Beef business performance

The following is a set of observations arising from Bill Holmes’ (formerly Queensland Government) involvement first in surveying grazing enterprise profitability in western Queensland in the 1980s, and subsequently in performing options analysis for northern Australian beef businesses until 2011.

Accounting framework – Cash flow and profit

Business analysis, both of past and prospective performance, is based in accountancy concepts. The most fundamental is the understanding of cash flow and profit.

Cash flow is the net of all cash in and out. In the short term we need to pay attention to cash flow because it has to provide for the ongoing expenses of the business and the service of debt.

Profit is a ‘wealth’ concept that includes changes in asset values as well as cash flow. Thus the profit for a period should include any increase or decrease in the value of stock on hand (usually due to a change in numbers) and of other assets (especially due to depreciation). For any year, opening net worth at the start of the year, plus net profit, less drawings, equals net worth at the end of the year. Net profit therefore is the amount that can be drawn from the business without eroding net worth.

Over the longer term, periodic revaluations of fixed assets (land) will come into the picture also, with the increase being considered as capital gain rather than net profit. With asset revaluations included, net worth at end of year will equal net worth at start, plus net profit, less drawings, plus or minus asset revaluation.

The usual accounting period is 12 months. The production cycle for a beef business may be as much as five years from conception to sale of a bullock, or ten years or more based on the life of a cow, and some depreciating assets may last 20, 50 or even 100 years. The profit accounting process seeks to slice up these longer cycles into units of one year, and estimate what each of the cycles has contributed or cost for each year. The slicing up process is achieved by depreciating ‘lumpy’ capital investments, and allowing for increases or decreases in livestock inventories as numbers fluctuate or herd composition changes.

It is possible to run a business to keep the cash flow coming, but end up broke because the assets have been used up. This is why profit has to include allowance for asset changes (inventory and depreciation). There is a cliché that says you go broke in the short term from lack of cash flow, and in the long term from lack of profit.

It is another cliché that farmers/graziers live poor and die rich – meaning that the main game is the value of the asset more than what you can make off it.

Increasing land value (capital gain) is generally not accounted as profit, though it is certainly true that some businesses have stayed afloat whilst drawing more than the profit by borrowing against increased land value – in effect spending the capital gain before it is cashed.

Compliance (tax) accounting and management accounting

A lot of people don’t understand their accounts, or don’t believe them. In part this is because tax accounts have their own rules, some of which are designed to misrepresent the ‘real’ profit, deferring the declaration of profit upon which tax is calculated. This is not altogether without logic, since it bends the payment of tax more towards the availability of cash flow. It does however make the accounts less useful from a management perspective.

Areas of concern with compliance accounts are:

• Livestock trading accounts using ‘valuation at cost’ can end up with inventory values typically $40 to $50/head, which of course grossly undervalues any change in numbers in any one year. The low values come about because ‘natural increase’ is brought into the calculation of closing value at the minimum allowable $20/hd and this progressively pulls the average down. To convert compliance accounts to management accounts, first recalculate the livestock trading accounts with realistic average inventory values. Opening and closing values can differ if herd composition has changed during the year.

• Some items of capital expenditure are subject to ‘accelerated depreciation’ for tax purposes, and this can vary from one Federal Budget to the next. Accelerated depreciation rates of 20%, 33% or even 120% can replace ‘real’ rates of 2%, 5%, etc. Accelerated depreciation can also mean that some quite young assets will no longer be on the depreciation list because they have been written off long before they are used up. If the amounts are significant, consider adjusting the depreciation calculation.

• Assets such as land will appear in the books at its value at the time of the last partnership reorganisation. This does not affect profit calculation, though it is relevant when declaring assets and liabilities for loan applications, calculating return on assets, or looking at annualised capital appreciation. To fix, redo the balance sheet with land at (conservative) current market value.

For the accounts to give a ‘true’ representation of the profitability and value of the business, it is perfectly legitimate and useful to calculate a set of ‘management’ accounts, using the tax accounts but applying different rules to livestock trading accounts (essential) and depreciation (possibly).

More accounting – Profit and cost structures

For a cattle business, the income side of the profit calculation usually will comprise the cattle trading account, plus maybe a separate bull trading account (more advantageous from tax standpoint), a horse trading account and some sundry income.

The cost side will have an array of cash costs, at least one major non-cash cost (depreciation), and financial costs (interest and leases, but NOT loan principal payments).

The accounts usually will not be split into fixed and variable costs, but this distinction is very useful when analysing business performance.

A variable cost is one which varies with small changes in enterprise size. For a cattle enterprise this means ‘one more animal, one more unit of cost’. For cattle we define the variable costs for each class in the herd. Examples of variable costs are weaner feed, supplement licks, vaccinations, labour for mustering (debateable) and yard work. Another name for variable costs is direct costs.

