Although farm business analysis is not restricted to the use of ratios, they can be useful tools to analyze 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 by gross revenue = gross margin ratio.
Gross margin is calculated by taking your gross revenue and subtracting costs.
In grain operations, the costs would be seed and seed treatment, chemicals, fertilizer and production insurance. In livestock operations they would be veterinary services, medicine, feed and market animals, but not breeding stock.
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Once you have calculated gross margin, divide that number by gross revenue to get the gross margin ratio.
The rule of thumb is to have a gross margin efficiency of 65 percent or more. This is a recognized industry standard and is relevant and applicable to a cross section of primary agriculture.
All farmers make decisions relative to how much money they invest in
their crop by spending on inputs. Farmers can allocate these costs to different enterprises with certainty.
Assumptions and key points
• The industry standard assumes accrual accounting.
• Government program revenue such as AgriStability should not be included as revenue for this analysis. Program payments are legitimate revenue and are included in net income. But, they are run by government and are beyond a farmers’ control.
• Incidental revenue should not be included. The purpose of calculating the efficiency ratio is to examine how efficient the farm is at getting a return over its productive inputs. If a farmer receives money for blowing some snow for a neighbour but does not have custom work as a primary enterprise, that money should be excluded from the calculation.
• Enterprise transfers should be included. An example is when farm-grown grain is fed to animals in the farm’s livestock enterprise. There is no sale, but a value should be placed on the feed and factored into the gross margin calculation as revenue for the grain enterprise and a cost for the livestock operation.
• The net result is the same (the actual gross margin value will not change) but the gross margin efficiency ratio will change.
Management application
The objective is to get the most net profit possible every year.
There are other variable expenses such as fuel and repairs, and fixed expenses, such as rent, taxes, interest and depreciation that are subtracted from gross revenue before net profit is realized.
However, if the efficiency at the gross margin point of reference is chronically poor, meaning a level of less than 60 percent, it will be virtually impossible to get a satisfactory net profit.
Gross margin efficiency is the first step in looking for ways to improve a less-than-desired bottom line.
There is another, excellent application to gross margin efficiency.
Farms that diversify 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. Bottom line net profit depends on how efficiently they are able to generate the additional gross revenue.
Maintaining or improving gross margin efficiency through expansion is important.
Following are some examples of where practices can change as a result of increasing production and result in poorer performance:
• less attention to details of production such as seed placement and nutrient application;
• the speed of field activities such as planting and harvesting;
• seeding and harvesting dates extended beyond optimal dates;
• less attention to marketing (related to time available);
• time constraints and impact on other management areas such as human resources.
Theoretically, it makes sense to spread fixed expenses over increased production. However, it is pointless to farm more and more if it means you do it less and less efficiently. If done improperly, expansion means more work, more capital and more risk but no more profit.
It doesn’t have to be that way. Growth, while maintaining efficiency, can be managed. Analyzing year-over-year gross margin efficiency performance will quickly reveal potential problems so you can take corrective action and continue to get the most from your operation.
Terry Betker is a farm management consultant based in Winnipeg, Manitoba. He can be reached at 204.782.8200 or terry. betker@backswath.com.
