Cost of Production and Profitability

Shadbolt N.M., Kelly T., Holmes C.W. (2005) Organic dairy farming: cost of production and profitability. AFBM Journal volume 2 number 2: 136-145 http://www.afbmnetwork.orange.usyd.edu.au/afbmjournal

Organic Dairy Farming: Cost of Production and Profitability Nicola Shadbolt, Terry Kelly, Colin Holmes College of Sciences, Massey University, Private Bag 11222, Palmerston North New Zealand [email protected] [email protected] [email protected]

Abstract. Organic milk production in the EU costs more than conventional production and therefore requires a price premium (15- 25%) and an increase in direct payments to ensure the same level of profitability. In European comparisons milk yields per cow are lower (9-30%) and stocking rates are also 20-40% lower due to lower yields in forage production. The IFCN (2003) comparison between organic and non-organic farms in the EU calculated 22-37% higher costs of production. Similarly the cost increase measured in California ranged from 13-23% for organic versus conventional milk production. However comparisons between low producing and low cost systems as described by MafPolicy (2002) and for the Argentinean farms compared by IFCN (2003) suggested a minimal increase of 3% in costs. This paper compares the cost of production and profitability of organic and conventional dairy farming over the first three years of a Massey University system comparison trial. The difference between these pastoral farming systems was predicted to be less than that noted in the more intensive EU and the US dairy farming systems as minimal changes are required to achieve organic certification. Recognising that the organic farm has only just achieved certification and has not reached its steady-state yet the results highlight the vulnerability of both pastoral systems to climatic variability and identify the additional risks of organic dairy systems.

Organic Foods main markets. Countries such as The food industry has been evolving Austria, Denmark, Netherlands and into an array of niche markets with Switzerland now have well established consumers demanding healthy, organic markets and growth is slow, nutritional and convenient food static or declining. When supply products. Organics is one of these exceeds demand in those countries niche markets offering perceived organic product is sold as non-organic benefits over undifferentiated product (Nieberg, 2004) commodity goods. Global markets in organics are expanding by an Prior to such recent expansion the estimated 20% per year with the motivation for adopting organic organic dairy product growth in the practices was farmer concern about European market in 2001 estimated risk to their health and the at 26% (Hallam, 2002). Dairy has environment from current been one of the fastest growing conventional practices. In the ‘90s segments of the organic foods consumer awareness about such risks industry in the US (from 1997-2001) also grew with much of the growth with milk cows now accounting for being motivated by fears of food over half of all certified animals safety. This resulted in an increased (Greene, 2002). The organic sector is consumer demand for organic principally located in the developed products. With demand growing at a countries, with the EU and the US the faster rate than supply higher prices have been able to be obtained for organic products. The third motivation for fruit and vegetables (20-40%), to convert to organics was, therefore, poultry (50%) and eggs and pork the financial one of support, (in (100%) than for meat and dairy Europe Governments policy has been products (20-30%). Nieberg & to support organics), and price Offerman (2002) also note a similar premia. Organic foods typically relationship between products and command a price premium over price premia, with the farmer of conventionally produced foods as a organically produced milk receiving an result of higher production and 8-36% premium over conventional distribution costs and as a result of milk and organic wheat growers demand exceeding supply (Hallam, receiving 50-200% higher prices. 2002). Government policy supporting organics through direct payments to The ability of price premia and farmers to assist them both through government support payments to and after conversion to organics is counter increased costs of production quite significant in the EU (Neiberg & on EU farms is illustrated in Figure 2. Offerman, 2002). Similarly in the US While the arable farmers achieve some states are subsidising quite significant improvements in conversions to organic systems, profit the dairy farmers on average funding for multidisciplinary organic achieve similar or slightly better research trials has increased in recent profitability than their conventional years and federal intervention has peers. included assistance with the costs of certification and market facilitation Figure 2: Profits of organic farms relative to (Greene, 2002) comparable conventional farms in the EU (Source Neiberg & Offerman, 2002) Table 1: Importance of price premia and support payments for organic farming. (Source Neiberg & Offerman, 2002)

Successful organic dairying requires exceptional proactive management ability and good record keeping skills; as with many niche markets it is not The goal of most European countries an easy option. As with all is to increase their area of organic management systems a range of skill production, even in those countries levels have been observed on organic with static growth in demand farms in the EU. It is useful to keep (Neiberg, 2004) this range in mind when determining cost of production and return figures for an ‘average’ farm.

