Procedure 3

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List options for improvement, evaluate benefits and feasibility of options, and choose the best strategy

An enterprise's strategy may include options ranging from simple modifications of existing operations to complex changes affecting the whole enterprise. Being able to explore options and quantify the benefits of change is integral to developing your farm plan and committing to that change.

Understand what information is required and the process of determining options.

Guidelines for exploring options to change enterprise strategy

There are many different enterprise strategies that you can evaluate that will improve farm profitability, natural resource management and your lifestyle. Once opportunities have been identified to improve your existing business, consider other information important to your final decisions, including:

  • your view of the value of future markets and commodity prices in the new enterprise
  • historical commodity price variation in real dollars over longer time periods (eg 10–15 years if available, corrected for inflation)
  • potential productivity improvements and how the new system fits the pasture growth curve
  • profitability and capital required for alternative enterprises
  • impact on environment and natural resources
  • impact on lifestyle and labour efficiency
  • your management skills to run the new or changed enterprise.

A wide range of scenarios can be reviewed initially for feasibility in a typical year using simple screening techniques. Depending on the type of changes considered, the options for improvement can be compared using the following techniques:

  • Simple gross margin analysis to compare enterprise income and direct (variable) costs. The analysis can be conducted on a total basis or per hectare, per DSE (dry sheep equivalent) or per livestock capital invested in the enterprise; depending on which resources are most limiting.
  • Partial budgets are useful to examine one aspect of change without including the whole farm business (additional returns minus additional costs). Tool 1.13 shows a worked example of a partial budget and the subsequent return on investment calculation. This takes into account all the variations in returns and costs, including additional capital associated with the proposed change. It mirrors the whole farm budget but only accounts for those items that vary if this investment or option is adopted and implemented. The returns on additional capital required are as important as the overall return on total capital. You can use the spreadsheet tool to analyse your own scenario.
  • With complicated investment decisions where large capital outlay or longer timeframes are involved before returns are generated, methods such as discounted cash flow analysis are useful analytical tools as the value placed on money changes over time – a dollar in the future is regarded as being worth less than current value (see 'Comparing analysis approaches' box, below). The discount rate chosen for ‘devaluing’ future returns is normally the assumed rate for borrowing, say 8%, plus an addition for risk, say 4%, giving a rate of 12% in this example. This is often referred to as a nominal discount rate because inflation is included.
  • When changes involved in the transition are substantial and multifaceted, (eg when purchasing more land or changing enterprise or time of calving), you should undertake a whole-farm budget to fully understand the consequences for the business including cash flow, liquidity and financing. Tools for whole-farm analysis that require you to quantify the marginal costs, marginal income, discounted cash flow analysis, time to break even, lifespan of the investment and the relative return on capital invested across multiple enterprises and with complex interactions between them, are complex. If they are required, you should seek professional assistance.
  • The biological impact of strategies should be investigated including potential impact on pasture utilisation, pasture growth rates, nutritional management and beef production. The Feed Demand Calculator (Tool 1.3) and MLA Rainfall to Pasture Growth Outlook Tool (Tool 1.4) are extremely useful to understand the impact of feed demand and feed supply with changing systems (eg time of calving, time of sale of stock or even changing enterprises from breeding to trading). Bio-economic models are available, usually with the assistance of a consultant, to assist complicated decisions.

Comparing analysis approaches

The differences in outputs from partial budget analyses and discounted net cash inflow analyses are as follows:

Partial budget analysis outputs

  • Net gain (returns minus costs).
  • Percentage return on extra capital invested (such as in livestock).

Discounted net cash flow analysis outputs

  • Net present value of the investment over the period of time (discounting the value of returns and costs in the future).
  • Internal rate of return is the interest rate that discounts a cash flow to zero (that can be used to compare projected returns with the opportunity cost of investing the money elsewhere).
  • Nominal net cash flow (inflation included).
  • Cumulative net cash flow.

Manage the risks

When planning a new enterprise, you should consider the effect of change on all option you are exploring. This should involve sensitivity analysis with budgeting to include a wide range of price scenarios and costs, the impact of drought and a range of productivity scenarios due to different seasonal conditions. Refer to Procedure 1 for more information on risk analysis. Undertake the same procedures for enterprise changes and operational changes.

Management needs to have the knowledge and skills to manage change. The main risks with transition of enterprises are failing to gain the highest enterprise profit and taking longer to achieve profit objectives beacuse:

  • investment is not scheduled in order of the highest rate of return
  • enterprise changes are not planned to maximise profit.

A worst case scenario is when the farm business is destabilised by declining cash flowsduring transition . This may contribute to reduced equity and liquidity. Options available to address this include:

  • re-calculating budgets.
  • stopping or limiting progress of change and re-directing investment to areas of higher returns and/or lower risk.
  • delaying or advancing implementation to better fit cash flow and management constraints.

In some circumstances, business equity can increase while cash flow is reduced. Such is the case when increasing stocking rates as sales are forgone and assets (livestock) are increasing.

