The easiest way to identify which expenses may offer the most opportunity to improve the operating expense ratio is to list the five largest expense items and challenge yourself to make improvements on these costs.
In January, the local banker Hans Immapocket asked many of our clients in the Grainews community for an updated net worth statement and income tax or financial statements in order to renew the operating line of credit for the next year. We do not want our clients to simply provide the bank with a number or ratio. Our focus is to work with the farm management team to build understanding about what this financial information means and how it can be used to make informed business decisions.
We help the manager develop a formal communication plan for all farm stakeholders and the financial institutions. This plan, like any good Clint Eastwood movie, summarizes the Good, the Bad, and the Ugly. The plan elaborates on any weak areas or risks, and also provides an opportunity to highlight strengths that mitigate these risks. This process provides a communication culture that is less prone to misunderstanding within the ownership team or with the financial institutions, both of which represent critical partners. It is often a natural tendency to avoid discussion around weak aspects of the business which compounds the risk. In reality, the management team should focus on these areas and gather input about how best to manage these areas of weakness.
This is part three in a four part series.
Today, we focus on efficiency within the business. The efficiency indicates one key message — how much does it cost me to generate income on the farm?
There are a number of ratios we can use to measure efficiency. 1) Operating expense ratio = Total expenses –term interest
–property taxes –land rent –depreciation over gross revenue
This ratio indicates how much it costs you to generate one dollar of gross revenue per acre on your farm. For instance if your operating expense ratio (OER) is 65 per cent, it costs you $0.65 to generate $1 of revenue. On an accrual basis, this figure remains surprisingly consistent year over year on a farm. It demonstrates that good farm managers consistently achieve higher margins than less efficient managers.
2) Gross revenue per production unit = Gross revenue over production units
This ratio indicates the revenue generated by every acre, sow, kg of quota, cow or whichever unit of measurement you want to allocate
These ratios indicate the current production per unit which begs the question: is this at its highest potential? A common trait among the most efficient producers is that they also have very high levels of gross income
per unit when compared to the rest of the industry. They will have higher gross revenue with the same amount of inputs.
Recognizing whether the operating expense ratio is high will indicate if there are opportunities to more thrifty with expenses. The easiest way to identify which expenses may offer the most opportunity to improve the operating expense ratio is to list the five largest expense items and challenge yourself to make improvements on these costs. It is not uncommon for these five expense items to constitute 60 per cent to 80 per cent of the total operating expense.
3) Machinery investment per acre = Total value of machinery over total cultivated acres
This ratio is typically of most value to grain producers to indicate their investment per acre. This is directly tied to depreciation costs
4) Machinery investment ratio = machinery investment per acre over Gross revenue per acre
This ratio is typically of most value to grain producers to indicate their machinery investment as a percentage of their gross revenue. This can indicate proper machinery capitalization.
5) Machinery cost per acre = Machinery repair & maintenance + custom work + depreciation over Total cultivated acres
This ratio indicates the cost per acre to get the work done right and on time for every acre
A brief look into the machinery investment and cost per acre can indicate whether there is an appropriate amount of iron on the farm. Looking at ratios such machinery investment ratio can indicate the earning potential that is being achieved per dollar of machinery. There is a balance between owning enough machinery to do jobs right and on time and owning enough machinery that depreciation becomes a monkey on the back of the operation.
6) Return on assets = Accrued net income + interest –living expenses –income tax over Total assets
This ratio indicates the net income produced on the asset base of the business.
So what do these numbers mean and why should you care? There are four reason. The numbers tell you:
Where do my opportunities to increase income efficiency exist?
Where do my opportunities to decrease expense efficiency exist?
Am I overcapitalized?
What can I count on when considering my next expansion or growth opportunity?
Understanding the relationship between gross revenue and operating expenses can be valuable when considering a structure change (growth or contraction). Knowing what each dollar of revenue costs you in operating costs can quickly help you assess a growth opportunity for the remainder indicates the residual that is available to cover fixed charges which we will cover in the next article.
There are no mitigating factors for being inefficient. Businesses that are less efficient can get by and survive with strategies like lower debt levels but if the long term goal for the business is growth or profitability, the lack of efficiency is the first hurdle in achieving those goals.
Andrew DeRuyck and Mark Sloane manage two farming operations in southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 and 204-825-8443.