Spending margins...

[smcgrath76]

Discussions on Cost of Production are always interesting on this forum. I would like to pick up a bit from cswilson's earlier post about the marketplace covering the cost of production.
While it is nice to make money, I often see producers who not only don't know their costs, but adjust them based on calf prices. In effect they spend their margins. Producers may be producing calves for $600 when prices are at $600 a calf. When the price for calves go up to $900 they will adjust their costs to $900. The challenge is that they have a hard time dropping back down to $600 again.
I am not entirely sure why this occurs. Perhaps it is just thinking, it would be nice to have one of those new tractors (or whatever else) and then buying or financing it when you have the cash available, or perhaps it is a tax strategy.
I do agree with cswilson's comment about the marketplace being unable to cover everybody's cost of production. This does not even happen in some of the quota systems such as dairy. While it may be easier to turn a buck in the dairy type system, I will guarantee you there are dairy farms running in the red, and some in the black that will have vastly different margins.
Comments? Thoughts?

[cswilson]

Hoorayyyyyyyyy finally somebody got what I was trying to convey. I stumped one of our Ag. Economists with that exact same train of thought. I'm as guilty as anyone of 'rewarding' myself when you have a good year. It takes great financial discipline not to let costs rise along with income. I guess if you have a profitable year at least put your money into things that generate income or cut costs-not things to make neighbors drool. I did catch one son of a gun admiring my new pitchfork handle-that's my indulgence for 2004.

[PureCountry]

I couldn't agree more gentlemen. I try to push my costs down wherever I can, and we only budget for $500 per calf. I mean we don't plan on getting any more than that when we sell them off the cow. Tight budgeting like this has kept us from overspending, and every year we've done it our calves have brought over $600 or better. So that allows us to put that extra money down on our loans-penalty free of course-or buy feed and things at the times when it's cheap.

I'll stop short of getting into too many details, and opening myself up for the critics. I will say, though, that I WANT to make a living in ranching, so I'm always determined to find ways to make it more profitable. I think that is the difference for some people - NOT EVERYONE - that they want a certain standard of living, rather than living by certain standards.

It's no secret that cattle are no lottery ticket, but when they do bring us a great return, I agree that we have to remember to keep our costs down.
Great post Sean.

[cakadu]

What works for us - and granted this may NOT work for everyone - is that we take the costs from our highest year and use them as a basis for other years. Why you ask? Because we know that the costs for the sheep will not ever go any higher than that. We have to buy an awful lot of our feed, although that is slowly changing as we attempt to move towards a more sustainable grazing management scenario. It hasn't been easy to do that with the drought and the grasshoppers and there are a couple of things we need to get under control, but we are attempting to move there.

We talked at length about how we wanted to do our costs and it made the most sense to go the route that we have chosen. When costs go down, as the others have alluded to, that is when people tend to trot to the bank for more operating capital or money to buy the "things" they need.

We still know what our actual costs are, but our budget allows for the worst case scenario (which now will be 2002), so that when costs are low, we have a really good year. As purecountry states, we are then able to take the extra and put it towards something that really counts instead of always looking to buy something that isn't really necessary. Wants and needs are two different things.

One of our bigger problems in North America is that we are overcapitalized and that is how the developing countries are going to outsmart us, if we don't get a handle on what it is we need to be doing. I am not saying that they will take everything over, we just need to be really aware of what they may be able to accomplish. Their labor costs are no where near what ours are and their feeding regime is far different from ours. In Chile, for example, they don't have to feed - they stay out on grass. Having said that though, they could stand some basic grazing principles. They are getting there and understanding that land that they have in things like rice production that are not making them money are going to have to be turned into something that will make them money.

When I toured down there, it seemed to me there was a lot of lessons we could learn from them.

[grassfarmer]

In Alan Savory's holistic management book he covers this in financial planning. His theory is that 5 years into managing holistically the farmer reaches the point where he can allocate half his output to cover costs at the beginning of the year. By setting this figure and then ruthlessly sticking to it throughout the year, even if this means putting off projects until the following year, real money can be made in agriculture.
I am not at the point of being able to do that yet but aspire to in the future. Many that have attempted this says it looks daunting to begin with but after taking two or three years to let your brain adjust to holistic thinking it becomes feasable.

[rsomer]

Definition of pure competition:

A market characterized by a large number of independent sellers of standardized products, free flow of information, and free entry and exit. The sellers are "price takers" rather than "price makers".

