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6 Ways To Higher Farm Profits

Economy of scale is one of the key competitive advantages for Australian — and Western Canadian — grain farms, and land expansion has been an important driver of productivity gains. But over the past decade, land prices have grown at a much faster rate than operating profits. This has made additional purchases of farmland less affordable relative to the income that land is capable of generating. If this trend is to continue, it will slow the rate at which family farms are able to expand through land purchases because it will take longer to accumulate sufficient equity through retained profits and we will have reduced capacity to service debt.

As a Nuffield Scholar, I spent 16 weeks traveling to Canada, the U. S., the U. K and New Zealand, as well as my native Australia, to identify opportunities for Australian farm businesses to make better use of their own resources. I came up with six key areas where farmers can make more efficient use of their capital. I’m sure many of these recommendations will make sense to Canadian farmers. Here are my six recommendations:

1. SEPARATE THE OWNERSHIP AND OPERATION OF LAND

It is essential that we separate the real estate and operational components of farm businesses and analyze the performance of each separately as well as their performance as a combined investment.

All of the farming businesses I visited were either operational businesses, real estate businesses or some combination of the two. Where individual businesses sat in this spectrum was governed by the relative performance of each component. In the extreme cases, this meant some farm businesses were all operational whilst others were all real estate.

In Australia, the real estate and operational businesses have complimented each other well over the years and there is no reason why this should not continue into the future. However, analyzing the performance of each component separately would allow individual farmers to identify whether their mix of operational and real estate activities is delivering the best financial outcome.

2. BASE LAND RENTALS ON A SHARE OF PROFIT

Leasing additional farmland represents an opportunity to improve a business’s return on equity. This is certainly the experience of many farmers in various parts of the world.

Leasing offers many opportunities to Australian broadacre farmers however a number of factors should be taken into account in establishing a leasing arrangement that is beneficial to both parties.

Lack of security of tenure is a concern because it forces lessees to act according to short-term interest, which is to the long-term detriment of both lessee and lessor. In the U. S., the relationship that develops between the two parties over time provides some security and the fact that such relationships have developed is perhaps a reflection of the maturity of the rental market in the U. S. relative to Australia.

Australian broadacre farmers deal with much greater income volatility from year to year compared to their U. S. counterparts. Consequently lessees take on much higher risks with fixed price rental agreements because there is a real risk they will not earn any profit after paying the

The financial costs of expanding to 1.5 times a scalable unit can be great

because you have 1.5 units of income but the full costs of running two units.

lease. Traditionally Australians have managed this risk by using their own equity in farmland as a buffer to absorb operating losses from any given season.

Ultimately leasing land needs to be a mutually beneficial exercise for both lessee and lessor. The obvious solution to the above issues is to structure lease agreements so each party receives a share of profit from year to year as opposed to a fixed cash rent. Crop share arrangements and variable cash rents indexed to grain prices are two working examples of this approach.

A share of profit approach would mean lessors have greater confidence to agree to longer-term deals knowing that they won’t miss out on higher returns should underlying farm profits change over the timeframe of the agreement. They also benefit from a lessee who has incentive to manage the land in a way that short and longer term profitability is optimized.

The benefits to the lessee would include much needed security of tenure and reduced risk from the fact that their rental payments will be reduced in years when operating profits are poor.

3. FOCUS ON SCALE

Another advantage of isolating the operating performance of Australian farm businesses is that it would bring greater focus to the issue of optimum operating scale. Whilst the “get big or get out” approach of previous times had merit, it ignored the reality of scalable units.

In the U. K., optimum scale is governed by harvesting capacity and other machines are grouped accordingly. Similarly, the large dairy operations are based upon multiples of scalable units.

In this case, the size of one unit is dictated by the number of cows that can be milked three times per day in an 80-stall rotary dairy. This concept is widely used outside of primary production. Fast food chains are a classic example where the number of cash registers

in a store is governed by the capacity of the kitchen. If there are large numbers of people waiting on a regular basis, they don’t install an extra cash register, they build a whole new store across the road!

