Assessing Your Business For Today's Market And Beyond

by

Harlan Hughes

Extension Livestock Economist

Dept Agricultural Economics

Agriculture Is Becoming More Business Oriented

Those closest to farming in North Dakota sense that farming is undergoing a pronounced transformation. Once characterized by enterprise diversification, reliance on family labor, and integration of family and business goals, North Dakota's farming and ranching seems to be becoming more specialized and business oriented. There continues to be a wide variety of crops and livestock produced among North Dakota's farms and ranches; but, individual farms are increasingly becoming more specialized, e.g., as specialized cash grain farms, specialized dairy farms, specialized swine producers, and so on. The transformation and emphasis on business orientation is not a new phenomenon, but probably has accelerated as a lesson learned from the flawed farm business practices of the mid 1980s.

The two key concepts in the above statement is 1) business orientation and 2) flawed farm business practices of the 1980s. Whether the farm or ranch business is entirely dependent on livestock or is diversified into crops, wildlife, or recreation, profitability in 1999 and beyond will require that careful consideration be given to the interaction of production, resource utilization and financial performance. In 1999, and beyond, everything must count and everything must pay; and, if it does not pay, don't do it.

North Dakota farmers and ranchers entered this decade facing increasing financial risks, little or no asset appreciation, increasing production costs, greater financial risks associated with specialization, and steadily increasing family living draws. Couple this with five years of low beef prices, five years of crop diseases and, now, low commodity prices in general; things are getting serious. It is absolutely critical that price volatility, unlike what we experienced under our past Government programs, appears to be a way of life under Freedom To Farm. North Dakota farmers and ranchers will need to combat these economic forces in 1999 and beyond through enhanced business management skills.

Livestock production appears to be experiencing a management revolution brought on by increased technology and more powerful management tools. For the last decade or so, the U.S. economy has been restructuring towards lower and lower costs. Think about the impact of Walmart on the retail businesses. This extremely strong economic drive for lower and lower costs of production is also impacting agriculture. What is becoming very evident is: 1) there are extreme economic pressures to being a low cost livestock producer, 2) these economic pressures are building and 3) this economic drive towards being a low-cost producer may well lead to a new order of production.

The battle lines between commercial livestock production and the large scale, professionally managed livestock factories, have been drawn. The fundamental issue is over how new management skills will be injected into agriculture to reduce costs of production. The lower cost production system will be the livestock system that will prevail in the next decade.

How Management Skills Will Be Acquired Is The Fundamental Issue

The fundamental debate at this conference is not about production technology - that is a given. Producers need to identify where their operations fits into this whole technology scheme. The key debate, in my opinion, is on how the new enhanced business management skills needed to capitalize on the new production technologies, will be injected into North Dakota's commercial agriculture. The key to survival is having the management skills to manage in today's market and beyond.

This same type of management skills question came up in the mid-west farmer/feeder cattle feeding sector in the 1960s. The new technology was the feed wagon and the ability to blend rations in a highly managed fashion. Farmer/feeders, in general, elected to not adopt the new management skills associated with this more capitalized ration formulation process. Since that time, farmer/feeders have lost considerable ground to larger, professionally managed feedlots.

Let's turn to a second example. Swine production has advanced to the point that genetics, nutrition, and capital equipment are fully integrated into a highly coordinated management package. The genetics program dictates the nutritional program which, in turn, dictates the facility layout which, in turn, dictates the marketing program. It all links together in a highly coordinated fashion requiring considerable, management detail. Many swine producers have elected to let someone else put the management package together and these contract swine producers have elected to concentrate on executing the production recipe prescribed by contracted management. After all, production is really their first love.

It will be critical to see how the management skills needed to combat today's low commodity prices and beyond will be injected to North Dakota's agriculture. Will these new management skills be injected through professionally managed, large, concentrated livestock production units or will these management skills be injected into agriculture by commercial livestock producers who have elected to upgraded their business management skills? Today, both of these options are still viable but how North Dakota elects to answer this question will determine the future structure of North Dakota's livestock industry.

If you decide that you are going to be one of those commercial producers that upgrades his business management skills, we at NDSU would like to be a partner in your skills upgrading effort. We want to be a primary provider of your business management skill training.

Winds Of Change

We are living in a time when one of the most important management skills that livestock farmers and ranchers can develop is the ability to stay abreast of change. Trend watching, information gathering, looking ahead, etc. are all important business management survival skills.

Those who have the insights about change will thrive and prosper. Those who have an obsolete knowledge base will suffer the consequences. (Wohlgemuth, pg 3).

