Cost of production (COP) influences competitiveness and efficiency, and determines whether your operating margin is positive or negative. Calculating your COP assesses where you stand and identifies where opportunities lie.
Cost of production (COP) is one of the most important metrics to evaluate a dairy operation’s financial status. However, when discussing COP, people typically refer to cash flow and include purchased feed, labor, principal and interest payments, and any cash capital purchases.
While cash flow is important, it fails to consider value created in forage production or heifer rearing and doesn’t include any unpaid bills on your accounts payables list or depreciation on assets. To get a clearer picture, COP should be viewed from an accrual standpoint.
For illustration purposes (and with 2018 financial reports yet to be finalized later this spring), factors included in calculating COP on a per hundredweight (cwt) of milk shipped basis are described below. Table 1 displays the average costs among all herds analyzed by Compeer Dairy Consulting staff as well as the top 25 percent of Compeer herds (2017 net income basis). Then, Worksheet 1 provides a more detailed look at COP calculations using the example herd and includes a blank column for you to calculate your COP.
• Feed costs per cwt = (Forage feed cost + grains + supplements) per cwt.
The largest cost for any dairy is feed, including purchased and home-raised feeds. Placing a market value on forages, including haylage, corn silage and grain will help determine total feed cost.
For Midwest dairy producers, Compeer Dairy Consulting is using these values for 2018: corn silage – $34.40 per ton at 35 percent dry matter (DM); haylage – $66.80 per ton at 40 percent DM; and corn – $3.30 per bushel. For 2017 (Table 1), the values are similar to 2018, except haylage, averaging $46.50 per ton.
Looking back at 2017, the average feed cost was $8.79 per cwt; Compeer herds in the top 25 percent for net income spent an average of $8.30 per cwt on feed ($5.75 per cwt on purchased supplements, 41 cents on grains and about $2.14 on forages).
Improve your COP: Harvesting and feeding high-quality forages translates into lower feed costs in two ways: inclusion of a higher percentage of forages in the diet, and lowering purchased feed and commodity costs. Feed costs can also be driven lower by reducing shrink through better storage and feedbunk management.
• Labor costs per cwt = (hired labor expense + owners’ draws) per cwt.
Labor costs include wages, payroll taxes, workers compensation and benefits paid to employees; and salaries and benefits paid to owners (including wages shown as draws). In the Compeer Dairy Consulting benchmark, 2017 total labor cost averaged about $3.40 per cwt. Some dairy operations in the top 25 percent for net income were below $2.80 per cwt. Labor costs have been fairly consistent over the last several years.
Improve your COP: It can be difficult to lower wages or owner draws. However, maximizing productivity from all personnel while focusing on employee retention yielded the biggest gains in labor performance. A key target for most dairy operations is to keep labor cost at less than 14 percent of total accrual income.
• Net herd replacement cost (NHRC) per cwt = [(total number of cull cows + dead cows) x $1,700 – cull cow income] per cwt.
NHRC is the cost of replacing cows in your herd. It is calculated by taking the number of animals leaving your herd (cull, dairy sale or death) multiplied by their balance sheet value, typically $1,700 per head, less any cull cow revenue. If the example farm culls 290 head (valued at $675 per head) and has 45 deaths per year, the NHRC would be $1.42 per cwt. ($1,700 x 335) - ($675 x 290) = $373,750/(72,000/100 x 365). The 2017 Compeer average was $1.33 per cwt; herds in the top 25 percent averaged $1.16 per cwt.
Improve your COP: A mark below $1.50 would be a key target in the current market. Key ways to lower NHRC include culling animals when they are at their prime condition to maximize value, managing heifer inventories to adequately supply replacement needs without artificially inflating the replacement rate and targeting death loss at no more than 5 percent. The most costly culls or dead animals are those within the first 60 days in milk. The best-performing dairy operations lose no more than 3 percent of their first-lactation animals and no more than 6 percent of second-lactation-or-greater animals within the first 60 days in milk.
