When did buying the farm next door become a cost of production?

By Andrew Sims, Dodd & Co

It often feels like we have been on a crusade in the last few years about ‘what is cost of production?’. In recent years, with higher milk prices, it hasn’t been at the forefront of too many people’s minds, but the last 18 months have brought it back into sharp focus.

To my mind – and there are plenty of people, particularly bankers, who don’t share this view – the cost of production is the price at which equity is maintained. So this would be profit less drawings – dividends and/or directors’ loan withdrawals for companies – and tax. This is the figure taken from your accounts, so it takes account of changes in stock levels and depreciation of plant and machinery and buildings. Drawings must be taken into account as you need to be able to draw a living from the farm without eating into equity.

So if you make a profit of £35,000 at 25ppl, but have drawings and tax of £35,000, then there is no increase or decrease in net worth – as after drawings there is no surplus. Obviously, in this case, the cost of production is 25ppl.

This figure includes your depreciation – the cost of replacing your existing buildings and plant and machinery – so allows you to stand still. If your annual capital expenditure replacing these assets is less than the annual depreciation charge then that results in a lower cash break-even point. Conversely, if you spend more than the depreciation charge, you have a higher cash break-even point.

This ‘equity cost of production’ dictates whether you are making money in the long term and indicates whether or not you can sustain your dairy business over the years. However, this figure can be very different to the cash requirements of the business – which is often where disagreements arise over what your cost of production really is. Banks particularly focus heavily on the cash requirements of the business to determine your ‘cash cost of production’, as this is key for a business to retain enough working capital to keep operating.

A primary example is that of a business that has purchased land and is paying off a mortgage. Any capital element of the loan being paid is not taken into account for equity, but is clearly a big drain on cash within a business.

Typically, we see many dairy farms that in normal years may have positive equity but run at a cash deficit due to paying off debt.

Conversely we also see many farms that are cash positive but are losing equity – usually due to a lack of reinvestment. Fundamentally, both of these figures are important to a business, and it is vital that dairy farmers understand both of these figures.

Simply put, they answer two fundamental points: firstly, ‘should I stay in the industry?’ (equity) and secondly, ‘can I do it?’ (cash). If you would like to further discuss your own business and its cash and equity position and cost of production, please speak to your usual Dodd & Co contact.

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Apr 24

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