arrie Ridler of Grazing Systems has presented an outline for better understanding of marginal cost-marginal revenue to dairy farmers in a recent paper titled The intensification of the NZ dairy industry – Ferrari cows being run on two-stroke fuel on a road to nowhere?.
Ridler and fellow dairy analyst Peter Fraser challenged the industry’s pre-occupation with average sector costs, which they say has contributed to a “production-plus” mindset over the past decade.
Instead Ridler’s work focuses on marginal analysis of farm revenue and costs, or the amount of additional revenue each kilogram of milksolids produces, compared to the cost of generating that revenue.
The analysis is done using linear programming (LP) methods that can play out varying farm scenarios, adjusting key inputs including stock numbers, feed levels and fertiliser to present a range of production, and profit, outcomes.
The concept of MR=MC is a well established economic waypoint for optimal business performance.
However, Ridler maintains a “less challenging” accounting view taken by farmers means profit has been viewed simply as total revenue minus total costs, over the entire production on the farm.
“The result is averaged figures and ratios are now readily accepted in farming and compared (through “benchmarking”) as if they contain all the information relevant to profitable farm decision-making across all individual farm environments.”
Historically, since World War Two the dairy sector had run with its average costs close or equal to its marginal cost, or constant returns to match increases in scale, as high-quality land was switched to dairy production.
However, past a certain point, and Ridler argues this has occurred within the past decade, the additional or marginal cost of new land coming into production, or additional cows per hectare being added, means diseconomies of scale have occurred.
This has pushed the marginal cost rises for each additional cow or hectare of land’s production up faster than the industry’s average cost, and beyond the marginal revenue earned from that additional milksolids contribution.
“That marginal cost becomes the industry’s long run supply curve, and results in excess supply against what the average cost curve would have delivered.
“It has seen the industry slip into a production-driven industry, not a profit-driven industry. De-intensification would lead to increased profitability, with marginal costs falling faster than the loss in marginal revenue.”
LP analysis calculates how shifting a farm’s inputs of stock numbers, nitrogen inputs, and irrigation can result in a more optimal level for that particular farm.
Within any analyses, fixed costs and variable costs need to be carefully separated, especially where averaged ratios are used (cost/cow or costs/kg MS).
The same principal applies to all additional input and output scenarios; the tipping point for each must be correctly defined.
This is not possible where averaged figures or ratios provide the economic input. Averages also fail to account for the individual farm’s unique ratio of different inputs.
“The problem is, the industry has been stuck using “average” industry costs, which may be simple to source, but every farm is different and can’t just have “averages” applied to it.”
Ridler describes a level of “systemic misinformation” that exists within the sector’s average cost analysis, with none of the commonly used farm management programmes using marginal cost analysis.
Ridler acknowledges LP planning is more complex and demands greater knowledge of an individual farm’s cost and production profiles than reaching for DairyNZ sourced industry averages.
Agricultural consultant Phil Journeaux said the shift to a sub $4/kg MS environment made understanding and knowing marginal cost-revenue much more critical.
“It does not matter so much at $8/kg MS, but at $3.80, it matters a lot.”
Application of the linear programme on the 160ha Lincoln University dairy farm over 2011-12 season provides empirical evidence of how it can work.
The farm reduced herd size by 5.2% from 667 to 632 cows, increased milksolids per cow by 16.8% and increased profitability by 15%.
“The work also established while it was possible to further increase per cow production via supplements, it was not economically profitable to do so without a significant lift in milk price to over $9/kg MS,” Ridler said.
That lift was necessary to counter the cost of the additional bought-in feed that every additional cow required. Traditional analysis would instead dilute that cost across the entire herd, as an average per (all) cows.
Ridler said it has been tempting for NZ farmers to exploit the genetic potential of their herd (the Ferrari cows), but it was a limited approach unless the marginal costs of tapping that marginal revenue milk were fully understood.
Journeaux said nutrient restraints being introduced by councils should also bring marginal cost considerations into farmers’ calculations.
“Enforcing those losses will mean farmers will have to calculate the nitrogen loss effect, so they are making the same sort of decisions, for a different reason.”
Meantime Journeaux said a structural shift within the industry to consider marginal costs more closely was likely only if the payout remained deflated for two seasons.