Benchmarking operations in the U. K. has played a critical role in quantifying the benefits that can come from working with optimum scale. Australian farmers should look to a similar process to identify the optimum scale for their own operations.

In terms of future business growth, we must be mindful of what the scale implications are of taking on additional land. The financial costs of expanding to 1.5 times a scalable unit can be great because you have 1.5 units of income but the full costs of running two units.

4. LEARN TO WORK WITH OTHER PEOPLE

The ability and preparedness to work with other people was a critical factor in improving the operational performance of many U. K. farming operations. Presently in Australia, the absence of a ready supply of rented land means the most common way to expand an operating business is by purchasing

additional land. This method of expansion requires large amounts of capital and limits the rate at which businesses can grow to their capacity to fund such expansion. Business expansion is important if we are to maintain our competitive advantage in scale. We can do this only by fully utilizing the ever increasing capacity of new machines and diluting the higher costs over a larger area.

The alternative for Australians is to learn to work with other farmers in joint ventures and collaborative arrangements thereby allowing operational businesses to achieve better scale without the need to fund capital intensive purchases of land. This is also likely to lead to greater productivity from total labour inputs across the industry.

Working with other people will require us to give up control over certain aspects of our operations and make us accountable for our actions. This will not be an easy transition to make for many farmers who over the years have become fiercely independent. However the reward for learning to work with others will be better scale and consequently better profits.

5. DON’T STOP BUYING FARM LAND

Australian farmers have benefited greatly from purchasing farmland over many decades. At worst, land has proved itself to be a very sound hedge against inflation in the long term.

The equity Australian farmers have in farmland has served as an important buffer against fluctuating profits and as a source of collateral to fund ongoing operations. Providing that additional land investments are affordable for the business, I believe farmers should continue to purchase land if and when suitable opportunities arise. However, following on with the concept of separating operational and real estate decisions, farmers shouldn’t assume that they are the ones best positioned to operate the additional land.

This particularly applies if the additional land would mean running an operating business that is no longer a scalable unit. The other major advantage with not being committed to operating all of the land purchased is that it opens up the possibility of buying property in other regions (including non-agricultural ones) which would deliver major diversification benefits. The success of real estate businesses like the NZ Rural Property Trust and Assiniboia Capital Corp in Saskatchewan has been largely driven by taking advantage of unique opportunities in their respective market places. Having a wider view that is not constrained by the need to operate the land directly would mean Australian farmers would be better positioned to take advantage of various opportunities as they arise.

6. CONSIDER THIRD PARTY INVESTMENT

The potential benefit of third party investment in agriculture to existing farm businesses would largely revolve around an increased opportunity to farm land that we do not own.

Some farmers have used third party investment to expand their operating businesses whilst others have used it to free up capital from within their existing area.

The performance of land as a long-term investment shows the potential for non-farming investors to benefit from a more diversified investment portfolio. Expectations within this group need to be managed in the light of long-term performance as opposed to some of the short-term spikes we have all witnessed in recent times.

Improving investment infrastructure will go a long way to facilitating external investment in agricultural assets. Two key issues here include establishing an industry benchmark (like the National Council of Real Estate Investment Fiduciaries farmland index in the U. S.) and developing standardized reporting procedures for individual projects. These two steps would allow investors to more accurately assess the performance of their investment in its own right and in comparison to other investments (both within and outside the agricultural world).

The other advantage of such investment is that it may lead to innovations allowing investments in farmland to be more liquid and affordable to a wider range of people.

Brendon Tierney and his family run a mixed farming operation east of Moora in Western Australia. Brendon’s Nuffield Scholarship was sponsored by the Kondinin Group, an information services group that publishes a monthly journal. Last harvest they did a thorough analysis on various wheat marketing options, which was a very valuable reference in our newly deregulated market. Their website is www.kondinin.com.au. As for the Nuffield Scholarship, it is a fantastic opportunity and I’d really encourage anyone who has the chance to apply. For more about the Canadian program, visit www.nuffield.ca.

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