Margin Compaction: Where Do You Stand?
Farm Business Management Update, August 2002
By David M. Kohl and Alicia M. Morris
Now that the Farm Bill has passed and the smoke has cleared, American producers need their income to determine where they stand. One of the key ratios to examine the margins in agriculture is the operating revenue expense ratio. This measure is one of the 16 key ratios the Farm Financial Standards Council developed to track the financial health of a specific business and benchmark industry segments.
How to Calculate
This ratio is calculated by summing total farm expenses and deducting interest and depreciation. This subtotal is then divided into total farm revenues. For example, if a producer had total expenses for the farm business, excluding interest and depreciation of $400,000, and revenue of $500,000, the ratio would be 80 percent. In layperson's terms, it costs this producer 80 cents to generate a dollar's worth of revenue, excluding interest and depreciation.
How Do You Stack Up?
The Minnesota West Community and Technical College compiles benchmark data on over 2,000 farm and ranch businesses that are representative of other operations nationwide. The average producer ratio has been 74 percent for the last seven years, which translates into 26 cents out of each $1 of revenue remaining to meet debt service (principal and interest), family living, new investments, and retirements.
The top 20 percent of producers averaged 68 percent over a similar time span. These producers demonstrate that efficiencies in cost control and production and marketing management, provide a higher bottom line.
In contrast to the top 20 percent, the results show that the bottom fifth of producers have averaged 88 cents to produce a dollar's worth of income over the time period. They only have 12 cents for debt service, living withdrawals, retirements, and new investments. Most likely these producers either relied on non-farm revenues, minimal living expenditures, or debt or survival strategies.
Compared to the bottom fifth of producers, the average producers have 14 percent more margin, and the top fifth of producers have a 20 percent higher margin, indicating the importance of maintaining business efficiency to combat margin compaction.
The most disturbing part of this research is observing the margin squeezes occurring across all management levels in the agricultural economy.
For example, in the 1995-96 era, the top 20 percent of producers averaged 64 percent. Fast-forwarding to 2001 finds the same group with an average ratio of 75 percent or 11 percent less margin.
A similar trend was observed with the average and bottom 20 percent of producers. For example, the average producer's ratio was 69 percent in the earlier era and is now 80 percent. The bottom ratio of the 20 percent of producers has increased from 86 percent in 1995-96 to 95 percent in 2001.
The implications to Virginia agriculture based upon this data are obvious. More agricultural businesses will operate for a lifestyle with dependence on non-farm income. The main source of net income will come from the off-farm employment or business. The secondary income, or losses, will result from the farm business. The business model strategy will be to make some net income in the good years but will only minimize losses when less than favorable economic, weather, and market conditions occur.
For the 4,000 to 5,000 commercial producers in Virginia, the following business strategy will be necessary. First, economies of scale and low overhead cost will be a requirement, not an option. Second, debt levels will have to be in ranges reasonable for the industry. For grain, crop, cow/calf, fruit and vegetable, and tobacco producers, percent equities will have to be above 60 percent. Dairy, horticulture, feedlots, poultry, and value-added businesses could lower this ratio by 20 percent with the proper management skills and modest financial lifestyles.
The traditional shoot-from-the-hip emotional decision-making producer must progress by developing a sound marketing and management plan, which will be necessary in the globally competitive, volatile marketplace of the future.
Margin squeeze or compaction is a fact of life for agriculture and any Main Street business. The Farm Bill may provide temporary relief. However, a plan including procedures to analyze the bottom line and benchmark with similar businesses will be necessary for businesses of all sizes as they carry out 21st Century business strategies.
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