In this blog, I thought I’d share some thoughts on efficiency. The efficiency measure I want to discuss, though, is one tied to the conversion of assets into bottom line profits. Dairymen often ask, “I’m milking 600 cows and netted about $800 per cow last year. This year I’m not even breaking even. How does that young guy down the road with 3,000 cows and $6,000,000 of debt make it?” After I ask them to clarify how they know that he has $6,000,000 of debt, I usually explain that the answer lies within the realm of productivity per unit or efficiency. Another way to explain it is to look at their costs per hundredweight (cwt.) as measured by the leading accounting firms in our industry. The dairy industry is a volume business, marked by the need for efficient conversion of assets into bottom line profits. Whether we like it or not, producers are “Price Takers” not “Price Makers.” Dairymen ship their product to their cooperative or other processing company without knowing what they will get for their milk. Unlike a “Price Maker,” such as an auto dealer who might be able to hold his inventory until he gets the price that he wants from a buyer, a dairyman sells a highly perishable product and thus needs to ship it for processing as soon as possible. Unless he has the ability to process it into a storable form, such as cheese, and then sell it later, he must take what the market offers him on any given day. That makes him a “Price Taker.” Thus, a dairy operation has two primary ways to influence its profit levels, either by increasing its volume of milk sold or by lowering its costs of production. The following equation is one that I like to use to explain dairy profitability: Profit = ((Revenue/cwt. – Variable Costs/cwt.) X Number of cwt.) – Fixed Costs
- Primarily the volume of milk sold per cow determines revenue.
- Variable Costs include expenses that vary with the number of cows milked such as feed, some labor, supplies, repairs & maintenance, veterinary & breeding costs.
- Fixed Costs include rent, debt repayment, most insurance, and professional fees.
What’s the message? Spread your fixed costs (and some of your variable costs) over a larger number of hundredweights or cows and watch your profits increase. Perhaps a numerical example would help: >> Year 1 << >> Year 2 << 600 Cows 3,000 Cows 600 Cows 3,000 Cows Milk Revenue/cwt. $14.00 $14.00 $11.50 $11.50 Less: Variable Costs <10.75> <10.05> <10.75> <10.05> Less: Fixed Costs <1.25> <1.15> <1.25> <1.15> Net Income/cwt. $ 2.00 $ 2.80 $ <.50> $ 0.30 X 200 cwt./cow X 200 X 200 X 200 X 200 X Number of cows X 600 X 3000 X 600 X 3000 Net Income $240,000 $1,680,000 $(60,000) $180,000 As you can see in the previous example, the larger operation does a fairly good job of spreading their fixed costs as well as reducing some variable costs per hundredweight. Thus, it is apparent why the larger operation has the ability to service substantially more debt in a given time period. Of course, in our current industry environment, dairies of all sizes will find it more difficult to make ends meet. Regardless of herd size, all producers should keep a close watch on their costs per hundredweight. These should be monitored on a regular basis both internally and via the accounting numbers from your CPA. To summarize, however, former General Electric CEO Jack Welch said it best when he advised:
- “Face reality as it is, not as it was or as you wish it were.” In essence, do the right things in your management system for the right reasons, but don’t waste time on those tasks over which you have no control.
- “Change before you have to.” This will assist you to stay ahead of the curve of change and position you to compete at a higher level. No doubt about it – You’ll be glad you did!