Profitability versus Return on Capital for Cattle Farmers

Is profitability or return on capital the most important driver for the cattle farmer? A recent question on a Facebook page about what farmers’ current production costs are for a 240kg weaner calf, made me wonder why there were such big differences in the answers to that question. Is there sufficient cattle farming information and research available to explain it?

There were not only significant differences in reported production costs, but also in the calculation methods used. (Read more about my favourite method of calculating production costs per calf).

The answer in short is that everyone’s input costs and capital layout differ. Both factors play a major role in each of the reported production costs, profitability and return on capital. It is therefore important that every farmer should consider his own circumstances in order to make informed decisions about cattle farming.

To illustrate the point, we will look at one farm of about 434 hectares on which there is no dwelling but it is fully equipped for cattle farming (camps, ponds and cribs). The same amount of cows and bulls will be farmed, but under three different options, namely:
1. The farm was inherited or bought in cash;
2. The farm is bought with a 100% loan at prime interest rate (farm financing); and
3. The farm is leased.

Main Assumptions (table 1):

Production cost per calf

Production costs for the three different options are unchanged for illustration purposes, except for the interest on mortgage (option 2) and rental expense (option 3) which are exceptions. Because everyone’s circumstances are different, their input costs will also differ e.g. one farmer can take out fire insurance while another does not or one mixes his own lick and another buys it already mixed, etc.

Summary of Production costs (table 2):

From table 2 it is clear why there is such a wide range of production costs per calf among cattle farmers. Option 1 seems to be the most profitable one, almost as if the farmer is making a clean profit with a sale price of R6,600 (220kg @ R30 / kg) against cost of R1,836 per calf. It is also clear from the table that option 2 is not very profitable where the farmer took a mortgage over the land. Option 2’s farmer will only start to show profit in year 9 when his interest expense is R347,345 (table 3) where it has decreased enough to lower his production costs to a profitable farm. (Refer to table 3 below which shows the farmer’s annual interest expense against the capital he invests annually in the land).

Amortization schedule for option 2 loan repayment (table 3):

Capital layout

To understand truly, which of our three options will deliver the best return on capital, we also need to look at the capital layout of each farmer. Farming, after all, is a business and must realize a reasonable return on capital that can beat other investments with similar levels of risk.

Capital layout at the end of year 1 – (table 4)

The inherited or cash purchased land in option 1 is stated at market value because the money could be invested in something other than land. The capital is allocated to the farming enterprise.

Option 2 includes the accumulated capital portion of the loan for land at the end of the specific year. In other words, the capital portion of all the instalments paid to date, as set out in table 3. In year 1 it is small but over the years it will increase until the end of year 20, where the full capital has been repaid i.e. R4,340,000.

Weaner calves inventory must also be included because it is working capital deployed to produce the weaner calves and will only be recovered when the weaner calves that are in stock, are sold. Weaner calves inventory value is calculated by multiplying the production cost per calf calculated in table 2 with the number of calves on hand. In the example, we produced 73 living calves of which 35 were sold. We therefore have 38 calves in stock. Option 1 is therefore 38 x R1,835.62 = R69,753.

Now that we know what each option’s capital layout is, we can calculate the return on capital for the year.

Return on capital (Table 5)

The question that must be answered from Table 5 is how does the return compare to another investment with similar risks? I think everyone will agree that a fixed deposit at a bank carries less risk than cattle farming. Cattle can be stolen, farms can burn and cattle can die from disease. A fixed deposit carries no such risks. We can therefore expect the yield on cattle farming to be significantly higher than the current 7% for a fixed deposit.

Although option 1 is significantly lower than the yield on fixed deposit, the farmer has the prospect that his land could increase in value if economic conditions allow, but it would have to be annual growth of +/- 4% above inflation to compare. Option 3 is just above the 7% of a fixed deposit.

Conclusion

It’s clear that every farmer’s circumstances are different and that there are many variables that will affect his production cost per calf, profitability and return on capital. Each farmer has to keep record and regularly calculate and manage his costs, profitability and return on capital, in order to farm sustainably.