North Dakota's Great Plains Counties

Researchers have classified 396 counties in 10 states as the Great Plains and they are identified in Figure 8 (Hinds). These 396 counties have had a unique, and somewhat turbulent economic history. Early enthusiasm for land acquisition in the Great Plains led to the build up of a farm-based population larger than what could be supported by farming activities for very long.

Many Great Plains counties reached their maximum population soon after initial settlement. Since that early settlement their economic history has been marked by population losses and the problems associated with population decline (Hines, pg 19). This description certainly applies to the Great Plains Counties in North Dakota.

These North Dakota Great Plains Counties have considerable land that can not be farmed efficiently; but, this land does lend itself to grass production. Range cattle is the number two enterprise in North Dakota's Great Plains Counties and range cattle is the number one current source of agricultural income in 8 counties in North Dakota (1992-1996 average).

Researchers, using cluster analysis, grouped the 396 Great Plains Counties into five agricultural subregions based on the primary agricultural commodity produced. They categorized North Dakota's Great Plains Counties as a Spring Wheat - Range Cattle Subregion characterized by its dependence on the farming sector for its economic activity. The farming and agribusiness linkages have been weak in this subregion in that the wheat and cattle were processed and marketed elsewhere. That has changed some now in wheat with the durum processing cooperative and the proposed spring wheat cooperative; but, these linkages have changed little in cattle.

North Dakota's Great Plains economy is subject to swings in supply and demand conditions in the international wheat market, swings in the cattle cycle and its resulting beef price cycle. Both commodities are subject to competition from foreign producers. North Dakota has a reputation for producing high quality spring wheat and high feeder cattle. A considerable part of this workshop is directed towards managing the production of these two commodities in 1999 and beyond. The key business management question addressed at this conference is: Are spring wheat and/or range cattle the best use of financial resources?

With the above background in mind, let's review some of the critical management skills that might become a part of future business management training.

Integrated Business Planning

Integrated Business Planning is the science and art of combining ideas, facilities, processes, materials, and people to produce and market agricultural products. I frequently define management simply as paying attention to details. The more intensive the management, the more details monitored. It is my observations that top managers pay attention to so many details they keep records to monitor all of them. While it has long been recognized that production records pay big dividends, it is now becoming evident that business management records are an absolute necessity to surviving in 1999 and beyond.

Managing a farm or ranch has never been easy, especially when commodity prices are low. Changing technologies, improved communications, and an information explosion, coupled with changing federal, state, and local regulations, are causing farmers and ranchers to ask "How do I ever get a handle on it all?"

A new way of approaching the many forces and factors facing farm and ranch managers is starting to spread across the country. This "new" management method is referred to integrated business planning.

Integrated business planning is a method of planing and managing the farm or ranch operation as a whole, rather, than on separate unrelated enterprises. Some are referring to this type of management system as holistic thinking. No matter the name, it provides a step-by-step method for working through the "overload" of information that managers must deal with on a daily basis.

Integrated business management can be broken down to three basic questions. 1) Financially, where am I today? 2) Financially, where do I want to be in 5 years? And 3), financially, how do I get there from where I am today? The rest of this workshop centers on these three fundamental integrated business planning questions. My assignment in this workshop is to address question 1.

Financially, Where Am I?

The very first management action that any farmer or rancher should take in coping with today's down market and beyond is to access his current farm or ranch total business situation. Five critical control points for assessing a farm or ranch business performance will be presented. These five critical control points should be used to evaluate the financial performance of your farm or ranch business. I have elected to highlight these critical control points to serve as benchmarks for the financial assessment of a farm or ranch business today and beyond.

Critical Control Point Number 1: Net Farm income. A farm or ranch family contributes three resources to your farm business - unpaid family and operator labor, management, and equity capital. These three resources are all the resources that you and your family contributes to your farm or ranch business. You know what your fertilizer dealer gets paid, you know what your banker gets paid, etc. but what does your family get paid? The earned returns to these three family resource is called Net Farm Income.

Figure 12 illustrates how net farm income is calculated. You begin with gross cash farm income, subtract cash farm expenses, adjust for inventory changes and capital adjustments, and subtract depreciation. In my example farm, Net Farm Income equaled $31,158. This says that this farm family earned $31,158 return for their unpaid family and operator labor, management, and equity capital. The objective is to compare your farm's numbers to the average numbers of the benchmark farms.

Comparative Analysis

A comparative analysis of your farm's financial performance to other farms is the single most powerful management tool available, bar none. First look for the areas where the benchmark averages lower and I identify those as my business strengths. Then look for those areas where the benchmark herds' averages are higher, and identify those as the farm's business weaknesses. When you start planning the future of your farm business, you need to first capitalize on your business strengths and second, try to change your business weaknesses.

