Using this model helps pork producers answer their “what-if” questions about production changes and profitability.
If my feed conversion in the finisher improved from 3.1 to 2.9, what would be the effect on my net profit margin? How much more per ton of feed could I afford to pay for such improvement?
This is an example of a “what-if” question participants in the NPPC Production and Financial Standards education program have asked during the past two years of training. Other popular questions include:
My breeding herd is currently producing 2.05 litters/breeding female/year. If I can raise farrowing rate such that my herd produces 2.20 litters/breeding female/year, what effect will that have on asset turnover, net profit margin, return on assets and return on equity?
Stillbirths and preweaning mortalities combined cause me to lose 25% of the piglets born in my herd. If I invested in extra labor to attend all farrowings with the goal of reducing total piglet mortality to 15%, how many extra labor hours could I afford?
If my cost of corn increased or decreased by 5¢/bushel, how would that affect my net income?
I see several opportunities for improving the production efficiency of my farrow-to-finish operation. Which improvement should I implement first, based on expected change in return on equity?
Compared with similar farms, my profit margin is satisfactory, but my asset turnover is low. Why is my asset turnover low, and how do I improve it?
Using the NPPC return on equity (ROE) model provides answers to these and many more what-if questions. The ROE model has been developed as a workbook of Microsoft Excel spreadsheet templates (Figure 1).
ROE Model Explained
The ROE model is based on the DuPont equation: return on equity = (asset turnover × net profit margin × leverage).
Asset turnover is a function of revenues and throughput. Understanding these measures and their relationships to costs, prices and physical productivity is the key to using the ROE model diagnostically to identify opportunities for improving net income and growing the business.
|Initial Value||New Value||Change||Percent Change|
|Return on Equity||15.90||16.88||0.98||6.2|
|Return on Investment (%)||8.15||8.67||0.52||6.4|
|Return on Assets (%)||14.26||14.76||0.50||3.5|
|Operating Profit Margin (%)||14.97||15.38||0.41||2.7|
|Net Profit Margin (%)||8.57||9.03||1.05||12.3|
|Net Income (Pork)||$60,962||$64,960||$3,998||6.6%|
Net profit margin may be improved by the prices received from pig sales and/or reducing production costs.
When net profit margin and asset turnover are at acceptable levels (and not before then) business growth may be accelerated by increasing leverage through borrowing more money. In other words, “get better before you get bigger.”
By filling out a blank workbook with farm-specific data for a typical production year, a working economic educational model of any pork production system can be assembled quickly.
The ROE model is not an accounting system. It is not designed nor intended to match the output of your accounting software for any particular period. Rather, it provides an integrated, comprehensive model of your pork production system, including physical productivity, animal flows, feed budgets, input costs and prices, revenues, assets and liabilities assigned to pork production. By adjusting the values of various factors and recording the relative change in key output measures, users can quickly generate the data to answer important management questions such as those posed above.
In Figure 1, the preweaning mortality rate for a farrow-to-finish herd was originally set at 9.4%. By changing the index number in cell AD50 from 1.00 to 0.90, the user has investigated the potential benefit of reducing preweaning mortality from 9.4% to 8.46%.
New output values immediately appear in the template shown in the top half of the split screen. Recording of before and after values followed by manual calculation of the differences in the worksheet (Figure 2) indicate the potential benefit of the improvement.
The physical change in this herd amounts to an increase of 157 weaned pigs/year, or 3 extra pigs weaned/week. Our calculations indicate that net profit margin would increase by 1.05% from 14.97% to 15.38%. The feed budget in the model automatically purchases more feed for the extra pigs, but it does not change the non-feed costs.
When modeling small changes, this approach may be appropriate. For greater changes in pig flow, however, it may be appropriate to increase selected non-feed costs such as animal health and labor to account for the additional costs of processing the extra pigs. If nursery and finisher capacity is already tight, then additional capital investment in facilities also may need consideration.
In our example, asset turnover increased from 95.2% to 96.01% because more pigs would be marketed with no change in the asset base of the production system.
