Chapter 4: Business Planning & Financials What Attitude Can Do for Aptitude

Transcription

1 Chapter 4: Business Planning & Financials What Attitude Can Do for Aptitude 25

2 Introduction An often overlooked yet vital resource to our industry is a cadre of effective dairy managers and consultants. Today s dairy managers and consultants must understand the fundamental drivers of dairy success and the need to constantly adopt emerging best management practices to maintain competitive advantages. For the dairy industry to remain economically viable and sustainable, it must offer the opportunity for wealth creation for producers, while balancing the risks with the rewards. If opportunities do not exist for wealth creation or are too risky relative to the returns, individuals even those most effective dairy managers will leave the industry, while others will never enter it. It s often said that Farming as a way of life makes for a terrible business model, while farming as a business can provide for a wonderful way of life. In this chapter, the analysis team evaluated the financial metrics on Pennsylvania dairy farms using data from the MSC Business Services annual publication and the Northeast Farm Credit Annual Summary. The chapter will also include a review of the best practices in business strategy on Pennsylvania s dairy farms, as well as a look at planning patterns and confidence levels of Pennsylvania s dairy farm businesses. Best Practices in Business Strategy For illustration purposes, a basic financial structure of a dairy business appears in Figure 4.1. Assets, which include the buildings, cows, feed and equipment, provide the means for production. Assets can either be owned by the producer (equity) or debt-financed assets. The management teams and consultants make decisions on how assets are to be used and what additional resources are to be used, with the objective to realize a net return above production costs. This net return can be used to pay down debt to grow equity and procure ownership of assets. Wealth accumulation occurs when the net returns are sufficient enough to pay debt obligations and grow equity at a rate competitive with other possible alternatives. A weighted cost of capital can be calculated for a dairy herd weighting the proportion of equity and debt assets by the respective growth rate of equity and debt rate obligation for debt (adjusted for tax shielding benefits), yielding a bench mark level of return needed to grow wealth, as shown in the Figure 4.1 diagram from Brealey and Meyers. Resources should be used within a dairy to offer the greatest opportunity of return to meet or exceed this baseline level. In most cases, this involves investing in strategies that improve yield per cow while maximally using existing resources (assets). Additional asset procurement (herd expansions) should occur when the rate of return on these assets exceeds the baseline rate. Diversification should occur when the returns on new economic activity exceed the benchmark weighted cost of capital and those offered for further investment in the dairy operation. Each of the four basic tactical business strategies has unique nuances and often has several means of implementation. For example, increasing milk yield per cow can be done directly through improved nutrition, using rbst technology, or pursuing three times a day milking. Increasing cow numbers can be done through internal herd growth or outright purchasing of animals. Increasing milk yield per cow and cows per herd are two of the major historical strategies of wealth accumulation pursued by dairy producers. These trends are global, likely to continue, and reflect their underlying influence on the economic efficiency of the dairy. The fundamental factor underpinning these trends is the principle of diluting fixed cost over more units of product. Increasing herd size dilutes overhead cost over more units of production (milk), while increasing yield per animal decreases animal maintenance and replacement cost per unit of product. Figure 4.1: Source: Brealey and Meyers BASIC TACTICAL BUSINESS STRATEGIES: There are four basic fundamental and tactical strategies for producers and consultants to consider as a means to increase wealth creation. These four options should be evaluated based on a given farm s specific circumstances. 1) Increasing milk production per cow 2) Increasing cow numbers (fill to capacity or expand) 3) Improving cost and price efficiency 4) Diversifying into other activities Figure 2: Modified from Source ~ Capper, et. al. 2007, Cornell Nutrition Conference 26