Everything that cannot meet the test of ‘one more animal…’ is either a fixed cost or a finance cost. On the above definition of variable costs, the fixed costs become those that remain the same regardless of (at least small) changes in animal numbers or herd composition.

Selling and transport costs are tied to number sold rather than to number carried, so I prefer to deal with them by reducing sale prices to a net basis.

For the management of financial crises it is useful to separate fixed costs into discretionary and non-discretionary groups (wants and needs). Discretionary expenditures may include some of the labour, a lot of the machinery, and maintenance (discretionary at least to the extent of whether to do it this year or next).

For business performance analysis however the big distinction is between variable costs and everything else, since it lets us pull out a very useful performance measure, the gross margin. The gross margin for the cattle enterprise is the livestock trading profit less the variable costs. Since the variable costs are defined as ‘one more animal, one more unit of cost’, and the fixed costs are by definition not tied to animal numbers, any change in gross margin is exactly equal to the change in net profit.

The gross margin (GM) for the whole herd is usually then expressed as GM per adult equivalent (AE) or sometimes per unit of livestock capital. The AE is used as a proxy for feed consumption. The GM can be used at two levels – GM/AE at a predetermined stocking rate, and GM per unit area, which allows consideration of stocking rates.

Using this distinction between the gross margin on the cattle enterprise, and the fixed cost structure which that enterprise supports, we can attack profitability on at least two fronts – by questioning the level of fixed costs, and/or by analysing herd performance through the gross margins.

As an aside, I found in those western Queensland surveys that the level of fixed costs tended to be driven by profitability rather than the other way around – in other words people spent what they could on their properties. The ‘fixed costs’ could arguably be considered to include elements of property development and investments in personal satisfaction. Since then I have left the cost cutting crusade to the consultants and concentrated my efforts on doing a better job of finding opportunities to improve the gross margins.

Accounting, budgeting and benchmarking

Accounting analyses the past, while budgeting analyses options for the future. Both use the same measures and conventions.

Benchmarking (which used to be known as ‘comparative analysis’ before it fell out of favour with the agricultural economics profession) relies on accounting to compare businesses in the belief that this comparison will show how the less profitable can become more profitable by adopting the methods of the successful, using indicator ratios.

The western Queensland surveys showed that people did not respond so simplistically. In these groups, the two or three producers at the top competed furiously while the ones at the bottom tried to pretend it wasn’t happening – so much for the good performers helping improve the rest.

Another lesson learned from ten years of data was the importance of one really good or bad decision in determining full term ranking within the group.

The best explainers of comparative performance were the gross margins, the management practices that went to make them, and the obvious judgement and application of the owners.

Benchmarking is a lot of work for a limited result. While industry still has experienced and capable extension officers, options analysis (budgeting) on practices currently in use, or not yet in use but revealed by research, will achieve a faster result than benchmarking.

Maximising herd profit

Recent North Queensland project work, including options analysis for participating properties, has led to some refinement of method. The following is the current state of play, assuming the same stocking rate (total AEs) for all options compared.

In all instances the current herd performance is modelled using the Bcowplus program (see Breedcow and Dynama free off the web). The purpose initially is to represent the current structure, turnoff and gross margin of the herd. This enables some assessment of current performance.

The next step is to look at age of male turnoff. Initially this was done as a simple comparison of whole herd modelling with different male turnoff ranging from weaners to bullocks. Now we also do ‘profit centre’ modelling. In this approach we treat the herd as two enterprises – breeding and growing out. The breeding enterprise ‘sells’ weaner steers to the growing/fattening enterprise. The sale or transfer value is based on market prices.

This modelling has shown almost universally that in North Queensland the profit centre of the herd is the steers. Another way of looking at this is to say that the market price for weaner steers falls short of what they are really worth to the breeder as stores for his own growing and fattening operation.

The ‘opportunity cost’ (true value) of these weaner steers can be calculated by one of the menu functions in Bcowplus. The profit target is whatever can be made with the best choice of male turnoff age. A trial and error calculation (automated by a menu function) then finds the weaner steer price that will just reach that profit target.

Another approach to dealing with the inequality between breeding and growing GMs is to improve breeder performance. Various husbandry options for improving breeder performance can be budgeted in Bcowplus, but in most instances they only lessen the problem, not remove it.

Some improvement in breeder GM may also be possible by fine tuning female sales choices. The most obvious choice is between culling a large percentage of the heifers and keeping the cows to an advanced age, versus culling fewer heifers and selling cows younger. The economics of this choice depend less than we might suppose on relative breeding performance, and usually come down to a straight comparison of prices for two year old heifers versus mature cows. Heifer sale age (weaners, yearlings or two year olds) can also be important.

