Know Your Cost of Production Before You Make Marketing Decisions
Sep 27, 2012
This important measurement can create a base selling price for your risk management practices.
By Kristen Schulte, Iowa State University Extension Farm and Agribusiness Management Specialist
Dairy profitability outlook has gained positive ground recently, with futures milk prices holding and commodity feed prices receding from market highs. Milk prices continue to move based on several factors, including an anticipated decrease in domestic supply over the next year due to the number of cows culled in recent months and the anticipated number in coming months.
In contrast, commodity feed futures prices have subsided since harvest has started across the Corn Belt.
Implementing risk management practices -- including futures, options or contracts -- can increase the level of price certainty and secure a profit margin. With continued volatility in the milk futures market, the question of where to buy and sell in the market is often one of the most important questions to ask and calculate prior to entering the market.
One cannot operate a business at a loss for an extended period of time without creating long-term negative financial impacts. Therefore, it is important for producers to be aware of their cost of production (COP) per hundredweight (cwt.) when implementing risk management practices. COP allows a producer to evaluate the breakeven value for production, which can create a base price to sell at and ensure a profit when selling the commodity. COP is one of several measures producers can use to make marketing decisions.
COP allocates the dollar value it takes to produce one commodity unit. For milk production, COP is measured per cwt. of milk produced. To calculate COP, total expenses are divided by total number of cwt. of milk shipped. Expenses included in COP are variable, fixed and labor and management costs.
Variable costs include feed, hauling, marketing, supplies, transportation, utilities and veterinary costs. Fixed costs include depreciation, interest, repairs, taxes, and insurance on facilities and equipment used for the dairy operation. Cost for labor and management is for all labor, paid and unpaid, for the dairy operation. When measuring COP, one should include all costs for the dairy enterprise, including associated cost or value for homegrown feed and heifer replacements. Additionally, accrual adjustments should be included with total costs to adequately measure costs against associated production in a given time frame. Total costs then can be calculated and divided by the total cwt. of milk shipped for a given time frame.
This measure varies between regions of the U.S. and between farms, based on several factors, including feed availability, facility value and associated overhead cost, and level of milk production. Current measures for COP range from $17 to over $24 per cwt. of milk. This range also includes variability in types of management.
COP should be recalculated when making marketing decisions to ensure a positive profit margin. It can be calculated for any given time frame, depending on the comparative analysis being performed. For historical measures, calculation on an annual or quarterly basis may be sufficient for financial analysis and management. For projected profit measures and marketing, however, one may want to measure COP on a shorter time frame, such as on a monthly or quarterly basis, depending on the change of input costs, such as feed purchased and variability in milk production.
Once COP is determined, a producer can evaluate where he or she can enter and exit the commodity markets to reduce price risk and secure a positive profit margin. Managing margins and determining COP are not new concepts for producers, but with futures prices as moving targets, continuous analysis of COP and related profit margins are important to monitor to remain in a positive financial position.
Kristen Schulte is an Iowa State University Extension farm and agribusiness management specialist. She can be reached at 563-547-3001or firstname.lastname@example.org.
Additional Thoughts: Strategies to Manage Your Finances
By Ron Mortensen, Dairy Gross Margin, LLC and Advantage Ag Strategies, Ltd.
What to do next? Cost of production, margins, cash flow, balance sheet and just plain managing the checkbook have become an issue. The problem is that this squeeze on profitability has come after the big losses in 2009. The second “squeeze” event is usually the one that causes the big financial issues. That is where we are all at today.
As part of your cash-flow plan or managing your checkbook, here are a few simple strategies:
1. Look at buying puts for the milk and buying corn calls. What does it do? It gives you a minimum amount of cash flow for the milk and leaves the top open. The corn calls will give you a maximum value for your corn. If corn rallies back, you will have value in the options to go buy physical corn. These will need to be paid for upfront, unless your local cooperative or processor will carry the positions.
2. Start looking at the Livestock Gross Margin for Dairy (LGM-Dairy) program that will be available on Oct 26, 2012. Why? It will give you very similar results to Strategy 1, but the bill will not be payable until Oct 1, 2013. The LGM-Dairy will give you a guaranteed margin between milk and feed (corn and soybean meal). One difference is LGM-Dairy uses a weighted average of all of the insured months when calculating gains and losses. Along with the subsidy, this is one of the reasons for the lower premium (versus puts and call options).
People always ask me what they should wish for if they do either of these strategies. You wish for milk to go up and feed to go down. If your wish does not come true, and milk goes down and feed goes up, you will have protection and cash flow.
Ron Mortensen is a principal of Dairy Gross Margin, LLC and president of Advantage Ag Strategies, Ltd., a commodity advisory firm. Email him at email@example.com.