This page is about overhead expenses, and how they trap many farm businesses

Debt is one of many overhead expenses in a farm business, and is very useful to some people, although under some conditions it can kill a business stone dead. You must decide how much debt, if any, is appropriate for your business.

The purpose of this page is to offer additional perspectives to your thinking when it comes to overheads. I am increasingly finding that many people now think these perspectives are important.

Setting the trap
The overhead trap is such a plausible thing that I have watched thousands of farmers willingly fall into it over the years, and I count myself as one of them as well!! Take a look at this drawing, because this is a picture of 'the trap', and then read on.

Effect of Overhead Expenses on Risk and Scale

The difference between the crops income and its variable expenses is called Gross Profit. Others sometimes refer to Gross Profit as Gross Margin, but it is the same animal.

Overheads expenses: are the expenses a business incurs regardless of what it does. Some overhead expenses are determined by people outside the business. For instance, local government rates or taxes are an overhead that somebody else sets. They must be paid regardless of whether or not the business produces any activity and income.

Some overhead expenses are totally under the control of the farmer. Telephone expenses are a good example. For all practical purposes a phone could be termed a necessary or obligatory expense, however some people use the phone more than others.

The point is this: how large a business allows an expense to become is not directly related to the scale of the business, but is a choice made by its managers. We know many examples of farm businesses of similar scale who incur widely varying expenses such as their phone, electricity, insurance and wages.

What this picture might mean for you...
Look out for well meaning salespeople
Expert salesmen are specialists at telling the truth. If not they lose respect very quickly and then they lose their job. However I think they are experts at telling part of the truth. For instance, I would be willing to bet that if you have ever been involved in cropping, at some stage a convincing salesman has been able to demonstrate to you that purchasing his brand new piece of equipment will enable you to reduce your costs of production. And he will be very persuasive indeed.

He will show you that the bigger equipment will cover more hectares (acres) per hour, and he will tell you that this means your labour cost per hectare will decrease. That is only correct if the driver is a casual employee. If the driver is a permanent employee, or the driver is you, then it is a different scenario altogether. You and your permanent employees are an overhead of the business and not a variable cost. Neither of you are paid more to pass over an additional hectare of the paddock, whereas a casual employee on hourly rates does.

The salesman will probably also demonstrate that fuel cost per hectare will decrease, and that will be correct, as fuel used in preparing, growing and harvesting a crop is a variable expense. In a rising fuel cost scenario the power of his claims will be persuasive indeed.

What he won't tell you
What the salesman won't tell you is the real impact on your bottom line if you buy the item he has for sale. If you have financed the equipment on a lease or some form of credit purchase, you have added a new overhead expense to the business. If you pay cash then the money invested in the equipment is not available for other purposes. In particular it is not available to strengthen the weak-link of the business.

What the picture is telling you...
Farm 1 and Farm 2 are identically sized, but the managers have each adopted different attitudes to risk and the scale of their overhead expenses. Each farm has identical income for each unit of product they produce, so the discussion is only about costs.

The Farm 1 manager has chosen to increase his overheads by investing, perhaps in new, high performance equipment. The effect has been to significantly reduce his variable costs, just as the salesman told him would happen. What the salesman never tells the farmer is that his overheads will increase.

For Farm 1 Overheads are now 4 Units, and the breakeven point is about 7.5 units of production.

The Farm 2 manager has kept his overheads low. In fact at 2 units they are just half those of Farm 1. But the cost of keeping overheads low is that variable expenses on Farm 2 are twice as much per unit of production as those of Farm 1. (For every dollar that Farm 1 spends on crop or animal inputs, Farm 2 spends two dollars).

But the breakeven point on Farm 2 is 5 units of production. This means that Farm 2 need only produce two-thirds of Farm 1 in order to break even.

Why this example might be important...
If the purpose of increasing overheads is to increase your farm profitability then listen up! In this example it is interesting to observe that Farm 1 only becomes more profitable than Farm 2 at 15 units of production (the vertical blue dashed line).

Farm 2 is profitable much earlier and remains more profitable until 15 units of production. Thereafter Farm 1 becomes ever more profitable but until that point is at greater risk.

If the equivalent of 7.5 units of production on your farm is risky to achieve on an annual basis, the farm business is at risk. In fact the Farm business is at greater risk right up to 15 units.