What is over-capitalisation, what does it look like on a dairy farm and how does it impact your business performance? It is important to be aware of how over-capitalisation can add to your business’s cost of production – adding to both cash and non-cash costs.
This month, Jake Musson (Data Analyst – Dairy Australia) describes over-capitalisation in a dairy business, the impact it can have and the risk it can create, particularly in times of volatility, if not managed well.
Useful resources related to this podcast:
· Jake Musson (Dairy Australia) – NSW System Performance presentation (~19:20 minute mark for ‘Plant and equipment vs. Depreciation)
· Tower of Resilience (John Mulvany)
This podcast is an initiative of the NSW DPI Dairy Business Advisory Unit – further information and resources are available here
It is brought to you in partnership the Hunter Local Land Services
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The information discussed in this podcast are for informative and educational purposes only and do not constitute advice.
The Business of Dairy
Episode #4 Transcript – “Over-capitalisation – is my business at risk?”
Sheena Carter: Welcome to the Business of Dairy podcast. I'm your host, Sheena Carter, development officer with the New South Wales Department of Primary Industries Dairy Team. Each month I speak with industry people generous enough to share their stories, knowledge and skills with us to help you in the increasingly complex area of farm business management. This month's podcast was recorded a couple of months ago with Jake Musson, who is Dairy Australia's data analyst, and it is prudent that I let you know he has since moved on from this role.
Jake was heavily involved in the Dairy Farm Monitor project at a national level, and he had a great knack for looking into the data and identifying trends and drivers of profitability. In this episode, I spoke with Jake about over capitalisation in the dairy industry. What it actually looks like on a farm, the impact it can have and the risk that it can create if it and other aspects of a business are not managed well.
This month, we're talking about over capitalisation and how it can impact the bottom line in your business. It's interesting, I think that we've seen over time with more complex businesses, there's a tendency to acquire more plant and equipment. And then we've also got those businesses, you know, those farmers that just like having shiny new toys. But for some farms, this can have an impact on the business in terms of risk management and also its financial performance by adding to cost of production. Jake Musson, data analyst at Dairy Australia, has taken an in-depth look at this through the New South Wales Dairy Farm Monitor data, which we will have a bit of a look at today.
So welcome, Jake, and thank you for joining me today.
Jake Musson: Thanks, Sheena. Pleasure to be on the podcast. Love what you do. Always a big advocate for podcasts around the country. Yeah, it's fantastic to be here.
Sheena Carter: Thank you. Yes, I think podcasts are a great way to get into people's ears without having to get into a room. Now we're talking about over capitalisation. Can you just describe to me what does over capitalisation look like? What are we talking about?
Jake Musson: Yeah, so it's probably difficult to put a definition on it, but I guess it's… if you use an example, a farm can have one tractor and do like – a small farm, pasture based farm – and can do most of the jobs fairly easily. And then they can go and buy, say, a little bobcat to clean out the calves, they can buy an excavator to do some trackwork, they can go and say, alright, well, I'm going to build a feed pad and buy another tractor and a mixer wagon. I'm going to leave the tractor on there because it's too much work swapping around either. So, I'm going to actually buy another tractor for… say, to do my hay, and it all compounds very quickly. And suddenly you look out in the shed and there's five tractors sitting there, Bobcats, excavators round the back, and you're thinking that's a lot of equipment and a lot of cost that you're racking up. And it's not a cost that we often see up front, but it's sort of a behind the scenes costs, known as depreciation, that really is the big killer for the business.
Sheena Carter: Yeah, okay, so there's quite a bit in what you've just said. And I think some of what you've explained is, is system change. We're looking at system change within dairy businesses, where we've gone from a quite a simple system of pasture based dairying, which has its own complexity, but relatively simple. And then moving along the continuum of, I guess, slightly more complexity with intensification within a system. And it's not necessarily a reason why there is more plant and machinery brought into a business. But, you know, we have described a system change where we will see a bit more planter machinery coming into the business. Why do you think this has occurred, this sort of system change shift in the, in the industry across Australia?
