I grew up on a family farm in southeastern Washington and graduated from college in the mid-1980s. My goal was to take over the farm from my father, who was nearing retirement. (I am the oldest of three children, and my dad was 47 when I was born.) Since I had an accounting degree from the University of Washington, I knew how to calculate numbers—a skill I got from my mother—and was able, in a rudimentary way, to calculate the economic farm unit (EFU) for our operation. My parents owned about 400 acres of good wheat ground, and right before they retired, they were renting about 500 more acres.
Based on the income generated by their farm, our EFU was slightly greater than one. That could not support two families at the time, so my father urged me to become a CPA.
An EFU is the amount of contribution margin generated by the operation, divided by the number of farm families involved. Contribution margin is the amount of income left over after all cash expenses are paid by the farm. From that number, it is prudent to remove any necessary capital improvements for maintenance. Divide the final number by the compensation the average farm family needs each year. This includes salaries, wages and other cash, nontaxable fringe benefits such as health insurance and meals.
Suppose the Bean family generates $300,000 of contribution margin each year and the average amount of family compensation is $100,000. That means the operation has three EFUs. If two or fewer families are involved, the EFU is very manageable. If three families are involved, there is no room for a hiccup, and with more than three, this farm operation should expect to be under extreme stress very quickly.
During the past five years, many farms have brought on new family members. Based on farm income, their EFU was greater than the number of families involved. But in light of lower prices, they should be mindful of how EFU calculations will be affected.
Let’s look at an example: The Jones family of Iowa has farmed for six generations. Dad employs two of his sons, and a third plans to return to the farm after graduating from college. The family owns 1,500 acres and rents 1,000. In the past few years, the farm has generated $200 per acre of net contribution margin. The family lifestyle figure is $115,000, much higher than 10 years ago. With a $500,000 contribution margin, there are slightly more than four EFUs. The operation can manage.
But the third son will raise the contribution margin from $345,000 to $460,000. Also, Dad is concerned corn and soybean prices might drop up to 25% for a few years. The farm’s contribution margin might drop and reduce the farm’s EFUs to fewer than four.
With those scenarios in mind, there are two main ways to increase EFUs:
- Increase contribution margins. Consider renting additional ground, improving per-acre income or changing crop mixes.
- Decrease compensation levels. In many cases, lifestyle costs have more than doubled in the past few years. Can families get by with less?
Conversely, there are two ways to decrease EFUs:
- Decrease contribution margins. Consider how lower prices will affect EFUs. Will input costs decrease faster than crop prices?
- Increase compensation levels. Younger farmers need less income, but that changes as they add children. Are you set up to handle these needs?
If your farm operation anticipates bringing on new family members, this calculation is a must.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog, The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at paul.neiffer@CLAconnect.com.
- Summer 2014