The need to measure ranch economic sustainability

Apr 4, 2014
by WLJ

It’s common for food service providers and retailers to communicate that they are committed to sourcing food from sustainable beef production systems. Most sustainability definitions note the necessity of an economic or financial component, but the challenge of measuring financial and economic sustainability at the ranch level is not effectively communicated.

The necessity to have information to determine if changes in ranch production and marketing systems are economically viable is seldom mentioned. Changes can be proposed without economic evaluation of their profitability. Many changes are cost-effective but lack the numbers to show their profitability.

It’s clear that if a production system used by a ranch business is not profitable, producers will cease production.

If it is not profitable, there is no economic incentive to maintain, invest or grow the business. The continued historical decline in the national beef cow herd certainly reflects an industry that is not being sustained. Profitability of change will be an important determinant if this trend is reversed.

The Internal Revenue Service (IRS) Schedule F, Profit or Loss From Farming, is the primary source of rancher financial reporting. It’s likely that more than 95 percent of beef cattle producers use cash accounting to comply with IRS rules. But the Schedule F does not measure profitability of the business or economic sustainability. Often inventory change, prepaid expenses, receivables or payables mean cash reporting does not measure profitability.

Following IRS rules, depre ciation

expenses are distorted. Producers should calculate depreciation using replacement cost with reasonable useful lives and salvage values to measure profitability. Replacements should not be expensed. There is no compensation for owner/operator labor and management in Schedule F. Working for nothing does not reflect business reality.

Every other major participant in the beef supply chain above the ranch level uses Generally Accepted Accounting Principles (GAAP) for financial reporting that measure profitability. These margin segments know their costs and profit margins.

Cattle Fax and other groups publish numbers on cow/calf cash profit, but cash profit is not a valid financial performance term. Profit is what’s left after all expenses are accounted for. Cattle Fax leaves out depreciation and returns to owner/operator labor and management. These are major costs at the cow/calf level and are completely inconsistent with GAAP accounting use by others in the supply chain. Cattle Fax cash profit cannot be used to calculate business return on assets (ROA) or return on equity (ROE), both fundamental measures of financial performance.

The methodology to measure financial or economic sustainability certainly needs to do more than use the IRS Schedule F cash-based reported “profit or loss” to define profitability. This was addressed in the Standardized Performance Analysis (SPA) methodology adopted by the National Cattlemen Association (NCA) in 1991 (see note below). The account ing

methodology used in SPA followed the Farm Financial Standards Council Guidelines (FFSC). These methodologies use an accrual adjusted income measure of profitability.

Suggested definitions of profitability and economic sustainability are as follows:

• Financial profitability is measured by calculating the accrual adjusted revenue and expenses reported in the business accrual financial or profit or loss (P&L) statement.

Interest is the cash and accrual interest paid. Raised feed is valued at cost of production. Breeding stock replacement cost is calculated using either the GAAP full cost absorption or the FFSC base value methods. Hired labor and management compensation equivalence is used for owner operator compensation. Financial profitability is for a fiscal year and does not include real estate appreciation.

• Economic profitability is measured with the same financial accrual adjusted information with the additional adjustments of an opportunity cost for land (cash lease minus property tax and maintenance cost covered in a cash lease), raised feed at market value and operating capital valued at opportunity cost. Opportunity cost of capital is a return expected on the next most profitable return on investment with similar risk.

Economic profitability is a measure of consequence of entry or exit of the business.

The best measure of sustainability is economic profitability because an individual business’ financial sustainability is heavily influenced by the owner equity and repayment capacity position.

For published comparative evaluation of ranch systems or practice purposes, profit measures are pre-income tax and do not include appreciation of land. Of course, the rancher should use both measures of performance as done in SPA.

With the volatility in commodity prices and production costs, a sustainable business does not have to be profitable every year. A lender would like to see financially profitable performance for the past three years and a business plan that can demonstrate cash flow and profit potential for five years. It’s not often they get this information, however. But the business debt situation and repayment capacity are critical considerations for an ongoing or sustainable business.

By a business definition, the cow/calf sector is not being sustained. The sector has the smallest beef cow herd since 1941. It’s going to be a challenge to measure an “economically sustainable” price level for cow/calf producers and impacts of alternative production and marketing systems that change environmental, social and consumer desired dimensions of sustainability.

The reporting and communication burden is on the ranch sector because others in the beef businesses in the supply chains have in place their reported standardized measures of profitability. Others in the supply chain will not take the responsibility to measure ranch economic sustainability of changes they wish to impose on producers. — Jim M. McGrann, Professor Emeritus, Texas A&M University

[Dr. McGrann wrote this article in response to Pete Crow’s March 24 comments, and the article, “Big names in beef attempt to define beef sustainability” from the same issue. McGrann retired as Professor Emeritus in the spring of 2004 after working 32 years in research and extension at Texas A&M University where he became a national leader in the development of the Financial Standards for Agricultural Producers and the Beef Cattle SPA methodology that measures beef cattle financial and production performance. He urges producers to visit and for aid in determining their operation’s economic sustainability.]