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Thursday, May 5, 2016

Managing for a Reasonable Profit Margin

By Don Nitchie, Extension Educator

Psychologically adjusting their expectations to the more typical long-term profit and loss environment we seem to have returned to—remains a big challenge for many farm managers.  We know from actual on-farm data, that prior to 2006, a profit margin of $50 or more per acre for cash rented corn production was a rare situation for the average farm.  It was not uncommon to experience a $20-30 per acre loss for the average farm.  If you go back beyond 1996, except for occasional supply shocks such as drought, profit margins such as occurred during the demand expansion years of 2006-12 were never experienced for such an extended period of time. Additionally, we know from actual on-farm data that there is a wide variation in a given year from farm to farm. The High 20% of SW Minnesota Farm Business Management Association Farms averaged a net return of $77.44/acre while the low 20% averaged a loss of $145.80/acre in 2015.  This variability represents opportunities for some and challenges for others.  Since 2012 it appears we may have returned to a world where, once again, sharp management will payoff.

What is “Margin management?”  It is focusing on a “margin” not just on a selling price.  Margin is the difference between your cost to produce per bushel or unit and your selling price. A favorable selling price is only a means to an end but, it is only one part of the equation.  Cost control—or reduction—while maintaining productivity is the other side of the equation. Really all you should care about is what your profit margin is and how frequently you are attaining it.

Margin Management and Price Probabilities.  A key reality that margin management is based upon is that in competitive markets like agricultural commodities, market prices spend the majority of their time in close proximity to the average breakeven cost of the market or industry. Therefore, over the long-term it is more likely that you will have numerous opportunities to select a selling price at modest profit margins than at high profit margins.  Many experts say that 2006-2012 grain prices are a historical aberration caused by record demand expansion triggering unsustainable profits.  Costs did eventually catch-up to price levels. Making it a practice to hold out for less frequent but, very high profit-margin prices can lead to realizing lower long-term profits.

To illustrate this, consider producer A whose 5 year goal is to realize $35.00/acre per year or $.20/bu. profit after all costs and labor and management at a 175 bu. yield. Let’s say Producer A achieves this goal 4 years out of the 5 but, 1 year out of the 5 he loses $.20/bu. Now, Producer B has the 5 year goal of making $70 per acre profit per year which would be $.40/bu. at 175 bu./acre yields.  He achieves this 2 years out of the 5 but, as is highly likely because waiting too long for high prices historically increases the risk of achieving lower prices--he loses $.20/bu or $35/ac. 3 years out of the 5.

What were the 5 year total profits achieved per acre?

Producer A & B; 5 yr. Accumulated Total Net Returns (profit) if each had 480 acres of corn
Producer A:   480 ac. X $105/ac = $50,400.00
Producer B:   480 ac. X $35/ac = $16,800.00

Granted the above example is hypothetical but, is likely given historical commodity price cycles. For your individual situation there are numerous scenarios that could be realized in a given production year or over several years depending on you, the manager and price patterns. The central principal of margin management illustrated here is that, making steady but modest profits can lead to more long-term success than holding out for big but, much less likely profits.  This is especially true in commodity markets that are fluctuating more typically, around long-run industry average breakeven costs.  This is even more true in continuous livestock feeding or dairy operations where there are numerous production cycles during the year and cash is coming and going constantly.

So, knowing what your costs are and establishing a reasonable profit margin goal is essential.  Then, managing toward that goal in a disciplined fashion can definitely pay off.  The above example does not imply that the profit margins used should be your goals.  You need to do some work and determine your own goals and what is reasonable.  You can have a huge advantage over other producers if you have access to benchmarking data ready to develop these goals from.  You need to commit to a goal and to acting upon it.  This is margin management.  It is not easy but, it can payoff in these economic times.

1 comment:

  1. The article on margin management is so vital for us to evaluate future predictions. Commodity tips


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