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Farm Flows - Understanding Gross and Operating Profit

Image from cover of “Slow Money”, by Woody Tasch.

If you’ve read our first blog post, you probably know that I have a background in finance. Whether I like it or not, numbers are always on my mind. That means I think a lot about Little Seed and how we’ll manage to stay alive in an industry like farming, which is notorious for bedeviling even the most astute financial planners. Probably the most important aspect of our financial plan is understanding our costs and our cash flows. Not just thinking about them, but actually writing (typing) them all down and planning a few years ahead. I can't emphasize how important it is to actually sit down and write it out. Until you do, you won't know what you don't know.

Money management is a complicated (and often sensitive) topic, so I’ll try to keep this particular discussion high level and offer some ideas for how to think about managing money in a small-farm situation. Very little of what I describe is appropriate from an “accounting” or “tax” perspective, but it’s very appropriate from a “I just want to think like a normal person about what’s going on with my money” perspective.

To begin with, I think it helps to define what I mean when I say “cash flow”. Cash flow at its most basic level is the sum of all the cash going out the door and all the cash coming in the door over a given period of time. The cash coming in the door is obvious, it’s the Revenues (also known as “Sales”) of  whatever product(s) you’re selling. Getting a handle on the cash going out the door is a little more difficult. When I work on Little Seed’s financial plan I tend to include ALL of the expenses. It’s not just the feed and fuel costs, but also the mortgage, the phone bill, and my serious addiction to Ben & Jerry’s Cherry Garcia. Yes, some of those expenses aren’t farm expenses, but the bank doesn’t care whether you miss a mortgage payment because you spent all your money buying in hay or because you spent it all digging out those magnificent tiny cherries hidden behind dark chocolate chips. They want their money and if you don’t have it they want your stuff.

This is where planning a small, family-operated business gets a little tricky. You need enough income to not only pay for your ongoing farm expenses (including reinvestment in farm equipment and maintenance), but you also need to take home a little extra to pay the everyday bills. If you’re lucky you might even tuck a few bucks away for a rainy day or the elusive idea of “retirement”.

What this means is that you have to think about your living expenses when you price and sell your product. It’s not enough to think solely about the farm expenses and ignore the other costs of life. The reality is that you are your employer and you have to make sure that as the employee you are taking home enough to pay your bills. BUT, you also don’t want to mix the farm expenses with the personal expenses. It’s important to separate farm expenses and personal expenses for two main reasons: 1.) tax and cost accounting purposes and 2.) so that you can track the profitability of each farm enterprise. You need to know if you’re breaking even, losing money or making money on everything you do. So what’s an easy way to keep track of everything, but still keep things separate? It’s called Gross Profit and Operating Profit.

Gross Profit is defined as the money that’s left over after you’ve paid all the expenses directly associated with the goods you’re selling. If you’re selling pastured pork, for instance, then your direct costs would include feed costs, slaughter/butcher fees, mineral supplements, etc. You could also include direct labor if you’re paying someone to manage the pigs. If I were managing my own pigs I’d wait to charge my labor expense in the operating expense section, for reasons i describe below. So once you have that direct cost number, just subtract it from the sales of the product you’re analyzing. It’s really quite simple and it tells you a lot about each specific product you’re selling.

Now that you have a gross profit figure for each farm enterprise you can easily calculate an operating profit figure. To calculate the operating profit for the entire farm just add up all the gross profit figures (which should be all of your sales revenue minus all of your direct costs) and then subtract all of your indirect costs. Indirect costs are the costs that can’t be associated with a particular farm enterprise. This would include things like mortgage payments, phone bills, cable bills, etc.  I also include a base salary for managing the farm in the indirect costs. If I later want to break that cost down across farm enterprises then it’s easy to multiply the entire salary number by the percent of my time that I spend on a given enterprise and allocate the cost accordingly.

Now you have a real simple way to think about how much money you need to make to pay the farm bills and and your personal bills and you can track it all very simply. Again, this is not a budget for tax purposes, this is a budget for your real life, so you must include ALL of your expenses. Anything that you can’t directly attribute to a specific farm enterprise should be lumped in the indirect category and only subtracted after you’ve already calculated the Gross Profit (direct expenses). When you subtract all those expenses from your Gross Profit you’ll come up with your Operating Profit, or your Earnings Before Tax. Operating Profit is the income you’ll pay tax on and I certainly hope that we’ll be paying taxes someday, because paying taxes means you’re making money and making money means that you can keep farming for another year!

One difficult question is how to think about capital equipment expenses that cost a lot upfront, but are typically depreciated over a number of years. The question gets into the differences between cash and accrual accounting and is certainly worthy of discussion. Perhaps another blog post is in the works, but what I would say here is that you need to make sure you have the capital to cover your equipment purchases (and repairs), but you don’t necessarily need to allocate all of those costs into one single year when you’re looking at the profitability of an enterprise. In fact, for tax purposes you can’t. I’ll follow-up with a separate post on cash flow management and the importance of “charging” yourself for depreciation and tucking away cash for future equipment and building replacement.

How do you think about finances in your life? If you operate a farm, what method have you found works best for you? I’d love to hear about it and also provide more detail for those that are interested!
Little Seed Farm, Scrapple, Grassfed Cheese Pastured Pork

 

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