For many operations, farm transition may be the single most important decision a family makes for their own livelihoods as well as the continuity of the farm business. An early question in this process would be, “How will the farm support the income needed by the new entrant?” It stands to reason that if nothing changes, then the net income must be shared by more people with each receiving a smaller piece of the pie. It’s a tough way to say it, but everyone loses in this scenario, so-to-speak.
There are better alternatives. One is that a new value-added component could be added that improves the profit margin, thus leaving all with a desired net income. Another alternative is that the current business model continues, but the total revenue pie is enhanced. The second option then begs the question, how much more do we need to increase total revenues?
Let’s assume Mom and Dad have an operation that averages $900,000 in gross revenues. After paying expenses they keep 15%, on average, as net profits, or $135,000. The 15% is a commonly used ratio called the Operating Profit Margin Ratio (OPM), which is:
OPM ratio=(Net profits)/(Gross revenues)
A son, his spouse, and two kids want to join the operation. After including the costs of withholding and benefits, the son would like to quickly build to $75,000 annual income from the farm. The farm must then generate $210,000 of net profit ($135,000 + $75,000). If $210,000 of net profit is needed, then how much more gross profit is needed?
A little math on the OPM ratio gives the following:
Gross revenues=(Net profits)/(OPM ratio)
If the 15% OPM ratio can be maintained and $210,000 of net profit is needed, then gross profits need to be $1,400,000 ($210,000 divided by 15%), or $400,000 of additional gross revenues. While not always easy, there are a variety of different ways to develop additional gross and net revenues including a higher price (quality premiums), lower costs of production, greater productivity, additional cows, greater non-milk income from calves and cull cows, or some combination. For example, a reduction in costs of production that results in a 20% OPM ratio provides $45,000 additional net profits.
Finding the right combination of cost-reducing, production-enhancing, or some combination of practices or technologies to pursue is hopefully the talent that the new entrant is contributing. Certainly, it is better than just creating a smaller slice of the pie for everyone.