Price premia observed by Hallam (2002) in the EU market are higher Cost of Production optimum profit level for that Cost of production is the sum of business; the level at which a both cash and non-cash expenses business sets its costs is a and includes both operational costs reflection of the ability of the that occur irrespective of how the farmer to both manage risk and business is funded or owned, and production efficiency. funding costs reflecting business ownership and financing. The Operating costs are a combination difference between cost of of the cash expenses incurred production and returns is termed (Farm Working Expenses (FWE)) the entrepreneur’s profit (IFCN and non-cash expenses that 2002) and is akin to achieving a account for changes in the amount positive EVA for the business. The of input inventory (e.g. chemicals, greater the entrepreneur’s profit feed supplement) on hand at year- the stronger the business is end, for the annual allocation of positioned for future growth and capital costs through depreciation wealth creation. It also provides charges and for the recognition of the business with a risk ‘buffer’ inputs that have not been paid for against adverse climate or such as family labour and markets. management.

While costs are often expressed on Funding costs reflect the fact that a per enterprise, per hectare or per capital employed by the business stock unit basis the most relevant can be owned or leased and that measure is cost per unit of output the capital that is owned, the as this can be readily compared assets of the business, can be against the returns per unit of funded by the bank (or by family output to determine the loans) as debt, or by the owner as entrepreneur’s profit. Factors such equity. as stocking rates, milk production per cow, replacement rates, Funding costs are the cost to the variable and fixed costs and net business from meeting the income from livestock all impact on requirements of the providers of cost calculations. Buron de capital. Leased capital usually Machado (2004) found when incurs an annual lease or rental, analysing four years of the Dexcel similarly debt requires interest to Profit Watch database that cost of be paid. capital and milksolid production per hectare were the two variables with Figure 2: The sources and costs of capital the greatest impact on cost per kilogramme of milksolids, TOTAL CAPITAL irrespective of the size of the farm and its feed policy. OWNED CAPITAL LEASED CAPITAL

As with all financial measures the cost of production should not be TOTAL ASSETS viewed in isolation. The obvious EQUITY DEBT benefit for a large farm from economies of scale is a lower cost of production but the profitability measures such as return on assets Cash and Interes Rent and EFS/ha need also to reflect Non-cash t advantages of scale (Shadbolt, returns 2004). Achieving the lowest cost of production may not result in the The cost of equity is owner specific seen that for some countries the reflecting the opportunity cost of milk price is greater than both the their money, attitude to risk, cash costs net of non-milk returns lifestyle expectations, capital gain and the calculated opportunity cost expectations, the stage in the of owned land, non-land equity and lifecycle of the business and the family labour. These farms can be family, their desire to invest in a said to be generating an farm in addition to non financial entrepreneurs profit for their reasons (e.g. being self employed, business. The remainder are able security, quality of life, fulfilling a to cover their cash costs with the dream…). Calculating a cost of price they receive but are not able equity can be therefore quite to cover their opportunity costs, an difficult. unsustainable uneconomic situation. The countries in the The cost of milk production is a net graph from left to right are (East) cost, that is, the total costs of the Germany, The Netherlands, dairy enterprise (operating costs Denmark, India, Argentina, Brazil, and funding costs) less the returns the U.S. and New Zealand and the from non milk returns. The non number of cows on each farm is milk returns include cull cows, noted on each country’s calves and, in some countries, abbreviated name e.g.NZ 447, a government payments. farm with 447 cows. In Figure 3, based on a sample of the IFCN Report (2003), it can be

Figure 3: Comparison of cost of milk production in 2002 for 10 countries (IFCN, 2003)

IFCN Dairy Report 2003 - final results

Costs of milk production only Opportunity cost (excl. quota) Quota costs (rent and opportunity costs) Milk price Costs from P&L account - non-milk returns

