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Driving Cost Out of the Production System

by 5m Editor
13 June 2004, at 12:00am

By Gary D. Dial, DVM, PhD, MBA, Janelle R. Roker, DVM, and Steven A. McWilliams, MS, Greenleaf Agribusiness Group and published by Prairie Swine Center - As recent history of the U.S. swine industry has evidenced, survival in today’s uncertain economic times depends upon a pig production business having either (1) marketing agreements that provide complete price protection against prolonged declines in both carcass and meat prices or (2) competitively low costs of production along with a marketing agreement that at least dampens declines in market prices.

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These proceedings offer one view on how cost management can be addressed in a contemporary pork production operation. Our ideas are offered as one approach for how costs can be managed. We do not believe that our method is the only, let alone the best, approach for managing costs. There are, no doubt, numerous approaches being used across the industry today to lower costs, as we all struggle to identify ways of surviving. Our approach has worked in one company, New Fashion Pork, Inc., dropping its costs by nearly $3.00/CWT liveweight over the last 3 years or so; so we know it works. Perhaps, there is something in our approach that will work for you.

Cost management occurs at two levels. The first level involves the control of the purchase price of inputs. The price of some inputs is established, often for long periods of time into the future, when the business structure is established; for example, whether barns are owned or contracted. The price of other inputs is established through the day-to-day purchasing practices of the company. Input purchasing is typically centralized, with responsibility being seated at the level of senior management or staff officers hired specifically to purchase the inputs used by the farms. The farm staff typically has no influence over the cost of the inputs that their farms consume. The second level of responsibility occurs at the farm level, where farm staff controls how many units of an input are consumed, called “unit use.”

Office staff has little influence on the rate of use of inputs, unless they restrict how many units of an input are delivered to a farm. While it may seem intuitive, low production costs not only require that inputs be purchased competitively BUT ALSO that they be used sparingly. Because cost management occurs at two levels, the office and the farm must work in concert to drive out costs: the office working to purchase inputs as cheaply as possible, the farm staff working to use as few inputs as they can. If either group fails in their responsibility, cost creep occurs.

These proceedings focus initially, but only briefly, on approaches that we have used to control the cost of its inputs. The majority of our writings will focus on the little understood area of how to control the rate of usage of its inputs.

Cost of Inputs

The business structure that the founders and managers of a pork production company establish has a major influence on the cost of some inputs. For examples:

  • Facility Costs: Contract production fees are typically more expensive than the sum of the costs associated with barn ownership (e.g. principle & interest or lease-to-own payments, utility costs, R&M expenses, and labor costs). We believe that long-term cost competitiveness will go to those that own their own barns or have production contracts and leases that are written down as fixed asset loans are paid off.

  • Manure: Building barns in geographic areas in which manure is viewed as fertilizer can result in manure being purchased for the cost of its land application by nearby crop farmers. As more and more crop farmers come to understand the relative benefits of organic fertilizers versus inorganic, chemical fertilizers, manure may someday be sold at a price above its land application cost. At this point, it will become a cost-offsetting revenue for production.

  • Feed: Feed costs are, obviously, lower in geographic areas where grains are produced cheaply and where there is insufficient transport infrastructure (e.g. trains, rivers) to transport grain to distribution and processing centers (e.g. some areas of southern Minnesota and northern Iowa).

The cost of nearly all inputs can be reduced from their normal retail level. While negotiations, in the form of traditional one-on-one interactions, can be used to lower input costs, there are several other methods of reducing input costs. Examples include:

  • Feed inputs can be hedged, and if done correctly, thereby provide price protection. Mark-ups on inputs (especially corn) purchased for inclusion in feed are often done while discounting manufacturing and delivery costs. Thus, total cost/ton of feed delivered to the site is the first metric that we use to evaluate cost competitiveness of feed inputs. Total feed cost (ingredient costs plus grind, mix, & delivery costs) per pound of gain provides a second metric.

