Measurement of profitability on Australian dairy farms (Option B)
By David Beca
Executive Summary
The national milk production in Australia has been in steady decline for almost two decades (since 2002). The international dairy market has been expanding over this period and Australia’s major competitors have been increasing their milk production. Australian dairy farmers have been progressively becoming less profitable compared to these competitor countries, and if this situation cannot be reversed then Australia’s national milk production is likely to continue to decline. Establishing a profit target for the Australian dairy industry would provide a focus for all industry organisations so that funds might be appropriately allocated towards this target. This profit target would also provide farmers a common focus for their discussions on farm business performance as well as for feedback to their industry organisations.
Return on Capital (ROC), otherwise described as ‘Return on Total Assets’, is the ratio that defines profit as the return on the value of all assets employed in the business. In this paper I propose an industry target for profitability of a 5% operating ROC. This is similar to the average level of profitability in Australia in the period 2000-2006 when the industry was competitive with most other countries, despite drought in some regions. This target would convert to a 7%-8% total ROC if an annual 2%-3% increase in the value of farm assets (capital gain) was added. However, the profit target could arguably be set somewhat higher or lower than this proposed level, and consultation with farmers would be recommended prior to a target being adopted by the industry.
All ratios that include total revenue will exhibit significant variability year-on-year due to the impact of changes in milk price. This would result in inconsistent annual results that would not be possible to monitor effectively. I propose a four-year rolling average of a 5% operating ROC as the industry target for profitability. Once a profit target is adopted, it could be devolved into a number of other profit-related ratios. This would provide a more developed description of business performance for farmers to monitor, as well as assisting extension and consultancy services. A suite of other ratios is included in Table 1 (grey shaded) based on recent benchmark data for each state and the three main dairy regions in Victoria. The profit-related ratios include profit per cow, profit per hectare, profit per kg MS or per litre, cost of production and operating profit margin. All these ratios vary significantly at a consistent profit target depending on the state or region and/or the farm production system implemented. However, all these profit-related ratios can be readily calculated for any state, region, production system or individual farm based on an agreed profit (ROC) target.
In the last 3-4 years, the average level of profit in Australia has been around 2% operating ROC. To lift this to around 5% will require significant reductions in cost of production, which will in turn require some significant changes in strategy by most participants in the Australian dairy industry.
Measuring dairy farm profitability ‘calculator’
In developing the tables for this paper, I created an Excel spreadsheet that allows users to calculate a range of financial performance ratios depending on their profitability goal. Users can select a level of profitability (return on capital), and after entering the business investment per cow, stocking rate, production per cow, and milk price, a group of financial ratios are calculated. These include profit per cow, profit per hectare, cost of production, profit (EBIT) per kgMS and per litre, and operating profit margin. This spreadsheet also highlights how straightforward it would be to expand a profit (return on capital) target to a range of other ratios that farmers could utilise.
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To view and download the spreadsheet please click here.