John Mulvany, ONFARM Consulting
The dairy industry never lacks issues that generate vigorous debate about the future of the industry. Production systems and pricing policies are regularly hot topics. Throw in a tough season and the intensity rises.
In 2013 in Victoria, the pressures being experienced by dairy farmers have led to meetings with politicians in an effort to achieve some relief from those pressures. In those meetings there was no doubt lots of talk about cost of production, lack of profit, breakeven price, and pressure for increased productivity.
Sounds good but a problem exists when individuals in these discussions have a different understanding of the definitions of what they are talking about. It's worth reminding ourselves what the various terms mean, so there can be common ground as a basis for rational discussion.
We'll use a dry land Victorian dairy farm's data from 2011-12. The data is real, but we will call the farmers David and Daphne Define. The farm details are presented in Table 1.
Table 1: David and Daphne Define – Dairy Business Profile
|Personals and tax||$119,412|
|Cash Surplus||~ $1,129,936 - $1,029,460 = $100,476|
|Other Financial Parameters|
So how do we interpret those figures? What do they tell us about the Defines' business?
Farm Working Expenses (FWE):
- These are the total direct costs; that is all cash variable and overhead costs ($744,576).
- When divided by the total solids produced (204,237 kilograms) FWE equals $3.64 per kilogram milk solids. This includes $0.46 per kilogram milk solids of paid labour.
- It is a guide to 'resilience' in low milk price years and to some extent cost control. FWE is not 'cost of production'.
Cost of production:
- This is the farm working expenses ($744,576), plus the commercial value of the owner operator's work in the business ($97,488, a subjective figure), plus depreciation ($25,800). The total is $867,864, or $4.25 per kilogram milk solids.
- This does not, and should not, include debt servicing. Debt servicing is associated with the payment of capital, which varies enormously between farms, irrespective of cost of production. If, in discussion, a dairy farmer wanted an allowance for the assets provided, then a nominal amount of say 6 per cent could be made, or $191,370 (6 per cent of $3,189,000), which is another $0.94 per kilogram milk solids. This would then be expressed as - it costs me $4.25 per kilogram milk solids to produce my milk and if I demand a 6 per cent return on the capital invested then $4.25 increases to $5.19 per kilogram milk solids.
- This is simply the total income ($1,129,936) less total expenses ($1,029,460), or $100,476.
- This is a critical measure to assess the ability to pay bills but it is not profit.
Break even milk price:
- This term is used loosely within the industry, particularly in times of low milk price. It generally means: at what milk price will my budget break even?
- This reflects a neutral cash position of a business, but nothing about profit or cost of production.
- In David and Daphne's situation, the break even milk price was $4.76 per kilogram milk solids. This was an important figure to them in the 2009-10 year, with a very low milk price and high input costs.
Operating profit or earnings before interest and tax (EBIT):
- This is income ($1,129,936) less farm working expenses ($744,576), less operator allowance ($97,488), depreciation ($25,800), and the addition of any inventory changes ($8,100).
- For David and Daphne this makes a profit of $270,172 or $1.33 per kilogram, milk solids.
- EBIT is a good measure of business profit not taxable profit.
Return on total assets:
- This is EBIT ($270,172) expressed as a percentage of the assets owned in the business ($3,189,500) and for the Defines calculates to 8.5 per cent return on total assets.
Return on equity:
- EBIT less interest ($78,750) is $191,422, and when expressed as a percentage of the owners' net assets ($2,139,500) in the business, calculates to 8.9 per cent.
- This ratio measures the efficiency with which the owners' capital is being used.
- This is not production or profit.
- Economists use the term productivity to describe changes in production efficiency. Productivity is a measure of how efficiently inputs are combined to produce outputs, (RIRDC), or productivity is a measure of the units of physical output that can be produced from a given amount of physical input, (DEPI).
- Productivity gains are made when output increases relative to the amount of input used. Productivity is not affected by a change in output price, because price is not part of the productivity equation. Generally, productivity is discussed at an industry level and has little use or relevance on individual farms.
- This is simply what it says – the amount of milk produced, preferably quoted in kilograms of milk solids.
- Increases in production do not mean increases in profit, unless the cost of the extra input is less than the income derived from the high level of output.
Note that all ratios were expressed per kilogram of milk solids, because it is the most consistent and least variable between farms. We know that as soon as cents per litre is mentioned the next question will be, what type of litre?
After all of the definitions, what are some sensible statements that David and Daphne could make about their business, if they were at a discussion group meeting, or even a farmer rally about their industry?
- David and Daphne said last year was a pretty good year for them. "We paid the bills (cash) and managed to put a bit away into farm management deposits (right at the end of the year) and reduce our tax."
- "Compared to other investments, we got an 8.9 per cent return on our money, which went into debt reduction and savings."
- "We think our farm working expenses at $3.65 per kilogram milk solids are a bit high, but we do employ labour and when we look at our total cost of production at $4.25 it seems not too bad."
- "At the milk price we are looking at in 2012-13 of $4.78 per kilogram milk solids, we are going to have try to reduce our farm working expenses where possible. This might even mean a reduction in production to maximise profit."
Vigorous discussion and debate are healthy but it certainly helps when we speak the same language.