We recently wrapped up our two day Economics Intensive where alumni of the Ranching for Profit School prepared their economic plan for the coming year. For many of us, if we are left to our own devices, we often put off making an economic plan or get stuck figuring out how to handle a certain cost. So I thought it might be a good refresher to go over the rules we follow when putting together our economic plan for the coming year.
- Do projections.
It is fine to do actuals, but you’ll find economic projections of the coming year are much more useful in helping make decisions. After all, what can you do about last year? You do have every opportunity to make a change for this year if the economics suggest it.
- Layout the business.
Break the business into divisions and enterprises. A division is a collection of enterprises that require a separate set of overheads. For example farming and livestock are separate divisions. Farming requires machines such as combines and planters that you wouldn’t need if you only had livestock. Once the divisions are established, decide on the enterprises. Inside the livestock division you might have cow-calf and stockers. Inside the farming division you might break out each crop as an enterprise. When in doubt, keep it simple. You can always come back later and break out another enterprise but creating too many enterprises right away can increase the complexity.
- Calculate gross product of each enterprise.
Gross product is the value of production. In a farming business it is likely as simple as price x production. In a stocker or finisher business it is sales – purchases. In a breeding herd business you’ll need to account for changing inventory values using the trading account you learned at the Ranching for Profit School.
- Total direct costs for each enterprise.
Direct costs are those costs that increase proportionally as the units of production increase. If you add one more unit to the enterprise, then this cost goes up by one. If it doesn’t pass this test, don’t call it a direct cost. Examples in a livestock business are feed, vet, marketing commissions. For a farming business direct costs include seed, fertilizer, and chemical. Also, keep all land and labor costs in overheads.
- Calculate gross margin for each enterprise.
Simply subtract direct costs from gross product to calculate gross margin. Gross margin is the money left over to service overheads and for profit. When we divide gross margin by the units of production, it gives us gross margin per unit which tells us the economic efficiency of the production unit.
- Total gross margins by divisions.
For example the gross margin of the stockers plus the gross margin of the cow-calf gives us the total gross margin of the livestock division.
- Subtract divisional overheads.
An overhead is a divisional overhead if it would go away completely if we canceled that division. For example, the baler and the swather are divisional overheads for the farming division. If an overhead is shared by two divisions it is a business overhead, not a divisional overhead. For example the tractor that pulls the baler in the summer and feeds cows in the winter is a business overhead.
- Total business overheads.
Any costs that remain that are not a direct cost in an enterprise, or a divisional overhead get put in the business overhead category.
When you have your economics completed then the fun begins. Where are opportunities to make changes that bring you closer to your profit target?