Last month, we looked at how a review and assessment of your marketing can help make your production sales more balanced, easier to manage and ultimately more profitable. This month, we’ll look at how these marketing practices are part of a bigger picture called gross margin efficiencies.
As we all know, commodity sales are your top line, 100-cent dollars, so even a five to 10 per cent increase on revenues can have a large multiplier effect on your bottom line. This top line revenue works its way in to your profit through the gross margin ratio calculation. The more efficient your gross margin, the more effective and profitable your overall operation can become.
Terry Betker at Backswath Management and I have talked many times about the important connection between gross margins and marketing. While reducing production expenses are one part of the equation to improve gross margin, the other part is increasing revenue from commodity sales. There are a few things that can be done to manage this revenue component, but first let’s take a closer look at gross margin.
Terry Betker explains that although farm business analysis is not restricted to the use of ratios, ratios can be very useful tools to analyze performance. A great example of this is Gross Margin Efficiency. Expressed as a ratio, Gross Margin Efficiency measures how efficiently a farm utilizes specific, productive inputs. To demonstrate, the calculation looks like this:
Gross Margin / Gross Revenue = Gross Margin Ratio.
Gross Margin is calculated by subtracting seed and seed treatment, chemicals (herbicides, fungicides, pesticides), fertilizer and production insurance for grain operations and veterinary, medicines, feed and market animals (but not breeding stock) from gross revenue and then dividing the number by gross revenue.
According to Backswath Management, the rule of thumb is to have a Gross Margin Efficiency of 65 per cent or better. This is a recognized industry standard and is relevant and applicable to a wide cross-section of primary agriculture that includes grains and oilseeds, special crops, cow-calf and dairy enterprises. Most farmers make decisions relative to the amount of investment in the productive costs as identified above. Farmers can allocate these costs to different enterprises with greater certainty. See the table in this article for an example.
Financially, the objective is to get the most bottom line net profit possible every year. There are other variable expenses such as fuel, repairs as well as fixed expenses like rent, taxes, interest or depreciation that are subtracted from gross revenue before net profit is realized. However, if the efficiency at the Gross Margin point of reference is chronically poor (i.e. lower than 60 per cent), it will be very challenging to get a satisfactory net profit. Gross Margin Efficiency is the first step in looking for ways to improve a less than desired bottom line.
Betker goes on to say that there is another, excellent application for Gross Margin Efficiency. Farms that diversify and/or significantly expand, generate increased gross revenue. However, this does not always guarantee an increase in their bottom line performance. Expansion can lead to reduced efficiency. Bottom line net profit depends on how efficiently they are able to generate the additional Gross Revenue.
Maintaining, or even improving, Gross Margin Efficiency through expansion is very important. Following are some examples of where practices can change as a result of increasing production and result in poorer performance:
- Less attention to production detail (e.g. seed placement, nutrient application);
- Field activity speed (e.g. planting and harvesting speed);
- Seeding and harvesting dates extended beyond optimal dates;
- Less attention to marketing (e.g. related to time available);
- Time constraints and impact on other management areas (e.g. Human Resources).
Theoretically, it makes sense to spread fixed expenses over increased production. It is pointless, though, to farm more and more – but as a result, less and less efficiently. This scenario has more work, more capital and more risk but with no more profit. It doesn’t have to be that way.
Growth, while maintaining efficiency, can be managed. Analyzing year-over-year trendline Gross Margin Efficiency performance will quickly reveal potential problems so you can take corrective action and continue to get the most from your operation.
Bottom line, gross margin efficiency is a key component of any farming operation so it’s important to maximize it in all stages of your business. Investing more time into marketing can help whether it’s an everyday approach to improving sales or part of an expansion to manage that extra risk. Hedging programs using options and futures can provide downside floor price protection with upside potential, capture weather rallies or simply earn the carry from grain sitting in the bin. Either way, they’re extra financial tools in the marketing tool box to help increase revenues and gross margins.