7 35 9

milk milk

kg kg 20

$/100 $/100 US-

0 - - 0 - - - - E L - - 5 0 0 0 0 7 5 - I D R R S S Z Z 0 0 D 6 N 9 5 0 1 I - 4 3 K 5 2 A 3 B 8 U 7 W U 2 0 N 4 N 8 N D 1 I 2 The Cost of Organic dairying Organic milk production in the EU the amount of expensive purchased costs more than conventional feed and made better use of pasture, production and therefore requires a operating costs also did not differ, and price premium to ensure the same herd replacement costs were 30% level of profitability. In European higher on a unit of milk basis. The comparisons (Nieberg & Offerman, costs included in his analysis are 2002; IFCN, 2003) milk yields per incomplete as full funding costs are cow are lower (9-30%) and stocking not included nor a value for family rates are also 20-40% lower due to labour and we do not know the value lower yields in forage production. In a of cow and calf sales. However on the high fixed cost system the cost of basis of his results and after removing production ($ per kg milk) is very the interest, tax and insurance figures dependent on milk yield, the lower the that were identified as being yield the higher the cost. anomalous, the difference between the costs he presented for organic and The IFCN (2003) comparison between conventional case study farms was organic and non-organic farms in the 13% per unit of milk. This is lower EU calculated 22-37% higher costs of than the state-wide costs of organic production using full economic costing milk production which he states is methods as described above. In 23% higher per unit of milk than Argentina, where the two production conventional milk production. systems are very similar the smaller Although these farms receive a higher difference of 11% in costs of price for their milk (21% net of production was mainly the result of marketing costs) their net farm the cost of organic certification. In income is 84% of their conventional Argentina the price premium is just peers on a per unit of milk basis. 3% so it is not feasible to increase costs under organic dairying. In the Conversely a three-year study in EU the higher cost of production are Canada comparing technical and met by price premia of 15-25% on economic performance of organic and milk, 20-46% on beef and 100-200% conventional dairy farming found on direct payments. superior technical performance on the conventional farms in terms of milk Converting to organic dairying in yield, whilst economic performance California where they rely on mostly was better on the organic farms purchased feeds and grow little of although revenues were lower their own requires a long-term (Stonehouse, Clark & Ogini, 2001). commitment (Butler, 2002). Butler (2002) proposed that with anticipated Another aspect to consider when lower production per cow, organic comparing organic with conventional feed costing 25-50% more than systems is how long the organic conventional feed, herd replacement system has been converted from costs being 10-20% higher, and conventional. Kim (2004) operating costs up 12% (including recommends that a long-term annual certification costs of $2000- approach is taken with such systems 3500) the overall effect would be 15- as it takes time for the changing 20% higher costs on an organic dairy biological and ecological processes relative to a conventional dairy. His and interactions to both be research with case study farms understood and to take effect. His indicated that feed costs were not research, with organic rice production significantly higher as farmers limited stated that it took 5 years before environmentally friendly systems milked by 7.4%. Based on this generated more revenue than strategy the farm required a price conventional systems. premium of less than 3% to return the same cash surplus as the This recommendation is reinforced by conventional model at that time. No results from a study in Italy in which allowance was made however for the an integrated economic- costs associated with feeding out environmental accounting framework maize silage. was applied to three case study farms to assess the sustainability of organic, The conventional model used for integrated and conventional farming comparison grew no maize silage, systems (Pacini et al, 2001). The made grass silage and hay and organic farming system performed applied just 65kg N/ha in the winter better than the other two on most and spring. Today a typical farm in environmental indicators and in a that area (IFCN, 2003, steady-state performed better ProfitWatch,2003) would apply twice financially that the conventional that amount of nitrogen, would system (due mainly to better market purchase or grow maize silage and be prices for its products). However the producing another 120kg milksolids study found that systems in per hectare. In comparison with this conversion experienced serious revised base the organic farm as financial difficulties that were not described in the MafPolicy report addressed by support payments at would require a 10% higher milk price that time. Improved returns have to achieve the same cash surplus. therefore