Financial ratios can be useful tools to analyze farm business performance. A great example of this is gross margin efficiency.

Expressed as a ratio, gross margin efficiency measures how efficiently a farm uses specific, productive inputs.

To demonstrate, the calculation looks like this: gross margin divided by gross revenue equals gross margin ratio.

Gross margin is calculated by subtracting seed and seed treatment, chemicals, fertilizer and production insurance for grain operations and veterinary, medicines, feed and market animals (not breeding stock) for livestock operations from gross revenue and then dividing the number by gross revenue.

The rule of thumb is to have a gross margin efficiency greater than or equal to 65 percent. This is a recognized industry standard and is relevant and applicable to a wide cross section of primary agriculture including grain and oilseeds, cow-calf, dairy, and special crops farms.

All farmers make decisions relative to the amount of investment in the productive costs as identified above. Farmers can allocate these costs to different enterprises with absolute certainty.

Financially, the objective is to get the most net profit (bottom line) possible every year. There are other variable expenses, such as fuel and repairs, and fixed expenses, such as rent, taxes, interest and depreciation, which are subtracted from gross revenue before net profit is realized.

However, if the efficiency at the gross margin point of reference is chronically poor (less than 60 percent), it will be virtually impossible to get a satisfactory net profit.

Gross margin efficiency is a first step in looking for ways to improve less-than-desired bottom line performance.

The accompanying illustration looks at gross margin efficiency scores for a number of farms in an aggregate benchmark over a 10-year period.

The blue bars are the farms in the top 25 percent quartile. You’ll see that in every year, the scores are greater than the industry standard.

The yellow bars are the average of all the farms in the benchmark dataset. The range from the top 25 percent to average varies through the years with the greatest variance being 29.7 percent and the smallest being 13.3 percent. The simple average is 19.7 percent.

In other words, a farm in the top 25 percent quartile will have $197,000 more gross margin than an average farmer for every $1 million of gross revenue. That will happen every year if the efficiency can be sustained.

There is another, excellent application to gross margin efficiency. Farms that diversify and/or significantly expand generate increased gross revenue. However, this does not always guarantee an increase in their bottom line performance. Expansion can lead to reduced efficiency.

Maintaining, or even improving, gross margin efficiency through expansion or intergenerational transition is important.

Theoretically, it makes sense to spread fixed expenses over increased production units. It is pointless, though, to farm more and more, but as a result, less and less efficiently. This scenario has more work, more capital and more risk but with no more profit. It doesn’t have to be that way.

Gross margin efficiency can be managed. Analyzing year-over-year (trend line) gross margin efficiency performance will reveal potential problems so you can take corrective action and continue to get the most from your operation.

My last comment is very important. Benchmarks are just that: benchmarks. They provide context. They don’t make decisions. Some farms may not be able to achieve 65 percent for a number of reasons, such as location and soil type.

If you you’ve done everything you can to optimize gross margin efficiency and you can’t get it above 63 percent, for example, then make sure that future planning and investment is based off the profit that can be generated from that level of efficiency.

Terry Betker is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or terry.betker@backswath.com.