There are three, and only three, ways to increase profit in any business. Stan Parsons called them The 3 Secrets For Increasing Profit™ and introduced them to Ranching For Profit students in 1980. Lately I’ve seen more and more articles by industry pundits that incorporate the 3 secrets in articles and conference proceedings. They rarely if ever acknowledge the source. Worse yet, they don’t always get them right. I’m going to use this ProfitTips to go back to basics and explain the 3 Secrets.
There is a common belief that profit is a function of weather and prices PERIOD. But weather and prices are, for the most part, beyond our control. If we believe that profit is determined by things beyond our control, it becomes easy to see ourselves as helpless victims.
In Ranching For Profit we don’t accept for one moment that we are helpless. Even if we can’t influence the market or make it rain, we can create and structure enterprises to fit this uncertain and volatile environment. In selecting our enterprises and building our business for profit we need to understand the 3 Secrets:
- Reduce overhead costs
- Improve the gross margin per unit
- Increase turnover
Secret #1: Reducing Overhead Costs
Overhead costs include land and labor costs. Land and labor are broad categories. Land includes rent and the cost of maintaining fences, pipelines, building and anything else attached to the land. Labor costs include salaries & benefits, vehicles, equipment, horses, dogs and anything else that does work.
Overhead costs tend not to change much as the units of production (e.g. cows, steers, ewes) change. Think about increasing a cow herd from 400 to 500 cows. That’s an increase of 25%. Would the interest, insurance or depreciation on our pickup increase by 25%? Of course not. As much as our hired hand might want a 25% raise, raising 500 cows is not 25% more work than raising 400 cows. Sorry Charlie, no raise.
Of course, anyone with a BLM or Forest Service grazing permit pays for land on a per-head basis. It doesn’t matter. While it may not behave like other overheads, rent is always an overhead. The video at the end of this article explains why.
Reducing depreciation on our truck, or refinancing it to pay less interest will not impact the number of cows we run, the productivity of those cows or the price I get for my calves. But it will increase our profit. That’s why reducing overheads is the first secret.
Secret #2: Improving Gross Margin per Unit
Gross margin per unit measures the economic efficiency of cows, steers, sheep or whatever our units are. The higher the gross margin, the greater the efficiency. When gross margin per unit increases it means that each animal makes a bigger contribution to covering our overheads and making a profit.
To calculate gross margin we have to know two things; gross product and direct costs. Gross product is the value an enterprise produces. It’s simple to calculate:
Gross Product = (Closing Inventory Value + Sales) – (Opening Inventory Value + Purchases)
Direct costs are costs that go up and down as the number of animals in the herd goes up and down. Direct costs include supplement and substitute feed, health and breeding related costs, trucking, marketing commissions and interest on the livestock note.
To calculate gross margin just subtract direct costs from gross product. Then we divide by the number of units in the enterprise to figure gross margin per unit.
We can use different units. In livestock enterprises we usually start by calculating gross margin per animal unit. Gross margin per animal unit is an effective way to compare the efficiency of a stocker enterprise to a cow-calf enterprise, or any other livestock enterprise. Gross margin per acre is a useful tool for comparing the efficiency of grazing enterprises to farming operations.
The ranch with the highest production per unit rarely has the best gross margin/unit. Smaller cows weaning lighter calves, but requiring fewer inputs, generally have a much higher gross margin per unit than larger cows. Whatever the enterprise, improving gross margin per unit is the second secret to increasing profit.
Secret # 3: Increasing Turnover
We may have a productive cow with a great gross margin, but one cow won’t be enough to cover our overheads. We need more cows … at least we need more something!
Turnover refers to the number of units in an enterprise (e.g. the number of cows or steers that we have). A business can increase turnover by increasing the scale of an enterprise or by adding enterprises. Increasing turnover, provided that the gross margin per unit is healthy, is the third secret for increasing profit.
There are three, and only three ways to increase profit in your business. All three are in play in your business all the time, but only one of them is the most important right now. Do you know which of the three secrets is your biggest problem and which offers you the greatest opportunity? If you are ranching for profit you’d better find out!