SW Financial Literacy
Fixed Costs vs. Variable Costs
We all create and update our cash flow or income/expense report throughout the year (at least I hope you are doing this!). Many cash flow projections for row crop producers at the start of 2024 were breakeven at best due to high input costs and lowering commodity prices. An up-to-date cash flow during the year can help you decide:
grain marketing.
if additional expenses (think chemical/fertilizer) will help the bottom line.
if there is enough profit for farm upgrades or purchases.
Here is one more powerful way to use your cash flow to determine strengths and weaknesses in the structure of your operation.
Variable Costs Variable costs are made up of your crop and operating inputs to raise the livestock/grain. Here is a full but not exhaustive list of what makes up your variable costs:
Car & Pickup, Chemicals, Custom Hire, Feed, Fertilizer, Freight & Trucking, Fuel, Insurance, Interest – Operating, Labor, Marketing, Rent – Land, Rent – Machinery, Repairs, Seed, Storage, Supplies, Utilities, Vet, Miscellaneous Expenses
You should be familiar with these line items, they come from the Schedule F on your tax returns. Together they make up your Operating Expenses.
Note: Depreciation is not included as Variable Cost or Fixed Cost as it is a tax number for purchased assets, not a physical expense you write a check out for each year. If you want to factor in replacement costs as ‘depreciation’, you can figure that math in at the bottom of the article.
Now, take these Operating Expenses divided by your Gross Farm Income to find your Operating Expense Ratio.
Total Operating Expenses / Gross Farm Income = Operating Expense Ratio A typical Operating Expense Ratio is between 70-80% for a row crop operation in the Midwest. Ask your lender if you are high or low compared to your peers. A lower % signifies you are more efficient at generating income.
If your cash flow is constantly tight and the operation is losing money, check this number. Often, the producer has an Operating Expense Ratio > 80% for several years going back. This makes them a high expense operator, and the money they spend raising the crop is not being realized with sufficient increases to their Gross Farm Income. The operation needs to reduce their input spending to return to profitability.
Fixed Costs Fixed costs consist of expenses that you must pay to keep existing assets, and there is very little movement in how much these will cost you. They include:
Term Principal Payments, Term Interest Payments, Taxes, Equipment Lease Payments
Wait, why are equipment lease payments included as a fixed cost while land rent and machinery rentals are not?
Lease payments are a signed contract very similar to a loan payment. You are locked into this and if you don’t pay, you forfeit the asset. Just like any asset you make loan payments on.
Land rental agreements can typically be negotiated year over year and the amount paid each year often varies with the market, just like many other crop input expenses.
Machinery rent by the hour from a dealership is not locking you into a multi-year contract.
Now, let’s create a Fixed Cost Ratio the same way we made our Operating Expense Ratio.
Total Fixed Costs / Gross Farm Income = Fixed Cost Ratio
You ideally want this figure below 20% as it represents how much of your income goes toward making debt payments. If your Fixed Cost Ratio is at 22% and your Operating Expense Ratio is at 83%, you are using 105% of your income to pay for expenses. This is obviously a problem.
If you have a very strong Operating Expense Ratio in the lower 70’s%, maybe you can handle slightly more debt obligations than your peers. Find where you are efficient and where your expenses are out of line and need correcting.
Ideally, you want to always keep your Fixed Cost Ratio <15%. This easy to achieve because you can make the Fixed Cost Ratio calculation before deciding to buy and finance any new purchase. If Fixed Cost Ratio is >15% with a purchase, put more cash down or don’t make the purchase!
Fixed costs are easier to control than variable expenses because variable expenses vary year to year, obviously!
Final Note: None of these include your living expenses! If you don’t have off farm income to cover living expenses, then these ratios better add up to <100% to leave room to cover for living!
Have a great day,
Grant
All views expressed on this site are my own and do not represent the opinions of any entity whatsoever with which I have been, am now, or will be affiliated. Information provided is authentic to the best of my knowledge, and as such, is prone to errors and the absence of key details. The content of this blog is for entertainment and informative purposes and should not be seen as professional advice to finances or any other field.