• Capital costs are comprised of three items: depreciation, interest and leases. Capital costs have risen nearly 40 cents per cwt for the average dairy over the last three years, predominately due to increases in interest expense. This is due to a shortage of liquidity, leading to increased borrowing to finance operating expenses and compounded with increasing interest rates. Additionally, this expense has become quasi-fixed as operating losses become termed out over five to seven years in most cases. An annual interest expense of $325,000 would be approximately $1.24 cwt for our example dairy.
From a depreciation standpoint, Compeer Consulting clients’ machinery is depreciated based on use. This is management-based depreciation, not from a tax perspective. For example, say machinery depreciates at an average of 12 percent, and buildings depreciate at 5 percent.
Our example dairy has a balance sheet value of $3.75 million for buildings and $1.75 million for machinery. The average annual depreciation might be $187,500 for buildings and $210,000 for machinery, for a total of $397,500 or approximately $1.51 per cwt. If this farm has no leases, the total capital cost of depreciation and interest is $1.24 + $1.51, or $2.75 per cwt.
Improve your COP: Keeping capital costs in check is dependent on properly structured debt and leases, reducing cash outflows that will require additional borrowing and maintaining buildings and maximizing the most output from equipment.
• Other production and overhead costs are essentially every other cost on the expense side of the ledger. Compeer Consulting breaks apart remaining expenses into:
o “Other production” costs, or dairy-related expenses covering animal health, bedding, breeding and supplies.
o “Overhead” costs, covering administrative, fuel, insurance, marketing, repairs and utilities, etc. Costs related to custom heifer raising, seed, chemical, fertilizers and other agronomy or non-dairy enterprise expenses are also included here.
Generally, “other production” comprises about $2 to $2.20 per cwt in cost, while “overhead” generally is in the $5.75-to-$6.75-per-cwt range.
While the big three expenses are feed, labor and herd replacement cost, the next five areas to monitor (not counting agronomy expenses) are animal health, bedding, breeding, supplies and repairs.
Improve your COP: Scrutinizing other production and overhead expenses to determine their importance to profitability and the pending consequences if they are removed will allow you to reduce less-than-vital expenses and maximize output of those that remain.
In the final phase of calculating COP, it is important to deduct all other revenue not related to milk and cull cow income. The two major sources of accrual earnings are:
• Crop production – The value of all crops grown in the calendar year, not necessarily what was sold. Similar to how Compeer Consulting treats forages as a feed expense, crops also have a set value on a per-cwt-of-milk basis. Crop revenues may be in the range of $3 to $3.50 per cwt, but it depends on the operation.
• Heifer appreciation – The increased value of heifers as they age. It is important to show increased value to offset the heifer-raising cost invested into it for the same time period. Generally, this is approximately $64 per month per heifer. So in a given 12-month cycle, one heifer will increase in value by $768, recorded as earnings. Our example herd has 800 heifers, with a 10 percent loss due to death or sales annually. The estimated total heifer appreciation would be $64 x (800 x 90 percent) x 12 months = $552,960, or $2.10 per cwt. While these are not current market values, it consistently marks the average value of heifers growing over time.
All other revenue is comprised of bull calf revenue, government receipts, patronage, custom work income and miscellaneous income. Generally, this total other income will come to about $6.50 to $7.50 per cwt, which gets subtracted off of the previous COP categories.
There is a lot that goes into accurately calculating your COP and, while operational expenses will vary farm-to-farm, driving down COP is the most long-term, sustainable method to achieve dairy financial success. As you complete your 2018 financials, take time with your lender, a consultant or adviser to help calculate your COP and assess where you stand and, more importantly, where opportunities lie to improve the bottom line.
Matt Lange is a business consultant at Compeer Financial, based in Baldwin, Wisconsin. For additional insights, visit Compeer.com/education