CEO Style Thinking

[rsomer]

Good Morning:

I was reading an article in a magazine "Farm Forum" sent out by Aventis.
The article was called Farm Planning: Real results, Real Cash and used the example of a farm family in Manitoba who had established annual management goals of 10% ROE, net operating profit margin of no less than 20% and a contribution margin of 50% or better on a total farm basis.
The farm was over 2 years into their business plan and the family had met most of their goals.

I find myself questioning the value or importance of short term goals when evaluating long term investments. Happily, the example in the article illustrated a short period of time when the outlined goals were met. But what if ROE was only 2% or indeed negative for the first year or two of the plan, what if profit margin was only 10%, what if you find yourself in a period of drought and you are lucky to get enough money to even put in another crop, forget about a contribution margin of 50%. What would this family done then?

While establishing annual goals seems on the surface to be "CEO style Thinking" as promoted in the article, the purpose of establishing the goals would seem to be to serve as a basis for evaluating some sort of action in the future, either to stay the course or to change direction in some manner.

My concern is that evaluating the farm investment in terms of short term benchmarks will introduce a bias for the decision maker to reallocate his/her resources to investments that promise to offer more stable short term returns as opposed to the typical farm which tends to offer attractive returns in "good" years which can many years apart.

Could it be that the real challenge facing producers is to maintain cash flow through the tough years so that they can remain in the industry when the good times come and that too much focus on short term benchmarks may serve to distract producers from seeing the longer term profitability of the farming industry.

Comments anyone?

Rob Somerville
Endiang, Alberta

[nakodo]

There are businesses like this, they work on maintaining cashflows in the hard years to reap profits in the good years.

These days the hotel industries and airlines are doing just that, whatever it takes to make payroll while waiting out the downturn. The losers in the cashflow game will make the profits higher for the survivors if all goes as expected in their projections.

Fairmont is building hotels and buying their cash starved competitors in targeted regions, aggressively positioning at a time of severe downturn!

Benchmarking your operation versus others in similar type of businesses is also a CEO's job.

[rsomer]

Thanks. Its never hurts to remember that other industries have periods of low profits and struggle to meet cash flow requirements. And yes, benchmarking against others in my industry is an important part of the job.

I do think that we need to be careful about setting annual goals such as 10% ROE, net operating profit margin of no less than 20% and a contribution margin of 50% or better on a total farm basis like the example in the magazine. For instance, the cow calf sector has a known profitability cycle of about 11 years. I think it is accepted industry knowledge that you really won’t know if you are going to make it or not until you have been through two cow cycles. Twenty-two years, that is a long time but that is the cattle business. If we look at profitability benchmarks for a cow calf operation on an annual basis then we are looking at information that is out of context of time. On any given year, profitability could be really low or really excellent but you wouldn’t be seeing a true picture of the operation.

I don’t know what the answer to this is. Maybe I should be setting annual goals of annual ROE that is 2% better than the industry for that year, profit margins 5% better than the industry, and so on. But benchmarking against the industry doesn’t take into account local variations in weather which can dramatically affect annual returns.

I tend to think there is a lot of wisdom to be found by looking at what producers actually do. I see a lot of benchmarking being done by looking over the neighbours fence. I see cashflow management as providing fuel for growth and the means to stay in the industry. Profitability comes in the long term from being able to stay in the industry long enough to benefit from periods of cyclical highs. I see producers as being somewhat suspicious of the suggestions made by management experts and economists, often with good reason. Finally, I see a real need to be careful when applying concepts out the of the management texts to agriculture that are out of context with the actual farm situation.

My opinion. I put these thoughts forward to spur thought and discussion so I might learn from the comments of others. I look forward to any comments and suggestions.

Rob Somerville
Endiang, Alberta

[pandiana]

An interesting discussion but could you please define ROE and contribution margin? I am not an economist and am unfamiliar with these terms.

[rsomer]

ROE is Return on Equity. Equity is what you would have left if you sold out and paid your debts. Your net income divided by equity gives ROE.

Contribution margin or contribution margin ratio is contribution divided by sales. Contribution is what you have left after you sell your produce and pay the variable costs (seed, feed, fertilizer, vet bills etc.) of producing those goods. Contribution is then what is available to pay your fixed costs (those costs you have to pay whether you grow anything or not like electricity and heat) and taxes. What is then left after paying your fixed costs and taxes is your net profit or net income.

I hope I got that right. These terms aren't used everyday in agriculture. I know I am still trying to make sense of them. I guess they came up because they appeared in the article that sparked my interest.

Have a good day, and thanks for your interest in the topic.

Rob