Procedure 3

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Evaluate and choose the best options for improvement

A strategy may include options ranging from simple modifications of existing operations to complex changes affecting the whole business. Being able to explore options and quantify the benefits of change is integral to developing your business plan and committing to that change.

Guidelines for exploring options to change your business strategy

There are many different strategies that will improve business profitability, natural resource management and your lifestyle. Once opportunities have been identified to improve your existing business, consider other information important to your final decisions. Information that is important to consider includes:

  • your view of the value of future markets and commodity prices in the new enterprise
  • historical commodity price variation in real dollars over longer time periods (eg 10-15 years if available, corrected for inflation)
  • potential productivity improvements and how the new system fits patterns of pasture availability
  • profitability and capital required for alternative enterprises
  • impact on environment and natural resources
  • impact on lifestyle and labour efficiency
  • your management skill to run the new or changed enterprise.

A wide range of scenarios can be reviewed initially for feasibility in a typical year using simple screening techniques. Depending on the type of changes considered, the options for improvement can be compared using:

  • Simple gross margin analysis to compare enterprise income and direct (variable) costs. The analysis can be conducted on a total basis or per hectare, per DSE or per livestock capital invested in the enterprise; depending on what resources are most limiting.
  • Partial budgets are useful to examine one aspect of change without including the whole business (additional returns minus additional costs). Tool 1.11 shows a worked example of a partial budget and the subsequent return on investment calculation. This takes into account all the variations in returns and costs, including additional capital associated with the proposed change. It mirrors the whole business budget but only accounts for those items that vary if this investment or option is adopted and implemented. The returns on additional capital required are as important as the overall return on total capital. You can use the spreadsheet tool to analyse your own scenario.
  • With complicated investment decisions where large capital outlay or longer time frames are involved before returns are generated, methods such as discounted cash flow analysis are useful analytical tools as the value placed on money changes over time – a dollar in the future is regarded as being worth less than current value (see ‘Comparing analysis approaches’ box). The discount rate chosen for ‘devaluing’ future returns is normally the assumed rate for borrowing, say 8%, plus an addition for risk, say 4%, giving this example a rate of 12%. This is often referred to as a nominal discount rate because inflation is included.
  • When changes involved in the transition are substantial and multifaceted, for example when purchasing more land or changing enterprise or time of calving, you should undertake a whole business budget to fully understand the consequences for the business including cash flow, liquidity and financing. Tools for whole-station business analysis that require you to quantify the marginal costs, marginal income, discounted cash flow analysis, time to break even, lifespan of the investment and the relative return on capital invested across multiple enterprises have complex interactions with each other. If they are required, you should seek professional assistance.
  • The biological impact of strategies should be investigated including potential impact on pasture utilisation, pasture growth rates, nutritional management and beef production.

Comparing analysis approaches

The differences in outputs from partial budget analyses and discounted net cash inflow analyses are as follows:

Partial budget analysis outputs

  • net gain (returns minus costs)
  • percentage return on extra capital invested (such as livestock)

Discounted net cash flow analysis outputs

  • net present value of the investment over the period of time (discounting the value of returns and costs in the future)
  • internal rate of return is the interest rate that discounts a cash flow to zero (that can be used to compare projected returns with the opportunity cost of investing the money elsewhere
  • nominal net cash flow (inflation included)
  • cumulative net cash flow

Manage the risks

When planning a change in your enterprise, you should consider the impact of change on all options you are exploring. This should involve sensitivity analysis with budgeting to include a wide range of price scenarios and costs, the impact of drought and a range of productivity scenarios due to different seasonal conditions. Refer to Procedure 1 for more information on risk analysis. Management needs to have the knowledge and skills to manage change.

A worst case scenario is when the business is destabilised during transition by declining cash flows. This may contribute to reduced equity and liquidity. Options available to address this include:

  • recalculating budgets
  • stopping or limiting progress of change and re-directing investment to areas of higher returns and/or lower risk
  • delaying or advancing implementation to better fit cash flow and management constraints

In some circumstances, business equity can increase while having reduced cash flow, such as is the case when increasing stocking rates as sales are forgone and assets (livestock) are increasing.

Constraints

Budget analysis does not directly take into account the costs or benefits to quality of life, but these factors are important enough to be considered in the trade-off between personal goals and maximising profit. Such unquantifiable benefits include the ability to take a holiday, the total number of hours worked each day, the timeframe in which the work needs to be undertaken, attitude to borrowing money and taking risks.

