Every business’s goal is maximizing its long-term profits. This simple yet daunting task has many trade-offs farmers must consider when making decisions. In the fall 2024 issue of New Holland Insider, I introduced the “Five Managerial Levers,” which is a simple framework to categorize business decisions. In short, any business decision a farm makes falls into one of these five categories: output price, yield, costs, assets and people.
I want to focus on two levers: costs and assets. Specifically, I want to explain how these two managerial levers are related to the financial concept of “earns” and “turns,” which are key drivers of profitability, and how a farmer’s decisions about what equipment they will use on the farm impact these two areas.
The profitability model
In the 1920s, financial analysts wanted a way to systematically assess the profitability of their companies. From this need, they developed what is now named the profitability model. This financial model allowed for the analysis of key drivers of profitability within the company while also helping managers make more informed decisions about improving the long-term profitability of the business.
The profitability model breaks down overall profitability into three key drivers: earns, turns and leverage. While leverage is important, let’s focus on the operating side of the business that relates to the managerial levers.
Earns
Earns are the margins a farm gets for the products it produces. In other words, it is the difference between the gross sales dollars of a farm and how much is left over at the end of the season to pay the ownership of the farm after all costs have been accounted for. As such, earns can be seen as a cost efficiency measure. This is also called the operating profit margin. According to the University of Minnesota FINBIN database, the average operating profit margin in 2023 for farms was 14.8%. This means for every dollar of gross sales that a farm produces, on average, farmers kept 14.8 cents at the end of the day to pay the ownership.
First and foremost, farmers need to benchmark their earns. While new equipment does decrease earns in the short run due to the capital expenditure and depreciation, new, more efficient equipment increases the earns measure of a farm in the long run. Decreased maintenance and operating expenditures that result from more efficient equipment make the farm more cost-efficient. The key question a farm needs to ask before purchasing a new piece of equipment is what type of cost-efficiency gains might be expected from the new equipment.
Turns
Turns is the asset efficiency of a farm. It is calculated by dividing the gross sales dollars by the dollar amount of farm assets.
The more assets a farm has relative to the total gross sales dollars, the less asset-efficient a farm will be. A good way to think about turns is how much equipment it takes to generate $1 of gross output on the farm. Once again, using the University of Minnesota’s FINBIN database, the national average turns metric for farms was 0.26 in 2023. This means that for every one dollar of assets on a farm, $0.26 (26 cents) is generated in gross sales dollars. After benchmarking their asset turnover, farmers need to ask what type of productivity gains they can expect from the new piece of equipment. Will the total gross output increase relative to the dollar amount of total assets?
Improving profitability
In summary, farmers need to understand their earnings and turns relative to the average. Farm equipment purchases can initially reduce a farm’s earnings and turns, but in the long run, understanding what equipment enhances in cost efficiency and asset efficiency will improve overall farm profitability.
Dr. Brady Brewer is an assistant professor in the Department of Agricultural Economics at Kansas State University. His research focuses on agricultural finance, farm profitability, production efficiencies and agribusiness strategy.