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Knowing Your Cost of Production Can Help with Sound Management Decisions

In any business, including natural resource-based enterprises like farming, fishing and forestry, knowing your costs has always been important. But in today’s world of tight margins, it is imperative. Knowing, and managing, your cost of production is essential to running a profitable operation.

In the following example, we look at the cash cost of production for a Northeast dairy producer, “Helen’s Holsteins.” This example is dairy, but the principles apply to any agricultural business. While the numbers here are hypothetical, they give an idea of how business owner, Helen, might track her cash costs.

Let’s start by looking at a few differences between this cash budget and an accrual income statement. Our cash budget does not include depreciation, as that is a non-cash expense, but we do include debt principal payments (accounted for in “debt service payments”), which are not included in the accrual income statement. Both cash budgets and accrual income statements are important management tools, but in this case we have decided to focus on cash flow.

Based on Helen’s costs, the operation’s break-even milk price (on a cash basis) per cwt. of milk is $18.67. This is, however, higher than current market prices. For the past three years, milk prices have averaged about $17.80/cwt. So what is Helen to do?

Reducing variable costs

One option is to work on reducing variable costs. Anything that Helen can shave off the cost of producing her product (in this case, milk), will help improve the bottom line. And the good news is that there may be room to negotiate some variable cost inputs. But, Helen needs to be careful – she doesn’t want to cut inputs to the extent that she hurts productivity too much. For example, cutting back on fertilizer may not be such a bargain if it cuts down crop yield.

Fixed costs

Another option is to look at fixed costs. The major fixed costs are land, including cash rent and principal and interest payments on owned property; machinery and equipment and the related repairs; maintenance and financing of purchases; and of course, family living. Lowering any of these costs will improve an operation’s cost structure. There is rarely one single item so far from the norm that changing it alone will fix everything. Rather, it is usually small, incremental changes in multiple places that add up to impact business performance. “Doing all the little things right, all the time” is time-tested good advice.

Adjusting costs is a smart strategy that can benefit every producer. For some, it will help get through a period of low prices. For others, it will position them to take advantage of opportunities. If your costs are high, work with your advisors to identify strategies to make your operation more competitive.

Helen’s Holsteins Course of Action

In this case, Helen addressed her variable costs by working with her nutritionist to optimize her herd’s feed ration to balance cost and productivity. She was able to pick up a five percent reduction in cost without significantly affecting production. She was also able to shave five percent off her labor costs, slightly trimming hours worked by making schedules more efficient. She also addressed her fixed costs by renegotiating her cash rent and trimming net family living costs. This enabled her operation to achieve better cash flow.

The above savings amount to about $0.58/cwt, or a 3.1 percent decrease in costs. While this may not solve all of Helen’s issues, the total savings can add up to real money.

Remember, while this example addresses a dairy farm specifically, the same principles apply to any business. Smart cost control and efficiency management can go a long way to improving cash flow and profitability.

Farm Credit East offers several programs to help producers manage their business for best results. Our Success Strategies Benchmarks and our Profit Analyzer programs can provide real-time income and expense management tools to help business owners make these minor adjustments and course corrections that can add up to significant differences in a business’s bottom line. Contact your Farm Credit East relationship manager for more information on how we can help your business.

Special thanks to Farm Credit Services of America for their contribution to this post.

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