CHAPTER 5: RANCH MANAGEMENT TOPICS
In order to effectively manage a ranch business we must first conceptualize it in a way that facilitates our understanding of it. Various methods for doing this have been employed over the years; however, most have been either a poor fit for the livestock business or are too impractical for use on the typical ranch.
One method for modeling ranch businesses and the method Ranch Vision employs is called enterprise analysis. This concept was first developed by an agricultural economist at Cambridge University named David Wallace and is rapidly gaining acceptance worldwide.
Enterprise analysis is a process by which a business is broken down into one or more profit generating centers called enterprises. An enterprise could be defined as any business undertaking which has a potential return and can be separated, at least partially, from other business undertakings. If we were to look at a typical grazing livestock ranch in this manner, we might see that it could be broken down into numerous different enterprises. Some would involve grazing livestock while others might involve non-grazing livestock, crops, services, etc...
Each enterprise is analyzed separately to identify its contribution to overall ranch profit. This requires the distinction of all ranch costs as either fixed (overhead) or variable (direct). Overhead costs are those costs that remain relatively constant regardless of what or how much is produced. Overhead costs are not assigned to any particular enterprise but are considered separately as expenses which must be covered by the ranch business as a whole. They would generally include such things as rent, fuel, utilities, wages, repairs, depreciation, insurance, professional fees, etc... The following illustration shows overhead costs as a function of production level.
Direct costs are costs that vary in proportion to production. As the volume of production increases, direct costs increase; as production decreases, direct costs decrease. Examples of direct costs for livestock enterprises would be feed, medicine, veterinary services, consignment fees, freight, interest on capital invested in livestock, etc... During enterprise analysis we identify the direct costs associated with each enterprise. The following illustration shows direct costs as a function of production level.
At the same time we determine the gross product or the total value of what is produced by each enterprise. The following illustration shows the gross product as a function of production level.
For each enterprise, the gross product minus the direct costs is called the gross margin.
Gross Product - Direct Costs = Gross Margin If for a business we sum the gross margins for the various enterprises and subtract the overhead costs from the total , we are left with profit.
We see that by doing an enterprise analysis we can appreciate the contribution each enterprise makes to profit. This process facilitates making profitable management decisions
Enterprises on a livestock ranch might include various grazing livestock enterprises such as cow-calf, stocker cattle, ewe-lamb, feeder lamb, doe-kid and feeder kid enterprises as well as various non-grazing livestock enterprises such as feedlotting, boarding, poultry, swine, etc... In addition there may be farming enterprises such as haying, crops, fruit trees, etc... as well as service enterprises such as a hunting club, "dude ranch", custom harvesting, etc... Each enterprise has a gross margin and, therefore, a specific impact on ranch profit..
The idea of opportunity costs is one of the central insights of economics. It is the concept that in order to get more of something we must necessarily accept less of something else. You cannot "eat your cake and have it too." Every time you are forced to make a choice, you are incurring opportunity costs. These costs are measured in terms of foregone alternatives. The opportunity cost of using something in a particular way is the benefit foregone by not using it in its best alternative use.
There are opportunity costs associated with all things used in production. The opportunity cost of raw materials purchased for use in production is their purchase price. The opportunity cost for hired factors of production is their rental price (or wages). The opportunity cost of using capital assets is their depreciation. The opportunity cost of money invested is the return that money could have produced in the best alternative investment.
Some of these costs we readily recognize, but others are less apparent and are often overlooked. When you use your own ranch for grazing your livestock, the opportunity cost is the rent you could have received by allowing your neighbor to graze the ranch. When you or your family or friends work on the ranch without compensation, the opportunity cost is the amount you would have been paid if your work had been done in the market place. When you invest your money in livestock, the opportunity cost is the return that money could have produced if invested elsewhere. These very real costs are often ignored; however, it is important to consider them.
Therefore, Ranch Vision greatly facilitates determining these costs and includes them, where applicable, in the gross margin analyses in the Gross Margins reports as well as the profit and loss analyses in the Profit and Loss report.
