A key financial management question frequently asked of our growers is, “What is your cost per acre?” This is an important question, but I think an even more important question to ask is, “How much is your contribution margin?”
Most farmers understand the concept of cost per acre, but they might not have a firm grasp on contribution margin, which is the difference between revenues and variable costs. It determines the amount of available income that can service fixed costs such as equipment, interest, management and labor. A key to these costs is to figure out which ones are truly variable and thus should be deducted and which are fixed and should not be deducted.
How To Calculate. Consider the following example, which illustrates how to determine contribution margin. Farmer Ben farms 4,500 acres. He has three full-time employees and plans to cash rent another 500 acres. He estimates gross revenue per acre will be about $800, and he will incur about $600 per acre of variable costs including cash rent of $250 per acre as well as expenses for inputs.
Since contribution margin per acre is $200, he elects to cash rent the farm. It will generate an extra $100,000 of available margin that can be used for debt service, for purchasing new equipment or for retention as additional working capital.
If Farmer Ben had calculated his cost per acre, he likely would have turned down renting the additional ground. His total fixed costs were about $1 million, or $225 per acre including machinery costs with depreciation, interest, lifestyle costs and other expenses. By simply looking at total costs of $825 ($600 of variable costs plus $225 of fixed costs), he would assume he is losing $25 per acre.
Yet contribution margin is positive by $200 per acre, and by renting the ground, he reduces his fixed costs per acre from about $225 to about $200 per acre, or $1 million divided by 5,000 acres.
As you can see, looking at total costs per acre including an allocated fixed cost will lead farmers to not rent ground that will actually increase their cash flow. Still, care must be taken in this analysis because many times, variable costs are not exactly variable.
For example, assume Farmer Ben is about maxed out on three hired hands at 4,500 acres. By adding another 500 acres, he now has to hire another person to get the farming done. Additionally, his equipment might be maxed out, and getting additional ground requires the purchase of a new combine that is not totally efficient for the new acres.
All of these situations must be addressed, but if the resulting calculations create contribution margin exceeding at least 10% of gross revenues, then it is worth getting the ground. If it is less than 5% of gross revenues, I would usually recommend passing.
Rank Rented Acres. Farmers should rank all of their ground based on contribution margin. This analysis will reveal which acres yield the best return and which acres should be jettisoned and replaced. Assume Farmer Ben has four farms, approximately equal in size, with the following contribution margin per acre:
- Farm No. 1: $450
- Farm No. 2: $325
- Farm No. 3: $225
- Farm No. 4; $100
In this case, Farmer Ben should consider trying to find ground to replace Farm No. 4. He might even shrink in size and be better off. Let’s assume the farm is 1,000 acres in size and contributes $100,000 to the farming operation. Farmer Ben finds 500 acres with contribution margin of $300 each. This now results in $150,000 of contribution margin.
The bottom line is to look at your total contribution margin and make financial management decisions based on this metric and not just cost per acre.