Constraints

Analysis with budgets of a new enterprise does not directly take into account the costs or benefits associated with quality of life, but these factors are important enough to be considered in the trade-off between personal goals and maximising profit. Such unquantifiable benefits include the ability to take a holiday, the total number of hours worked each day, the timeframe in which the work needs to be completed, attitude to borrowing money and taking risks.

Similarly, you may want to put constraints on some forms of development because of concerns about potential environmental or resource management effects.

In these instances, it is useful to assess the cost of these constraints in terms of any decrease in profitability, so you are in a better position to consider the pros (positives) and cons (negatives) and make a more informed decision.

What to measure and when

It is not uncommon for potential returns from on-farm investment to vary from 10% to more than 30% and therefore it is critical to identify better investment opportunities.

Assessing the competing investment options for a farm’s scarce resources involves quantifying or qualifying the:

  • net change in income, accounting for increased income and any trade-offs or income reductions, such as lower income, if there is an increased focus on an alternative beef production enterprise.
  • net change in expenses, accounting for any increased costs (both cash outlays and any non-cash costs such as additional owner-labour requirements or depreciation on plant and equipment) and reduced costs.
  • scale of the investment (capital and human resources). For example, an investment in pastures will need to be accompanied by an often greater investment in additional livestock and may require increased management inputs.
  • likely repayment period for the investment and the cash flow implications, accounting for the climatic and production risks involved.
  • life span of the expected benefits from the investment. An investment of $50,000 in a change that produces a benefit of $15,000 per annum over ten years ($150,000 in total) is better than an investment of the same amount with the same benefit but only for five years ($75,000 in total).
  • nature of and additional exposure to risk associated with any new or alternative enterprise.

It is critical with all options to initially calculate the marginal return on investment, the overall annual impact on enterprise profit and overall return on capital and cash flow, business equity and liquidity. Undertake annual reviews to ensure strategies adopted are working to expectation and budget.

Guidelines to determine the sequence of investments when implementing change

Once you have identified the best strategies, develop a sequence and list the key steps needed to implement each strategy. Devise an approach that suits your farm and management ability and includes rigorous review of both biological and financial indicators.

The first step is to decide how your enterprise will change (eg time of calving from March to August or herd structure from predominantly breeding to a mixture of breeding and trading). For each strategy being adopted, list the practices by month, in order of their application, and align the costs and benefits. Quantify the total productivity (kg/ha) and profitability ($/ha) for the enterprise and business.

Document the sequence of investments to identify cash flow and management inputs

Being able to explore the options and quantify the benefits of change is integral to committing to that change. The two critical outcomes of any change are that:

  1. the change makes a good marginal return to the capital invested, and returns are over and above alternative, less-risky uses of capital, such as off-farm investment
  2. investments in the farm go into the area of next-highest return on capital and effort invested.

To ensure you will improve the returns over the whole farm, any calculations are best done on a whole-farm basis.

Farm businesses most often involve multiple enterprises with complex interactions between them. Tool 1.12, taken from MLA's publication Towards Sustainable Grazing: The Professional Producer's Guide, provides a framework for quantitative and qualitative information to be included as the basis for implementing a planned change. In a relatively systematic way, it assesses the benefits and potential flow-on effects and implementation challenges. It is most suited to evaluating the sequence of investments and likely benefits of important decisions that affect the operation of the farm. You might make several of these types of decisions in a year.

The focus is on decisions that can have flow-on effects across the system, or decisions in areas where you lack confidence to do something 'off the top of your head'. Examples of such decisions might include applying fertiliser, re-sowing a pasture, changing grazing strategies or selecting a different market sector.

Manage the risks

The main risks of any new project are taking too long to achieve enterprise goals and failing to gain the highest possible profit. This is likely when:

  • investments are not scheduled in order of highest rate of return on investment
  • enterprise changes are not planned to control cost and maximise returns.

Aim for minimum time and a cash flow when implementing transition plans

Key variables influencing the outcomes, such as fluctuations in sales and market prices, are used as long-term average values in the initial analysis. Use a range of prices (eg real 15-year beef price percentiles) to assess the risk at the bottom 20% of price and 'good case' scenario at the 80% percentile. On this basis you can select your preferred order of action to account for what you think are the areas of greatest risk.

Calculate the enterprise scenarios using inputs and outputs that are likely to vary.

What to measure and when

The following areas should be measured:

  • marginal return on investment for each project and option
  • annual enterprise profit (return on capital)
  • yearly cash flow, business equity and liquidity
  • pasture utilisation on a monthly basis (for projects that change pasture growth or feed demand).

Further information

Other sources of local information include:

  • being a member of a production or marketing group
  • attending field days, seminars and industry conferences
  • reading widely to keep up-to-date with new technology and to gain insights from other producers.
  • A reference for determining comparative return on investments is The Farming Game: Agriculture Management and Marketing, 2nd Edition, Cambridge University Press, 2005.
  • Across Australia, a number of established private training and agricultural service providers deliver training courses and offer advice on choosing business strategies. You can find these in the Yellow Pages or by web seraching 'agricultural training'.
  • MLA's EDGEnetwork offers practice learning opportunities to help  producers gain knowledge and develop skills necessary to improve their livestock enterprises. For further information visit www.mla.com.au/edgenetwork or email edgenetwork@mla.com.au