Jake Musson: Yeah, well… and I guess the explanation, you know, overcapitalised doesn't necessarily mean you've got a system change, but often when we do change systems, that's when it occurs, because you can justify the decision if you're changing a system to buy all those extra items. Whereas if you're in the same system and it's a bit more of a, aw do I really want to get that next tractor, is it adding that much to business? That's where this system change often comes with that over capitalisation risk as well. And look, that system change, we've certainly seen it go on for a number of years. Probably seen a bit more over the last sort of five or six years, certainly drought has been pushing that. Milk price as well, you know, particularly up north, we're looking at flatter milk price. Producing milk all round, so that brings with it its own challenges. You need to feed those cows out of season so, it probably pushes more in the favour of putting some infrastructure in there to be able to feed those cows on feed pads or get that flatter production to get that milk price, the fresh milk State. And certainly droughts push that as well. So there's a few factors in there that really have pushed that system creep over the last few years.
Sheena Carter: Yeah, and another thing that comes to my mind is, particularly we see this in areas of New South Wales, and probably other state dairying regions within Australia, but we have kind of ended up in a situation where we don't necessarily have a critical mass of farmers for service provision, so I'm talking, you know, contractors for hay and silage making. If those contractors are there, they're often not enough of them, and the timeliness of getting on to farm to make hay and silage sometimes isn't there. So people have tended to say, well, you know, I need to buy my own equipment to do this.
Jake Musson: Yeah absolutely, and, you know, I guess that depends, do you have the staff to do it? I’m from a farm, as you know, down south west Victoria, and I don't think anyone down here would say they've ever had their silage done on time from a contractor. It's simply how it is. You know, you never get that quality silage down this way. It is a struggle. But the reason why most people don't go and buy that equipment is because they don't have the staff that can drive that machinery or, you know, their business might be a little bit too big to allow that as well. So you do get more breakdowns and people crashing into fence posts and the rest of it. If people, you know, aren't skilled and it's not the owner that's driving a tractor around so, but like you just said, in New South Wales particularly and Queensland, some parts of Western Australia as well, you sometimes just don't have a choice and you do have to buy that equipment. And so you’re sort of pushed into that position, I guess.
Sheena Carter: Yeah, okay. So, I guess moving on from here, we've landed in a situation where we do have this equipment. And you mentioned earlier a term called depreciation, which we're looking at understanding our business performance and trying to work out our cost of production, which true cost of production obviously has cash costs, but also non-cash costs. And depreciation is one of those that we look at in our cost of production. Can you explain what is depreciation and why is it important to consider?
Jake Musson: So, depreciation is how much that value of the asset goes down each year. So, for example, you've got a bike, a quad bike, and generally they're not going to last that long. You know, you buy a brand new quad bike and five years later, it might be pretty much a total mess, depending how well you maintain that bike. Now tractors and the rest will have a longer life cycle but if you sell them at the end of that 10 years, they're not going to be worth a lot. So, you know, you've outlaid say, a hundred thousand for a tractor, and you sell it for ten thousand – that's ninety thousand dollars that you've effectively lost through depreciation over those 10 years. So, it's often businesses don't really look at it, but it is a real cost, for particularly farms when you do have that capital in place and you do have, certainly machines that do depreciate quite substantially over time.
Sheena Carter: And then the challenge at the end of that 10 years is you've got to start again and buy something to replace that.
Jake Musson: Exactly. And that's where you get into that vicious cycle if you’ve got too much machinery on farm.
Sheena Carter: Yes. So, in terms of an impact on a business, it's not, you know, you don't necessarily see in your financials dollars going out for depreciation, but it is something that's sitting there and it can't be ignored because in the long term, it's something that you actually end up paying in the business.
Jake Musson: Yeah, and it's often surprising at how big a cost depreciation is as well. I mean, for New South Wales, you could be looking at, you know, 40, even 60 cents per kilogram of milk solids that you’re spending, or that you're losing through depreciation each year. And yes, that might be okay when you're a profitable business and you're looking at great seasonal conditions, fantastic milk price. But if you have a series of drought years, poor milk price, that's when, you know, that pinch really hits you and you do need that extra wiggle room of, you know, 20, 40 cents to get by. So that's where it does catch up with people a lot. Suddenly they're replacing equipment in those five years of drought, and that's where the cost really hits them.
Sheena Carter: Yeah. So I guess if we're looking at costs in the business, we've obviously got variable costs, which are those costs which are attributed to, perhaps scale or size of the business. They go up and down with that and our overhead costs, which are more sort of fixed costs, they’d tend not to vary with the amount of production in a business, that's where our depreciation sits, alongside with repairs and maintenance. So it's very hard to reduce those overhead costs in those tight years. You've got very little flexibility. You still have to pay them regardless.
