At an Executive Link meeting last year, a board was reviewing financial statements in a member's business report. The numbers looked good. The gross margin appeared healthy, and the business appeared to be profitable. There was only one problem. The business was actually making a loss.

The numbers hadn't been doctored, but two important numbers had been left out — the opportunity cost of cattle and the opportunity rental of the land. An opportunity cost is the return you could achieve if the money invested in land or livestock was invested in the next best investment. Opportunity costs provide critical information about real opportunities facing your business.

Take, for example, a ranch with a herd of 1,000 cows valued at $750/head grazing 20,000 acres of rangeland. The total value of the herd is about $750,000 (1,000 cows x $750/head).

If gross income is $400,000 and direct costs (not including the opportunity costs) are $150,000, the gross margin would be $250,000. That's a gross margin return of 33% of the value of the inventory.

According to the benchmarks we use at the Ranching for Profit School, that's not bad. All of the land is owned. Total overheads equal $160,000, which leaves $90,000 profit (Table 1).

Table 1
Gross Income $400,000
- Direct Cash Costs - $150,000
Gross Margin $250,000
- Overhead Cash Costs - $160,000
Profit $90,000

Now let's throw in the opportunity costs. In the Executive Link program, we charge opportunity interest of 10% on the cattle (slightly less than the long-term return on a general stock fund in the stock market). That adds $75,000 to our direct costs, making our gross margin only $175,000. That's a 23% return on the beginning inventory value. According to our benchmarks, we ought to do better.

Table 2
Gross Income $400,000
- Direct Cash Costs - $150,000
- Opportunity Interest - $75,000
Gross Margin $175,000
- Overhead Cash Costs - $160,000
- Opportunity Rent - $150,000
(Loss) ($135,000)

Now, let's see what happens if we add opportunity rent. Let's say we could have rented our pasture to someone else for $150/head/year. That's a total opportunity rental of $150,000, which makes our total overhead $310,000. Instead of a $90,000 profit, our business really suffered a $135,000 loss (Table 2).

We would have been dollars ahead to sell the cows, invest the money and rent out our land. Our decision to ranch cost us $135,000. That's why Stan Parsons called his latest book: “If You Want To Be A Cowboy, Get A Job.”

An Opportunity to Buy Cattle

Some ranchers still are not persuaded that opportunity costs are real, so let me propose another valuable definition. “An opportunity cost is the cost of pursuing increased profit.”

As I've described in previous columns, there are three ways to increase profit:

  • lower overhead costs,
  • improve gross margin/unit and
  • increase turnover.

We'll have interest costs on our loan to finance our livestock purchase if we increase turnover. By including the costs of pursuing this opportunity in our gross margin calculation, it becomes clear whether expansion makes sense.

You can argue that 10% on a loan to buy cattle is too high. You'd be right if we valued the cowherd at its replacement value, but we don't. The herd should be valued at its liquidation value. Using that conservative value makes the 10% interest rate come out just about right.

Opportunity Rent

Ranchers should also charge rent for the land they own to their cattle business. Failing to account for land rental makes it impossible to determine which part of the business makes the money, the land or the cattle.

As with the opportunity cost of cattle, opportunity rent can be looked at two ways. The classical view would be the income you could receive if you leased the land out for someone else to graze. I prefer to ask, “What would I have to pay to lease a similar property if I wanted to expand my enterprise?”

Base the opportunity rent on the rental value of the grass, not the purchase price of the property. As I've discussed in previous articles, grazing is only one of many values contributing to the total value of land in most areas.

Most ranchers ignore opportunity costs, but then most ranchers are failing economically. They survive financially only because of internal subsidies like off-farm income, borrowing against appreciating land values, living on inherited wealth and relying on low-cost family labor. You must include opportunity costs in your calculations if you are ranching for profit.

David Pratt of Ranch Management Consultants teaches the Ranching for Profit School. For more information, visit www.ranchmanagement.com, call 707/429-2292 or e-mail pratt@ranchmanagement.com.