should be sufficient to repay the debt within specified period.

High performing farm business managers share some common management practices and skills that further enhance the profitability of their businesses. Surveys of some top performing farm business managers highlight they are focused on the business performance as well as the farm operations and have good planning, organizational and tactical skills to profitably manage seasonal volatility.

Understanding profit

Profit is simply the income left over after all costs have been paid and is calculated as:

Net profit = Gross farm income – costs

Gross farm income, also referred to as total revenue or gross farm receipts, is typically calculated as price multiplied by production volume sold.

Net profit is gross farm income less all costs associated with production and running the business. Costs include fixed and variable operating costs, allowances for the replacement of livestock, plant and machinery (which may be in the form of depreciation), finance costs (interest, lease costs), management allowances (if a salary is not drawn) and taxation.

Many people focus on gross margins, but there are significant costs not captured in the gross margin that need to be factored in when making comparisons across enterprises, analysing profitability and setting price targets.

Analysis across various profit points (that is, gross margin versus operating surplus versus EBIT versus EBT) will depend on the purpose. For example, a farm manager when comparing enterprises may look at the earnings before interest and tax (EBIT) level; when considering expanding the farm area may look at the net profit after tax level; or when comparing crops that have the same fixed costs may look at the gross margin. We typically would analyse at the EBIT profit level to compare across farm business performance as taxation and finance costs will vary depending on the structure and financing of the business, ie family trusts, partnerships, company, debt level etc.

Know your farm’s profit drivers

Profit varies across farm businesses and between years and is driven by changes in price, production and costs. Farm business managers should know how each of these key profit drivers affects their business profit. Understanding this enables key decisions, particularly around returns on investment of time and money, to be made with confidence. Knowing a farm’s profit drivers assists managers to analyse the risk and resilience of their business and make expenditure decisions within a season and between seasons.

It is the capacity of the farmer to effectively manage each of these drivers that determines a farm’s profitability under a range of conditions. Management skill is often the differentiating factor between the top and bottom performers operating in similar environments.

Managing price to drive profit

In most businesses, changes to price have the largest impact on profit, marginally ahead of production volume and costs. This is largely because any increase in price will flow directly into the business as profit net of any sales commissions or levies.

The market price of most grain and livestock products is largely driven by global and local demand and supply fundamentals. Agricultural producers do not ‘set’ the prices they receive. Prices for many agricultural commodities are highly volatile and difficult to predict. They are influenced by the unpredictability of global weather conditions and subsequent impact on global and local production (that is, supply). Prices are further impacted by changes in the exchange rate.

There is opportunity to improve profit through active management of both downside and upside price movements. Any marketing strategy or plan must take into consideration both whole of business cost structures and potential production levels under different seasonal scenarios.  This helps identify price ranges to target for your marketing and selling decisions.  It also assists with the decision making around opportunities presented by ‘price spikes’ created by uncertainty around global production.

Management strategies available to assist in managing price risk and to improve the average price received include:

Marketing tools and sales strategies

• Increasing your marketing skills and knowledge or seeking professional support.
• Monitoring of the global and local markets, to take advantage of opportunities to sell as they arise, that is, use volatility to your advantage.
• Having marketing plans in place with strategies on how to respond to changes in price and season.
• Forward selling to lock in a favourable price for a proportion of production. However, you need to be confident in ability to deliver the volume of any produce under contract.
• Considering derivatives, such as swaps and options to manage price risk.
• Selling as close as possible to the consumer (direct) to by-pass part of the supply chain and associated costs.
• Selling produce through time, price averaging.
• Targeting niche markets.
• Establishing a brand that is recognisable and associated with attributes desired by the consumer.
• Identifying and, if possible, selling into market windows when prices are typically higher. This may involve changing production schedules (for example, time of harvesting, joining). However, the opportunity needs to be weighed against any additional costs or yield penalties associated with meeting this market window.
• Timing the sale of your product and holding some produce as stock so you can sell if price spikes without production risk. Retain grain/hay as feed if drought occurs and/or don’t get caught being forced to sell in a weak price market. The cost of holding stock needs to be considered including the opportunity cost of what cash could have been invested in.

Production planning

• Controlling or managing the quality of produce to avoid downgrades or penalties.
• Producing ‘premium’ quality products to improve price (blending grain, grass fed livestock, managing yield/protein relationship).
• Diversifying the enterprise mix to reduce the whole farm profit impact of a significant downward price correction in one commodity.

