Profits entice cattle producers to expand to capture more profits
Asking any veteran cattle producer about profits will likely elicit several "I remember back in…" stories. Cow-calf returns over variable costs were $121 per cow in 1979. That’s $503 per cow in today’s dollars. It’s also the highest return in the three cattle cycles (1979-1990, 1990-2004 and 2004-2014) prior to the current cycle, which started in 2014.
Profit means different things to different people and in different situations. A basic formula is Profit = Revenue – Expenses. Revenue must exceed expenses to turn a profit. Deciding which expenses to include is the tricky part.
One profit calculation is money left over after the business pays all costs. Producers must consider this calculation when making investment or expansion decisions. No matter how high current revenues are, an enterprise must cover all expenses to be economically sustainable over the long haul.
Another view of profit is return above variable costs. This measure can help guide short-term decisions on production levels. When times are tough, economic theory says to maintain full production as long as expected revenues are projected to cover variable costs. Any returns above variable costs would leave something to apply toward fixed costs. A revenue short fall between covering total costs and variable costs suggests how much cash must come from other enterprises or off-farm income to cover overhead expenses, pay salary and living expenses.
Cattle earnings swings persist
Cattle production returns can fluctuate considerably year-to-year. USDA‘s Economic Research Service provides annual cow-calf costs and returns estimates for the United States and key production regions. Annual US returns over variable costs in the current cattle cycle have averaged $124 per cow with a high of $391 per cow in 2014 and a low of $12 per cow in 2022.
Short-term swings can be quite extreme. Yearling steers finished in October and November 2014 earned returns above variable costs of over $300 per head. That profit gave way to losses of over $400 per head by October 2015, according to the Iowa State University Estimated Livestock Returns.
When feedlots make money, feedlot operators tend to bid up feeder cattle prices, which boosts fed cattle breakeven prices. Midway through 2015, fed cattle entered an unexpected price slump (Figure 2). The combination of high placement costs and an unexpected plunge in fed cattle prices triggered record losses for some cattle feeders.
Risk management tools are available
Many producers, especially beginning and more leveraged producers, simply cannot self-insure against the type of market risk experienced in the not-so-distant past. The Chicago Mercantile Exchange introduced live cattle futures in 1964 and added feeder cattle futures in 1971. In 1984, the CME first introduced options on livestock futures. For decades, producers have successfully used futures and options or forward contracts to manage price risk.
Another tool is federally supported livestock insurance which was first offered in 2003.
Livestock Risk Protection (LRP) seeks to cover decreases in output price (fed cattle or feeder cattle). Livestock Gross Margin (LGM) works to cover the decrease in margin between input prices (feeder cattle and corn) and output prices (fed cattle). Recent updates to the livestock insurance products took effect July 1, 2022. With the revisions, the hope is to reach more producers, offer greater flexibility for protecting operations, and ultimately, better meet the price risk management needs of producers.
How much risk a producer can afford to take on is a key consideration in choosing to use or not use price risk management tools. In good times, risk management strategies that strive to hedge a price level or set a price floor may leave some money on the table. But in tough times having a floor can generate enough earnings to keep the business in business.
Future earnings appear promising
Cow-calf returns are in the midst of what could be a meteoric upward trend in the next couple of years. Unfortunately, costs have not moderated, which may limit margins. Profitability projections for cattle feeding are generally positive for 2023.
Solid earnings give producers opportunities to choose how to allocate profits. Their challenge is balancing investing to expand in hopes of capturing more earnings, while preserving enough cash to weather the inevitable bad times. The old saying goes, "hope for the best but plan for the worst."
Cattle producers have many investment choices. An individual producer’s best option depends on their situation and the goals of their operation.
Ramping up amplifies risk
On the surface, projecting profits from adding a few more cows to an existing profitable cow-calf operation would seem to be a simple matter of applying the same proportional increase to expected revenue and expenses. That’s not realistic. Financing the additional cows and the extra feed and operating expenses takes cash from equity or debt. Both approaches boost risk exposure.
Suppose an expansion calls for adding facilities. Taking on debt would boost debt service requirements now, and in the years to come. Per head operating costs might not rise much, but extra cash needed to pay for operating expenses would up cash flow needed. That’s why producers need to do a lot of pencil pushing before embarking on expansions that require capital expenditures.
While an operation may be profitable for the year, the monthly and weekly cash outflows may not coincide with revenue inflows. Cattle sales are often seasonal. Producers must typically pay expenses before sales generate revenue. That creates a need to dig into cash reserves, liquidate assets to generate funds, or borrow money to meet expense obligations.
Good records aid sound decision making
Keeping good records is the first step in managing for profitability. The key financial statements–balance sheet, income statement and cash flow statement–provide information to analyze financial position. The liquidity ratio, solvency ratio, profitability, financial efficiency and repayment capacity provide financial benchmarks. Records of calf crop or weaning percentage, average weaning weight, average daily gain, and total cost per pound of gain provide measures to evaluate production performance.
Debt is an integral part of most businesses. Everything in agriculture is cyclical. Trimming debt in the good times improves staying power for the lean times. Reducing debt provides a guaranteed return on investment and builds equity available for borrowing against in the future.
Investing to chase profits carries risk
Use caution when reinvesting back into the business during periods of high profits. Make sure the proposed investment "fits" with the long-term business plan. Many producers see high profits and invest, invest, invest hoping for many years of favorable returns. Then, when profitability wanes, they’re forced to liquidate, liquidate, liquidate, often on a lower market. A good investment ultimately produces profitability from the time the investment is made through its entire useful life, whether short- or long-term.
As you consider decisions about expenses, cash flow, debt and investment, also focus on specifics. Prioritize investments in areas with high expected payoffs. Some examples include: improving cattle genetics; improving the forage base; repairing, replacing, or expanding infrastructure; acquiring productive assets; investing in technology; and/or adjusting production activities (i.e., ensuring marginal benefits equal or exceed marginal costs).
Strive to make investments that improve productivity and efficiency, or lower costs. Key performance indicators from your records can help measure progress. Make comparisons to industry measures for benchmarking purposes.
Finally, understand the adjustments you need to make to improve, and then make those adjustments. Investments that improve productivity and efficiency, or lower costs, can pay dividends in future years. Those gains can put you among the producers who make money even in the "bad years."
Enjoy fruits of your labor
Much has been written about management strategies when times are tough. In reality, decisions producers make during good times are often more crucial. Good times bring temptations to splurge on items that contribute little or nothing to productivity and profitability. So, justify each transaction in the context of the goals of your business.
If the overriding goal is to grow the business, then consider strategies to acquire productive assets. If the ultimate vision is maintaining long-term profitability, then plan ahead for future times when generating profits might be more challenging. Building or supplementing savings is an option.
If one goal is to produce profits for personal use, then profit taking is in line with operational goals. Long hours and hard work deserve a reward when income is available. Take the time, and a few dollars, to enjoy the blessings of prosperous cattle market.
Lee Schulz, extension livestock specialist, 515-294-3356, firstname.lastname@example.org