One of the great constants in the livestock business is change. There will be change. In the past there was not a lot a rancher could do but react. It was very difficult and time consuming to do the careful analysis required to see the affects of change on all the different parameters of the ranch business. Left with few options, he was, to a large degree, at the mercy of the waves in the tide of market forces.
Fortunately this is no longer the case. Ranch Vision gives you the capability to foresee the affects of changes in the market forces that define the environment of your ranch business. Ranch Vision allows you to see the potential results on all aspects of your ranch business of changes in market prices, inflation, interest rates, grazing costs, etc... before they ever take place. By simply making an entry, you will instantaneously see how such changes will affect your sales, purchases, gross margins, cash flow, profit and loss, balance sheet etc...
Given the capability to anticipate the affects of these changes, you can develop strategies to take advantage and even profit by them. This is exceedingly important because as a livestock producer you are, in reality, a competitor in a very large game. If you see things before others, you can profit from your knowledge. If they see things before you, their profit comes at your expense. We see that Proverbs 29:18 also applies to the livestock industry, "Without vision the people shall perish."
The National Research Council (NRC) has done extensive work determining the caloric requirements of animals in different physiologic states (maintenance, pregnancy, lactation, growth, etc...) under different environmental conditions and various levels of weight gain, etc... Ranch Vision uses this information to calculate the amount of grass energy needed to meet the needs of the animals on the ranch.
Ranch Vision uses the Grazing Unit Month (GUM) as the unit of measure for grass energy. The GUM is the amount of forage required to provide 10 megacalories (Mcal) of net energy per day for one twelfth of the year. This is approximately equivalent to the energy requirements for one month of a 1000 lbs. (450 kg) dry cow in late pregnancy.
Once we have completed a gross margin analysis for each enterprise (see Enterprise Analysis, page 196), it is helpful to compare them to one another to see which gives the more efficient return. In order to do this we must establish a method of comparison. This is done by dividing the gross margin for each enterprise by some common resource utilized in production. In keeping with this idea agricultural economists have created such ratios as gross margin per acre, cow, ewe, doe, etc...
However, there are problems with each of these ratios. The standard must be consistent, and it must be common to all enterprises under comparison. We see that an acre of land is unacceptable because no two acres are alike. An acre of irrigated pasture is vastly different than an acre of arid range land. Unless the characteristics of the land used by the different enterprises are identical, any comparisons based on an area of land will be misleading. In the same way, all cows, ewes or does are not alike but they vary in size, genetics, physiologic state, etc... How would one compare a cow-calf enterprise composed of 1100 lbs. lactating cows plus bulls and calves to a stocker enterprise composed of 400 lbs. steers? A greater problem, however, when using an animal as the standard is how to compare enterprises composed of different types of animals. How does one compare cattle enterprises to sheep enterprises to goat enterprises? There are rough rules of thumb but they do not provide the accuracy required to make confident enterprise comparisons and financial decisions.
When we look closer at a grazing livestock ranch we see that, in fact, it is a business that takes forage and converts it into a marketable commodity such as beef, lamb, wool, chevon or mohair. We see that grass is the most basic resource available to the ranch, and in order to be maximally profitable that ranch must take grass and convert it into something that it can sell as efficiently and economically as possible. It becomes apparent that an ideal resource for enterprise comparison is grass.
The next question becomes how to measure grass? The best measure should be useful for forages of different types and be based on a nutrient that the animals require from the forage. One such measure would be energy (see Grazing Requirements). Energy is the primary nutrient determining an animal's feed intake. The more energy available from a forage, the less forage required by the animals consuming it. Because of this we see that the energy contained within forage would be an ideal measure for us to use when doing comparisons of grazing livestock enterprises.
In light of this, Ranch Vision uses the ratio Gross Margin per Grazing Unit Month (GUM) when comparing grazing enterprises. It answers the question, "How efficiently will an enterprise convert grass into gross margin?"
