In the dairy industry, nickels and dimes make a big difference over time. Dairies have the unique ability to compare their financial performance against their production numbers, giving them information on a per-hundredweight basis. They also have access to benchmarking data from other dairy operations in the same format. This allows an owner to evaluate and compare their cost structure to other operations, regardless of size or structure.
As owners look for ways to increase their competitive advantage in the market, many have focused on maximizing their herd size and experimenting with supplementation to increase milk output. Higher milk output dilutes per-hundredweight operating costs and reduces the operation’s overall breakeven costs. As the old saying goes, when milk prices are high, milk more cows; when prices are low, milk more cows. This strategy works as long as you have a place to sell your milk.
As many dairy processors began to enforce production caps in 2020, producers began to question the above strategy. If we look at over-base deductions for 2020, the price received for over-base milk often did not even cover animal care and feeding costs. The most prominent consideration relative to herd expansion for 2021 should be whether the processor will pay full price for the additional milk produced. Most processing facilities are “at capacity” and do not have a need for additional milk. The only way to fix this problem is for processors to expand their production capacity (long-term) or for producers to stabilize their production (short-term). For most dairymen at a production quota ceiling, a herd expansion is a step backward. Producers in this situation should consider a few options.
First, you will need to evaluate some of your long-term goals and ask yourself why you want to grow your herd. Some producers grow because of the tax benefits they receive, and some expand as part of “next generation” planning, while others expand to obtain a competitive advantage (size) and reach economies of scale (efficiency). No matter the reason, just make sure you understand why you want to grow and how it fits into your long-term goals. As part of this evaluation, you also need to examine your current financial position. Do you have the equity in your animals and facilities to allow for expansion? How much margin should you maintain on your borrowing base to feel comfortable to ride out the next lull in the cycle?
Second, you need to determine how you can sell the additional milk. Most processors are not accepting additional milk capacity, so you will need to acquire shipping rights from another dairy operation. As accountants, we saw the acquisition market for dairies heat up in 2020 and expect that to continue for the near future. Many producers see that they can recapture their investment in additional shipping rights in a relatively short amount of time.
Another benefit of these acquisitions is the opportunity to evaluate your herd and the herd acquired. The less desirable animals are culled, leaving the ideal milking herd. Many producers have found that they need to increase their production threshold when evaluating animals to cull. This evaluation process results in a younger, healthier and more productive herd.
Third, you need to evaluate your herd management practices. If you are not able to purchase additional shipping rights, you need to determine how to manage your herd production appropriately. Can you increase your cull rate for the near future? Do you have more replacement animals than your operation can handle? Do you need to sell some excess heifers? What can you change in your feed rations to increase butterfat or protein versus fluid pounds? These are not easy questions to answer, and most producers do not want to consider this route. Producers who ignore making the necessary changes will be penalized on their milk checks and impede their profitability.
As you consider the options above, you also need to determine the financial impact of these decisions. If you are evaluating purchasing additional shipping rights or selling animals, you should work closely with your banker and your accountant.
The banker will be important to work with on the option of financing shipping rights or the effect of selling animals on your borrowing base. You want to ensure your margins are still strong and you keep your banker happy. Your accountant can help you determine the tax consequences of selling additional animals and help you with planning for the transaction. The sale of raised animals is taxed as a long-term capital gain.
As of the writing of this article, those tax rates are at historic low levels. On a joint tax return, your first $80,000 of capital gains is tax-free, the next $416,000 is taxed at 15%, and anything above would be taxed at 20%. Also, check your state tax laws. For example, if you are operating in the state of Idaho, then the capital gain on those cow sales are eligible for the Idaho capital gains deduction, yielding a reduction of 60% of the capital gains on an Idaho tax return. This effectively reduces your Idaho tax burden to 3% on that transaction. Altogether, an Idaho dairy selling cows will pay 25% on the income from this scenario, which is substantially less than ordinary tax rates on the same level of income.
If you are going to pay income tax, capital gains are the type of income and rate you want to pay. Pres. Biden is suggesting changes to this treatment, which would have a long-term effect on this strategy, so keep an eye on this going forward in 2021 and beyond. There will still be planning opportunities surrounding this, and your accountant will play a pivotal role in tax mitigation.
Based on the items covered above, it is clear herd management is a complex issue with many factors influencing decisions. As the complexity and the necessity for speed in decision-making increase, it behooves dairy operators to ensure they have a good working relationship with their banker, attorney and accountant as a part of their management team. These decision evaluations in our current environment are paramount to the long-term odds of success and should be given the due diligence they deserve.
