Gross margin

For a generic overview and understanding of what a gross margin is, wikipedia has information available on their [Gross Margin] page.

This page explains gross margins in the context of a cattle business.

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Gross margins in Breedcow+

Breedcowplus uses gross margins to measure the profit outcomes of a set of herd structure, turnoff and husbandry decisions. Gross margins are shown as an aggregate for the herd, per head, and per adult equivalent.

Typically, livestock gross margins comprise gross income from cattle trading (sales less purchases) less those costs that vary as herd size or herd composition change (variable costs) plus or minus the value of inventory change. The calculation of a livestock gross margin in Breedcowplus is simplified through the use of a steady state herd modelling approach that removes the need to value inventory change (since there is none). This approach does not reduce the validity of the livestock gross margin produced as a tool to quickly scan and rank the choices available for improving herd profitability. Indeed it should give a more consistent estimate of gross margin than the accounting approach.

The only costs used in the calculation of Breedcowplus gross margins are variable costs. The essential characteristic of a variable cost is that it changes proportionately to changes in enterprise size (or to change in components of the enterprise). Apportioning overhead or other costs to various production systems is likely to give a misleading comparison. The test for a variable cost as used in Breedcowplus is “one more animal equals one more unit of cost”.

A secondary profit measure, gross margin after interest on herd capital, is also calculated in Breedcowplus. This calculation includes a notional interest cost on herd capital and is one method of accounting for the differing capital requirements of alternative herd structures. Strictly speaking, this interest rate should be the “opportunity cost” of capital, i.e. what it could earn in its best alternative employment if it was not tied up in cattle. For example, a management change that leads to a reduction in herd capital could use the rate paid on the most expensive loan as the opportunity cost, since paying off some of that loan off would be an obvious use for surplus capital. If no loans are held by the business, the long term deposit rate could be the most applicable interest rate to use.

Using gross margins in comparisons Whether a cost is considered a husbandry or variable cost depends in the end on why gross margins are used as a comparison instead of net incomes.

For example, if the gross margin per adult equivalent is $90, substituting one adult equivalent at $90/AE for one unit at $50/AE will increase net profit by $40 per adult equivalent substituted, or running one less adult equivalent, where the gross margin per adult equivalent is $90, would reduce net income by $90 (ignoring any stocking rate effects).

Because gross income and variable costs (hence gross margin) change as herd size changes but fixed costs largely stay the same, specifying net income rather than gross margin per adult equivalent (or per head) can be very misleading, as net income will not vary by the same amount when more or fewer adult equivalents are run.

The total cost per head or per adult equivalent is also often quoted and misused. While an interesting historical figure, it does not tell us by how much total cost changes if we change the number of adult equivalents, since only the variable costs change when herd size changes. The “fixed” part of total costs – by definition – does not change for small changes in herd size.

When relating changing herd size to changing net income via gross margins, a stocking rate effect may have to be considered. If so, stocking rates may be compared by doing two or more runs of Breedcowplus with each run specifying rates, price and husbandry costs consistent with a particular stocking rate.

The definition of a variable cost is tied intimately to the meaning and use of the gross margin it is used to calculate. Gross margins are calculated first for a whole enterprise but then are usually expressed per some unit of input, such as per $100 of capital, per full time labour unit, per unit of land or, as in the Breedcowplus program, per adult equivalent.

Husbandry costs include items like vaccines and supplementary feed, where one more animal incurs one more units of cost and one less animal saves one unit of cost.

Gross margins are used in the Breedcowplus program to compare turnoff or husbandry strategies that use the same resources and therefore incur the same fixed costs. The difference in the herd gross margin will therefore be the same as the difference in net income when two or more options are compared. We use the gross margin because it is simpler to determine the costs and the outcome is the same.

Take the example of a herd with figures of $120 per adult equivalent for sales less purchases (and inventory adjustment) and $20 per adult equivalent for variable costs. The gross margin per adult equivalent is $100, telling us that if we ran one less adult equivalent we would reduce the gross margin and hence net income by $100.

By contrast if we had calculated net income per adult equivalent after deducting all the fixed cost, the figure might be say $20/head. This has no relevance for estimating the effect on net income of running more or fewer adult equivalents. A corrupted calculation of gross margin that includes some enterprise fixed costs, such as yard and fencing repairs and vehicle costs, is no better.

The value of inventory change is a vitally important component of the gross margin calculation in any accounting type historical or dynamic analysis. Given the seasonal variation in much of Australia, it is not unusual for this inventory change, when valued at market (not tax) values, to be at least equal in value to sales less purchases. Calculated gross margins will then vary according to the inventory values used, and the conclusions drawn from comparing such gross margins will also change according to the inventory values used.

Inventory valuations are much less of a problem with defined groups of turnoff cattle, as analysed for example in the Cowtrade or Bullocks programs. With a breeding herd the problem is that there is a multiplicity of groups, so overall changes in value depend on changing herd composition as well as on change in total numbers. Even with herd composition taken into account, decisions have to be made on valuing or not valuing changes in weight or body condition.

It was to avoid this problem of gross margins distorted by uncertainty over inventory valuations that the concept of the steady state herd was adopted for the Breedcow+ program. In a steady state (stable) herd there is no inventory change, hence no valuation issue. This simplification is satisfactory and desirable for comparing future management strategies where the objective is to compare the likely profitability of different turnoff or husbandry options.

Where a significant change in herd structure is shown in a steady state analysis, the criterion for comparison is the Gross Margin per Adult Equivalent after interest. In this case, the gross margin is adjusted for the change in herd capital between the two steady state models being compared thereby allowing for the opportunity cost of the change in herd capital.

In interpreting these gross margins users should remember that a gross margin is a profit measure that has both cash and non-cash elements. A herd undergoing build-up will show a cash surplus (sales less purchases less variable costs) which may be much less than the gross margin. The gross margin in this instance can be viewed as the total of the gain in cash and the gain in kind (cattle).

Given the problems of inventory valuation, a steady state model based on the known variables of weaning and death rates, sale values and husbandry costs will give a more consistent estimate of the underlying gross margin than the traditional accounting approach.