Is this farm's $31,158 net farm income a reasonable return? How does this compare to the net farm income from other farm and ranch families? A comparative analysis of this farm is compared to the State-Wide Farm Business Management Benchmark Farms ( Figure 13). These benchmark farms were sorted on net farm income and grouped according to net farm income into the low 20 %, average, and high 20%.

The $31,158 of net farm income was 16 percent below the benchmark farms' average of $37,272. While the net cash farm income was well above average, high depreciation cost brought net farm income below the benchmark farms' average.

This producers went to his local NDSU Extension Agent and asked for an Integrated Resource Management (IRM) analysis of you beef cow herd. His beef cow IRM analysis indicated that the earned net farm income from the beef cows was $61 per cow. Given the 166 cows in the January 1 inventory, this suggests that $10,126 (or 32%) of the $31,158 was earned from the beef cows. This implies that the remaining $21,032 (or 68%) of net farm income was earned from the 1200 crop acres. This, then, figures out to an earned $18 net farm income per crop acre.

This comparative analysis points out that earned net cash farm income is one of my business' strengths. It comes from low cash farm expenses. The primary business weakness comes from the very large depreciation costs. Why is my depreciation cost so high relative to others? Are my investments too high? Are my assets newer than others? Something is setting my farm's depreciation at this high level.

Critical Control Point Number 2: Capital Investment. Investment capital is a major resource of any farm or ranch business. Investment capital is managed through the financial statement. A financial statement is a snap-shot of the business resources controlled on a given day. It typically is prepared on Jan 1 (or the first business day) of each business year. This management power comes from a time-series comparison of annual financial statements. Is net worth increasing or decreasing?

Preparing a financial statement consists of taking an inventory on that day and putting a dollar value on those assets. Two schemes are typically used to value assets. One is the cost basis and the other is the market value basis. Cost basis is based on the remaining un-depreciated value of assets. Market value, on the other hand, is based on the current market value of the assets if they were sold that day.

Figure 14 is an abbreviated summary version of my farm's market-based financial statement for both the beginning and the ending of the year. An average column represents the average of the beginning and ending values. On average, $575,866 of assets are controlled by this business. Liabilities averaged $363,119 giving an average net worth of $212,747.

A review of this financial statement summary reveals one serious problem in the liabilities line. While assets increased during the year, it appears that no debt payment was made as the liability at the end of the year was equal to the liabilities at the beginning of the year. Either no principal was paid off or it was paid off and then borrowed back again before the end of the year. In these tough times, this is a red flag.

Financial stress can be measured by the percent of the assets that are owned by creditors referred to as percent-in-debt. If the percent-in- debt is under 40 percent, the business is considered financially sound. If the percent-in-debt is greater than 40 percent but less than 70 percent, the business is considered to be financially vulnerable. If the percent-in-debt is greater than 70 percent, the business is considered under severe financial stress. If the percent-in-debt is above 100 percent, the business is considered insolvent.

This example business has a calculated percent-in-debt of 63 percent. This suggests that creditors own 63 percent of the business assets and the family owns only 37 percent of the business assets. This suggests that this business is financially vulnerable and financial caution needs to be practiced.

One further refining of the capital investment analysis was done through the IRM analysis prepared for the beef cow herd. This IRM analysis identified that $346,276 of the total farms assets were utilized by the beef cow profit center -- breeding herd, beef cow facilities and equipment, and pasture land. This leaves $229,560 for the crop land and farming machinery. This, in turn, figures out to be a capital investment of $2086 per cow and capital invested of $191 per crop acre.

North Dakota's IRM benchmark herds had an average capital investment of $2,086 per cow (1997 data). The study herd's capital investment is almost exactly at the benchmark herds' average. Investment per crop acre, at $191, is also very reasonable. It appears that capital investment in this farm business is in a favorable range.

Critical Control Point Number 3 - Money Borrowed And Debt-Service Per Cow And Per Crop Acre: The financial statement for the study farm had $356,060 borrowed at the end of the year. This averages out to 63 percent of the assets. The beef IRM analysis identified that $84.328 of this these debts were associated with the beef cow herd averaging $508 per beef cow in the January 1 inventory. North Dakota's Benchmark Herds Averaged $326 per cow (1997 data). While the herd's debts per cow were well above average, $452 of this debt per cow is in long term pasture debt. Debt service per cow (interest and principal) was is $56 per cow.