Similarly, you may want to put constraints on some forms of development because of concerns about potential environmental or resource management impacts.

In these instances, it is useful to get an assessment of the cost of these constraints in terms of any decrease in profitability, so you are in a better position to weigh the pros (positives) and cons (negatives) and make a more informed decision.

What to measure and when

It is not uncommon for potential returns from on-property investment to vary from 10% to more than 30% and therefore it is critical to identify the better investment opportunities.

Assessing the competing investment options for the business’s financial resources involves quantifying or qualifying the:

  • net change in income, accounting for increased income and any trade-offs or income reductions, such as lower income.
  • net change in expenses, taking account of any increased costs (both cash outlays and any non-cash costs such as additional owner-labour requirements or depreciation on plant and equipment) and reduced costs.
  • scale of the investment (capital and human resources). For example, an investment in improving property infrastructure may need to be accompanied by an investment in additional livestock and require increased management inputs.
  • likely repayment period for the investment and the cash flow implications, taking account of the climatic and production risks involved.
  • life span of the expected benefits from the investment. An investment of $50,000 in a change that produces a benefit of $15,000 per annum over 10 years ($150,000 in total) is better than an investment of the same amount with the same benefit but only for five years ($75,000 in total).
  • nature of and additional exposure to risk associated with any new or alternative enterprise.

It is critical with all options to initially calculate the marginal return on investment, the overall annual impact on enterprise profit and overall return on capital and cash flow, business equity and liquidity. Annual reviews should be undertaken to ensure strategies adopted are working to expectation and budget.

Guidelines to determine the sequence of investments when implementing change

Once you have identified the best strategies, develop a sequence and list the key steps needed to implement each strategy. Devise an approach that suits your property and management ability and includes rigorous review of both biological and financial indicators.

The first step is to decide what you want to change to, for example changing herd structure from predominantly breeding to a mixture of breeding and trading. For each strategy being adopted, list the practices by month, in order of their application, and align the costs and benefits. Quantify the total productivity (kg/ha) and profitability ($/ha) for the enterprise and business.

Document the sequence of investments identifies cash-flow and management inputs

Being able to explore the options and quantify the benefits of change is integral to committing to that change. The two critical outcomes of any change are that:

  • it makes a good marginal return to the capital invested and returns are over and above alternative less-risky uses of capital, such as off-property investment
  • investments in the property go into the area of next-highest return on capital and effort invested.

To ensure you will improve the returns over the whole property, any calculations are best done on a whole-property business basis.

Tool 1.10 provides a framework for quantitative and qualitative information to be included as the basis for implementing a planned change. In a relatively systematic way, it assesses the benefits and potential flow-on effects and implementation challenges. It is most suited to evaluating the sequence of investments and likely benefits of important decisions that affect the operation of the station. You might make several of these types of decisions in a year.

The focus is on decisions that can have flow-on effects across the system, or decisions in areas where you lack confidence to do something 'off the top of your head'. Examples of such decisions might include bull selection, changing grazing strategies or selecting a different market sector.

Manage the risks

The main risks of any new project are taking too long to achieve goals and failing to gain the best profit. This is likely when:

  • investments are not scheduled in order of highest rate of return on investment
  • changes are not planned to control cost and maximise returns.

Aim for minimum time and a cash flow when implementing transition plans

Key variables influencing the outcomes, such as fluctuations in sales and market prices, are used as long-term average values in the initial analysis. Use a range of prices, perhaps real 15-year beef price percentiles to assess the risk at the bottom 20% of price and 'good case' scenario at the 80% percentile. On this basis you can select your preferred order of action to account for what you think are the areas of greatest risk.

Calculate the enterprise scenarios using inputs and outputs that are likely to vary.

What to measure and when

The following areas should be measured:

  • marginal return on investment for each project and option
  • annual enterprise profit (return on capital)
  • yearly cash flow, business equity and liquidity

Further information

  • Sources of local information include:
    • being a member of a production or marketing group
    • attending field days, seminars and industry conferences
    • reading widely to keep up-to-date with new technology and to gain insights from other producers
  • Across Australia, there are a number of established private training and agricultural service providers that deliver training courses and offer advice on choosing business strategies.