Watch your COP – in good times and bad

By Mark Mapstone

Ever notice how the topic of cost of production tends to come up often during periods of low milk prices? My observation is that when milk prices dip to very low levels, a producer’s cost of production determines their degree of operating loss.  In other words, the higher the cost of production, the bigger the operating deficit.  So during periods of low milk prices, producers tend to explore ways of lowering cost of production to help minimize the equity they bleed.

The habit of focusing on cost of production just during the low milk price cycles frustrates me as a farm business consultant.  It’s  just as important – if not more – during the good times as during the bad times.  This is because a producer’s cost of production is the same factor that determines their level of profit during high milk price periods.  
In short, producers need to realize that a management strategy that helps them capture as much profit as possible from the marketplace during the good times should be the same basic strategy they use during the bad times to minimize losses.  A management strategy that results in a below average cost of production accomplishes both.

Cost of production is one of the least understood terms in the industry. One reason is that there are several different ways to measure cost of production in an operation. Farm Credit’s Northeast Dairy Farm Summary has used net cost of production (NCOP) for the past 30 years to measure cost of production and determine profitability on Northeast dairies.  We’ll use that the measure in this article.

The average farm in the Northeast Dairy Farm Summary had a cost of production of $17.88 per cwt.  That was up $1.58 per cwt., primarily as a result of higher input costs.  The bigger story was in this year’s range in net cost of production between the top 25% profit group and the bottom 25% profit group of $5.45 per cwt. The top 25% profit groups cost of production averaged $15.90 per cwt. and the bottom 25% profit group’s cost of production averaged $21.35 per cwt.

With milk prices averaging $19.59 per cwt. in 2008, the difference in cost of production between top and bottom group represented 28% of the milk price received.  In essence, the top 25% profit group was able to capture 28% more of the milk price as profit than the bottom 25% profit group did.  To put this in perspective, using an average-sized farm in the benchmark of 272 cows, the top 25% profit farm made a profit of $223,817 while a bottom 25% farm lost $106,753. 
Let’s face it, milk is a commodity –  you don’t have a significant amount of influence on the price you receive for your product.  A producer should do everything he or she can to achieve the highest milk price possible, but your best way to get a competitive advantage in the industry is to work on keeping your cost of production low.  

Keeping cost of production low is the best indicator of viability in the dairy industry because it allows you to maintain strong profit margins and remain competitive in the industry through both good times and bad.  A reasonable goal to shoot for is to keep your cost of production below the Northeast summary average by $1.00 per cwt. at all times.

Steps to improve your dairy’s net cost of production

Step 1
Use the attached worksheet to calculate your 2008 net cost of production.  When comparing your farm to benchmarks, always use the top profit group benchmark. 

Step 2
Use the flow chart to see whether you have an expense problem or a production problem.  Remember that a production problem could be a per-cow production issue or an under-capacity issue with facilities. 

If production per cow is the issue, determine the most probable underlying issues and work to improve on each. 

Example: poor cow comfort, poor reproductive performance, high SCC, poor forage quality, poor water etc. Getting more milk from existing cows may be the quickest way to impact cost of production, especially if no additional capital investment is required.

If you have the potential to milk more cows and ship more milk but never seem to be able to keep your existing facilities full, you most likely have an internal herd growth problem  resulting in undercapacity. You need look at your like milking herd cull rate, your youngstock noncompletion rate or your herd’s reproductive performance and work to correct it.  

If the big picture problem is with expenses, “drill down” farther and determine what areas you need to improve.  Pay particular attention to the following: The exercise of separating variable from overhead expenses can tell you a lot about why your farm’s cost of production is the way it is.  

Variable Expenses. If variable expenses are higher than benchmark, it’s an indication that you need to work on production efficiency. Production efficiency measures how effective you are at converting raw materials (your variable inputs) into finished product (milk). Variable costs are those costs that tend to change with each additional cow milked or hundredweight sold.

Note: Expansion generally does not help improve production efficiency. If production efficiency is low, expansion only magnifies the problem.

Overhead Expenses.  Capacity measures how effectively you are using your dairy’s facilities and equipment to their potential.  Overhead (or fixed costs) as a percentage of sales is a good financial measure to track and measure capacity or capital efficiency for any business. Overhead or fixed costs include those costs that tend not to change with every additional cow milked or hundredweight of milk sold. 

Achieving more milk per cow should be the first focus to help reduce overhead costs.  If production per cow is strong, expansion may help dilute fixed expenses per hundredweight as long as your variable expenses (cost of goods sold) is average or better than benchmark.  

Step 3
Develop action plans with your team for improvement in a particular area. Involving your farm professionals like your vet, your nutritionist and your business consultant is always a good idea.  If you haven’t considered starting up a dairy profit team for the farm, now may be a good time.

Step 4
Set goals and monitor performance. Adjust the action plan if goals are not being met. Hold people accountable.  This is a proven way to make progress on improving cost of production in your operation.