Jake Musson: Absolutely, and the really interesting thing about overhead costs as well as a whole, and obviously we've got, you know, labour both imputed and employed, and a couple of repairs and maintenance, which is another one that can really catch up with you when you’ve got too many tractors and have over capitalised on the farms, and depreciation, as well as a few other overhead costs that fit into the category. But what we've found when looking at the historical Victorian data, and you know, in a few years hopefully we'll be able to see New South Wales do this as well – but we just don't have enough years to look at it – but every time there's been a run of four years, we've seen those overhead costs shoot up on a per kilogram milk solids basis. So, an example, 2007/8 – fantastic milk price, and then we were slammed by the global financial crisis. Year after that was pretty poor performance as well. And depreciation costs increased by around twenty five cents a kilogram of milk solids over that time. And that's, you know, those repairs and maintenance people, not reinvesting back into the business, suddenly instead of repairing your tractor, you’re saying, oh I can hold off another year and suddenly your repairs go shooting up the next year because you've been hit by a double whammy. And again, after 2015/16, the exact same thing happened. So we're seeing this cycle where, you know, people don't want to probably overcapitalise, repairs and maintenance shoot up after like two or three years of poor conditions because they're not reinvesting back into the equipment. They're not maintaining it. And as you know, if you don't keep your car's maintenance up to scratch, it's just going to fall in a heap and suddenly you’re left with this big bill at the end of two or three years and you’re replacing the car. And that's essentially something that's coming out of the data when we look at it over time.
Sheena Carter: Yes, and it's a challenge. I think we are tending to see these days that, you know, volatility, and whether that's related to milk price or cost of inputs, it's intensified. It's more frequent. There's always been volatility, but it seems to come around more regularly. So it is a challenge for businesses to manage that and therefore manage their repairs and maintenance, as you as you're saying, in those tough times. I think if we look at, from a New South Wales point of view, I know, and listeners can click on our show note links and we'll have a link to a YouTube presentation that you did, Jake, last year as part of our Farm Monitor presentations for New South Wales. But you looked at the New South Wales data with plant and machinery and against depreciation as a cost, and looking back in the New South Wales data, so we've done Dairy Farm Monitor in New South Wales for nine years, this will be a 10th year, but on average, we sort of see a cost of around 38 cents per kilo of milk solids in New South Wales, which is about a 2.9 cents per litre. And this is, that's average, so the southern part of the state, we tend to see it's slightly lower, around 35 cents per kilo of milk solids or about 2.6 cents. And Northern New South Wales, it's about 40 cents per kilo of milk solids – probably reflective of the systems. But in that graph, there's, you know, a reasonably strong, well sorry, there's a number of farms that have got quite high depreciation above 60 cents a kilo of milk solids, which is a significant impost on that business in times of volatility. And I guess it's an area where we need to start thinking about risk management in our business, if our business is set up like that. What are some of the ways that businesses can manage that risk?
Jake Musson: Yeah, certainly. So, I like to think that, you know, you try and manage your feed costs as much as possible, increase the home grown feed, so you've got that buffer when you come into drought and you can utilize that, you bring down the costs, and depreciation is exactly the same thing, really. You just want to manage how much equipment you've got, and yeah, actually well-maintained machinery, maintain equipment, which, you know, isn't captured, but it certainly gives you that salvageable value at the end of the day. And that's going to give you an extra, well those farms that are doing around that $0.80 – $1.00 depreciation costs, if you get half that well, you know, that's 40 cents you can play with if a drought hits or if milk price drops by 40 cents, then you've already gained that back in that area. So, it's always one of those ones where, you know, as a farmer you should look at those costs and say, can I do anything there? I know it’s fixed and it’s often difficult and it's often not a quick fix either. It's often a couple of years of investment to get everything running as effectively and as efficient as possible. But after those couple of years of investments in the right place, then suddenly we can reduce those overhead costs and give us a bit more buffer in those feed costs. You know, when those droughts do hit, or those poor conditions hit, and like you said, it's a volatile industry, and we do have to play with that volatility. And, you know, you can cut costs in one year, but as soon as you cut costs in two or three consecutive years, well, we've seen what happens to the folks down in Victoria when they do shoot up and up after a couple of years of cutting costs. So, yeah, it's just something to keep in mind, I guess.
Sheena Carter: Yes, and I guess we haven't, well, I suppose there's a couple of things you need to really be considering in your business. Is this piece of equipment… is it a ‘nice’ to have, or is it a ‘need’? Is it a want or need? So making some of those, you know, having a good hard look in the mirror first. Do I really do I really need that Bobcat? Do I really need, whatever it might be? And how much time is it going to spend sitting in the shed, not actually working for me? All those sorts of questions. Am I better off, you know, getting a contractor in to do some of that work instead of investing in that equipment as well?