3 Figure 4.2 (on page 22) best illustrates the dilution of animal maintenance and replacement cost, where the dairy industry is contrasted over time in terms of the percentage of energy consumed captured in the product. Assuming similar cow body weights over time, 10 Mcals of energy per cow per day are needed for cow maintenance and 7.3 Mcals/d are needed for replacement animals, resulting in 17.3 Mcals of energy per day that are fixed relative to milk production. In 1925, with cows averaging 13.4 lbs. of milk per day, only 20 percent of the total food energy was used in milk production. In 2005, the average milk yield in the US was 62.3 lbs. per day, resulting in 53 percent of the food energy going into milk. Based on the historical levels of milk yield/cow, it is estimated that cows will average about 85.9 lbs/cow/day by 2050, resulting in 62 percent of the total food energy captured in the milk. These underlying physiological principles are fundamental to dairy production and will continue to influence the trends in the dairy industry. Adding cows to an existing herd should be pursued to maximally dilute overall operational fixed cost (facilities, labor, etc.), as long as the productive integrity of the herd is maintained. Expanding herd size often involves the procurement of additional assets (land, buildings) and should be considered only if a herd is already yielding returns well above the benchmark level and the herd has the necessary intangible assets (managers, consultants). Successful producers on small herds having excellent management skills resulting in high yields per cow will often expand the use of this valuable intangible asset (dairy management skills) by increasing herds size and assets associated with expansion. Costs and price efficiency should be pursued in all economic climates. Milk prices are primarily determined by regional supply and demand trends, tending to follow a threeyear cyclical pattern. These prices can be modified by milk quality characteristics, which can be influenced by management practices. Feed is a major input cost of production of all herd sizes. Business Planning Metrics 70.00% As part of the Producer Survey, the analysis 60.00% team asked producers to indicate use of the 50.00% following business tools: 1. A financial consultant or accounting 40.00% services; 30.00% 2. A written business plan; 20.00% 3. A written succession or transition plan; 4. Crop Insurance; 10.00% 5. Other risk management tools 0.00% besides crop insurance; or 6. Risk management education. Shown in Figure 4.3, although more than 60 percent of the respondents indicated use of a financial consultant or accounting services, less than 20 percent have a formal business plan, transition plan or risk management plan in place. Only 18.1 percent have participated in risk management education. Nearly 70 percent of the respondents have a manure management plan in place. A Family Business Confidence Survey was conducted by the Elizabethtown College Department of Business and S. Dale High Center for Family Business in 2012 to evaluate the business best practices and confidence levels of small businesses in the Lancaster County region. The Center for Dairy Excellence served as a partner in this survey. A total of 278 business representatives participated in the survey, with 61 percent representing dairy farms. On average, the businesses surveyed in the Elizabethtown project had three generations holding control or ownership in the business. While the majority of the respondents expected the family would retain ownership in the business in the future, only 25 percent had a formal ownership transition plan and only 17 percent had a buy-sell agreement in place for the transition. Only 15 percent of the small businesses surveyed had a written strategic plan. What both of the surveys indicate is that, while the majority of family businesses look to the next generation to take over management, strategic and succession planning seems Figure 4.3: Percentage of Producers Who Have Utilized Various Business Tools intuitive and informal rather than deliberate and intentional, as referenced in the 2012 Family Business Confidence Survey. The Elizabethtown College survey also asked respondents to indicate their views on the overall economy. A large proportion of the dairy farmers responding the survey indicated they were either very pessimistic or somewhat pessimistic about the state of the U.S. economy in the next 1-3 years, as shown in Figure 4.4. Figure