Accounting involves the collection, summarization and reporting of financial information. However, there are various acceptable methods for doing this. Each method has certain strengths and weaknesses. The two basic forms of accounting are cash accounting and accrual accounting.
Cash accounting is generally easier to perform and is the type of accounting most commonly performed on farms and ranches. This method simply records costs and incomes when cash changes hands. Events occurring within the business that do not result in an immediate exchange of cash are not recorded until they do so.
The drawbacks to cash accounting is that a great deal may take place within the business that does not result in the immediate exchange of cash, and these things will be hidden from scrutiny by the businessman. For example, all of the livestock on a ranch might die, and yet using cash accounting no indication of it would appear on the financial statements. Also, a ranch might start the year with 100 cows and at the end of the year have 100 cows plus 90 calves yet this too would not be reflected in the financial statements. Conversely, some events will result in an exchange of cash while their non-cash impact will be hidden. For example, a rancher selling all of his livestock would show a great increase in revenue when using cash accounting. However, there would be no consideration given to the fact that he no longer has any livestock. Also, a rancher buying livestock would show a great expense but the increase in the size of his herd would not be reflected.
These deficiencies are greatly reduced through the use of accrual accounting. Accrual accounting is based on the premise that the effects of transactions and other financial events should be given recognition at the time they have their primary economic impact, and not necessarily when cash is received or disbursed. With the previous examples, these events would now be reflected in changes in the values of the livestock inventories and would, thus, have a direct impact on profit. The best reason for a rancher to use accrual accounting practices is that it better indicates what is happening to the ranch business. He will, therefore, have better information when making decisions, and more likely be able to increase profit. However, accrual accounting is generally more tedious and requires the maintenance of inventories and valuations.
Ranch Vision automatically determines the inventory valuations and uses accrual accounting methods when determining gross margins in the Gross Margins reports as well as profit in the Profit and Loss report.
Profit is often loosely interpreted in every day usage. For the purposes of Ranch Vision we will use the much more concise definition of economic profits. Economic profits are defined as the value of what is produced minus the opportunity cost of the resources used to produce it. "Negative profits" are called losses.
This definition of profit is different from what an accountant would report as well as from what would be reported on your standard income tax form. However, it is a much more meaningful definition from the standpoint of a rancher trying to maximize his profit within his business situation.
Generally accountants do not include as costs all opportunity costs such as use of the owner's own labor and capital, and thus these items are recorded as profits. When an accountant says that you need profits of a certain amount to stay in business, he is making sense within his definition. Within his definition you need "profits" large enough to pay for those factors of production that are used but the accounting profession does not include as costs.
An economist would express the same idea by saying that you need to cover all your costs, including those not covered by the accounting profession. If you are covering all your costs, in the sense that we have defined costs, then you could do no better by using the resources in any other way. In fact, you would probably do worse to use them in any other way. Therefore, in the context of economic profit, zero profit is satisfactory. This is how profit is defined when found in the Profit and Loss report. Therefore, don't be disturbed to find very low, zero or even negative profits (losses) reported here. But do look for ways to increase them. Net Ranch Income, as found in the Financial Measures report, would be a representation of the more common usage of profit as the accounting profession uses the term under accrual accounting principles. While net cash flow, as found in the Cash Flow report, is similar to the usage of profit as the accounting profession uses the term under cash accounting principles.
A cash flow analysis is an indispensable part of any business evaluation. This critical step in ranch planning is often overlooked. A venture may be profitable, but if the cash resources are not there when necessary, it will fail. The two important aspects of cash flow are "when" and "how much." We need to know when cash is coming in or going out and how much of it will do so.
Ranch Vision provides both monthly and annual cash flow projections. The cash outflow for livestock purchases for the twelve months following the inventory date is given in Purchases Outflow. The cash inflow from livestock sales for the twelve months following the inventory date is given in Sales Inflow. Annual cash inflow, cash outflow and net cash flow for the five years following the inventory date are given in the menu item Cash Flow. All of these reports are found in the Current Plan menu.
