My last ProfitTips article focused on the difference between being productive and being profitable and I used gross margin as a measure of profitability of an enterprise.
In introducing gross margin I made the statement, “The best measure of profitability that I know of, is gross margin per unit.”
I misspoke … or mistyped … and thankfully I was called out on it. Too high overheads are usually the greatest impediment to profit for most ranches.
Ranching for Profit School alumni know there are only three ways to increase profit in any business. They are:
- Reduce overheads
- Improve the gross margin per unit
- Increase turnover
Which of those three do you think North American ranchers struggle with the most? Where does the greatest problem lie? Is it that overhead costs have inflated over time and are out of line with what the business can support? Is it that the gross margin of chosen enterprises is too low, or that turnover is too low and we are not operating at a reasonable scale?
If you selected overheads, you’re right.
This is where I misspoke. I should have said, “Gross margin per unit is the best measure of economic efficiency of the production unit” but it is not the best measure of overall profitability in ranch businesses today. Profitability is the best measure of profitability and overheads that are too high is the leading cause of unprofitable ranch businesses.
For many … not everyone … overhead costs have grown to the point that the business is structured to make an economic loss before we even begin. Let’s look at an example.
A rancher 20 years ago, built the business based on frugality and determination and put together a place that runs 300 cows. The couple who built the place now want to create an opportunity to bring Junior into the business but they haven’t substantially grown the business. While the founder created success and profits over the past few decades, they used those profits to invest in machines that made the work less physically demanding and more efficient. 15 years ago, the annual overheads to support one family and the annual machinery budget on the place was $90,000 or ($300 per cow). Now with adding another family to the business, additional machines and the rapidly rising costs the annual overheads for the ranch have ballooned to $300,000 ($1,000 per cow). Even with a strong gross margin of $400 per cow there isn’t a chance of profitability. This business is structured to fail before they even begin.
As we teach at the Ranching for Profit School, overheads are land and labor. Labor includes people and the things people use. Here is a test to see if your overheads are out of whack on your ranch. Take the total overheads of your business and the carrying capacity of your ranch business then use a custom grazing rate as the gross margin.
For example, if the custom grazing rate in my area is $1.50/hd/day or $45 a cow month and my ranch can support 500 cows for 10 months then the total gross margin is $45 X 500 X 10 = $225,000. What if the total overheads of my business are $500,000? Even if I double the carrying capacity of my place, I still won’t be able to cover my overheads. Overheads must be addressed before we can begin to structure a profitable business.
Overheads are often the most difficult costs to address. Increasing overheads (adding people and new toys) is easy, because it is often the stuff we want even if it is not what the business needs. Reducing overheads can be difficult, but the results can be liberating.
“Ranching is a very simple business, the complicated part is keeping it simple.”– Tom Lasater
Take a hard look at the overhead costs in your business and challenge each line to be sure it is creating value in excess of its costs. Not sure how to free up capital currently locked up in your overheads? We can help, join us at our next Ranching for Profit School so we can show you how.