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1108 PD: Consider rising raw material costs in your expansion plans

Larry Davis Published on 24 July 2008

With milk prices having reached near record highs just a year ago and the outlook for international demand for U.S. dairy products remaining strong, it is understandable for dairy producers to be looking at future expansion plans. However, these plans should be contemplated with a number of considerations in mind. Here are several points to keep in the forefront of planning an expansion.

Cost of production
Through the years, much has been documented about individual herd cost of production per hundredweight. The fact is that each herd is unique, and although herds may be comparable in many ways, every herd has a different cost of production. The important point to consider is that crop prices have caused feed costs to be at record levels and, whatever a herd’s historic cost of production may have been, it will be much higher in the foreseeable future. Whether a farm raises its feed, purchases its feed or a combination of both, the cost will be higher than history has ever recorded. We are in totally uncharted territory when it comes to feed costs and other costs of production.

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Traditionally, lenders have asked farms to provide three or more different projections on an expansion project. Usually this consisted of a best-case, worst-case and most-likely case based upon various prices. With such dramatic increases in feed costs, a more complex set of projections might be in order, which would include a sensitivity analysis on the impact of various changes in grain prices or prices of other inputs that have shown volatility in recent months.

Another consideration on this very important point is for a farm to consider contracting or hedging feed and other inputs in the near term (12 months into the future). This allows the cost side of the equation to become more predictable, and if the milk price is also contracted or hedged, the overall projected net income has much more credibility with a potential lender.

Milk production and quality
An old saying is, “History is the best predictor of the future.” This is certainly true of a herd’s annual milk production per cow and milk quality as measured by somatic cell count and bacteria. It has typically been shown that a herd will not increase production per cow during the initial expansion phase, and quality almost certainly will suffer because of all the new cows being introduced into the herd. Although an expansion may include updated and improved facilities, including freestalls and a parlor, it is not realistic to project increases in milk production per cow.

Other considerations in this area include cow cull rates and the budget for replacing cows. As is the case with grain prices and feed costs, the price of cows and bred heifers is also very high at the present time and does not appear to show any signs of decreasing any time soon. Cull rates during an expansion are always higher than normal because of the number of cows being brought into the operation from the outside and the stress associated with that movement. It is critical that various cull rates be taken into consideration in the projections so that additional replacements can be budgeted in the cash flow and funds can become available to keep cow numbers at capacity. Not keeping cow numbers up where they should be for the expanded facility is almost always a leading reason for failure during an expansion.

Many times lenders will find they under-budgeted for replacement cows, and this creates additional stress on the cash flow of the operation during the ramp-up time. It is very important to keep the barn capacity full. Again, projecting cull rates at historic levels or better is not realistic; and they should be projected at higher levels so there will be more funds available for cow purchases.

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Project costs
Just as feed costs and cow prices have risen, so has the cost of construction. Concrete, steel and other costs have gone up and are higher than ever. This needs to be given careful consideration when projecting the cost of expanded facilities.

Another common mistake is to underestimate facility construction cost. Almost every project comes in over budget by 10 to 20 percent. With the price of material rising and the tendency to underestimate construction cost, the area of project cost can be a very slippery slope to navigate.

A related problem is a delay in completion and, ultimately, a delay in cash flow from the expanded operation; more money is needed to finish the project, and it will take longer before the project begins to pay for itself. Farms and lenders should plan accordingly by budgeting and approving 20 percent more than the highest cost expectation and by assuming another 90 to 120 days to completion from the latest projected date.

Summary
These are only some of the many considerations that are important in dairy expansion. Items such as labor, management and strategic direction also are of significant importance and need to be carefully contemplated.

However, the areas highlighted in this article are of particular importance today, given their impact on overall expansion costs. The producer and lender need to discuss these areas in great detail to ensure that the appropriate steps are taken to avoid potential pitfalls down the road. PD

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