Thursday, February 21, 2013

By the Numbers: Looking at Scale from the Opposite Direction

As a small farmer, I’ve struggled with the idea of appropriate scale.  I’d like my sheep operation to be small enough to be manageable and community-focused, but large enough to pay me a reasonable wage.  I’ve often started with an idea about the proper scale (number of sheep, in my case), and tried to come up with a reasonable salary.  Recently, however, I’ve worked at this question from the opposite direction – I’ve decided to evaluate the size of operation necessary to generate a specific salary target.

First, let’s review some economic theory.  My own salary (or draw) from our sheep business is an overhead expense - that is, my salary is fixed whether I'm managing 10 sheep or 1000 sheep (at least in theory).  My direct costs - for things like vaccines, mineral supplements, meat processing and shearing - vary directly with the number of sheep.  My "gross product" - the total value of my sales (and net increases in my sheep inventory) - minus my direct costs results in my "gross margin."  If my gross margin exceeds my overhead expenses, I make a profit.

Next - a few assumptions:
  • The retail value of a whole lamb at my current prices is about $300.
  • Each year, I market about 75% of the lambs born.  The remaining lambs are kept as replacement ewe lambs.
  • To finish lambs on grass, I need one acre of irrigated pasture for every 7 lambs (from June through October).
  • To graze my ewes, I need approximately 12 acres of annual rangeland for every 6 ewes (for the entire year).
  • According to the U.S. Census Bureau, the average cash wage earned by Placer County residents in 2011 was about $35,000.
  • If I want the sheep business to contribute financially towards my eventual retirement, a contribution equally 5 percent of my salary seems like the minimum amount.
  • Catastrophic health insurance for me and my family is going to cost at least $4,000 per year.
  • I'd like my business to earn at least a small profit above and beyond my salary (or draw).  $5,000 seems reasonable.
  • My non-salary overhead expenses (which include pasture lease, irrigation water, fuel costs, dog costs, and other "fixed" expenses) is roughly $25,000.
Now for the math:
  • Total salary and benefits (for me - the owner of the business): $40,750
  • Salary + Other Overhead + Profit = $70,750.  This means that I have to generate this much in gross margin (gross product - direct costs).
  • Based on experience, I know that my direct costs will be around 45 percent of my gross product (or total revenue).
  • This means that I need to generate almost $129,000 in gross product to pay myself salary and benefits totaling $40,750!
What does this mean in terms of the scale of my operation?
  • To generate $129,000 in gross product, I would need to sell approximately 429 lambs at $300 each retail.
  • To produce 429 lambs each year - and have enough replacement ewes, I would need 476 ewes at my current lambing rate (we figure that we wean 1.2 lambs per ewe on average).
  • To finish lambs on grass, I would need 61 acres of irrigated pasture.
  • To graze my ewes year-round, I would need 715 acres of annual rangeland.
Obviously, any business is much more complicated that it's numbers!  I have found, however, that this exercise gives me a useful tool for thinking about scale from a financial perspective.  I hope other farmers, ranchers and small businesses will weigh in with their own experiences and thoughts!

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