Cost of Production – More Than Just a Metric
January 6, 2021
You’ve probably been asked this question dozens of times – “What’s your farm’s cost of production?”
And while you might roll your eyes and think, “Oh great, this again,” it’s a serious question that you should be able to answer. And we’re not talking about a ballpark figure. You should know your exact cost of production down to the nearest penny.
But why is knowing your cost of production so important? Because cost of production is the foundation to a good marketing plan, and it can help determine where you might need to make adjustments to reduce costs and identify opportunities to grow your business. Not only is it an important metric to memorize, but it’s also a valuable tool.
During a recent Professional Dairy Producers of Wisconsin Dairy Signal webinar, Gary Sipiorski, owner of Gary Sipiorski Consulting LLC, and Kevin Bernhardt, professor of agribusiness at UW-Platteville School of Agriculture, spoke on the importance of knowing your farm’s true cost of production.
More Than Just a Metric
While understanding your cost of production is an important metric, it’s also a valuable tool to help you make decisions on a day-to-day basis in order to make your farm more profitable, according to Bernhardt.
“When we think about [cost of production] as a metric, it’s something that can be used as a marker on the yardstick to look and see how our cost of production compares to what our peers might be doing, how our cost of production compares to what the industry states what we should be at, or other kinds of comparisons,” he says.
Some of the areas your cost of production can help with might be your farm’s marketing plan, management decisions, purchasing decisions, investing and transitioning from one generation to the next.
Additionally, from a lender’s standpoint, it is important to know what numbers producers are tracking and if they truly know their cost of production, Sipiorski says. Then it’s important to share those numbers with the lender.
“There is nothing that will knock a lender off their chair quicker than a producer coming in that understands their financials, their cost of production and can articulate just exactly what they put [into their operation],” he adds.
Calculating Cost of Production
When it comes to figuring out what your cost of production is, there are several questions you must first ask yourself. The first should be ‘Which cost of production?’ according to Bernhardt.
“We often talk about cost of production as if it’s just one number,” he says. “That’s really not the case. There are lots of different kinds of cost of production that we can look at.”
Some examples include total operating costs of production, accrual costs of production, as well as feed, labor and cropping cost of production. Basically, your final number can be broken down into as many specific areas as you’d like.
“When we talk about cost of production, there are really two parts to that,” Bernhardt says. “There’s the cost itself, but then there’s how much production I have. So, there are two sides to this equation and a balancing act between the two. You need to know what your costs are and what your income is and what you can do about it to take advantage when there’s an opportunity,” Bernhardt says. “But you need to know where you stand before you can do anything.”
While determining your cost of production may not be as simple as taking something and dividing it by the hundredweight, it can be relatively easy, according to Bernhardt. One tip he shares is that producers often forget to categorize some of their farm expenses. For example, the expenses you incur to grow soybeans or produce beef should not be included in the expenses it takes to produce milk.
“Why am I charging the cows to pay for the soybeans and the beef?” Bernhardt jokes. “That’s not fair. Let the soybeans and the beef pay for themselves.”
One easy mistake producers commonly make is taking their total cost and dividing it by how much milk they are selling and saying that is their total cost of production. However, if other enterprises are involved, then it’s not quite that simple, he adds.
“It’s really important that we don’t take and put all of this cost of production burden on the backs of the cows,” Sipiorski says. “Particularly when we have other enterprises on the farm. That’s why it’s good to break [your cost of production] apart.”
Another factor to consider when calculating your cost of production is your own labor. Don’t forget to pay yourself for the time you put in, Sipiorski warns.
“People work so hard on dairy farms, not only from a thinking process, but also a physical process,” he says. “There are some long hours put in and people really need to [add] their family living cost and what they’re actually earning on a per hundredweight basis [to their cost of production,]” he says.
A Risk Management Tool
One question producers commonly ask Bernhardt is if knowing their cost of production will help them make some of their risk management decisions.
“I don’t know how you make good price risk management and marketing decisions if you don’t know your cost of production,” he says. “You need to know that number in order to make important decisions in a timely manner. It’s not just for the sale of milk, but for the purchase of feed as well.”
Sipiorski advises calculating your farm’s cost of production for producing milk, then comparing it to the trend of milk prices over the years. This is also known as a “stress test,” which allows you to see what your margins might look like under different prices of milk. From there, it should paint a clearer picture as to what coverage you need should prices dip below a certain level.
“It can be really dangerous going out and blindly picking prices and locking them in if you don’t know what that cost of production is, because that’s obviously a starting point,” he adds.
Control the Controllable
Once your cost of production has been calculated, it might feel like you are constantly monitoring milk and feed prices to know when you are making a profit. However, the beauty of knowing your cost of production is that when margins are tight, you have the ability to control parts of the equation.
“The dairy business is a commodity business, that means we are price takers and we can do some pre-pricing,” Bernhardt says. “But, in terms of what the ultimate cash price is, as an individual producer, we can’t do anything about that. We’re stuck with it. But we’re not stuck with what our costs are and we’re not stuck with what our production is. So, we do have some of these things under our control that we can do more about.”
So, the next time you are asked that annoying little question – “What’s your cost of production?” – don’t just spit out a random number. Have these figures memorized and formulate plans around them.
“You become a much better business person when you come in with a plan,” Sipiorski says.