Despite the gains that can be made by better female sales choices, the really big gains still come from getting the male turnoff age right.

Vertically integrated breeding and fattening

A variation, or perhaps a complication, of the turnoff age issue is the vertically integrated operation combining a breeding property with a fattening property. If it is a bad thing to sell weaner steers when you have only a breeding property, how can it be a good thing to transfer out weaners when you have your own fattening country?

For the integrated operation, the task is to come up with a steer transfer strategy that maximises profit for the combined operation. Should they go as weaners, allowing the breeding property to increase breeder numbers and weaner turnoff, or should they go older? This decision is affected also by the relative size of the two properties.

The most obvious way to analyse the integrated operation is to model the whole operation as a unit to compare transfer strategies. There are some (soluble) issues with keeping track of total AEs on each place when modelling the two as a unit, but it can also be quite messy when the carrying capacities of the fattening and breeding properties are mismatched.

Fortunately, there is a way to simplify the two property analysis. The breeding property is modelled as if it was the only property, best age of turnoff determined, and breakeven prices calculated for all plausible steer turnoff ages. This ‘locks in’ the profitability of the breeding property on the assumption that all steer transfers are made at the breakeven prices.

Using these breakeven prices as the transfer prices we then test the profitability of various steer ages going on to the fattening property. This is done in the Bullocks program (another part of the Breedcow and Dynama software package).

For instance, we can calculate the GM/AE from transferring weaner steers to turn off Japan Ox. Alternately we can try transferring yearling steers to turn off Japan Ox, or transfer weaners but sell them sooner as feedlot steers. Just for completeness we can also consider some options with purchased steers. The task then is to select an age group, or even a portfolio, that will maximise profit on the fattening property, bearing in mind that steer output from the breeding property will vary with transfer age (sending weaners will allow the more cows to be carried and more steers produced). Turnoff numbers at each age are calculated very easily by Bcowplus.

Since the profit of the breeding property was already held at the maximum by using breakeven transfer values, finding the profit maximising combination of steers for the fattening property ensures that the overall profitability is maximised.

Analyses so far indicate that a combination of a rough breeding block with prime fattening country will almost certainly be most profitable if the weaner steers are transferred to the good country as young as possible.

What is good for a vertically integrated breeding and fattening operation – sending steers to good country as soon as possible – must also be good for industry as a whole. Current price structures however favour the fattener, so breeders are better off hanging on to their steers and capturing the fattening profit for themselves, even if this results in a worse outcome fro industry as a whole. Higher relative prices for weaner steers would enable breeders to concentrate on breeding without sacrificing profit. Higher weaner steer prices could come either from supply chain arrangements, or indirectly from increased breeders resistance to selling weaner steers.

Calculations on the Beef CRC Representative Herds Templates for Northern Australia indicated breakeven prices for weaner steers of between $2.10 and $3.40 per kilogram liveweight. These are the prices required to make the sale of weaner steers equally profitable with the combined breeding and fattening operations being modelled. The area covered in this analysis was all of Queensland and the Northern Territory, and Western Australia north of 26° latitude. The higher prices were for favoured fattening areas such as Central Queensland Brigalow.

The ‘store trap’

When comparing herd structures for the same herd with a range of male turnoff ages, the obvious difference is that younger male turnoff means more breeders and more calves for the same total adult equivalents. Less obvious is that the herd valuation is lowest for weaner turnoff and highest for bullock turnoff. This is due mostly to the difference in value of cows and heifers relative to steers, especially the older steers.

Producers may argue that this is irrelevant since they already own the cattle. The relevance can however be demonstrated by looking at what happens over time when a change to age of turnoff is implemented.

If the change is to a younger turnoff (as in the shift from bullocks to live export), breeder numbers are increased as male age groups are sold down. There is a flush of cash over the transition as normal turnoff bullocks are sold, and some or all of the next age group as well, depending on the availability of females to take up the carrying capacity. The income sacrifice from reduced female sales is more than covered by the extra male sales. Whilst this is usually seen by producers as income, it would be more correct to see it as a capital withdrawal.

Conversely, changing from a weaner or yearling steer turnoff to older turnoff requires holding back on the weaner or yearling sales and finding some cows or heifers to sell instead. The result is less money, and the same again for maybe another year or two. Making the change to a more profitable herd thus requires the accumulation of more capital. If the producer cannot afford this sacrifice, then the change is impossible.

The ‘store trap’ refers to the situation where the producer knows an older male turnoff would be more profitable, but cannot achieve it because the income sacrifice required to get there is out of the question.

The ‘store trap’ can strike new owners trying to establish, or existing owners who have made ‘temporary’ changes to younger turnoff, or owners coming out of drought.

For more information see Age of turnoff economics.