A balance sheet tells you your present financial position. It is composed of assets which are things you have and liabilities which are things you owe. The difference between assets and liabilities is known as equity or net worth. Looked at another way, net worth is how much you have contributed to what you have.
Ranch Vision produces a balance sheet with a detailed description of assets and liabilities for your ranch. This is found in the menu item Balance Sheet in the Current Plan menu.
Financial measures provide information about the health and vitality of a business just as a physical examination does for the body. Each measure is slightly different and gives a different insight into the business. Some financial measures help to assess the profitability of the business, while others help to assess the efficiency, liquidity or solvency of the business, etc...
In addition to a balance sheet, income statements, cash flow statements and other reports previously mentioned as well as some not mentioned, Ranch Vision produces fourteen different financial measures recommended by the Farm Financial Standards Task Force which is composed of representatives from the Farm Credit System, American Bankers Association, cooperative Extension Service, as well as lenders and accountants. Together this information gives you and your banker tremendous insight into the financial health of your ranch business for the present and into the foreseeable future.
These measures as well as others can be found in the menu item Financial Measures in the Current Plan menu.
A pivotal question for every livestock producer with a breeding enterprise is whether to raise his own breeding replacements or buy them elsewhere. The cost to raise a breeding replacement is extremely important information for a livestock producer. A large percentage of a his costs are involved in producing that next generation of breeding females. After these females begin producing offspring, it generally takes several years of production before the producer recoups his initial costs. Many of these costs are hidden and, therefore, difficult to appreciate. Some of these would include the opportunity cost of not selling that female animal at weaning, the opportunity cost of the investment in that animal, grazing costs, the costs involved in maintaining a breeding male, losses incurred from death, infertility, poor performance and culling as well as other cash and non-cash direct costs such as feeding, veterinary services and supplies, etc... These costs are usually partially offset by sales that result from the process of producing these replacement females. These sales could come from culled breeding females and wool or mohair in the case of sheep or goats respectively. All of these factors need to be considered in order to determine what it actually costs to produce that breeding replacement.
Ranch Vision takes all of these things and more into consideration for your operation and calculates this cost before the price is ever paid. The replacement costs are presented in the menu item Replacement Costs in the Current Plan menu.
A break-even analysis is an extremely useful process for a livestock producer to undertake. It provides him with information which will facilitate making profitable management choices. A break-even analysis simply determines the point at which an enterprise will neither make money nor lose money. This is where the enterprise will "break-even."
A break-even analysis may be done for the purchase price of livestock entering an enterprise or the sales price or sales weight of livestock exiting an enterprise. For example a break-even analysis regarding the purchase price for a stocker enterprise identifies the purchase price for those cattle above which the enterprise will be losing money and below which it will be making money. A break-even analysis regarding the sales price for a feeder lamb enterprise identifies the sales price for those sheep above which the enterprise will be making money and below which it will be losing money.
A break-even analysis regarding the sales weight for a feeder kid enterprise identifies the sales weight for those goats above which the enterprise will be making money and below which it will be losing money. A proper break-even analysis must take into consideration sales and purchase weights and prices as well as the opportunity cost of the investment in that animal, grazing costs, expected death losses as well as other cash and non-cash direct costs such as feeding, veterinary services and supplies, etc...
Ranch Vision takes all of these things and more into consideration for your operation and calculates these break-even values before you ever enter into a venture. These values can be found in the menu item Break-Even Values in the Current Plan menu.
When using accrual based accounting practices the cost of a capital asset is recognized incrementally over a period of time rather than all at once when it is purchased. This is done in acknowledgment of the asset's declining value over time due to physical wear and tear and obsolescence. This is the concept of depreciation. Accountants use various methods of calculating depreciation.
One of the simplest and most common is known as the straight-line method. The straight-line depreciation method is calculated by subtracting the salvage value of an item from its purchase price and dividing the result by the assets expected useful life in years. The result is the depreciation for the asset for each year of its useful life.
This is the method Ranch Vision uses when calculating depreciation on future capital purchases.
