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Evaluating and Managing Capital Costs in the Dairy Industry

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Jim Moriarty
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Dairy
Home > Education & Events > June 2019 > Evaluating and Managing Capital Costs in the Dairy Industry
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While navigating through narrow and negative profit margins over past years, many farms in the dairy industry deferred replacing or investing in major capital items like facility upgrades or additions, dairy and crop equipment, and land purchases. Given milk price levels, this decision was completely appropriate.  
 
Deferring replacements for short periods is acceptable, however, it may not be the best long-term tactic. In order to maintain and enhance operations long-term, it will most likely be important to reinvest at some point. So, the question is, when, where and how much? Capital expenditures must be a balance between investing to grow and enhance our dairy business while not overleveraging our cash flow and balance sheet
 
Evaluating Capital Balance
When working with dairy clients, one of the measures we use to evaluate the capital balance is comparing capital costs to milk produced. Capital cost is measured both on an economic basis and a debt service basis. From an economic view, capital cost is calculated as the annual total of depreciation plus interest on debt (cost of debt capital) plus lease payments on capital items. (It is important to note that depreciation in this calculation is based on the useful life of an asset and not tax based depreciation).
 
From a debt service view, we calculate debt service as the sum of principal and interest payments on term debt plus lease payments. We then divide either the capital cost or the debt service by hundredweights of annual milk production. We have found that levels of capital cost or debt service under $2.50/cwt are manageable from an economic and cash flow perspective.  On the other hand, capital cost or debt service above $2.50/cwt can take too much out of total milk revenue and cash flow, particularly when milk prices are lower.
 
In certain circumstances operations may successfully go above $2.50/cwt capital cost for a specific investment such as a larger expansion or robotic milking, but those investments need to generate a high level of efficiency and productivity to support the added capital cost. Over time the operation should then work back down to under $2.50/cwt capital cost or debt.
 
When considering reinvesting in your operation while maintaining reasonable capital and debt service levels, there are a number of strategies to manage capital investments:
  • Establish a capital replacement plan: map out timing of capital investments to advance the dairy operation while spreading out purchases and maintaining reasonable capital cost and debt service position.
     
  • Prioritize high use assets that are key to the income producing ability of our dairy. Those tend to be milking systems and feeding equipment as well as cow comfort enhancements that enhance daily production.
     
  • Consider custom hiring or equipment share arrangements for equipment used for limited periods, including forage harvesting, combines, and manure pumping and application equipment.  This option comes with some trade-off in control and timing, but with the increased cost and capacity of new equipment, this is an area that should be strongly considered.
     
  • Think about outsourcing part of heifer raising. This will generate grower payment for facility investments costs, but can pay off in reducing fixed capital costs and adjusting our expenses to the number of heifers we need for herd replacement.
Hopefully milk price recovery will begin later this year and into 2020, providing more opportunity for capital replacement and investment options. Evaluating our current capital cost and debt service levels is a good starting point in the capital planning process. From there, prioritizing capital needs and using other strategies to manage capital needs in your operation, will help position your business for long-term success.
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