Jake Musson: And I think on that, I always ask, you know, does it save me money and does it save me time? And if the answer is no to one of those, then you probably should be looking at those contractor options.
Sheena Carter: Yeah, for sure. And I guess another cost that we haven't particularly spoken about is the interest cost – you know, purchasing. Unless you're fortunate enough to be in a position where you can pay for new plant and equipment out of cash flow, they generally come with equipment finance and the interest cost that is also a cost to the business, which can't be ignored. And it is often a challenge, we’ve sort of spoken about volatility and tough times, and those interest and principal costs in equipment finance are a little hard to negotiate with your financiers and, you know, perhaps go to an interest only arrangement when times are tough as well, aren't they?
Jake Musson: Yeah, and that's the real problem, isn't it, negotiating when times are tough, because often the red flag can go up. So those financing firms will say, well, am I actually going to get paid out? And you can have the hard word put on you, that no, you've got to still pay back that debt during these couple of poor years. So, that's when things can compound quite quickly. And again, it's that risk of just taking on a little bit too much too quickly, and having those, particularly those, yeah, equipment costs, and equipment interest payments compound very quickly. And yes, that does get people in trouble.
Sheena Carter: Yes. And I guess if we're looking at that short term debt, you know, a lot of work has been done looking at perhaps some guidelines around setting up a resilient business. And some people don't like the word resilient, but, you know, a resilient business being one that is set up to be able to, you know, whether or get through volatility. You know, margins might still be reduced, but they come through and manage quite well out the other side of tough times, like drought or whatever it might be. One of these measures that we look at is, you know, percentage of equity in a business. Which obviously percentage of equity in a business is going to vary for many reasons, depending on the stage of the business cycle that you're at, whether you're a new business or you've expanded and taken on some new land, all those kind of things. But in general, we're talking, you know, a resilient business, having about 65 percent equity, because it does give you that wriggle room to go back to the bank and approach them to help through with cash flow and things like that. But another thing that we've sort of looked at is having perhaps 20 per cent of debt as short term debt rather than being overexposed with too much of that short term debt – that equipment finance. Have you seen much of that in the data, or what are your views on that position?
Jake Musson: I haven't really seen too much of it in the data. I certainly would agree with that, though. Certainly that short term debt probably carries a lot more risk. And often you don't have those relationships with the equipment, and financing the equipment companies, that you might have with your bank manager. Certainly those relationships can help a lot of people, if you bank manager does understand your business. They can get you through those tough times and pull those strings, but it certainly doesn't happen to that extent with equipment. And yeah, certainly debts an interesting one with John's, yeah, Tower of Resilience, which yeah, fantastic concepts, and I think it really helps look at your business as a whole, because, you know, some people look at debt as a necessary evil, I guess, to expand and some people look at that as an opportunity. And I guess that's where, you know, you do need debt to expand your business and to grow your business, and, you know, that's fantastic. Farmers wanting to expand, make more money, grow their wealth. But, you know, back to that point of that volatility, we do live in that volatile environment. So if we do say a couple of hard years, a lot of farmers can get into trouble when they run into those interest payments and principal repayments after a couple of cash strapped years. So, if your business, I suppose, in the tower context, is fairly resilient in every aspect, then you probably can take on a little bit more debt and you can compound your wealth quite quickly if you run low equity. But at the same time, you are taking on a lot more risk. So essentially, farmers that successfully do this de-risk the rest of their business and take on yet more debt and try to expand it at a quicker rate. But you have to have some exceptional management skill set, particularly up north when you're dealing with that volatility of droughts as well, and the severity of drought, as you would know, Sheena, in your region. But yeah, to expand you’ve got to take on that, so it's about looking at the risk profile, I guess, of your business. How many of those building blocks really stack up in the tower? And if you are too risky, then you probably don't want to push it too much. You probably want to taper in exactly how much debt you take on, because when those difficult years do arrive, yeah, you certainly don't want your business toppling over.
Sheena Carter: No, very good points, Jake. So, yeah, I think, you know, there's perhaps we could say that there's good debt and then there's debt that's not so good – perhaps sometimes necessary, but you don't want to expose yourself to too much of it in the business.