The leverage measure shows no change. In fact, it will have changed very slightly. As growing pigs are valued on an accumulated cost basis, more pigs in the system will increase the value of current assets, thus changing the ratio of assets to liabilities.
The changes in net profit margin, asset turnover and leverage compound to improve return on equity by almost 1% from 16.88% to 15.9%. The potential improvement in net income from pork operations is almost $4,000/year.
Armed with this information, the producer can then proceed to evaluate and compare competing opportunities for improvement and rank them in order of financial attractiveness.
Reduction in preweaning mortality influences each of the three factors that feed into return on equity. Profit margin is increased as most of the non-feed costs (e.g. rent, utilities, taxes and depreciation) for their littermates already were covering the extra (marginal) pigs. Asset turnover increases because more pigs are being marketed from the same asset base.
|Wean pig||Nursery pig||Finisher pig||Finisher pig/CWT||Finisher pig % gross revenue|
|Acc. feed cost||$12.60||$27.42||$75.15||$28.83||53.4%|
|Acc. labor cost||$2.69||$5.29||$8.99||$3.45||6.4%|
|Weighted avg. price||$25.00||$58.00||$140.78||$54.01||100.0%|
|Margin over total cost||$2.75||$5.85||$20.96||$8.04||14.9%|
Other opportunities may have different effects. For example, modeling an increase in feed efficiency or a decrease in production costs shows no effect on asset turnover. So, in circumstances in which profit margin is already high but asset turnover is low, the model can help identify opportunities to increase throughput and revenue needed to boost asset turnover.
Version 1 Revamped
The scope of the Excel spreadsheet (Version 1) of the ROE model has improved greatly over the past two years, thanks in part to the suggestions of many producers who have used it throughout the Production and Financial Standards educational programs.
Due to the restrictions of the spreadsheet environment, the decision was made to develop Version 2 as a stand-alone software application (Figure 3).
Experienced users should be pleased to learn that the familiar “yellow cell” data-input process has been retained. And, the content of each template has been preserved within a series of tabbed input screens.
Once completed, a data file for each model is saved on disk. Partial or completed data files may be exchanged among users. Floating summary tables may be pulled up and placed anywhere on the computer screen so that changes in output values may be monitored instantly as input values are changed. Also, partial or full schematic views of the ROE model (which were impossible to produce in the spreadsheet environment) now can be viewed on screen and printed on a single sheet of paper (Figure 4).
The manual approach to calculating the benefits and costs of proposed changes has been automated. Floating tables showing a summary of the changes of important measures (Figure 5) and summaries of costs and margins of producing weaned, nursery and finisher pigs (see “Financial Summary” screen with Figure 3, page 11) may be positioned and displayed anywhere on the computer screen to provide users with instant feedback as input values are changed.
Moving the model out of the restrictions of the spreadsheet environment makes it possible to improve its realism.
The ROE model is an especially powerful tool when used in conjunction with complementary information sources. The National Pork Production and Financial Database facilitates comparisons amongst pork production systems. Knowledge of your farm's performance compared to the performance of similar farms identifies opportunities for improvement, backed by hard numbers that also define the scope for improvement.
Diagnostic use of your on-farm production and financial records systems completes the trio of power tools. For example:
Where are my opportunities for possible improvements? What is the scope for each opportunity? Answer: National Pork Database.
How do those opportunities rank financially? Which physical performance measures, costs and revenues need to change in order for me to take advantage of those opportunities? Answer: ROE model.
What management changes must I make in my daily routine to improve productivity, control costs and enhance revenue? Answer: Production and Financial Records.
These questions, tools and resources are fundamental to increasing your knowledge and understanding of the economics of your production system. The answers can improve your profitability and help your business grow.
Will Marsh, FarmWise Systems Inc., Little Canada, MN
To request a printed copy of this article and accompanying sample reports and educational spreadsheets, please click here to e-mail Jenny Felt or call (800) 767-6888.