There are plenty of financial indicators of which dairy producers should keep close track. Milk prices, of course. Your income over feed cost is certainly important, and knowing your margins is a key to maintaining healthy liquidity. But if there’s one number that every dairy producer should know, it’s the cost it takes to produce 100 pounds of milk. Regardless of herd size or breed, knowing your farm’s cost of production could provide the answer to the crucial question: Is this the year I make an investment, or do I tighten the belt?
With milk prices changing from year to year, knowing your cost of production can help you determine your financial performance. Knowing your income over cost of production allows you to build working capital, reinvest in the business and grow your net worth. But if your income is below cost of production, you’ll need to dip into working capital reserves to meet expense and debt service obligations.
Determining your dairy’s cost of production is a vital piece of knowledge in today’s world, especially with all the volatility in the market – on both the revenue and expense sides. If you divide your profit-and-loss reports into percentages, you’ll see that most of your expenses can be broken down into four categories: feed, labor, custom expenses and variable expenses. The nice part about these expense categories is that you can get a firm control on three of them.
Feed on most dairies accounts for about 35 to 40 percent of the expenses. You can control much of these costs by working with your nutritionist to develop a budget to go along with the diet. Granted, these diets change based on forage quality, but it gives you a number to budget for when you contract dried distillers grains (DDGs) or protein, for example.
Labor typically falls between 12 to 15 percent of expenses, and that’s merely based on the size and complexity of your operation. Custom expenses can range from 5 to 20 percent depending on whether you pump your own manure or have it hired. The same conditions apply to whether you plant and harvest your own crops or have it hired to be done. Regardless, you can control custom expenses through planning.
The remaining variable expense can be the hardest to nail down from a budget perspective. You might have that unplanned engine overhaul or parlor repair that was not accounted for. The majority of these expenses shouldn’t have ample fluctuations, as they don’t make up high-dollar items compared with the other three expenses. Taking a three- to five-year average of the history of these expenses will usually provide the correct number you need to budget.
An ongoing process
Once you’ve calculated your cost of production, you’ll have a better view of your margins. Typically you’ll want to include your principal payments in the formula, which will help you assess how much cash you’ll have at the end of the year that will contribute to working capital or equity growth.
If your margins need a boost, review each of the major categories highlighted above to find ways to reduce costs while maintaining productivity. You can start with the biggest expenses, or focus on small changes across multiple expense categories, which can add up to more significant reductions in total costs. You can also benchmark your costs with similar dairy operations; your banker can provide some of this benchmark data.
Not knowing the cost of production for your dairy can be a risk in itself. You won’t know, for example, if your labor costs are too high or if your feed costs are too low. In the end, your cost of production is the figure that can help you strategize for market opportunities if you hedge your milk. On the other hand, if you’re not a hedger, this number will help determine what you should do with your current cash position. In either case, knowing your cost of production puts you in a position to make the best strategic decisions for your operation.
For more agriculture industry insights, visit the BMO Harris Bank website.
- Assistant Vice President, Agricultural Banking
- BMO Harris Bank
- Email Barry Doerfer