Managing production volume to drive profit

Production volume means tonnes of grain or fodder, kilograms of wool cut or number of livestock head produced per hectare. Farm businesses are generally comprised of a variety of enterprises. As the manager you have a critical role in analysing the profitability of various enterprise mixes that may suit your property and personal circumstances. Ensure synergies between the enterprises are captured.

Whilst the weather is a key, but unpredictable, driver of production volume there are some management strategies that assist producers to capture the maximum yield potential available in each particular season. These include:

Systems and management

• Good planning and preparation so that time critical tasks are met. For example, maintaining machinery in good condition to avoid delays and break-downs, quality labour contracted well in advance, critical spares kept in stock on farm, logistics management plans in place during peak periods.
• Have plans in place on what to do if the season outlook and prices change from what was budgeted. Review budgets regularly and adapt to the changes in prices and seasons. For example, if it is a poor season what option is most profitable for your business – fallow, trade sheep, drop a paddock out of crop, leave standing crop etc. If the prospects are for a highly favourable season then examine the feasibility of increasing the crop area, fertilising for a higher yield, increasing the stocking rate on pasture lands and/or maybe consider some crop grazing.
• Investigate the merits of crop grazing including an increased stocking rate, climate risk mitigation and reduced disease pressure.
• Investigate yield response levels and associated profitability of different rotations.
• Choose varieties and genetics that are most suited to the climatic conditions of your farm.
• Consider a ‘phased’ rotation approach for mixed farming to manage weeds, disease and nutrition for the cropping phase and generate high density pastures to allow higher stocking rates.
• Regularly monitor crops and livestock so that pests, diseases and weeds are detected early and can be treated early or pre-emptively.
• Analyse test results to identify and address any production constraints. For example, conduct soil tests for acidity and nutrient composition so lime and fertiliser can be applied to optimise yield response rates for both crop and pasture.

Cropping

• Weed management to conserve moisture, avoid allelopathic impact of weeds, limit seeding hold ups.
• Maintain low weed burdens and prevent weed seed set.
• Use variable rate management of inputs including lime, fertiliser and chemicals to achieve optimum yields on highest quality land and avoid over-applying inputs on less responsive land.
• Adjust your mix of crops and crop area to the seasonal prospects. This can help lessen costs in poor years but also lifts profits in the best years.

Managing costs to drive profit

Farm business managers must understand their cost structures, know breakeven production volumes required to cover all costs and have strategies in place to curb expenditure when it looks like production targets may not be met.

Costs can be fixed or variable. Fixed costs are expenses that the business will incur regardless of the season or volume produced. They include both fixed operating and non-operating costs such as permanent wages, overheads, depreciation and finance costs. Variable costs are direct input costs that vary with the season or volume produced such as fuel, repairs, fertiliser, livestock purchases, supplementary feed, animal health, seed, casual wages, freight costs, levies etcetera.

Given the variability in seasonal conditions, farm businesses need to have strategies in place to manage their cost structure. This provides for the flexibility to maximise production opportunity through additional expenditure in the favourable seasons and minimise costs in the poor seasons.

A farm business with a high proportion of fixed costs is at greater risk in areas of volatile seasonal production than a business with low fixed costs. Businesses with low fixed costs are able to buffer a series of low return years more easily. Farm business managers need to be acutely aware of this when considering additional land, machinery or other capital purchases as the interest and capital allowance expenses will be incurred regardless of how favourable future seasons are.

Assessing business decisions

Farm business managers should calculate the return on investment (ROI) for every option when considering an investment decision.

Return on investment (ROI) = profit / cost of investment

When considering an investment in a new technology or upgrade calculate the expected cost savings or increased production value first so you can work how much you can spend to justify the investment or the payback period of the investment.

Ways to Improve your Farms Profitability

Conclusion

It is the effective management of price, production and costs that drive profit. Whilst price is generally the leading profit driver by a small margin, effective management of all three profit drivers is essential. Every business has different cost structures and essentially the smaller the profit the larger the profit impact (in percentage terms) of small changes in each of the profit drivers. The more diverse the business the smaller the profit impact is of any one price or production shock, thus creating a more resilient business through the cycle.

Farm businesses should critically assess their cost structure and its flexibility under different seasons and through a series of seasons, to gain a better perspective of how reliably the business can generate profit. Once the cost structure and profit resilience is well understood decisions on appropriate debt levels and price targets can then be made without unduly jeopardising the health of the business.

There are number of strategies adopted by farm business managers to manage price, costs and production volume and some of these have been discussed in this article. Furthermore the management and organisational behaviours of the top performing farm business managers illustrate what is required to ensure business success.