The remaining $271,732 debts are associated with the cropping land and farm machinery. This calculates out to $226 of debts per crop acre. Based on the 19 years left on farmland payment, this amortizes out to a required annual debt service of $27 per acre.

Critical Control Point Number 4: Cost of Producing A Dollar Of Gross Income. An abbreviated version of the study farm's income statement is presented in Figure 16. Gross cash income totals to $163,652 from livestock and crop sales. Operating expenses ($109,500) are 67 percent of gross cash income. In other words, $0.67 of each dollar of income goes for operating expenses. From a gross margin, concept, it takes $0.67 to produce a dollar's worth of income. If depreciation is added to the cash expenses, it costs $0.84 to produce a dollar of gross income. If inventory adjustments (the $6,084) are added in, accrual adjusted gross income goes to $169,736. Operating expenses and depreciation cost $0.82 per dollar of accrual adjusted gross income.

A final cost that needs to be accounted for is the family living draw that this family places against this farm business. The family living draw against this farm business is $30,000 per year - $15,000 of this family living draw was placed against the beef cow herd ($90 per beef cow) and the remaining $15,000 draw was against the 1200 crop acres for a family living draw of $12.50 per crop acre. At the total farm level, the total family living draw calculates out to $0.18 per dollar of gross income.

If all costs per dollar of accrual adjusted gross income are added together - operating costs ($0.64), depreciation ($0.17), and family living draw ($0.18)-- it totals to $0.99 per dollar of gross income.

Critical Control Point Number 5: Conducting A Gross Margin Analysis Of Your Farm or Ranch Business. Today, most farms and ranches are not very profitable; but, most farms and ranch businesses can be made profitable through a gross margin analysis. It's as though the business is a chain with three economic links - overheads, gross margins, and turnover (Pratt, pg 1). There are only three ways to increase profits in any business - including yours. They are 1) decrease overhead costs, 2) increase gross margin per unit, or 3) increase turn over (Pratt, Pg 1). These are the only three ways to increase profit of any business. But, only one of these three ways is the way to increase profits in your business.

Overhead costs are defined as those costs that do not change as production livestock numbers change or crop acres change. There are three kinds of overhead costs - land, labor, and family living draw. While economists call these fixed costs, they can be changed and that is one of the three ways to increase profits (Pratt, pg 1).

Gross margin is calculated for each enterprise by subtracting the direct costs of production from the gross income from that enterprise (Pratt, pg 1). Gross margin is a measure of the economic efficiency in your livestock and cropping enterprises. Gross profit is the sum of all profit centers' gross margins added together. Profit/Loss is determined by adding up all gross margins and then subtracting overhead costs.

Gross margins for the total business can be expressed in terms of profit per dollar of gross income. In the study farm, gross margin per dollar of $1 of income is $0.36 ($1 minus operating costs of $0.64). Overhead costs in this study farm consists of depreciation and family living draw as a proxy for labor and management wage. In the study farm, depreciation cost was $0.17 per $1 gross income and family living draw was $0.18 per $1 of gross income.

Turnover is a term being used o measure the size of the farm business. The higher the turnover, the larger the business. If gross margin per $1 is positive, then increasing turnover (size) will increase profit provided it does not also increase the overhead costs.

Decision Making Process

Figure 20 illustrates the process that Dave Pratt goes through to diagnose the weak link in a business (Pratt, pg 2). Profit is calculated by subtracting overhead from gross margin. So if profit is low, it is either because gross margin is too low or overheads are too high.

Gross margin is calculated by subtracting direct costs from gross income so if gross margin is too low, it is either because direct costs are two high or gross product is too low.

Gross product is a measure of how much is produced and how much we get paid for it. If gross product is too low, it is either because of lack of production or market price was not high enough..

If we did not get paid enough it is either because the market is too low or marketing is not adequate.

If Gross product is low but price is reasonable, then production is too low. If production is low it is either because we didn't produce enough (reproduction in beef cows) or we did not produce enough (gain).

If gross margin is low, but gross product is not the problem, then the focus turns to direct costs. There are only two major direct costs in beef cows - feed costs and health costs.

If gross margins are healthy but the business still is not profitable, the problem might lie in the overhead cost category. There are only two kinds of overheads - land costs and labor costs (family living draw is considered a labor cost).

We also know that cutting overheads and improving gross margins are not the only way to increase profits. Increasing turnover is the third way to increase profit. If gross margins are health and there is no room left to cut overheads, then turnover is the most promising way to increase profit (Pratt, pg 3).

