Farming has lots of sayings about “go big or get out.” Growth in agriculture is usually measured in more acres, more livestock and frequently bigger debt. Before growth, you should worry about profitability and management. The benefits of economies of scale are much smaller than many farmers realize. There is a sweet spot for farm size as bigger farms don’t always mean better farms.
There is definitely some scale required to make a living at farming. In some situations, like milking dairy cows, the milk truck will not show up if you don’t meet minimum volume requirements. You can not, however, grow your way to profitability. The three big enemies of any farm are labour, debt and inability to manage the agronomy. The key focus should always be on growing the margin and improving profitability over direct growth.
Sometimes a farm with fewer acres and a smaller herd with less debit will be more sustainable than a larger farm. If you’re not profitable at 500 acres, the odds are that you will not be profitable at 1,000 acres. To expand, you need to be the best manager possible of those first 100 acres before you can even consider adding more acres.
Sales to Assets
There is an interesting difference between asset prices and sales. Higher assets would imply a bigger farm. Looking at the 2016 Census of Agriculture results, 20% of farms have over $3,500,000 in farm capital and 22% have less than $500,000 invested. In total, 54% of farms have more than $1 million in farm capital. The three components of farm capital are land and buildings, livestock and poultry, and farm machinery and equipment.
The same data set showed that approximately 7% of Canadian farms have sales over $1 million, and a further 56% of farms have sales under $100,000. In fact, 18% of farms have less than $10,000 in annual gross farm receipts.
Let’s convert this into numbers for farm growth, to get $100,000 in sales, you would need:
- Sheep: Sell 500 lambs if prices are $200 a lamb
- Goat Milk: 94,339 litres of goat milk at $1.06/L which means you need to milk at least 105 goats at 2.5L daily.
- Cow milk: 149,253 litres of cow milk at $0.67 per litre which means you need need to milk at least 13 cows with 30L each daily.
- Finished hogs: 670 hogs if the price is $150/hog
- Goats: 572 goats if you get $175/goat
- Corn: 500 tonnes of corn if the price is $200/tonne which requires 125 acres (more crop yields here)
If you look up the mortgage payment on a $1 million farm, you’d find it to be around $4,208.16 monthly (20% down, 4% interest over 25 years) which is $50,497 in payments. You would need a lot more than $100,000 to make that kind of payment from both cash outflow and interest expense.
If you are considering expanding, you should always consider the return on investment which is your net income over average operating assets. For example, if you are looking to add another 50 acres to your farm and land in your area averages $5,000 per acre, the operating value of those assets is $250,000. If you want an ROI of 5% (acceptable for agriculture), that parcel needs to boost your net income by $12,500.
More sales, lower margins
A study by the Farm Management Council shows that since 2000 almost 30% of Canadian farms have had profit margins over 20% each year. The top margin category includes farms of all sizes. The same study found that roughly 30% of farms lose large amounts of money each year, with profit margins of minus 10% or worse. This means that roughly 70% of farms in Canada are profitable, most years.
The Census of Agriculture also calculates an operating expense-to-receipts ratio for farms. The data is available by sector but the average in both 2011 and 2015 (the most recent years available) was 0.83. This means that the gross margin was 17% on average for Canadian farms before interest and amortization (1 less 0.83 equals 0.17). In short, the ratio means that for every dollar earned, the farm spent $0.83 in expenses. Where it gets interesting is looking at this expense-to-receipts ratio (2015) by sales:
- $1 to $9,999 had a ratio of 2.09
- $10,000 to $24,999 had a ratio of 1.20
- $25,000 to $49,999 had a ratio of 0.95
- $50,000 to $99,999 had a ratio of 0.85
- $100,000 to $249,999 had a ratio of 0.81
- $250,000 to $499,999 had a ratio of 0.79
- $500,000 to $999,999 had a ratio of 0.79
- $1,000,000 to $2,999,999 had a ratio of 0.80
- $3,000,000 or more had a ratio of 0.87
The sweet spot for sales and corresponding farm size appears to be $250,000 to $1 million in sales. This makes sense as a 0.83 ratio would translate to $42,500 in income for the average farm with $250,000 in sales. Farms in that size range are likely family farms with few if any employees and that kind of income can make farming full-time a definite possibility.
Keeping in mind that interest and amortization expenses are not included in the ratio, average profitability starts around $50,000 in sales. However, when you get to $3 million-plus in sales, the ratio increased beyond that of small farms. These larger farms typically require more employees and more debt to produce enough products to generate $3 million worth of sales.
I could not find any data sets that combined profitability, invested capital and sales but you can glean some facts, there are definitely farm out there that have invested more than $1 million dollars in farm capital and are not grossing more than $100,000 in sales. Taking into account the average expense ratio at that sales level, there are farms with investments over $1 million dollars making less than $15,000.
Economies of scale do exist but even agriculture is not infallible to the curve as seen earlier where the ratio of expense-to-receipts increased for larger farms. Economies of scale are the cost advantages that farms obtain due to size, production, or scale of operation, with cost per unit of production generally decreasing with increasing scale as fixed costs are spread out over more units of production. Where this fails is often the fixed costs (including interest) increase as the production increases.
It’s not uncommon for farms to grow in an attempt to chase profit. Farms grow in bad times with their yields to try and get more from tighter margins. If margins get better and times are good, they grow again to earn more profit. This approach is so pervasive in agriculture, it even has a name, Cochrane’s Treadmill. To have sustainable growth, it is important to not get on the treadmill and focus on tangible actions that improve overall profitability instead.
The most profitable farms are those that are mid-size, with enough production to sustain a full-time career farming for the operator. On average these farms don’t carry as much debt as big farms. They also don’t have all the expenses and management associated with a big staff and big payroll.
If you are growing your farm operation as justification for your latest financing deal, it is time to re-evaluate your plans. The expansion needs to generate enough additional revenue to meet your farm’s ROI targets as well as improving or keeping your existing margins. Make sure your decisions to grow are sustainable over the long run and not climbing on the treadmill.