been recorded for organic farms but the length between being A recent survey of organic dairy conventional and benefiting from farmers in NZ (Shadbolt & Evans, pers being organic could be a deterrent to comm.) identifies, from a limited those considering converting. sample (6 farmers), a reduction in stocking rate of 13-20% had occurred The approach taken by MafPolicy on those farms once fully converted. (2002) was to develop a view of what The farms analysed had been organic a steady-state organic operation from 6-25 years. There also had been would be like and do the cost no significant change in feed comparisons on that view. This supplement provided, there were no approach was driven as much by the farms that had gone from grass and lack of organic farms to analyse as by hay supplement to maize although the hope that such an approach would some had continued with their enable a model to be built of what existing maize policy. One of the could be by as wide a group of common issues identified by these interested people (organic and farmers was the inability to source conventional farmers, scientists, organic feed off-farm hence the consultants and policy makers) as requirement, as presumed in the possible. The result was an organic MafPolicy study, that feed be sourced dairy farm that replaced nitrogen on-farm. For these farmers in the enhanced grass growth with maize absence of maize silage this resulted silage grown on farm, a strategy they in a drop in numbers. Both the much acknowledge some organic farmers greater drop in stocking rate and the may be reluctant to pursue. The farm absence of a significant shift in feed reared fewer replacements (19% policy are in contrast to the against 22%) and ran them on-farm assumptions made in the MafPolicy and reduced the number of cows study. If we impose the changes that c) animal production occurred on these survey farms on and health; the current conventional farm model 3. identify practices that improve (IFCN, 2003, ProfitWatch,2003) for the biological activity of soils; the Waikato as described above, the 4. develop pasture management increase in actual milk price required practices for organic dairy to offset their reduced milk production pastures that optimize clover is 17% to achieve the same cash content and best maintain surplus. biological N fixation; 5. determine the stability and Massey University sustainability of high Organic/Conventional Comparison biodiversity organic dairy Trial pastures including the control In 2001, Massey University set up its of weeds; and Dairy Cattle Research Unit (DCRU) as 6. develop best management a system comparison between organic practices for mastitis control and conventional farming. It is and other health issues in unique because it is the only organic milk production comparative grassland-based open systems. grazing dairy study in the world. The DRCU began its organic conversion This farm was chosen because of its period on 1 August 2001, at which research capability but its size time the unit was split into two similar (41.6ha running 88 cows) has meant farms, one conventionally managed careful interpretation of results is and the other organically managed. required before comparisons can be On 1 August 2003, the organic farm made of economic performance. achieved its full AgriQuality organic Average levels of production for certification. smaller farms (47ha) in this region of The long-term aim of this research is 298 kgMS/cow and 839 kgMS/ha to better understand organic dairy (Buron de Machado, 2004) are below farming systems by investigating this farm at 410 kgMS/cow and 935 component interactions in these kgMS/ha so it must be clearly systems, and by determining how understood that this trial has not impacts and interactions change over started from the low production low time as organic systems mature. cost system assumed in the MafPolicy Extensive monitoring continues to be study. On that basis alone it can be carried out on both farms, which surmised that the difference in cost of forms the basis for a long-term production and therefore the price project with the following objectives: premium required will be greater. 1. develop farm and herd management systems that In general, the results of the first two optimise performance over years of the trial showed little time; difference in productivity, animal 2. compare the impacts of health, and soil and herbage quality organically and conventionally between the two farms. The managed dairy systems on: conventional and “in conversion” a) soil health (quality, organic farms produced similar flora and fauna) & water amounts of milksolids per cow and per quality, hectare, and somatic cell counts were b) pasture and forage low for both herds. crop productivity (quantity The first year for the two herds and quality), and (2001-02) had favourable grass growing conditions which, with the The small size conventional farm lower stocking rates, meant similar average data also had a higher cost of quantities of supplement were fed and production (29%) than the Massey good production levels were achieved. University conventional unit, due to Milksolids per hectare were 993 and its lower milk production. 