The Profit Tree
There are only three things anyone, anywhere in any business can do to increase profit:
- Decrease the overhead costs
- Improve the gross margin per unit
- Increase the turnover (the number of units)
Only one of these three things is the most important at any particular time. If high overheads are the problem, increasing production efficiency won’t solve your problem. If gross margin per unit is the problem, then decreasing overheads won’t help much and increasing turnover could actually help you go broke faster. It isn’t enough to know your numbers. You have to know what your numbers mean.
I created this “Profit Tree” to help find dead wood and profit drivers in businesses. We define dead wood as things that cause us to lose money. Profit drivers are the things that make us profitable. We teach participants in the Ranching for Profit School how to use the profit tree to find problems and opportunities in their businesses. Let’s take a closer look.
We calculate profit by adding the gross margin for each enterprise and subtracting the overhead costs. If the total is positive, the business made profit. If it is negative, the business lost money.
Gross Margin (enterprise a)
+ Gross Margin (enterprise b)
+ Gross Margin (enterprise z)
– Overhead Costs
Since profit is calculated by subtracting overhead costs from gross margin, if the business isn’t making enough profit it’s either because the total gross margin is too low or overheads are too high.
The total gross margin includes two things: the gross margin per unit and turnover. If the total gross margin is healthy, and the gross margin per unit is good, the problem must be turnover. There are two ways to increase turnover. We can either add an enterprise or increase the scale of existing enterprises. Therefore, if turnover is a problem we either need to increase the number of units in each enterprise or add another enterprise.
If the total gross margin is bad, but turnover is healthy, then gross margin must be the problem. Gross margin per unit is calculated by subtracting direct costs from gross product and then dividing by the number of units in the enterprise (animal units, acres, etc.). So, if gross margin is too low, it is either because direct costs are too high or gross product is too low.
Gross product measures the value of production, so if the gross product is bad the problem is either production is too low, or we aren’t getting a high enough price for what we produce. If we didn’t get paid enough it is either because the market is too low, or our marketing is ineffective.
If the gross product is low but the price is good then low production is the problem. If production is low in a cow-calf business, it’s either because we didn’t produce enough calves per cow (reproduction) or the calves we produced weren’t big enough (gain).
If gross margin is bad, but gross product isn’t the problem, we need to focus on direct costs. The three biggest direct costs are generally opportunity interest on owned cattle, feed and health related costs. Interest is crossed out on the profit tree because it’s the only thing on the tree that we can’t do anything about. We can influence weaning weights, prices, renegotiate the rent, change enterprises, but as long as we own livestock and want to use the RMC benchmarks, it is important that we charge opportunity interest. If the gross margin per unit is good, and we’ve included opportunity interest in the calculation, it indicates that economic efficiency is good and that increasing the scale of the enterprise will increase our profit. If we don’t include opportunity interest as a direct cost, we can’t draw this conclusion.
If total gross margin is healthy but the business isn’t profitable, the problem must be overhead costs. There are only two kinds of overheads: land costs and labor costs.
We put land costs go into one of two groups: the cost of getting land (e.g. lease payments) and the cost of maintaining the land and the infrastructure on it.
If overheads are too high, but land costs aren’t the problem, then labor costs are. There are two major labor costs: costs associated with people (e.g. salaries, retirement plans, health benefits, etc.) and costs related to vehicles and other equipment.
At the Ranching for Profit School, participants review a case study of an actual ranch business in dire economic condition. When asked for solutions on the first day students come up with a shot gun array of possibilities. After using the thought process I’ve described here to guide them, they turn their shot gun blast into a rifle shot, discovering the source of the problem. They also realize that some of the suggestions they made before they knew how to find the dead wood and profit drivers would have actually made matters worse.
This procedure can help you pin point problems and opportunities in your business. And that’s essential if you want to be Ranching For Profit.