Measuring Profitability on a Dairy Farm

Author: Marc R. Sholder

One of the most frustrating management tasks on any dairy farm certainly has to be the evaluation of a farm's financial position. In light of the recent volatility with respect to the key components impacting profitability, the last thing most owners want to spend time doing is analyzing their operations financial position. This can no doubt be a daunting task for owners and farm advisers alike. However, by gathering a few necessary financial statements, including beginning and ending balance sheets, income statements, and cash flow statements a dairy producer and his advisers can begin to analyze the financial performance of the farming operation.  This analysis is the primary quantitative measure of business performance. There are two key metrics that adequately measure and begin to help benchmark profitability. Return on Investment, sometimes referred to as Return on Assets, illustrates the amount of income a farm was able to generate with the assets that were available. The DuPont Model uses two key components, margin and turnover, to shed light on profitability.

Return on Investment (ROI) is a simple rate of return calculation, amount of return/amount invested.  In the case of a dairy operation, we can use net income, from the income statement as the "amount of return" and average total assets as the "amount invested." It is important to use average total assets as the denominator. Using the balance sheet from the beginning of the year and the balance sheet from the end of the year, one can calculate average total assets (prior year end total assets + current year end total assets/2). One must use the average total assets because the total assets from one balance sheet only represents a point in time while the net income is representative of income earned over the entire year.

Let's look at a simple ROI example. Feed Additive X claims to increase milk yield by 1 pound per cow and costs $0.12/head/day to feed. At a milk price of $16/cwt, the ROI would be 33% ($0.16-$0.12/$0.12= $0.33.) Put another way, for every $1.00 spent on Feed Additive X, the cows will generate $1.33 in increased milk revenue. Remember, this is a simple example. More thorough analysis of year-end numbers and historical performance is vital for making sound management decisions.

The DuPont Model expands upon the basic Return on Investment calculation. Incorporating margin and turnover, the DuPont Model allows users of financial statements to easily determine where the strengths and weaknesses can be found in a dairy enterprise.  In other words, management and investors can much more easily identify the cause of changes to ROI from year to year.  The question of whether investment in assets, such as more land or equipment increased profitability or increased revenue from the sale of inventory or assets was the profitability driver. The two key elements of the DuPont Model are margin and turnover.  Margin, or earnings, is net income/sales (gross revenue) and specifically measures efficiency. Put another way, the margin is a way of expressing the net income resulting from each dollar of revenue. Turnover is sales/average total assets and measures how well assets are being utilized to generate revenue.

Most dairy producers and their advisers would benefit from a more thorough understanding of the DuPont Model.  Since turnover is concerned with how much revenue can be generated from the utilization of assets, it makes sense that many dairies hire custom operators to manage crops or send their young stock to a custom heifer raiser. By limiting these costly investments in assets such as machinery, facilities, and feedstuff inventories a manager has a positive impact on the turnover portion of the DuPont Model of ROI analysis.  Most of these reductions in assets, if done correctly will have no impact on gross revenue. The margin portion of the Model takes into account the impact that these business decisions have on profitability. Net income, a key part of margin, is the difference between gross revenue and total expenses. So, margin will allow the decision makers to determine whether the reduction in the assets associated with sending the young-stock to the custom grower is driving up expenses in such a way as to negatively impact profitability.

Every dairy producer should familiarize themselves with Return on Investment and the DuPont Model.  Many producers take the position that cutting expenses is the only way to remain profitable in volatile markets. The DuPont Model is invaluable for truly drilling down to areas of the business that are hindering financial performance. Understanding the specific areas of an operation that are driving profit or loss will make an operation more adaptable in uncertain market conditions. Seeking the counsel of an accountant or another adviser to become more familiar with the quantitative tools available is much easier than trying to figure out what could have been done differently to save a failing dairy.

Article Source: http://www.articlesbase.com/agriculture-articles/measuring-profitability-on-a-dairy-farm-2643221.html

About the Author

Marc Sholder is a Dairy Consultant with Cargill Inc. in southeastern Pennsylvania and an MBA student at West Chester University of Pennsylvania