959 and per cow were 451 and 436 for the conventional and organic There was a drought in the second farms respectively. These compare year of the trial; the impact of the dry favourably with the district average of conditions in that year was that feed 314 kgMS/cow that year (Dairy costs were increased significantly on Monitoring Report, MAFPolicy) and both farms. The decision to provide 302 kgMS/cow from small size farms similar ME intakes to both herds in the region (Table 2). throughout the milking season to maintain target condition scores and In year one breeding, fertiliser, feed, predicted production levels meant 20t wages and administration costs were more feed had to be supplied to the slightly higher in the organic unit organic cows in that year. The organic reflecting both the higher cost of feed was also more expensive to organic inputs and the cost of purchase. Both herds were dried off in establishing an organic management March resulting in lower milk yields plan for certification. These increases (Table 3). combined with 3% less milk resulted in the cost of production per ProfitWatch Organic/Conventional small farms Comparison Trial MU kilogramme of milk being 9% greater. 02/03 02/03 02/03 No price premium was available and Av.conv. Conv. Org. this was reflected in the reduced Cows Milked 123 49 48 return on assets. Eff Dairy Ha 48 21.32 20.38 Stocking Rate 2.56 2.30 2.36 ProfitWatch Organic/Conventional kgMS/cow 275 318 317 Comparison Trial MU kgMS/ha 703 722 742 01/02 01/02 01/02 Av.conv. Conv. Org. Gross Farm Income $/ha 3268 2860 2858 Cows Milked 116 44 44 Operating Eff Dairy Ha 47 20 20 Expenses $/ha 2695 3178 4061 Stocking Rate 2.5 2.2 2.2 Operating Profit kgMS/cow 302 451 436 $/ha 573 -318 -1203 kgMS/ha 743 993 959 Return on Assets % 2.3% -1.3% -4.8% Gross Farm Cost of Capital Income $/ha 4430 5247 5173 $/ha 1250 1250 1250 Operating Cost of Milk $/ha 3586 4428 5311 Expenses $/ha 2758 2875 3102 Cost of Milk $/kg 5.10 5.77 6.90 Operating Profit Difference % -11.6% 19.6% $/ha 1672 2373 2070 Return on Assets % 6.7% 9.5% 8.3% Table 3: Data from year two of the Cost of Capital Massey University trial and $/ha 1250 1250 1250 Profitwatch data from small size farms Cost of Milk $/ha 3520 3650 3841 Cost of Milk $/kg 4.74 3.68 4.00 Difference % 29% 9% As in year one breeding, fertiliser, feed, wages and administration costs Table 2: Data from year one of the were all higher in the organic unit. So Massey University trial and although milk production per hectare Profitwatch data from small size farms was slightly higher from the organic unit the cost of production per kilogramme of milk was 19.6% greater than the conventional unit. No about 10%. The outcome however price premium was available as the was the conventional unit exceeded unit was still in conversion to organic its production in year one and production. produced 18% more than the organic unit (Table 4). This was the result of Not all farms represented in the small 12% more milk per cow and a 6% size conventional farm average data higher stocking rate. The organic unit were affected by drought conditions. produced 9% less than year one but Their production was only 6% less still produced 13% more per hectare than the previous year while the than the MafPolicy estimate for Massey University farm was 37% and Manawatu dairy farms in that year. 29% less for the conventional and organic units respectively. Their MafPolicy Organic/Conventional operating expenses reduced by 2% Monitoring Comparison Trial MU 03/04 03/04 03/04 while the Massey University farm Conv. Org. increased operating expenses by 10% Cows Milked 230 51 46 and 24% for the conventional and Eff Dairy Ha 90 21.32 20.38 organic units respectively in response Stocking Rate 2.56 2.39 2.26 to the drought. Their cost of kgMS/cow 320 457 410 kgMS/ha 817 1094 925 production per kilogramme of milk was, as a result, 11.6% less than the Gross Farm Massey University conventional unit. Income $/ha 3554 4872 4529 Operating Expenses $/ha 2899 3069 3038 The dry year doubled the requirement Operating Profit for feed on the conventional farm and $/ha 656 1803 1490 tripled it on the organic farm when Return on the target was to achieve similar Assets % 2.6% 7% 6% feeding levels for the cows and similar Cost of Capital $/ha 1250 1250 1250 levels of production. One of the Cost of Milk $/ha 4149 4319 4288 outcomes of discussions subsequent Cost of Milk $/kg 4.71 3.49 4.06 to that season was to develop Difference % 35.0% 16% systems on the organic unit that provided a better buffer for climatic Table 4: Data from year three of the uncertainty. These include reducing Massey University trial and MafPolicy stocking rate by 6%, delaying calving monitoring farm estimates from the date by a week, developing pasture Manawatu. swards that include species that will produce better at both ends of the There were few constraints to grass season and developing sources of growth in that