Don’t cut cost at the expense of profitability

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Efficiency is one of the most overused and misunderstood economic terms brandied about by farm management experts today. While efficiency is important, it is not the sole determinant of profitability.

Efficiency refers to production cost — often measured by the cost to produce a hundredweight of milk. Productivity pertains to a dairy farm’s success in generating output (milk) using a given stock of resources (assets). In order to be profitable, dairy producers must strike a balance between efficiency and productivity. Focusing on cost-cutting measures may improve efficiency; but it also can reduce productivity, thereby lowering profits. Similarly pushing for higher milk production and higher productivity can drive profits lower if the actions taken to gain the extra production raise your cost, thereby lowering your efficiency.

Track your progress
Dairy producers can use two financial measures to assess the productivity and efficiency of their dairy farm business. The turnover ratio reflects the farm’s productivity, and the operating profit margin reflects the efficiency of the operation.

The turnover ratio reflects the income a dairy generates from each dollar invested in assets. This ratio is computed using the following equation:

Turnover = Gross Income/ Total Assets

The higher the turnover ratio, the more successful a dairy is at producing milk with a given stock of assets. Thus, a firm’s turnover ratio rises as it increases productivity.

Operating profit margin ratio, meanwhile, measures the net return on assets (earnings before interest cost) per dollar of gross sales. This ratio is computed using the following equation:

Operating Profit Margin =   1/P [P-AC]

Where: P is the milk price and AC is the cost to produce 100 pounds of milk.

The profit margin rises as average cost declines. This relationship between profit margin and average cost is noteworthy because it means increased efficiency (lower average cost) results in higher profit margins.

However, a higher  profit margin does not guarantee higher overall profits for the business. The chart below shows two hypothetical dairy farms. Both have the same stock of assets, but differing levels of productivity and efficiency. Dairy Farm A has the higher turnover ratio, so it is the more productive of the two farms. Dairy Farm B has the higher operating profit margin ratio, making it more efficient than Dairy Farm A.

When you compare the profitability of the two farms, you’ll see that Dairy Farm B earns a rate of return on assets of 7.02 percent, while Dairy Farm A earns 7.2 percent.

Many are surprised that Dairy Farm A can generate a higher rate of return on assets, even though its average cost of producing milk is 12 cents per hundredweight higher than Dairy Farm B’s. The higher production cost for Dairy Farm A is offset by the farm’s higher level of productivity, which is reflected in its higher turnover ratio. Dairy Farm A produces 60 cents of milk per dollar of assets, while Dairy Farm B only produces 54 cents of milk per dollar of assets. Dairy Farm A’s greater productivity is the reason it can generate a higher rate of return on assets, even though the farm is somewhat less efficient than Dairy Farm B.

Understand the trade-off
This example clearly shows that dairy producers should not focus their attention solely on cutting cost in order to improve efficiency. The drive for greater efficiency can raise profits, but it also can have the opposite effect when cost cutting results in big declines in productivity.

Producers must be aware of the trade-off between productivity and efficiency as they consider cost-cutting measures.

Bruce Jones is a professor of agricultural economics and farm management specialist at the University of Wisconsin.

 

How efficiency, productivity affect profitability

 

 Dairy Farm A

 Dairy Farm B

Price of milk ($)

 12

 12

Cost of producing milk/cwt. ($)

 10.56

 10.44

Turnover ratio

0.60

0.54

Profit margin ratio

0.12

0.13

Return on assets (percent)

7.2 

7.02 



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Ali    
MALAYSIA  |  May, 16, 2012 at 10:38 PM

very fantastic


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