Allow me to bore you for a minute, for some of you maybe what I have to say might just turn on a light, for others I don’t want you to think I am trying to tell you how to suck eggs. In the current farming & economic environment Gross Margin analysis is a very important tool to determining the level of farm profitability.
Many of our farming clients cringe when I start talking about financial ratios, in particular enterprise Gross Margins, the common response is ‘we farm what we know we can farm and hope the season is a good one”.
So what is a ‘Gross Margin? What does it tell us and why should we compile a Gross Margin of all our enterprises? Like many, you might then ask “how do I calculate an enterprises Gross Margin?”
A Gross Margin is simply the difference between the Gross income earned by an enterprise and the direct costs (or cost of inputs) required for production. It is an important tool for you to know how to compile and understand the resulting values. I will explain the reason shortly.
Specifically the Gross Margin formula is:
Gross Margin = (yield per ha or acre x price received per unit (eg tonne or Kg etc) minus Direct costs. (eg seed, chemical, fertiliser, machinery cost (fuel + R&M) & insurance and casual labour).
For livestock GM = average return per head x No of head per Ha (or acre) minus direct costs per head. For example (agistment costs per head, if applicable, supplements & fodder, veterinary costs, eg drenches and vaccines, tags and freight etc and casual labour cost).
From a Farm economics point of view to understand why this is important you need to consider that with crop production most of the overhead costs, except for the direct costs previously mentioned, don’t change very much when other crops or livestock are produced.
For a cropping enterprise even the fuel costs are similar. In most instances the same tractor, tillage implements, planter and harvester are used for a similar amount of time for most of the crops grown. For that reason the operational and fixed costs are very much the same for each crop. So what does this mean?
It means that the gross margin of each crop is a very good indicator of how much each particular crop contributes (referred to as a % contribution) to covering the overhead costs of the farming business and thus ultimately its bottom line. It is a key ratio used by financiers to help determine the business’s ability to meet immediate and future finance commitments.
Knowing the gross margin of the crops grown and other enterprises you run on your Farm is a good planning tool to determine how much money the different enterprises are capable of generating on your scarce resource – your farm. Even with the need for crop rotation it is obvious that you would want to grow the crops or manage the enterprises on your land that have the highest gross margin return.
The economic environment surrounding farming today is changing faster than the agronomic environment and it is really necessary to do the numbers each year. Always strive for the maximum gross margin returns. In consideration of crop rotation factors you should choose the top three or four performing crops or enterprises.
As with most financial ratio tools, gross margin analysis also has its limitations. The approach works well if the enterprises us the same resources and the operational and overhead costs are the similar. However, this changes if specialised equipment is required and more passes with some equipment is necessary or different cultivation applications re required etc. Even-though with these and other limitations you can still do some calculations for each crop on paper, this will give you a pretty good understanding of the direction you need to take.
I guess to most of you this is all familiar. Gross margin considerations are the foundation of good Farm Business Management as a whole.
Remember this:
1. Planning for short term profitability is the foundation for long term success.
2. Farming is no longer just a way of life. Farming is a business and it must be treated as such.
My father once said to me something I have always remembered-
“Son, if it works on paper it is more likely to work in the paddock.”
Kym Michael