Jake Musson: Yeah, and that's why it's so individualized where that debt level is, so you really do have to look at your own business, and if you are taking on more risk, if you've got less home grown feed, if you're more exposed to the water market, then that's a big flag that, yes, you probably want to taper in that debt level a little bit. Which is all well and good to say, but yeah, it's difficult in practice.
Sheena Carter: Yeah, it's very easy for us to sit here and talk about it, Jake.
Jake Musson: That’s it.
Sheena Carter: No, but I think, look, it's been a good discussion. And I think, you know, we are seeing more complex businesses in the industry as time goes by because of all sorts of different challenges that the industry faces, and people are trying to position their businesses to manage things like drought, water shortages, all those sorts of things. So, yeah, look, I guess the summary is essentially that over capitalisation can be an issue for businesses and you really need to consider when you're buying plant and equipment, is it something that I really need to have? Are there alternative people to do that job for me, etc.? And really manage those other aspects of your business to make sure that you're managing that risk, as you say, you know, managing the amount of home grown feed that you've got. And that doesn't necessarily mean, purely in a pasture based system, even in those TMR fully intensive systems, they really need to be managing the amount of fodder that they're growing as well to set up their business as well and reduce the impact of things like depreciation, repairs and maintenance and interest payments on their business.
Jake Musson: Yeah, that's it. And you know, if you’ve got a tractor with a rake on the back, or a mower, do you want to be footing the bill for that in a drought year when things break down? Or would you rather that flexibility to be able to, you know, go into a contractor. So, one’s certainly locked in and one’s a bit more flexible? But yeah, as everyone would know on this podcast, it's just one aspect of the business and I guess, to run the best business we can, we've got to really put every single section under the microscope here and say, can we do this even a little bit, just two percent better. Because it certainly adds up if you get those two percenters right.
Sheena Carter: Yeah, which probably should lead into a bit of a plug, a segue for the Farm Business Snapshot, Jake. You know, there's many businesses that do look at their business performance and the industry, through Dairy Australia, has been developing quite a few tools to help people do this. Obviously, we've got Dairy Farm Monitor across the country and then we've got Dairy Base, but we've also got the Farm Business Snapshot as a tool for industry. Do you want to just say a quick few words about the Farm Business Snapshot tool?
Jake Musson: Yeah, yep certainly. So, it's an app where you can input all your costs in just a couple of physical metrics into the tool. A little bit like Dairy Base, just certainly not the complexity of Dairy Base so, you don't have to put every category of cow and feed and the rest of it, which as we know, can take a bit of time. So it's a great first step and it all feeds into Dairy Base, so you don't have to worry about putting it in twice. Essentially it just gives you comparison with the Dairy Farm Monitor projects when that comes out, your costs versus the regions, and gives you a little traffic light system on, certainly costs, if we look at it, cents per litre or kg per milk solids. So you might get a red if your costs are a bit higher, a yellow if they’re between the top 25% and average, and then a green if they're below that level. But certainly it's only, it's not a red to say, aw you shouldn't be doing that. It's a red to say, alright, why am I doing that? Why are my costs higher in say, the herd or shed costs? And if I don't have an answer, then I probably should look a little bit closer. So it's a really great first step towards Dairy Base. Pretty easy to use – just put your costs in, straight from your P&L. Straight from your accounting system, into there, and yeah, it's a great conversation starter.
Sheena Carter: Yeah fantastic, thanks, Jake. And I think that's the power if we're going to have a discussion about the costs in our business. If you can actually know what they are and understand them, you've got a much more informed conversation to have and the ability to look at, you know, particular areas in the business that you might want to address and try and improve or identify areas that you're doing really well in as well. So, look, thank you, Jake, for your time today. It's been very enjoyable and a great discussion on what can be a bit of a complex area of the business. And yeah, thank you very much again. And I hope to speak to you sometime soon.
Jake Musson: Thanks, Sheena. Pleasure to be here and hopefully you'll get me on here again one day.
Sheena Carter: Thanks, Jake. Thank you for listening to this month's The Business of Dairy podcast, produced by the New South Wales Department of Primary Industries Dairy Business Advisory Unit. This series is also brought to you with funding and support from the Hunter Local Land Services. This month's show notes contain a full transcript and resources mentioned throughout this podcast, including links to Jake Musson's New South Wales system performance presentation, John Mulvany’s Tower of Resilience video, a link to Dairy Australia's Farm Business Snapshot calculator and the New South Wales Dairy Farm Monitor reports.