4 Dairy farm respondents in the Elizabethtown College survey tended to respond very similarly to other small businesses. They responded with a conservative attitude in respect to farm growth indicators. More than 85 percent plan to keep employment constant, while eight percent plan to make changes. Sixty percent expect no change in net income, while 15 percent expect income to decrease and 25 percent expect it to increase. Thirty-five percent expect to increase capital expenditures within the next year, while 15 percent plan to reduce prices and a third expect to increase prices, as shown in Figure 4.5. Figure 4.5 Financial Metrics Financial analysis of Pennsylvania s dairy farms was done using several publications presenting financial information on dairy herds in Pennsylvania and the Northeast. This information was gathered from the MSC Business Services annual report and the Northeast Farm Credit s annual summary. Figures from 2012 were compared to 2002 financial estimates for the following herd sizes: Under 100 cows; 100 to 250 cows; Over 250 cows; and Top 10% of profit-making herds during each year. Physical Production Metrics Changes Milk sold per cow, in Figure 4.6, has been associated with profitability. Pennsylvania herds in the Over 250 Cows saw a 22 percent increase from 19,229 pounds per cow to 23,499 pounds from 2002 to 2012, while herds with under 100 cows realized only a 2% increase. The number of cows per herd in the Greater than 250 Cow class increased by 25 percent, while cow numbers decreased by 6 percent in Under 100 Cow. When comparing the range of herd averages in the various categories in 2012, the range broadened as herd size increased. Larger herds have achieved higher levels of production and milk growth over the ten-year period, as shown in Figure 4.7. Milk sold per worker only increased by 10 percent in the Greater than 250 Cow class, compared to a 23 percent improvement in the Under 100 Cows class. The larger herds produced 373,456 pounds per worker. Smaller herds (Under 100 Cows) had a 17 percent increase in cows per worker, from 35 to 41 cows, while large herd decreased from 54 to 49 cows per worker. Financial Metric Changes Milk sales per cow in herds with more than 250 cows in 2012 increased 59 percent ($1,884) from 2002 to 2012, compared to only a 44-percent increase ($1,317) in herds under 100 cows. In 2012, milk sales per cow in large herds exceeded small herds by $750. Feed cost per cow increased dramatically Figure 4.6: Change in Rolling Herd Average in Various Herd Sizes Figure 4.7: Range of Herd Averages Across Varying Herd Sizes in all groups, shown in Figure 4.8, with large herds seeing the largest increase at 135 percent. Labor per cow increased for all herd classes. Herds in the top 10 percent of profit-making herds had milk sales of $4,963, similar to the large herd class. However, they also had less feed and labor costs. 28

5 Figure 4.9 shows that milk prices per hundredweight have been fairly similar between herd sizes and have followed a three-year cyclical pattern through In Figure 4.8, feed costs have gradually increased over the ten-year period to reach $1,600 per cow for larger herds in Net Income per cow followed a similar pattern to the milk price over the 10 year period, as shown in Figure Larger herds experienced higher income per cow than smaller and midsized farms in periods of positive and negative margins. Debt per cow increased for all herd classes across the 10 years, but the highest profit making herds had the lowest level of debt in 2012 at $2,429. Assets also steadily increased over the ten-year period, with smaller herds having the highest number of assets per cow, as shown in Figure Figure 4.8: Feed Expenses Per Cow Figure 4.9: Milk Price Per Hundredweight Figure 4.10: Net Income Per Cow (Numerator of ROA) Figure 4.11: Assets per Cow (Denominator of ROA) Figure 4.12: Return on Assets Per Cow Figure 4.13: Crop Acres Per Cow Profitability relative to total assets is a key financial indicator, which determines competitiveness of the dairy industry relative to other investment opportunities for capital. In Figure 4.12, larger farms achieved higher levels of return on assets. Herds with less than 100 cows had lower rates of return on assets over the 10-year period, while larger herd generally saw much higher returns on assets over the 10 years. All farms increased assets per cow over the 10-year period, with smaller farms showing the greatest increase. Small farms also carried more crop acres per cow than farms from the other two size categories, shown in Figure The research suggests that, with the higher level of assets, smaller farms must consider either increasing net income per cow or spreading fixed assets over additional cow numbers. 29

