The article I submitted last month discussed financial efficiency, which is defined as the ability of a farm business to use its resources (inputs) efficiently.
There are three groupings of financial efficiency, in which expenses are categorized to yield margins and ratios:
- production expenses (fertilizer, chemical, seed, crop insurance, feed, veterinarian)
- operating expenses (fuel, repairs and maintenance, custom work, labour, supplies, freight)
- overhead and administration expenses (all fixed expenses other than interest and amortization/depreciation)
The groupings are subtracted from gross revenue (sales) to create margins. The margins are then divided by the gross revenue to create ratios, which measure how efficient a farm is at generating a return on the investment being made in the inputs.
Margins associated with the above groupings of expenses are:
- gross margin (net of production expenses)
- contribution margin (net of operating expenses)
- operating efficiency margin (net of all expenses except interest and amortization)
Some farms are more financially efficient than others, and some farms do a much better job of managing costs through each of the expense groupings.
There is less variance from farm to farm when looking at the gross margins after production expenses are subtracted from gross revenue. The variance widens significantly as the operating expenses and then the overhead and administration expenses are subtracted. In other words, some farmers are much better at overall cost control.
Most farmers have multiple enterprises within their farm. The enterprise breakdown can be general: a mixed farm with its operations separated into individual grain, oilseed and livestock enterprises. It can also be more detailed: the grain and oilseed enterprise has each crop analyzed individually, such as wheat, canola, soybeans and barley.
Purpose of enterprise analysis
Enterprise analysis can be used for various purposes. Time and capital on a farm are constraining resources and as such, farmers need to make decisions where to best allocate them.
Different enterprises will report differing contributions to overall net profit. I’ve witnessed farms where one enterprise will be making an acceptable contribution to net profit while another is losing money — with the overall net effect being poor or unacceptable bottom line profit.
By grouping the expenses and calculating efficiency ratios as described above — and importantly, for each enterprise — a farmer can begin to know where to look to see where improvements can be made.
Managing expenses is one way to improve profit. It helps to know which expenses should be looked at first, and better yet, it helps to know which enterprise to look at first.
Slippage in multiple entity farms
The “slippage” I’m referring to is financial efficiency slippage. It happens as described above with farmers who are not as cost conscious as they could be when factoring in all the operating costs that are associated with running their businesses. There can be financial efficiency “slippage” between enterprises. The “cost” to bottom line net profit can be hidden within the enterprises.
There can also be slippage in multiple entity farms, where the actual “farm” is made up of more than one corporate or partnership entity, joint ventures of multiple entities or arrangements where the senior generation is incorporated and farming with children who are working in a sole proprietorship structure.
The families in most of these situations tend to think of their “farm” as being the aggregate of the entities. Decisions are often made on a “farm” basis and not an “entity” basis.
The opportunity for financial efficiency slippage in these arrangements can be very large unless someone is consolidating or combining the revenue and expenses into one statement of income and expenses and then grouping the expenses as described above and calculating the efficiency ratios.
There is a specific intergenerational transition application to consolidating financial statements and analyzing financial efficiency. In most situations, where the parents and their farming children are farming together and using different entity structures, the children will ultimately be farming the total operation, notwithstanding what legal structures they may end up with.
The family absolutely needs to know what the overall financial efficiencies are — or aren’t. Obviously, more financially efficient farms stand a better chance at successfully transitioning the farm to the next generation.
It’s somewhat akin to the question, “ do you know where your children are,” as in, “ do you know where your financial efficiencies are?”
Terry Betker is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or firstname.lastname@example.org.