Establishing Key Performance Metrics for Farmers
The Farm Financial Standards program is a continuing effort to help farmers better understand the financial performance of their businesses. When the committees were formed decades ago, the first step was to establish standard definitions and key performance metrics. This goal was achieved. Farmers and those helping them (such as accounting software makers and accounting service providers) have since adopted and implemented the standards, but with limited success. The need remains great, and the task remains significant.
Operating Profit Margin Ratio
Operating profit margin ratio is an indicator that supports the purpose and need mentioned above. This ratio is designed to show the farmer the profitability of the farm business. Non-profitable businesses fail over time. Profitable businesses have a chance to make it. The purpose of this article is to review the definition of this ratio and some of its strengths and weaknesses.
The operating profit margin ratio must be understood for what it is—a ratio, or one number divided by another, expressed as a numerator over a denominator. The numerator is a measure of profit for the business while the denominator is a revenue measure, which we will discuss below, called value of farm production. Thus, this ratio is an attempt to “grade” the farmer on efficiency, indicating how many of the available dollars are retained. More profitable operations keep more of the money for themselves with less going to suppliers and market makers.
Most businesspeople understand that there are a number of “profits” or “margins” that people strike. The reason for this is that different people care about different things. For example, the operations manager may not need to worry about incomes and expenses that relate purely to the capital side of the business (to how the business is financed). Likewise, a lender may have different needs and concerns than a potential equity investor. Therefore, the reason for talking about different “profits” or margins is that they communicate different nuances of business performance.
Calculating the Operating Profit Margin Ratio
The Numerator—Profit Measure
For this ratio, we are pulling out a very specific margin for our numerator. In this margin, we are trying to get a feel for how much money is left after all the vendors and employees are paid, including the owners, whom we assume are active in the business, and after the asset costs have been assessed. For the asset costs, we look to the net of depreciation expense and gain on the sale of assets as a measure of what the true asset costs are. Even though it is typically not expressed this way, the numerator is
Numerator = Gross Revenue – Cost of Goods – Operating Expense – Depreciation + Gain on Sale of Assets – Family Living
Note that in our margin, we have yet to consider how the business is financed. In other words, our margin (our numerator) does not yet reflect interest expense or monies paid into the business from those with an equity stake (e.g., an owner’s off-farm income). Additionally, our margin does not yet reflect income tax.
Before we talk about the denominator, it is important to discuss some of the caveats regarding the numbers included in the numerator:
- There is a risk that an inflated tax depreciation would distort our perception of profitability, so we should use management (or “true”) depreciation.
- Gain or loss on the sale of assets could be a significant number and therefore could lead to distortion of perception.
- The family living draw should be reasonable and not inflated one way or the other.
- The values for all the numbers should be accrual (or accrual adjusted) numbers, not simply cash-basis numbers. In lieu of such numbers, a cash-basis, multi-year set of numbers could be used to feed averages into the calculation.
The Denominator—Revenue Measure
As previously mentioned, the denominator in our ratio is the value of farm production (VFP). VFP has a specific and well documented definition but it is easily understood as total revenue from production activities minus the cost of pass-through expenses like the cost of feeder animals, the cost of feed itself, or the cost of items purchased for resale (e.g., when grain is purchased to fulfill a contract).
Denominator = Total Revenue from Production – Cost of Pass-Through Expenses
Again, in the spirit of accrual accounting, the cost of these items would be applied when the revenue is realized (or use accrual adjusted cash methodology). It should already be apparent to the reader that without good accounting practice in compliance with standards, the two numbers used, numerator and denominator, could be materially distorted, and dividing them would give a materially distorted ratio. Garbage In = Garbage Out.
Interpreting the Ratio
Now that we have our numerator and denominator, we can divide them and will generally get a number between zero and one. We target 0.10 to 0.20 for this metric. It is mathematically possible to have a number greater than one, and this would mean that a large, profitable gain on assets occurred. This highlights a shortcoming of our ratio: the idea that we can make sustainable profit by selling off pieces of the business is clearly wrong. Other profitability ratios, therefore, are superior to this one. It is also mathematically possible to have a number less than zero. This result shows a lack of profitability and thereby calls loudly for understanding and corrective action. Given the complexity of our numerator, the ratio itself cannot inform as to root cause, just the need for investigation.
In summary, operating profit margin ratio is complex enough and includes enough potential for extraordinary events (e.g., accelerated depreciation, excessive draws, significant asset liquidation events) in addition to the normal volatility in farming (acts of God, market price shocks) that its broad benchmark usefulness is challenged. Other ratios may better exclude these risks. That said, for benchmarking internal to the business (for example, from one year to the next) and in the situation where management knows that depreciation, draws, and assets sales are appropriate and not extraordinary, the ratio will show whether and to what extent the business operated profitably when considering asset costs and owner labor.
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