6 Income Over Feed Costs Historically, Pennsylvania has received a higher average all-milk price compared to other states, as reported by the USDA s National Ag Statistics Services (NASS), as shown in Figure In 2009, Ken Bailey and Virginia Ishler at the Pennsylvania State University developed the Pennsylvania Income Over Feed Cost (IOFC). Starting with market data from 2001, monthly prices for alfalfa hay, milk, corn and 48% soybean meal were used to determine feed cost per cow per day on diets developed by Ishler for cows averaging 65, 75, and 85 pounds of production. The alfalfa and milk prices were obtained from NASS, and the corn and 48% soybean meal prices were from the Chicago Mercantile Exchange (CME). In Figure 4.15, the information was graphed over the multiple years and compared to the Penn State dairy herd s IOFC. The results showed that trends were identical using the simplified (market based) version compared to the more in-depth calculation using actual feed and milk prices. In Figure 4.16, each ration was balanced for three levels of milk production: 65 pounds, 75 pounds, and 85 pounds. The 65-pound level is the most common reported IOFC because it most closely matches the average milk production in Pennsylvania. For 2006, NASS reported the average milk production for Pennsylvania at 19,390 pounds. The diets were formulated for 65, 75 and 85 pounds of milk production using increasing amounts of the corn, soybean meal and alfalfa representing a greater feed cost investment for higher milk production. Even with increased feed costs, IOFC is still markedly greater at the 85-pound production level compared to 65 or 75 pounds, indicating that higher milk production results in greater profitability on the farm. Figure 4.14: Average All-Milk Price as Reported by NASS Figure 4.15: All-Milk, Feed Cost and IOFC in Pennsylvania Figure 4.16: IOFC at Varying Levels of Milk Production Figure 4.17: IOFC at 85 Pounds for CA, NY & PA Using state-specific alfalfa and all milk prices (NASS, USDA), the Income Over Feed Costs for 85 pounds of milk production in Pennsylvania was compared to New York and California in Figure California has received lower milk prices and has dealt with higher feed costs, decreasing the IOFC compared to Pennsylvania and New York. However, Pennsylvania and New York have had very similar market opportunities as indicated by a very comparable IOFC. Based on these IOFC comparisons, milk prices and profit margins for Pennsylvania s dairy farm families are as or more competitive than in other key dairy regions, when production levels are comparable. It is important to note that fluctuation in milk prices over time result in larger differences year to year than between states, which does demonstrate the need for a risk management strategy to be implemented on Pennsylvania s dairy farms. 30

7 There are four basic business strategies Pennsylvania s dairy farms can follow. Those include: increasing milk production per cow; increasing cow numbers; improving costs and price efficiency; and diversifying into other activities. Successful dairy producers with smaller herds having excellent management skills resulting in high milk yields per cow will often increase their herd size. However, in Pennsylvania, this industry trend hasn t followed other dairy regions in the U.S. Regardless of herd size, the analysis reflects a tremendous need for greater integration of risk management and business planning on Pennsylvania dairy farms. Return on assets is a key measurement of a dairy s competitiveness. In smaller herds, a higher level of assets per cow and a lower net income per cow decreased the return on assets, allowing larger dairies to show significantly greater ROA, despite having a similar milk price to the smaller herds. The greater net income was attributed to the higher milk production levels produced by the larger herds, while higher assets per cow were attributed to additional crop acres and other fixed costs associated with the smaller operations. Prescriptions for the Industry: Each Pennsylvania dairy farm should identify one of the four basic business strategies as the platform to grow farm profitability by 5 percent to enhance net income and return on assets. Focusing on increased milk yield per cow and improved price efficiency can allow the farm to maximize profits at the current size and scale without additional investment. If the overall annual on-farm income on Pennsylvania s dairy farms is improved by 5 percent, that would result an additional $60 million in on-farm revenue. a. The four basic business strategies identified in this report include: i. Increasing milk production per cow ii. Increasing cow numbers (fill to capacity or expand) iii. Improving cost and price efficiency iv. Diversifying into other activities A farm s competitiveness is measured by key business ratios such as net income and return on assets. According to the producer survey, many Pennsylvania s dairy farms have not used business tools, such as financial planning resources. Support organizations should encourage more Pennsylvania dairy farms to leverage financial planning resources, such as the Dairy Decisions Consultant and Dairy Profit Team programs, to enhance their net income and return on assets. The intense variation of the milk price, along with a volatile upward trend in feed costs, demonstrates the need for dairy farms to implement a thorough risk management plan. The industry should encourage greater use of risk management tools to protect dairies from volatile margins caused by a cyclical market. Feed is an important economic input to the dairy operation and a critical driver of milk production. Feed costs are ultimately the result of the volume of feed used and the prices paid for the various components. Feed price efficiency should be followed at all times. The volume of feed used should be increased, as long as the marginal value of milk exceeds the marginal cost of additional feed. While high production per cow is associated with higher feed costs, it must also result in higher income over feed costs. 31