Check out Porters Five Forces of Competition at http://www.quickmba.com/strategy/porter.shtml for the answer on why producers spend their margins. Agriculture is an industry characterized by:
· powerful suppliers (seed, fert, machinery),
· powerful buyers (large packing plants, grain companies),
· few barriers to entry, land available to anyone, even quota is available to anyone
· threat of substitutes (hogs, beef, chicken, lamb)
· intense rivalry between participants (many farmers, slow market growth, no brand indentification, high fixed costs)

What smcgrath76 describes is exactly what you would expect to find in a nearly pure competitive marketplace. The producers are not bad managers if they are spending their margins, they have no choice. It is dictated by the marketplace. Tight free cash flow is a characteristic of primary agricultural commodity production. This compels producers to focus on being excellent cash flow managers rather than profit managers.
The market certainly is not able to cover everybody’s cost of production and there is no reason to believe that will ever happen. Why? Because being the least cost provider does not necessarily provide the producer with a competitive advantage. Rather a producer gains a competitive advantage by being best able to manage his cash flow more so than his costs. While there are benefits to knowing your costs on a per unit of production basis, those benefits are overrated.
For example, take two hog producers. One has a brand new $1 million hog barn for which he is debt, the second has a paid for, older yet still efficient hog barn that has a higher cost of production per hog. A downturn comes in the hog industry which one survives, the producer with the lowest cost of production of the one who has no debt and can best manage his cash flow. The producer with the higher cost of production yet better cash flow survives.

There good reasons why nearly 100% of successful producers know their cash flow situation at any given moment even if they do not know their costs per unit of production. They are concentrating on what they need to know to survive in order to carry on another year in a nearly pure competitive marketplace.

[blackjack]

rsomer... you are so right about being a pricetaker... when you have a few hundred feeders and the margins are not there I guess a guy can get a bit cranky!

[cowman]

I do believe rsomer has pretty well got it right on this subject. When all the smoke clears it is the producer with the deepest pockets who will survive? You can be very efficient but when the banker owns you it doesn't really matter?
There are a whole lot of cattlemen out there who really could "hang in there" for as long as they have to, but there are a lot more who are getting near the edge? Unfortunately a lot of the ones who are going down are the young ones? And that is the true tradgedy of this whole situation...the loss of the younger generation(well what few there are)!
Talked to a young landman last fall who sold his cows. His father, brother and himself had 450 cows in east central Alta. Drought and BSE got them. The old man retired and both the boys went into the oil patch. He said both he and his brother never had a clue how good it was to have so much money! Unlikely he'll ever go back. Too bad, but that's just how it is.

[whiteface]

I think actually most farmers would never go back having had a taste of money inexchange for "their way of life." Cash in your pocket is a pretty nice way of life.

[rsomer]

As cowman says, the producer with the deepest pockets will survive. Although there are some things producers like myself who lack the deep pockets can do in order to carry on. We can create pseudo deep pockets with careful risk management. That includes crop and forage insurance and being a self sufficient producer of many of my inputs such as feed and pasture as well as not requiring very much custom work. This reduces the number of cheques I have to write in bad times. Even though a cost analysis might show my costs have not changed or in times of drought even gone up (example feed and pasture) it can be real important, a matter of survival, not to have to write that cheque.

I know I adjust my expenditures (costs if you will) to match my cash flow. When time are tight I put off spending where I can, which tends to create a delayed need to spend later on, which is what I believe smcgrath76 sees when calf prices are $900. Am I spending my margins, perhaps. I see it as reinvesting in my farm.

Regarding tax strategy. The average farm is running on cash flow from deferred income tax. Deferring income tax only helps profitability in so far as that money can compound value within the farm investment at the farms discount rate. Still careful tax management is crucial to preserving free cash flow.

One of the examples I see most often where producers are managing cash flow rather than profitability is retaining heifers. If we were to follow Harlan Hughes advice we should be retaining heifers when prices are low and selling our heifers, reducing herd numbers when prices are high. Typically producers do the opposite. It is cash flow driving this behaviour. In order to pay the bills when prices are low many producers are forced to sell some extra animals. But they rebuild their herds when prices are strong and they can afford to. It seems that this is counter productive to profit but it is cash flow driving the producers to do this.

The farm must be able to finance its growth. If the producer strives to grow too fast and cannot generate the cash to finance most of that growth internally, that farm will soon be gone. Cash flow is king in any operation even partially financed with debt.