year; it is assumed at reliable and lower cost supplement. this stage that it was the conventional farm’s ability to apply nitrogen By the third year the organic farm had fertiliser throughout the season that achieved its accreditation status and enabled them to grow more grass and its milk began to receive the 10% achieve a higher milk production. As a premium from Fonterra. There were result of the yield difference even excellent grass growing conditions in though the absolute costs of the that year due to consistent rainfall organic unit were less the cost of throughout the season. The production ($/kgMS) was 16% expectation was that the two units greater. In comparison with the would revert to the production levels MafPolicy monitoring farm estimates of year one and the cost of production for 2003/2004 the return on assets difference between them would be were doubled and nearly tripled by the organic and conventional units and the Argentianian farms compared respectively, and the conventional by IFCN (2003) then the price premia farm’s cost of production per required is significantly reduced as the kilogramme of milk was 35% less. difference between the two systems is less. Years two and three of the trial can both be described as quite extreme Acknowledgements environmental conditions, one very Natalie Butcher (Technician), Peter dry and the other wet throughout the Meirs (Farm Manager) and Gareth summer. In the first the organic unit Evans (Farm Supervisor) from was disadvantaged by the high cost of Agricultural Services, Massey out sourced organic feed and in the University, for the collection of data; second it was not able to compete other members of the Science Team with the nitrogen induced boosts Drs David Horne, Alan Palmer, Peter available to the conventional farm. Kemp, Kerry Harrington of the Institute of Natural Resources and Although the organic farmlet has Alan Thatcher of the Institute of achieved full certification, the actual Veterinary and Animal transition from conventional to organic production is continuing, with References many of the biological systems taking Buron de Machado 2004, Risk analysis of low, longer than two years to make the intermediate and high input dairy systems. adjustment from conventional Unpublished Postgraduate Diploma thesis, management (Dabbert and Madden Massey University, Plamerston North 1986). Thus, the whole farming Butler L J, 2002, “survey quantifies cost of system, and resulting profits, is still in organic milk production in California’ California Agriculture, September-October, transition. 2002 157-162 Dabbert S, Madden P 1986, ‘The transition to Summary organic agriculture: A multi-year simulation The Massey University model of a Pennsylvania farm’, American Journal of Alternative Agriculture, 1 (3): 99- Organic/Conventional Comparative 107. Systems trial to date suggests the Greene C, 2002, ‘U.S. organic agriculture ability to return a profit on NZ organic gaining ground. USDA-ERS Agricultural dairy farms will be a factor of Outlook (April): 9-14 production levels achieved, prices Hallam D, 2002, ‘The organic market in OECD received, cost of production and the countries: past growth, current status and future potential’, in OECD Organic ability to make the transition to Agriculture: Sustainability, Markets and organics quickly and manage ongoing Policies (E-book PDF Format) Co-edited with environmental uncertainty. CABI Publishing 179-186 IFCN 2002 These results are similar to overseas IFCN 2003 studies so price premia are as Kim C-G 2004, ‘Economic performance of relevant for pasture based systems as sustainable farm management practices in Korea’ OECD Expert Meeting on Farm for housed systems with high Management Indicators and the Environment, concentrate use. It should be noted March 8-12, 2004, Plamerston North, New that the Massey University Zealand conventional system is highly MafPolicy 2002, Understanding the costs and productive and profitable. If the base risks of Conversion to Organic Production conventional system against which Systems. MAF Technical Paper No.2002/1, Minstry of Agriculture and Forestry, New comparisons are made is low Zealand. producing and low cost as described Nieberg H, 2004 pers comm.. in the analysis by MafPolicy (2002) Neiberg H, Offerman F, 2002, ‘Economic Shadbolt N M, 2004, ‘Financial measures of Aspects of Organic Farming –the profitability business success’, in Proceedings of Large of organic farming in Europe’, in OECD herds Conference, March 28-31 2004, NZ Organic Agriculture: Sustainability, Markets Large herds Association Inc. 35th Annual and Policies (E-book PDF Format) Co-edited Conference, Napier, NZ, 64-70 with CABI Publishing 141-152 Stonehouse D P, Clark E A and Ogini Y A, 2001, Pacini C, Wossink A, Giesen G, Vazzana ‘Organic and conventional dairy farm C,Huirne R, 2003 ‘Evaluation of sustainability comparisons in Ontario, Canada. Biological of organic, integrated and conventional and Horticulture, 19:2, 115-125 farming systems: a farm and field scale analysis, Agriculture, Ecosystems & Environment, 95,273-288