Costs are Bad, Right?

By John Ritten, UW Extension Economist

A lot of advice these days seems to be focused on cutting costs, with overhead costs getting a lot of the attention. As an economist, I whole-heartedly agree that we should not spend money that doesn’t add to our operation. However, I think it is too easy to start cutting costs that don’t appear to be needed and end up hurting our operation in the long run.

When cost cutting, it is important to understand the long-term implications of our actions including any added risks that may be incurred. There is no “silver bullet” that will ensure profitability in any given year. It is important to have a thorough understanding of the linkages in your system – across and among separate enterprises – before making drastic changes in order to cut costs.

In the cow/calf industry, a lot of the “war on costs” proponents seem to advocate the elimination of the hay enterprise on a ranch. While it is often more expensive to put up your own hay as compared to buying hay on the open market and the move eliminates the machinery costs associated with haying/stacking/hauling, there are two reasons I would think very hard before making such a drastic decision.

The first is that while in an average year you may be able to buy hay cheaper than you can produce it, there will be years where hay prices spike, and I am fairly confident you can produce hay cheaper than you can buy it in those years. You need to look at the frequency that your costs exceed the market price and by what margin.

The second reason I have concerns for eliminating an on-ranch hay enterprise is tied to risk. The years when hay prices spike are probably the years when you need hay the most. You really place yourself at the mercy of the market when you rely on others to supply your fed feed.

Another risk to consider is that you have to be concerned with the quality and any weeds that may be introduced when buying someone else’s hay. Instead of eliminating a less profitable hay enterprise, putting ourselves at risk both in terms of high prices when we need hay and potentially inviting weeds onto our ranch, we should buckle down and focus on how we can improve the profitability of the hay enterprise.

A lot of these sorts of recommendations really aim at cutting the underperforming enterprises and focusing on the profitable ones, but sometimes we just need to focus a little more attention and sometimes money on the struggling enterprises in order to bring them up to speed.

To illustrate why cutting overhead costs is not a sure-fire way to increase profits, here’s an example from Kansas.

The Kansas Farm Management Association (KFMA) recently released their annual profit summaries. I’ll focus on the wheat farmers just to illustrate a point. While farming and ranching are very different activities, wheat farmers are also often low-input, low-margin commodity producers, so I think we can learn something from this report.

The KFMA data shows that the most profitable wheat farmers actually often have the highest overhead costs. In fact, the top 20 percent of operations in terms of profitability spend more on machinery and depreciation than any other group. When I first read that, I have to admit I was kind of surprised. But when looking into the report a little deeper, a few things jumped out at me.

We need to remember that total costs are comprised of overhead and operating costs. The farmers with higher overhead costs were able to reduce their per-unit of output operating costs while also eliminating some production risk. From a wheat farmer’s perspective, it often pays to have machinery that works when you need it, and larger machinery allows you to get the wheat out of the field in a timely manner. To get the wheat out of the field, larger equipment allows you to cover more ground, and newer equipment breaks down less often, leaving it available when you need. Both larger and newer equipment makes farming easier and reduces some production risk but also adds to overhead costs.

Now back to cattle. The KFMA also recently published cattle profit summaries. When looking at the cow/calf sector, the most profitable herds did have lower costs than the least profitable but not by much. The most profitable herds actually had higher costs than the middle third of producers.

The main difference that made high profit herds profitable was a difference in per-cow revenues. While high profit herds had 18 percent lower expenses than low profit herds, the high profit herds had almost 40 percent higher revenues on a per-cow basis. Calf prices were on average $15 per hundredweight higher than their low profit counterparts.

This is where, I think, wheat farmers differ most from cow/calf producers. While calves are still technically a commodity, there is a much wider range in selling price for calves than wheat. No two lots of calves bring the same price at the sale barn, which implies we can have some impact on the prices we receive. Therefore, I think it is even more important in this industry to make sure we spend the right amount of money to ensure a quality product.

Sure, if you can cut costs without impacting output, go for it. However, it is very important to make sure that when you cut costs, you are not also cutting revenues as well. This is why I stress the need to be cautious when cutting overhead. It is sometimes difficult to see how these costs contribute to our operation, but they do interact with both the quality and quantity of output we are able to produce as well as the operational costs we incur.

From an overhead perspective, if you are artificialy inseminating your heifers, having better facilities and the related overhead costs associated with them will likely make working them easier, reduce labor costs and might even result in better conception rates, especially if you are able to work your heifers more efficiently. Or, if you rely on hired labor, are you more likely to keep good, trained hired help on if you keep them supplied with new trucks and equipment? It might be better to keep the good workers happy, rather than continually having to hire people to fill the vacancies as good people move on to better operations.

Also, when cutting costs, make sure you look at the long run. Cutting costs may make money this year, but what about the next drought or major blizzard? How much worse off will you be then? Don’t make any decisions based on a year or two worth of data. Run the numbers over a decade, with varying weather and cattle dynamics, to see how likely this is to pay off on average, not just in years with good forage, low feed costs and strong calf prices.

The “war on costs” can be an effective management strategy, but to do it right, make sure you put in enough time and energy to make sure you understand the implications of lower costs and surgically cut the right ones, leaving the valuable costs intact. While you’re at it, I would challenge you to find some good costs you should increase. Regardless, remember only the unnecessary costs are bad, but I’d happily spend $1 to make $1.01. I’d do it a million times a day if I could.