The “5% rule” of farm management shows how all the pieces matter

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I am preparing to teach Farm and Ranch Management to juniors and seniors here in the College of Agriculture at MSU. In doing so, I’ve spent some time gathering wisdom from my favorite farmers, educators, and other management experts. These lessons become increasingly important as we think about farm business viability during a period of lower commodity prices.

One simple idea that I’ve seen in various places is a “five percent rule” for improving farm profitability. Danny Klinefelter, former Professor at Texas A&M University (and legendary farm management guru) states the rule this way:

“A 5% increase in price received, a 5% decrease in costs, and a 5% increase in yield will often produce more than a 100% increase in net returns. The effect is cumulative, multiplicative and compounding.”

The gist of the five percent rule is that small improvements in multiple areas, made together, can generate large changes in the bottom line. This doesn’t mean that five percent changes are easy or likely. (If they were, everyone would have made them.) But it does provides strong motivation for continuous improvement. Since the variables that go into determining farm profitability interact in ways that generate positive, multiplicative feedbacks, the total effect is much larger than the sum of its parts.

Not as simple as 5%+5%+5%

As an example, take the following simple per-acre profit/loss calculation for spring wheat production in Northeastern Montana. (For simplicity, I’m using round numbers.)

Price$5.50+5%$5.78
Yield40+5%42
Revenue$220.00$242.76
Costs$200.00-5%$190.00
Profit/Loss$20.00$52.76

Here, these five percent changes lead to a 164% increase in profit. 5% + 5% + 5% does not equal 15% because production, marketing, and input use don’t work together that way. The relationship is multiplicative, as Klinefelter notes. He also says it is compounding, so several consecutive years of five percent improvements will similarly create more than a 15% increase in profit overall.

This said, the calculated percentage increase in profit can be manipulated by changing the starting conditions.

Price$5.50+5%$5.78
Yield40+5%42
Revenue$220.00$242.76
Costs$215.00-5%$204.25
Profit/Loss$5.00$38.51

If margins are very tight to begin with, we can calculate huge percentage increases in profit. In this second example, five percent changes in production, marketing, and expenses lead to a 670% increase in profit, even though the changes made here were the same as those in the first example. Rather than focus on a specific calculation, we need to focus on the principles underlying the ‘rule’.

The key insight from the five percent rule is that our brains don’t always intuitively comprehend how different components of a farm business interact with each other to affect profitability. Small improvements in all of these components areas lead to big swings in profitability. The flip side to the five percent rule is that when these interaction effects are present, farms can’t afford to fail at any one business function. Mistakes in marketing will cancel out gains made in agronomy or cost containment. Particularly in this period of tight margins, growers need to critically evaluate all functions of their business and get help in those areas where their performance is weakest.

(Photo by 401(K) 2013 is licensed under CC BY 4.0)

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About Author

Joseph Janzen

Joseph Janzen is an assistant professor in the Department of Agricultural Economics and Economics at Montana State University. His research addresses price and trading dynamics in agricultural commodity markets. Some of his recent projects include commodity price shock identification, commodity futures market microstructure and the location of price discovery in world wheat markets, and the influence of international food aid procurement in pulse crop markets. Joe received his Ph.D. in Agricultural and Resource Economics from the University of California, Davis in 2013. He also holds M.Sc. and B.Sc. degrees in Agribusiness and Agricultural Economics from the University of Manitoba. Prior to his doctoral studies, he farmed with his father and brother, growing wheat, canola, oats, and soybeans at St Francois Xavier, Manitoba, Canada.

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