Putting The Farm Back In The Blank

Let's put overheads and gross margins together into a graphic analysis focusing on putting this farm back in the black. Overhead costs consists of land and machinery ownership and family living draw as a proxy for labor and management wage.

Overhead costs are not "fixed" and do not vary with output. In my farm analysis, depreciation totaled $29000 and family living draw totaled $30,000 for total overhead costs of $59,000.

Direct costs are on a per unit basis and increase linearly as production is increased. These direct costs are placed on top of the fixed costs so that the direct cost line represents total costs in Figure 21. In my farm example, direct cost was $0.64 for each dollar of gross income generated.

Farm size is represented by the turnover along the bottom of the graph and can be thought of as gross sales. As the business goes to the right, the farm business size and gross sales gets bigger and bigger.

Gross income, at the total farm level, can be graphed as a 45 degree line out of the origin. Where the gross income line intersects the direct cost line is the breakeven production level of the business. It turns out that my example farm was about at breakeven size. All direct costs and overhead costs, including family living draw, were covered but there is no marginal left over. Given this farm's percent in debt, there is no margin for price risk or yield risk. Something will have to change in 1999 and beyond to ensure financial survival of this business.

The rest of this workshop will focus on how the gross margins might be increased, how overhead costs might be reduced, and increasing turnover might increase business profits.

Intensive Management

I have spent the last decade developing, testing and teaching intensive business management systems with North Dakota beef cow producers. We have focused on integrating financial management into the production management of beef cow profit centers. Let me share four key points that we have learned about integrating business management into an overall on-farm management production/financial system.

First, you can not manage what you do not measure. If a manager does not measure unit costs of production, he can not manage unit cost of production. If a manager does not measure his capital investment, he can not manage capital investment. He may try, and even say that he is managing it; but, he has no documented way of knowing if he is making any progress.

Second, it appears that managers are looking for a quick fix.... "Tell me the one thing that I need to do...." But, we found that things are so inter-related there are no quick fixes. Also, the easy things have already been adopted.

Third, we learned that good management is not doing 1 thing a thousand percent better. It is doing a thousand things 1 percent better. To often managers try and hit a home run.

Fourth, if you are going to do a 1000 things better, you cannot monitor a 1000 things in your head. You have to have some production and business management records or you soon loose track. Remember, if you do not measure it, you can not manage it.

If you are serious about managing in today's markets and beyond, your business management tools will be upgraded to monitor the land, labor, and capital resources under your control. Most farmers and ranchers have not focused on the business management aspect. This is going to change.

" Your motto needs to be: "Everything must count and everything must pay."

Summary

I have tried to make the case that North Dakota agriculture is in a period of change and this change must be towards becoming more business oriented. Farmers and ranchers know how to produce and now they need to focus on the business of production. The fundamental issue, in my mind, is how will the needed business management skills, needed to make North Dakota an absolute low cost producer of wheat and cattle, be accomplished? Will it be through professionally managed, large concentrated livestock and crop production units or will these management skills be injected into agriculture by commercial livestock producers who have elected to upgrade their business management skills? Today, both of these options are on the table. How North Dakota elects to answer this question will determine the future structure of North Dakota's livestock industry.

If you decide you are going to be one of the commercial producers that upgrades business management skills, we at NDSU would like to be your partner in the skills upgrading effort. We want to be the primary provider of business management skill training.

Most managers spend most of their time working on the items on the extreme right of Figure 18. NDSU Extension Service spends most of its educational time also on those things on the right. In reality, the items on the left that may well make the difference in 1999 and beyond.

Instructors at this conference have spent considerable time discussing and "cussing" the current farm crisis and we convinced that the key to survival for all North Dakota farmers and ranchers is to focus their 1999 and beyond management attention on the left-hand management actions. Dwight Aakre will spend considerable time with you on working on improving "gross margins" and will probably conclude that the big pay off is in reducing "overhead costs."

I am arguing that the big payoff is increasing your management skills for setting up and operating an intensive management system.

Bibliography

Mintert, James, Ted Schroeder, Gary Brester, and Dillon Feuz. 1994. Beef Industry Challenges & Opportunities." Managing For Today's Cattle Market And Beyond - a series of 36 fact sheets available on the cattle industry.

Pratt, Dave. 1998. Diagnosing Problems & Opportunities." University Of California Livestock & Range Management Advisor. Presented at the NCBA and Extension Western IRM Meeting, Reno, Nevada, April 28, 1998.

Wohlgemuth, Kurt. 1990. "IRM Opportunities For The Veterinary Practitioner.", Integrated Resource Management NEWS, NCA, Volume 1, Issue 2, Summer 1990.