The Bottom Line: Why More Variable Costs is Good

March 18, 2017 02:54 AM

The past three years have been tough. While expenses have come down some, it hasn’t been at the pace of grain prices. Managing margins is all the buzz, but that’s easier said than done. Understanding the two types of leverage can be helpful:

  • Financial leverage has to do with the ratio of assets to liabilities and the impact gains or losses on those assets can have on bottom-line profitability. The lower the equity the better return when margins are good; however, when margins turn negative, high financial leverage can cause insolvency or bankruptcy. 
  • Operating leverage has to do with costs rather than assets and liabilities. The concept focuses on the amount of fixed costs compared with costs that vary based on revenue.

The higher the percentage of fixed costs to total costs the higher the operating leverage. If operating leverage is high, a small change in revenue equals a big drop in net profit. When operating leverage is low and more costs are variable, revenue drops but profit margins vary less and although smaller, they remain positive.

Prior to 2014, most farmers thought it was better to have more fixed costs, such as cash rents, fertilizer and machinery. In the past three years, the opposite is true. Over time, the more variable your costs, the better you can manage margins. Why? As you know, costs can go down. For one of my clients, seed, fertilizer, chemical and fuel costs are down $48 per acre for corn production this year.

Agriculture is precariously cyclical and, therefore, could benefit by having more variable costs when/if costs go down. Understanding the concept and applying it year after year can benefit your bottom line over the long run.

Productivity, optimal use of assets and return-on-capital are defining the success of a farmer. It is increasingly important for farmers to borrow a page from their industrial brethren whose survival, like their own, hinges on their creativity in extracting every measure of utility and productivity from their physical business assets—land, equipment, grain storage and buildings.

Return on capital and return on assets are two key measures of effective management and imperatives in our businesses.

We can learn from those who have deep industrial management experience, such as my colleague Ryan Bristle, who’s also a farmer and Farm Journal columnist (The Bottom Line). Bristle, who worked for 13 years for an equipment manufacturer, challenges farmers to realize a farm is just like a factory. As the manager of that factory, you have to challenge every cost. What fixed costs are really fixed? Can I buy inputs at a lower cost? Can I cut costs by outsourcing tasks I just don’t need to do myself, I’m not proficient at or that aren’t as critical to my operation? The future of farming hinges on new creative means to liberate non-essential cost and put capital to work in ways that drive tangible economic return.

In our client base, we’ve observed machinery cost as one of the four major leverage points to improve bottom-line profitability. Combined, machinery and labor costs vary $200 per acre in our client base. These are big rabbits to chase.

The farmers who prosper in the future will be those who recognize idle steel in the shed or labor that’s not optimally used as readily available and cheap sources of capital for re-investment in grain storage, alternative fuel production or equipment. This then allows you to diversify your operation and improve productivity, marketing leverage, revenue growth and cash flow.

With volatile times, keep in mind you control your own destiny. 

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Spell Check

Fanie Brink
Bothaville, AL
3/25/2017 05:13 AM

  I cannot see how fertilizer can be a fixed cost!

Fanie Brink
Bothaville, AL
3/25/2017 05:50 AM

  The principle is that you can add variable costs only as long as your marginal income is higher the your marginal costs. When it becomes equal then you have reached the optimum production and maximum profit level!


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