Supplementation

Supplements used in North Queensland are typically urea to get through the dry season and phosphorus in the wet (and in the dry for breeders).

Some budgeting work done for an MLA phosphorus workshop in 2009 showed that phosphorus supplementation of phosphorus deficient cattle was still very much worthwhile, despite the then higher prices of the lick components.

This modelling was based on assumptions of higher weaning rates, reduced breeder mortalities, and superior growth in all classes, but especially steers.

An important observation from the modelling was that the changes in animal weights and herd structure (more total cattle for the same number of breeders) greatly increase the number of adult equivalents resulting from a fixed number of breeders. Put another way, if supplementation was to be done without increasing total AEs, breeder numbers had to be reduced by approximately 30%. The assertion that phosphorus supplementation is still profitable included allowance for this 30% reduction.

This calculation is based only on weight changes and herd structure changes. Nutritionists at the workshop pointed out that the reason supplementation works is that it helps animals eat more, i.e. a 400kg animal with supplement eats more than a 400kg animal without supplement. This means that I have underestimated the increase in total AE with supplementation, and that the 30% breeder reduction is an underestimate.

These calculations suggest that overstocking is an insidious and perhaps inevitable consequence of successful supplementation.

The calculations also underline the value of thinking of herd size in terms of feed consumption (total adult equivalents) rather than the number of breeders.

Economics of stocking rates

If you think you know how stocking rate affects growth, reproduction, survival and supplement costs, it is possible in Bcowplus to model the herd at two different stocking rates, expressed as different herd sizes, for example 3,000AE or 4,000AE.

We expect that, at the higher stocking rate, branding rates will be reduced, deaths increased, growth will be slower, price per kg might be lower on account of increased age at target weight, and supplement costs higher. Importantly, capital requirements for livestock will increase in proportion to herd size while the increase in production (if any) will be less than proportionate to the increase in numbers.

By comparing the total GM at the two herd sizes we can see what the budgeted difference is. To deal with the extra capital requirement of heavier stocking either compare GM after interest on livestock capital, or set the extra GM (assuming it is extra) against the extra herd capital required. For more information see Stocking rate economics.

The short-term outcomes of stocking rate decisions are however not the whole story, since excessive stocking rate will lead to a progressive decline in pasture productivity, and thus of the level of future GM that is possible from the country.

Loss of future GM from land condition decline can be valued and capitalised, and will represent production loss to the landowner (current or future). Whether this loss is reflected in the price that a naïve buyer would pay for the land is irrelevant in an industry context, since whoever owns the land will pay the production cost.

The other issue in stocking rate is that of production risk – heavier stocking increases drought risk and reduces the management options available to the producer going into a drought. The long term financial impact of a single management coup or disaster has already been noted under ‘Accounting, budgeting and benchmarking’.

The Ten Commandments

The following are some observations from analysing beef businesses in North Queensland:

1. The profit centre is the steers. The one sure way of really messing up the profit is to get the male turnoff age badly wrong.
2. The worse the breeder performance, the more likely that older male turnoff will be most profitable (depending also on steer performance). Really good breeder performance (80% weaning) might make younger turnoff acceptable.
3. The better the steer performance (i.e. the better the country), the more you lose by selling the steers as weaners, and therefore the more you have to get for them to make weaner sales worthwhile (there is some offset here since the breeders will also be doing better).
4. If you’ve got good fattening country, get the steers on to it as young as possible.
5. The market generally undervalues weaner steers relative to what they should be worth to their breeder as a growing or fattening proposition. Breakeven prices calculated for the Beef CRC Herd Templates project in 2008 (all of northern Australia) ranged from about $2.10 to $3.40/kg. These are prices at which weaner turnoff would be equally profitable with older turnoff.
6. Some producers are caught in the ‘store trap’, meaning that they know an older male turnoff would be more profitable, but cannot afford the income sacrifice needed to make the change.
7. There is a choice between selling say 50% of heifers while keeping the cows to an advanced age, versus selling say 20% of heifers and selling the cows younger. The most profitable choice depends on relative branding rates and sale prices, but will be driven mainly by the relative price of heifers and cows.
8. Supplementation, whilst desirable and profitable, brings with it the possibility of unintended overstocking. Breeder numbers may have to be reduced by 30% or even more to compensate for the effects of supplementation on herd structure, animal size and animal appetite.
9. In considering stocking rates or carrying capacity, numbers of breeders can be very misleading. A particular number of breeders can mean wildly different numbers of total adult equivalents (AE) depending on branding rates, age of male turnoff, and probably supplement use as well. The preferred method of expressing herd size is to use adult equivalents (AE).
10. Over the long term, asset growth is usually more important than the physical production from the business, which highlights the importance of looking after the country rather than hammering it in pursuit of short term gain.

Bill Holmes, formerly Queensland Government.