Case study – Mixed farm business in medium-high rainfall region in WA
What is the largest driver of profit - price, production or costs?
To help answer this question we use a case study as an example being a 2500ha mixed farm business operating in the medium/high rainfall area of south west WA to demonstrate how changes in price, production and costs impact profit. Our case study business is a 50/50 crop/sheep enterprise mix. The sheep enterprise is running merino ewes crossed with a terminal sire and 100% lambs are being turned-off (sold). The crop enterprise’s average wheat yield is 2.8t/ha. The assumptions on revenue and costs underpinning our case study analysis are summarised in Appendix A.
Management decisions that deliver small favourable changes in price, production and costs can significantly improve profit. If the case study farm business was able to adopt management changes that achieved a 1% increase in price, a 1% increase in production and a 1% decline in costs (excluding finance) the business’ profit would increase by over 10%. Put another way, a 10% improvement across all three variables would double the farm’s before tax profit. If your business currently generates a before tax profit of less than $191/ha the percentage impact on profit of 1% changes across these variables would be even higher.
| Mixed farm 50/50 crop/sheep | Profit before tax and drawings $/ha | % impact on profit |
|---|---|---|
| Base case* | 191 | - |
| 1% increase in price (grain, wool and lamb) | 198 | 3.9% |
| 1% increase in production ( wool cut, marking rate and grain yield) | 197 | 3.5% |
| 1% decrease in operating costs | 196 | 2.4% |
| 1% decrease in capital allowance costs (machinery and livestock) | 192 | 0.6% |
| combination 1% everything (revenue and production up 1%, operating costs and capital allowance down 1%) | 211 | 10.4% |
| Impact of finance: | - | - |
| Interest rates rise 1% (from 6.5% to 7.5% @ 79% equity) | 181 | -5.3% |
*See Appendix A for cost and revenue assumptions underpinning the base case pre-tax profit.
We found similar results for a cropping only business operating in the region with price being the largest profit driver.
Stocking sheep at optimal levels for your region is recommended as long as there are tactical plans in place to modify labour, feed rations and stock numbers to accommodate changes in the seasonal conditions. Strategic plans around stocking rates that flex with the season will increase profit. Increasing stocking rates to optimal levels will have an additional labour cost or management requirement which needs to be considered and costed in. Be aware of ‘management stretch’ of trying to do too much yourself and ensure other business enterprises are not adversely impacted.
We have assumed the sheep enterprise is running at an optimal stocking rate for the medium-high rainfall area at nine Dry Sheep Equivalent/Winter Grazed hectare (DSE/WGha). If your sheep enterprise is stocked at lower than optimal rates a lift in stocking rate may be a key driver of profit. If stocking rate was sub-optimal in our case study, say 10% lower at 8.1DSE/ha, pre-tax profit would fall by approximately the same percentage (9.6%), assuming supplementary feed costs do not change. If however, feed costs fell by 10% due to the 10% lower stocking rate net profit would fall by 7.6%. Therefore it is still more profitable to stock sheep at optimal levels.
Price
Investing time in managing price risk, both upside and downside, is essential to maximising profit. In our case study price had the largest impact on profit, marginally ahead of production volume and costs. In the case study, every 1% increase in price lifted profit by 3.9%. Note that if your farm business profit/ha is lower than our case study farm business then changes in price are likely to have a larger percentage impact on your profit.
| Commodity | Wool | Lamb | Grain | Combined |
|---|---|---|---|---|
| Price - base case | $11.50/kg clean | $4/kg | Wheat $300/t FIS | - |
| Profit before tax - base case* | 191 | 191 | 191 | 191 |
| Profit before tax - after 1% price increase | 192 | 193 | 195 | 198 |
| % change in profit before tax | 0.5% | 1.3% | 2.1% | 3.9% |
*See Appendix A for cost and revenue assumptions underpinning the base case pre-tax profit.
In general, for our 50/50 mixed farm case study business operating in the current market, changes in grain prices had a similar impact on profit as changes in sheep (lamb and wool combined) prices. For the mixed farm business in our case study, a 1% increase in grain prices led to a 2.1% increase profit while a 1% change in lamb and wool prices had 1.3% and 0.5% impact on profit respectively (1.8% combined impact).
Production
In our case study a 1% increase in the volume of grain, wool and lambs in the mixed enterprise results in a 3.5% increase in profit, assuming neither further increases in costs nor decline in quality.
| Variable | Wool cut | Lambs marked | Wheat yield | Combined |
|---|---|---|---|---|
| Production - base case | 5kg/hd | 90% | 2.8t/ha | - |
| Profit before tax - base case* | 191 | 191 | 191 | 191 |
| Profit before tax - after 1% price increase | 192 | 193 | 194 | 198 |
| % change in profit before tax | 0.5% | 1.2% | 1.9% | 3.5% |
*See Appendix A for cost and revenue assumptions underpinning the base case pre-tax profit.
Changes in grain yield had a slightly larger impact on farm profit than the same percentage changes in marking rate or wool cut per ewe in our mixed farm business case study. We found that a 1% increase in grain yield increased profit by 1.9% whilst a 1% increase in production in the sheep enterprise, being lamb marking rates and wool cut, had a 1.7% increase in profit. When breaking down the sheep enterprise further we found that changes in marking rate (from 90%) had double the impact on profit as similar percentage changes in kilograms of wool cut (from 5kg/head).
Note that if your pre-tax profit is lower than that of our case study of $191/ha the profit impact of increasing production volumes, in percentage terms, will be higher.
Costs
In our farm business case study a 1% reduction in all costs (including finance) led to a 3.3% increase in profit. Costs that have the biggest impact on profit, and where managers need to apply rigorous discipline, are cropping input costs, capital replacement allowance (machinery and livestock replacement) and finance costs.
A breakdown of the profit impact of a 1% reduction in each cost item for our case study farm business is summarised in the table below. Please note the assumptions behind the costs are summarised in Appendix A.
| Medium-high rainfall 50/50 crop/sheep enterprise | Base case $/ha | Pre-tax profit impact of 1% reduction in costs |
|---|---|---|
| Total revenue | 821 | 821 |
| Fixed operating costs 1 | 67 | 0.3% |
| Variable operating costs 2 | 285 | 1.5% |
| Post farm gate selling costs 3 | 102 | 0.5% |
| Capital replacement allowance 4 | 110 | 0.6% |
| Finance costs 5 | 67 | 0.3% |
| Total costs | 631 | 3.3% |
| Net profit before tax | 191 | 197 |
- Fixed operating costs include administration, insurance, rates, water and one full time equivalent employee (manager’s allowance $70 000).
- Variable operating costs include crop and pasture inputs, shearing, crutching, mulesing contractors, feed and animal health costs.
- Post farm gate costs include freight/cartage, receival charges, commissions and levies.
- Capital replacement allowance is calculated at 12.5% equipment value (replaced every eight years) and 20% ewe flock value (we assume 100% lamb turn off and ewes kept for five years).
- Finance costs are calculated at 6.5% term debt and 7.5% on working capital on a balance sheet with 79% equity.
In summary, price is the largest driver of profit in our case study, followed by production followed by costs. If the business manager could increase the prices received by 10%, increase production volume by 10% without incurring higher costs, and reduce the cost base by 10% this farm business’s profit would double. Some strategies to how to work towards achieving this are highlighted throughout this report.