It will come as no surprise that the reserve banks intention to increase the requirement for banks to hold increased levels of capital means that there is building pressure by the reserve bank for debt reduction. Then there is the Fonterra share / unit now down to $3.72 (at time of print). The lack of a dividend and the well published demands on the dairy industry are not helping. With a $1.45/share peeled off the balance sheet in the last twelve months it will mean further erosion of every supplier’s equity. The message for dairy farmers is that if your existing business needs further funding, or you wish to expand, then the business case has to be 5-star, and don’t be surprised if you get knocked back.
Profit = ? It might have been a simple mathematical equation, but there is a weakness in the way some dairy farmers do business.
The equation looks like this... Income less Expenditure = Profit.
Clearly the farm sells milk and meat to get income, less the cost of running the farm and what is left is the profit. This is technically correct, but the mindset is “I work out what I want to produce, I spend to get it, and what’s left is profit”.
Now think about the same equation, but presented another way... Income less Profit = Expenditure.
If it is the same numbers, then surely the answer is the same? Again, technically speaking yes. But! Rather than looking at this as a math’s exercise, consider this a philosophical exercise. If you know what your income is, and most importantly you know what profit you want, then the balance between the two is what you can afford to spend.
Too often farmers get the wrong outcome because they see profit as the residual, rather than the crucial input for doing business. So how do you make this work? Start with this years’ income; $6.75 milk price + 50 cents livestock returns and let’s say 10 cents of sundry revenue. Total revenue $7.35/kg MS.
Now how do you set Profit? It could be based on an operating profit goal, say $3,000 EBIT per HA. Or back out from what you want as free cash after all commitments are met, say $50,000 free cash after all the bills, the bank, IRD and lifestyle is paid for. Here is another example. Your farm assets might be worth $40/kg MS and you want a 6% return on capital – so profit needs to be $2.40 per kg MS.
Now use the equation, “Income less Profit = Expenditure”. From above: $7.35 less $2.40 = $4.95. For a healthy business this $4.95/kg MS is an operating cost fully adjusted. It includes depreciation, which for the average kiwi dairy farm that’s about 25 cents. This needs to come out so that cash farm operating costs result. I.e., $4.95 – $0.25 = $4.70/kgMS. Then, if you produce 150,000 kgMS and multiply by $4.70 = $705,000.
Now do your budget so that you produce 150,000 kgMS and only spend $705,000 getting there. This is the tough bit, but what’s the size of the prize? If a farm spent $5.35/kgMS less 25 cents depreciation = $5.10/kgMS cash farm operating expenses.
If this farm can reduce costs by 40 cents/KgMS on 150,000 KgMS = $60,000. Surely a prize worth chasing.