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Measuring Operating Efficiency With Gross Margin

Right now, many sectors of agriculture are in a downturn, with market prices for commodities like row crops and milk, in many cases, below breakeven. It’s always important to keep a close eye on financial results, but especially at times like this, tracking your gross margin can be a good way to monitor your business’ financial strength.

Gross margin is basically a measure of how cost-effective you are in producing your primary products. Take your operation’s revenue for a specific time period, subtract your cost-of-goods-sold, or variable expenses, and you have a good snapshot of your gross margin.

If expenses exceed revenue for a short period of time, it may not necessarily be a ‘red flag’ for your operation. Agricultural markets fluctuate constantly, and sometimes prices go below cost of production. But, if that’s the case for a longer period -- and not solely due to adverse market conditions -- it may be time to take a hard look at why, and what changes you can make to get back in the black.

And, if your overall expenses exceed your revenue right now, it is a good time to make changes to tighten your belt and become more efficient.

Behind The Numbers

There are reasons beyond adverse market conditions for a low short-term gross margin. If a business is expanding, diversifying, or in “startup mode,” expenses may be higher than normal. If that is the case, any growth plan should include how and when those expansion or startup expenses will decline or be exceeded by sales or revenue.

How can you tell if your low gross margin indicates a more systemic problem? Frequency and duration can have a lot to do with it. The longer, and more often, your gross margin is low, the more likely it’s a sign of a bigger issue. Having expenses exceed revenue one out of every three or four years, for example, may be survivable if you can make up the shortfall in more prosperous years.

What Not To Do

A common trap for some producers with a low gross margin is capitalizing operating loans into long-term debt. Sometimes, it’s a matter of survival, but doing this can erode your operation’s equity, and when that begins to happen, it’s a real sign that something needs to change, such as adjusting production or cutting costs in a significant way.

Another thing to avoid during times with high expenses: don’t rely on inventory as a liquid asset. It’s been said that, “Inventory is a liability disguised as an asset.” This is because a large inventory can make your balance sheet look good, but it won’t pay the bills (at least not right away), and may require carrying costs or maintenance. This can be a major challenge for inventory-heavy businesses like nurseries.

If these questions reveal a change in your operation is warranted, it’s best to act sooner rather than later. At Farm Credit East, we can help you work through the steps necessary to get back to operating efficiently. Contact us by email or call your local office to discuss how we can help.

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