Planning for long-term profitability

The profitability of farming has been under the spotlight in recent months, particularly with the Government's proposed changes to inheritance tax (IHT).

While IHT is a significant factor for farmers when considering future financial security, effective planning and accurate accounting for incurred costs are equally crucial.

Our analysis of milk to feed price ratio place the industry in 'the expansion zone' after being in a difficult position for the last few months.

There is no doubt that farm businesses must be more focused on profit to stay competitive or even afloat. The big question is, how do you plan for profit?

Understanding farm costs and profitability

Andersons consultant Tony Evans said there were "many costs associated with running a dairy farm". He explained that some expenses, such as feed and labour, are direct cash costs, while others - like family labour, owned land and depreciation - are hidden and often overlooked but can accumulate over time.

Tony recommended following the 'third, third, third' principle, where dairy income is divided as follows:

• One-third allocated to variable costs
• One-third to overheads
• One-third retained as gross income before rent

Achieving this balance is not always straightforward, but it provides a structured approach to financial management.

Tony explained that high investment requires repayments and leads to increased depreciation costs. He emphasised that farmers must ensure they achieve a return on investment for every penny spent on overheads.

Higher-yielding herds often demand a greater investment in infrastructure, but the yield must increase accordingly to cover those additional costs.

Even grant-funded capital purchases should account for the depreciation of the original cost, as there is no guarantee that grant aid will be available when replacements or upgrades are needed.

With profit comes tax and there is often an approach within the industry to offset this by purchasing machinery, subsequently increasing our hidden costs in the way of depreciation.

If machinery purchase is placed within an investment plan and a budget and the return on capital is scrutinised, it can be a shrewd move, but planning is key.

Where do you start when it comes to working out a budget?

Tony explained that the first step is to determine the required profit for the business, suggesting that a 10% return on capital is a sensible target. Adding in drawings, pensions, capital repayments and any planned investment spread over the depreciation term.

He emphasised the importance of reviewing the previous year’s costs to assess whether these financial needs can realistically be met in the coming year.

Since management accounts can sometimes be misleading, he recommends using a Comparable Farm Profit (CFP) form to gain a more accurate financial insight and determine whether the 'third-third-third' principle is achievable.

Steve West, AHDB Knowledge Exchange Manager, added:

"You can gain insight into a five-year rolling average milk price from the AHDB market intelligence page and track milk market value (MMV), which gives an indication of direction of travel for milk price three to four months subsequently."

Tony explained:

"Once you have an achievable budget, you can use this to split it into a month-by-month cash flow based on last year's milk profile. It is very powerful for conversations with lenders and negotiations on inputs."

Planning for the future is not limited to buying equipment. Farmers also need to be mindful that the number of generations reliant on an income can be as many as three. So, as expectations on the business grow, so must the business.

Tony added:

"Retirement is a reasonable expectation for any generation and the hard work over many years ought to facilitate that. This can be planned for by adding the expected drawings to the profit target and plan the business structure around this."

Tony stated that a return on investment (ROI) on capital of 10% is a good starting point, with a rental value for owned land helping to supplement this.

He emphasised that, as a rule, farmers should never enter retirement with tenant type capital debt, as this represents their ROI.

Additionally, he advised that tenant farmers should aim to maximise the lifespan of every investment to ensure long-term financial stability.

Rough Grounds Farm case study

AHDB Strategic Dairy Farmers Justine and Graham Worsey run a profitable tenanted 300-cow dairy business in Derbyshire. Both farmers have seen many changes with tax and outgoings during that time.

Graham explained:

"It has not always been that way, early on it was difficult, we were working very hard as we built up (cow) numbers and we certainly weren’t able to take time off or have holidays.

"We even had to be very selective with our shopping. We knew we could make a profit as we had planned for that, but there is a journey you have to go through to achieve that as capital costs need to be spread across litres."

The Worsey’s moderate output system at an average lactation yield of 6,500 litres with 4,500 litres from forage on a split block calving system.

A lot of the profitability is credited to the grass management, particularly grazed grass and ensuring feed costs are kept to a minimum.

Margin over purchased feed (MOPF) is 37ppl (pence per litre) with purchased feed costs sitting at 4.82ppl or 1p/kgBF (pence per kilogram of butter fat).

They currently have a joint-venture agreement with Dan Jones, a local young farmer, who has invested money into the business along with hard work to help it to grow.

The business involves husband and wife, Graham and Justine and their daughter, Jess. Their son, Tom, had previously been involved but has extracted capital to take on a new tenancy locally. Capital was mobilised by selling some cows and passing across some machinery.

One area the business plans to work on during the three-year Strategic Farm Programme is to strive for improved output from forage, aiming for 5,000 litres or 500 kgMS (kilogram of milk solids).

Animal welfare is another area of strength and in particular, calf health and subsequent growth rates. Justine has worked hard with her vet Beckie Harrison of Peakfield Farm Vets to reduce the impact of pneumonia, and this will be the subject of a Strategic Farm event in spring.

Dairy NZ podcast

DairyNZ produced a podcast that made a reference to a study looking into the purchase habits of the most profitable herds. They found that those that kept to a strict budget that was carefully thought out and moderated their capital expenditure were more profitable and therefore resilient to changes in milk price or increases in input prices. Listen to the podcast