Margin compression – what does it mean for my business?
You are hearing more agricultural economists recently using the term margin compression. What the heck is margin compression? Margin compression is simply where input costs rise faster than the prices received from sales of the products sold leading to decreasing margins over time. This is a common phenomenon in most industries.
Figure 1 shows the milk prices and cost of production for Minnesota dairy farms from 1993 to 2011 with separate trend lines for each. Even though the cost of production and milk price varies greatly from year to year it is apparent that the costs of production and milk price trend lines are becoming closer over time. Over these 18 years, the cost of production has increased an average of 35.5 cents per cwt per year. During that same time frame, the milk price only increased an average of 24.3 cents per cwt per year. The margin compression over these 18 years is about $2.00 per cwt resulting in the current margin being about half of what it was in 1993. Because the average milk sold per cow has increased 4,800 pounds over the same time period, the margin per cow has not dropped as much as margin per cwt.
Figure 1. Prices Received and Cost of Production for Minnesota Dairy Farms1
The other clear trend in the graph is the increasing volatility of both costs and milk prices. The cost of production was fairly stable from 1993 to 2003. It varied from a low of $9.81 per cwt in 1994 to a high of $11.15 per cwt in 1996 with an average cost of production of $10.61 per cwt during those 11 years. This followed a three-year period from 2004 to 2006 where the costs were higher but fairly stable averaging $12.28 per cwt. However, since corn prices exploded higher in 2007, the average cost of production has soared over $3.00 per cwt to an average of $15.69. During those same years, the volatility of costs has increased with a range of over $3.00 per cwt over those 5 years.
Milk prices have been even more unpredictable than the cost of production. From 1993 to 2003 milk prices received varied by $3.29 per cwt and averaged $13.62 per cwt. However, from 2004 to 2011, the volatility of milk price has nearly doubled with a range of $6.61 per cwt. Milk prices have averaged $16.54 per cwt during those 8 years.
During those 18 years, family living expenses had doubled. Minnesota dairy producers have adapted to this margin compression by expanding and improving labor efficiency. The average number of cows on farms in the farm business management program has more than doubled. The number of pounds of milk sold per full time worker has also nearly doubled.
Margin compression is not unique to dairy producers or agriculture or even small main street businesses. Recently there has been much written in the business news about how Apple Corporation is struggling with profit margins because of competition from other tablet computer makers and smart phone producers. Financial analysts believe there will be continuing pressure on margins unless they develop some new innovative high margin product.
Below are a few ideas of how you might maintain your current standard of living with decreasing margins.
- Increase milk per cow and decrease expenses fast enough to compensate for margin compression. This might work if you are close to retirement, but likely is a futile effort if you are a young producer.
- Expand your herd to keep up with the decreasing margins.
- Diversify your operation. We are fortunate that many (most) Upper Midwest dairy producers’ whole farm profitability has been somewhat shielded from the rapidly increasing feed costs because they raise much of their own feed. Long term milk and feed prices will tend to move higher and lower together, but there is a lag time before this happens. This is a great advantage and helps minimize the volatility of input costs.
- Explore value added opportunities. Your skills may give you a competitive advantage in some area. These businesses could be related to your core business such as custom chopping or manure hauling. Others might include selling high value animals or on-farm processing. These can be profitable long term, but usually require substantial upfront investment and a very different set of skills than either cropping or livestock production. Some producers might even be able to expand into other areas such as agri-tourism.
- Strategically invest in technologies that will increase long term efficiency and provide your business with a competitive advantage.
It is important to recognize that over time the dairy industry, like most industries, suffer from margin compression. Strategies must be developed or your family’s standard of living will decrease over time.
1University of Minnesota Center for Farm Financial Management. Data from MnSCU Farm Business Management.