Farming is a long-haul business. There is no “get-rich-quick” option. There are no guarantees and no fail-safe methods. I am a huge advocate for having a detailed business plan with full financials, following it and amending it as needed. However, there are always situations where you need to react and make a decision quickly. This is where having a set of calculation techniques to help you in your decision-making process is always a good tool to have. This post is about back-of-envelope math and how to build your skillset to do this math quickly for informed decisions.
Luck is when opportunity meets preparation.Seneca
Prepare in advance
It’s always good to be ahead of the game. Luck is just having made all of your preparations so that when an opportunity knocks you can react fast. A key component of this is to know your contribution margin for the products you sell. The contribution margin is defined as the amount of revenue leftover to cover fixed costs after covering variable costs. Knowing your profit margin is also very helpful, especially on a per-product basis.
It will always come back to the calculations. You’re welcome to use a spreadsheet but a pen, paper and a calculator work just as well. First, you will need some basic cost and revenue information. If you are working on a new venture involving crops, the following resources will be helpful:
- Ontario – Pub 60 – OMAFRA
- Saskatchewan – Crop Planning Guide
- Alberta – Cropping Alternatives
- British Columbia – Enterprise Cash Budgets
- Nova Scotia – Department of Agriculture
For livestock, it is more complex. Various provinces have enterprise cash budgets as do individual livestock organizations. Ontario’s Risk Management Program (RMP) is a decent starting point. The guide includes their estimation of the quantity of feed cattle require for finishing. If you’re curious, this is what they are using:
"For feedlot steers, the cost of feed is based on the average cost over 26 weeks to feed 1,802.4 pounds of corn silage, 3,715.4 pounds of corn, 964.9 pounds of distillers dried grain and 272.4 pounds of concentrate to take a steer from 900 to 1,500 pounds at 3.25 pounds of gain per day. For feedlot heifers, the cost of feed is based on the average cost over 26 weeks to feed 1,817 pounds of corn silage, 3,749 pounds of corn, 974 pounds of distillers dried grain, and 275 pounds of concentrate to take a heifer from 850 to 1,400 pounds at 3.01 pounds of gain per day."
To make your contribution margin calculations, you need the following:
- Total sales
- Total variable costs which are all costs other than mortgage interest, utilities, rent, property taxes (basically any cost you would have for your property whether you produce something or not)
- Divide by the number of production units (acres, animals sold, etc)
For the examples in the rest of this blog post, I will use the following information from Publication 60 and other OMAFRA data. Amounts include interest on operating loans but not land interest. I got the price for sales based on estimates from Grain Farmers of Ontario.
- Corn – Cost $646.05 per acre, $210 per tonne market price, with a yield of 160 bu/acre (4.064 tonnes)
- No-till RR Soybeans – costs $306.65 per acre, the revenue of $430 per tonne, the estimated yield of 45 bu/acre (1.224 tonnes)
- Winter (soft red) wheat – costs $367.30 per acre, the revenue of $260 per tonne, with a yield of 75bu/acre (2.041 tonnes)
The cost includes interest on operating loans but not on mortgage of the land or other fixed costs like property taxes. So the contribution margin on this sample of crops would look something like this:
- Corn – Revenue $853.44 less cost of $646 per acre = CM of $207 per acre
- Soybeans – Revenue $526 less cost of $307 = CM of $219 per acre
- Winter wheat – Revenue $530 less cost of $367 = CM of $163 per acre
Margins to Decisions
Now that we have the CM for your venture (by the way, if your CM is negative, take note of your cost per unit), it is time to see how this applies to back-of-the-envelope math.
For starters, you can use your margin per unit of production to evaluate new opportunities. Using the crop CMs from above and your own risk tolerance, we can work out what you might be comfortable with in terms of interest payments. Based on a lending interest rate of 3.5% and you not wanting to spend more than 30% of your margin on long-term interest, we can calculate the leveraged land cost that you might be okay with:
- Corn – 30% is $62.10 which at 3.5% interest works out to $1,774.28 of leveraged land cost.
- Soybeans – 30% is $65.70 and at 3.5% interest, your tolerated leveraged land cost would be $1,877.14
- Wheat – 30% would be $48.90 and a leveraged land cost of $1,397.14 using 3.5% interest
Unfortunately, there’s not a lot of areas where you can grow corn and only have a mortgage of roughly $1,775 per acre. You can adjust these values based on your risk tolerance. The general formula is contribution margin x percentage you can spend on long-term interest divided by the interest rate. Example, your corn CM per acre is $270, you can tolerate 50% and your interest rate is 3% (270 x 0.5 / 0.03) you’d get $4,500 per acre.
You can use this margin to calculate most purchases. For example, if you are building a barn for sheep and the monthly payment on the barn is $500, you can take your contribution margin per lamb and divide the payment to get how many extra lambs you need to sell each month. If your margin per lamb is $45, you’d need to sell an extra 133 lambs per year to make those payments. By using the contribution margin, you already factor in the additional production costs. Using revenue will give you distorted results, as if you get $180 per lamb, you’d only focus on producing 34 more lambs.
The same margins can be used to work out the break-even point for any venture you might be looking at. Break-even analysis is finding the point of production where all of your costs are covered by your sales. The basic formula for break-even is:
Revenue X Units = Variable Cost X Unit + Fixed Cost Or (Revenue-Variable Cost) X Unit = Fixed Cost Or Fixed Cost / (Revenue-Variable Cost) = Units
If you recall from above, revenue less variable cost is your contribution margin (CM). This means that if you divide your fixed costs by your CM, you will know how many units you need to produce to break-even. As an example, let’s use the corn information from above:
- The CM per acre is $207
- Your interest, cost of living, property taxes and utilities cost you $85,000 (fixed costs)
- You would need 410 acres producing 160 bushels per acre to break-even.
Since you are more likely to be constrained on your acres, you can use your contribution margin per bushel to figure out your break-even. Or if you know your yields and costs, you can work out what kind of selling price you need to break-even. When doing fast math, the last formula works the best.
There are some obvious flaws in using your contribution margin if the above example did not illustrate it. The contribution margin can change with yield and the selling price. Fixed costs can be significant. If your inputs depend on other commodities (like feed), it makes the contribution margin even more variable.
However, you can use it for fast math. It can be used to make a quick decision on whether or not you should investigate an option further. If you continuously keep your costs well-tracked, you can update your margin quickly as all you have to look up is the selling price. Situations you may want to use fast math:
- Estimating if you can afford the payments on a purchase
- Determining how much product you have to move to make a new investment worth it, or a farmer’s market stand fee
- Market prices worth taking advantage of, making a quick sale on the spot
Overall, I use variations of the above methods almost daily to figure out what purchases to make or which market opportunities to use. If the fast math does not pencil out nicely on the back of the envelope, it is often not worth looking into in further detail.