The four buckets
Improving Your Farm Profitability: #3
by Craig Chase, program manager
The “four buckets” is not a technical financial term, but it is a helpful way to think about profit margins.
Imagine you have four buckets in front of you and $100 in your pocket from a recent sale. You really can’t keep the $100 in your pocket, because you have bills to pay, inputs to purchase, loans to pay back, etc.
You take the $100 out of your pocket and go to the first bucket, marked “operating expenses.” These are the production and marketing expenses you incur as you take your product from seed to ultimate sale. You look at your bills and determine that you need to drop $82 into that bucket to cover the share of operating expenses coming out of your sale.
The second bucket is marked “interest expense.” You put in $5 to cover part of the interest on your loan.
The third bucket is “depreciation expense.” Although you don’t have a lot of machinery and equipment, you need to put $3 in it to help cover the wear and tear on what you do own. (Make sure you set aside money for future purchases. Don’t reassign these dollars to another bucket.)
Last bucket: net income
The last bucket is marked “net farm income.” The money in this bucket covers all of your family living expenses, savings and retirement, and farm growth. You have $10 left over, and put it in that bucket.
You can convert this leftover $10 to a percentage (10%). Use it to indicate that you’ll keep $10 out of every $100 in sales as net farm income. This comes in handy when you think about what scale of farming operation you need in order to reach your net farm income goal.
Let’s say your net farm income goal is $40,000 per year and you have a 10% net profit margin. You will need to sell $400,000 of products to achieve your income goal. Does your farm have the capacity to achieve that level of sales? If not, how can you either increase sales or increase your profit margin?
What if you increase your profit margin to 20% by reducing your operating expenses, changing product mix (i.e., what you sell), or raising your prices? Then you would need $200,000 in sales to achieve your $40,000 net income goal. Is that level of sales achievable given your farm business? If you believe your sales will max out at $100,000, is a 40% profit margin achievable? If not, is your $40,000 income goal realistic?
Figuring your profit margin
Determine profit margin at the whole-farm level using an income statement. You can figure it at the enterprise level using enterprise budgets. In either case, you simply divvy your total revenue into the four buckets. Then determine what expenses you need to cover and how much of each sale you get to keep as income.
Knowing that number and what sales revenue level you need to achieve your income goals, you can determine what it will take to increase either your sales or your profit margin.
Profit margin can be increased in any of three ways:
- increase your prices
- decrease your expenses
- change your product mix (the combination of the products you sell)
You can determine which of these, or combination of these, makes the most sense for you by drilling down to the enterprise (product-specific) level. Developing an enterprise budget for your major products (those that contribute a combined 80% of your total revenue) shows how your sales revenues are divided and where possible changes can be made.
I have worked with a lot of farmers over the years. Once they determine their enterprise-level information, many make some kind of change to their operation.
Do you want to know where your money goes (which bucket it goes into)? Once you receive dollars from a sale, develop an income statement or enterprise budget (or both). Drop those expenses into one of the first three buckets (figuratively speaking). Once you have that information, you will know what you need to do to achieve your income goal—or whether your income goal is actually achievable.
Questions? Contact me.