What are the drivers of profit in your dairy herd?
May 11, 2013
One of the most universal measures of business profitability is rate of return on assets (ROA). Return on assets is simply the return that a business gets on the assets invested in the business. The DuPont equation is a great way to examine return on assets because it is easy to evaluate the drivers of profitability within the business.
In the DuPont equation, return on assets is simply asset turnover ratio (ATO) multiplied by operating profit margin (OPM). Operating profit margin is a measure of operating efficiency. It indicates the average operating margin per dollar of farm revenue. This is the amount left for debt payment, capital purchases, and family living. Asset turnover ratio is gross farm income divided by average total farm assets.
Let's look at a simple example. If a farm has a total of $1,000,000 of assets and a gross income of $400,000, the asset turnover is 40% (400,000 / 1,000,000). If the costs required to generate this income is $300,000, the operating profit margin is 25% (300,000 / 400,000). The return on assets in this example is 10% (25% x 40%). Table 1 shows these average numbers for Minnesota dairy farms over the past five years. The average profit margin was 16% and the turnover rate averaged almost 37%. Overall, more profitable farms have higher operating profit margins and improved asset turnover.
This equation shows that drivers of profitability are how well the business uses assets and input cost to generate gross revenue. Operating profit margin is a measure of operational efficiency or how many cents are needed to generate a dollar of income. Asset turnover ratio is a measure of efficient asset use or how well the farm is able to generate income with the business's assets.
If a farm's operating profit margin is the cause of low profitability, look at costs and income. The three biggest costs on most dairies are feed, replacement costs and labor. Is milk income per cow low compared to other farms? If the reason for low return on assets is a low operating profit margin, focus on better cost control and improved revenue.
If asset turnover is the cause of low profitability, examine income and use of assets. Look for unused or underutilized assets. Will these assets be better used in the future or can they be sold? Many dairy producers have under-utilized equipment because of limited hours for fieldwork between chores. Could equipment be shared with or leased to another farmer? Can some field work be custom hired? Often forage quality is better if this is custom harvested. Are facilities being fully utilized?
Think about new investments carefully. Will new investments improve future earning potential? Does the new investment fit the long term goal of the farm? It is tempting to make quick investment decisions around tax planning time with the goal of minimizing taxes. It is better to anticipate good years and invest in assets anticipated to have a high return, such as better transition cow facilities or improved cow comfort.
In general, farms with a limited land base that only own cows tend to have lower operating profit margins, but higher asset turnover ratios. Dairy farms with large land bases tend to have lower asset turnover ratios, but higher operating profit margins. However, farms that control less land and purchase feed are at a higher risk of widely fluctuating feed prices.
Understanding the DuPont equation can be valuable in helping farm managers drill down and understand the factors that are driving farm profitability. Benchmarking your farm with other similar farms will help you determine your strengths and opportunities. If your profitability, asset turnover and operating profit margin are high – keep up the good work. If some of the areas could use improvement, work with your advisors and others to develop a strategy to improve farm profitability.
|Item||Average||Low 20%2||20-40%||40-60%||60-80%||High 20%|
|Return on assets||5.9%||-4.1%||2.6%||5.5%||8.5%||13.1%|
|Operating profit margin||16.0%||-15.1%||7.7%||15.1%||22.3%||29.8%|
|Asset turnover rate||36.7%||27.3%||33.8%||36.7%||38.2%||44.0%|
|1FINBIN – Data from MNSCU Farm Business Management for herds from 51 to 200 cows – cost basis.|