Debt, Risk, Overheads and Scale


Video Clip

To play Video Clip, just click once on the play icon. (If you have slow internet connection such as Satellite or dial up then you may need to press pause for a minute to allow streaming of clip for a continuous viewing)

Audio Clip

To play Audio Click, just click once on the play icon. (If you have slow internet connection such as Satellite or dial up then you may need to press pause for a minute to allow streaming of clip for continuous listening)

Please watch the video first.

Overheads can destroy a business from the inside, out.  The chart below shows the effect of increasing overheads.
Note: This exercise takes a few minutes to get your mind around, so please be patient and give it the time it deserves. It will be worthwhile.



In this example there are two farms, ‘Farm 1’ and ‘Farm 2’.  Each are similar in landscape and area.  The variable between the two are as follows:
Farm 1 has 4 units of Overhead costs
Farm 2 has 2 units of Overhead costs (50% that of Farm 1)
Farm 1’s variable costs per unit of production are half that of Farm 2.  You can see that the red line is much flatter for Farm 1 than it is for Farm 2.  Put another way, for every $1 per hectare that Farm 1 spends on seed, fertiliser, chemicals, planting, harvesting etc, Farm 2 needs to spend $2.

Both farms obtain equal yields per hectare and receive the same price per tonne for the products.  The green line on both is the same.

Effectively, Farm 1’s low variable expenses have been ‘purchased’ at the expense of increased overhead costs (perhaps Farm 1 has bigger, more modern equipment, but the reason is mot material to the discussion).  

Analysis
Farm 1 requires more than 7 units of production in order to break even, whilst Farm 2 needs only 5 units of production.  That is a difference of 45% in Farm 2’s favour.
 
In practical terms, how does Farm 1 overcome this situation?  It is difficult to see how Farm 1 can increase yield by 45%.  Equally, it is difficult to imagine that Farm 1 will be able to sell his product at a 45% premium to Farm 2!  Farm 1 is in a spot of bother, as neither option is within their immediate control.

Looked at another way, Farm 1 requires $5 per unit of production in order to break even, whilst Farm 2 requires about $3.50, again a difference of about 45%.  The reality is that under most circumstances no amount of marketing expertise can overcome such a gap!  Farm 1 is at much greater risk in the event of a price decline.

The cause of the difference between Farm 1 and Farm 2 is very simple - each made their decisions differently.  
Of course, if Farm 1 can consistently increase his production through adopting (say, new technology) he will at some stage enjoy a market advantage compared to Farm 2.  If the higher rate of productivity is difficult to consistently achieve, the farmer is doomed to high risk and lower reward.

Here is the take home message.  At the end of the day:

Profit
Is a function of your cost of production, not the sale price of your production

                                        Return to Main menu                                         Feedback and Comments