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1206 PD: Measuring dairy profitability

Elliot Block Published on 11 December 2006

Today it takes more than hard work to operate a profitable dairy. Financial measurements help make it possible to not only understand and measure but to sustain profitability despite expense rates that have risen from 50 percent of gross income in 1980 to 70 to 80 percent of gross income today.

Veteran banker Gary Sipiorski, president of Citizens State Bank of Loyal, Wisconsin, has worked extensively with dairy producer clients throughout Wisconsin. When he asks producers how they measure profitability, the answers Sipiorski hears typically fall into these categories:

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•I have money left over in my checkbook at the end of the month.
•My tax preparer says that I am making money.
•My banker says I am doing okay.
•I have more land, cattle or other assets than I had a year ago.

The challenge, says Sipiorski, is true profitability means that income taxes have to be paid. Many producers (no matter what agricultural commodity they produce) are not very happy when they have to pay taxes. The IRS allows agriculture to operate on a cash basis. Therefore taxes can be deferred by prepaying expenses into the following year. This may help ease that tax burden, but remember you are deferring, not avoiding them. Don’t take your eye off of profitability because of the tax issue.

Profitability is when you spend less than you make. True profitability equals the real earnings after depreciation is taken away. A dairy producer should hire an accountant not only to prepare taxes but also to complete an income and expense statement that shows where real profitability is, Sipiorski advises. The proper breakdown of specific income and expense items will give a dairy producer useful information.

Besides hiring an accountant who understands how specialized a dairy operation is, a consultant who works in the field of dairying serves as a good information source. A banker who is knowledgeable about the dairy industry is also a must for today’s dairy producer.

A good accountant, consultant or lender can point out to a dairy producer areas that need to be addressed. A good producer with good records can make sound decisions on the information that is generated. A very good producer will know which management decisions drive the income statement, Sipiorski explains.

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Producers can improve the way they measure profitability by knowing what management decisions drive the income statement. There are three key profit-measuring indicators that are important for dairy producers to track, according to Sipiorski. They are return on assets (ROA), return on equity (ROE) and asset turnover (ATO).

While there are many ways to size up financial health, Sipiorski shares the most important indicators to evaluate in what he calls the “7 Ayes of Dairy Cow Profitability.” The following outline these key indicators:

Cost of producing 100 pounds of milk
Every dairy producer must know the cost of production, including depreciation and all labor and family living costs. If a producer sells 20,000 pounds of milk per cow with a cost per hundredweight of milk at $12 and a gross income of $13, that equates to $1 per hundredweight or $200 net income per cow. Dairy producers should strive for $400 to $600 net income per cow to achieve profitability.

Return on assets (ROA): Net income + interest divided by total assets
This is a national business standard of adding interest you’ve paid back into your income. Over the last 15 years, dairy producers have had an average return of 4 percent. If you can receive 4 to 5 percent on a certificate of deposit from a bank, your target should be twice that return or 8 to 10 percent ROA. Dairy producers are independent business operators and should be receiving a higher rate of return on assets they have invested.

Return on equity (ROE): Net income divided by net worth
This is a return on your equity. Across agriculture, 15-year averages have been 3 percent. Again, producers should be doubling their return from a cash investment to at least 6 percent.

Asset turnover (ATO): Total assets divided by gross income
The goal is to generate income equal to your total assets as quickly as possible. An ideal business would turn its assets every two years, such as one million dollars of assets generating $500,000 of gross income. But the national average shows that it takes dairies over three years. To analyze ATO, dairy producers must determine whether they have too many assets or if they need to produce more gross income.

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Operation Cost: Total Schedule F expenses minus depreciation and interest
In 1980, the average expense rate on a dairy was 50 percent. That left half the milk check to spend on cattle, machinery, land, etc. Today expense rates are running 70 to 80 percent.

We all know margins are being squeezed. Basically, the average price of milk over the last five years is the same as it was in 1980, yet inflation is on the rise. Cost control and maximizing income work together to help manage expense rates.

Debt coverage ratio
This ratio measures the cash available after all expenses, including labor and family living expenses, to pay interest and principal. Dairy producers need to have at least $1.25 available for every $1 to be paid in interest and principal.

Debt per cow
This is calculated by dividing all liabilities by total number of cows.

Generally, safe levels range from $2,000 to $3,000 debt per cow; $4,000 can be manageable with greater than 24,000 pounds of milk sold per cow. Even $5,000 debt per cow is possible with the correct repayment terms. Beyond this, it will be difficult to handle in low milk price years.

Lenders are now using dollars of debt per hundred pounds of milk. At this time $20 of debt per hundred pounds of milk appears to be manageable. An example would be 300 cows producing 24,000 pounds of milk, equating to 7,200,000 pounds of milk or 72,000 hundredweights. If the dairy has $1,000,000 of debt, this amounts to $13.89 of debt per hundred pounds of milk.

Sipiorski concludes that when a producer makes changes in how they determine profitability it can add to the long-term success of their dairy business. You have to make sure that you are measuring the “right profit triggers.” If you are measuring how many taxes you do not pay or what you have to do to get the most depreciation, you are not looking at the “right profit triggers,” he explains.

Every dairy’s nutrition program has a number of potential “profit centers” that can significantly impact your bottom line. For example, adding Omega-3 and Omega-6 essential fatty acids to rations has been repeatedly shown to boost cows’ overall reproductive health and efficiency, thereby triggering an increase in pregnancy rates and, ultimately, profitability.

Estimates are that each percent increase in pregnancy rate is worth $35 per cow per lactation, meaning that improving pregnancy rates from 20 percent to 23 percent in a 1,000-cow herd equates to $105,000 annually.

Depreciation deductions are important and should be maximized, but do not buy more machinery for the sole purpose of getting an extra deduction. It is better to measure real cash income. Measure the investment per cow, Sipiorski advises. How much do you have invested per cow compared to other areas in the country or your region?

The more assets you have invested, the greater your return must be. If your goal is to have the most and best machinery or most number of acres, you may be measuring the wrong things. You need to be measuring your return on the assets that you manage or own, Sipiorski says.

A number of modern-day producers will rent and lease and invest their money in cattle. Your return should be better than a return on a bank certificate of deposit. If not, why are you working so hard? PD

References omitted due to space but are available upon request.

Elliot Block, Senior Manager, Central Technical Services, ARM & HAMMER Nutrition for Progressive Dairyman

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