  • Gilts: Replacement females destined for company farms can be produced in multiplication systems reducing, in most but not all instances, both their genetic costs and costs associated with rearing. We have obtained volume discounts on genetic purchases arising from group discounts when we have entered into joint ventures with other producers. We have also used with-in herd, internal multiplication to control gilt genetic costs. In these farms, gilts are produced within the herd that they are being used. While multiplication costs may be cheaper with internal multiplication systems, we find that cost control usually becomes more difficult. In fact, we have found that costs may increase when (1) excess gilts are sold for market (i.e. wasted) rather than being retained as herd replacements, (2) herd productivity is compromised due to insufficient gilts being available (especially during summer breeding), and (3) sales of byproduct barrows and non-select gilts are discounted.

  • Supplies: The purchase price of health products and supplies can be reduced with the volume discounts afforded purchasing groups. Labor costs typically are managed through the control of starting wages, turnover rates, and farm staffing levels. Labor rates, in themselves, are all-to-often often blamed for the creep in labor costs or for labor costs being non-competitive, when manning levels and sub-optimal production are more often the primary cause.

  • Utilities: As with many commodities, LP gas can be purchased on the Board to lock in prices during periods of anticipated high market prices.

Services and products can often be provided to other producers, resulting to two cost savings effects: (1) the additional volume reduces the cost of all inputs being produced, and (2) the production and sale of an input at a profit can result in cost off-setting revenues. Examples include:

  • Culled breeding stock sales can be contracted for sale, thereby ensuring optimal revenue as markets change. Culled stock revenues are significant cost-offsetting revenues for weaned pig cost of production.

  • Company-owned facilities can be leased to or contracted with other producers at rates greater than their cost, thereby reducing the facility costs associated with the production of company-owned pigs.

  • Semen can be produced on a cost-plus basis for other pork companies, resulting in an additional volume of semen being produced by the stud, which reduces semen production costs, and the creation of cost-offsetting revenues. Both effects lower the cost of producing semen for company-owned breeding farms.

  • Feed: Toll-milling feed for other producers adds volume to the mill, thereby reducing the manufacturing cost of all feed processed through the mill. If the feed is sold at above its cost of production (e.g. toll milling), then the external feed provides cost off-setting income for feed manufactured for company owned farms.

  • Utilities: With capital investments in on-farm generators, electricity can be sold back to many power companies, resulting in cost-offsetting income.

Unit Use of Inputs

The rate and efficiency of input use on the farm is controlled by how much of the product is released by office management staff from company stores to the farm (i.e. central control) and by the amount used and wasted on the farm. In order for either to happen, the involved staff, regardless of where they work in the organization, needs to know how much of an input should be used as the production of the farm varies. We believe that all levels of management need to be involved, if costs are to be managed effectively. We follow a 6-step approach in the control of the number of units of an input used on a farm:

  • Set production budgets that accurately project performance.

  • Use unit-use budgets to predict line-item costs on the P&L.

  • Link budgets to P&Ls to identify cost variances and their sources.

  • Use compliance reports to identify input wastage.

  • Link production and line-item variances to financial opportunities.

  • Empower farm and service staff to drive out costs.

When any of these are not adhered to with rigor, the cost management process breaks down. Here is how we approaches each of the six steps.

Production Budgets. Production budgets project what herd productivity will be during the coming fiscal year. We establish weekly budgets in advance of each fiscal year that extend from the first week of the year to its end. As illustrated in Table 1, the outcome of production budgets for the breeding herd is number of pigs weaned/week and weaning weight. The prime numbers driving weaned pig output are:

  • number of females served

  • % farrowing rate (%FR)

  • number of pigs born alive/litter (BA/L)

  • % preweaning mortality (%PWM)

As shown, the production budget module that we use for the breeding herd holds number of sows farrowing/week constant throughout the year. As % farrowing rate changes during the year with projected circannual changes in fertility, the number of females served changes with each week of the year. We have designed our production system to compensate for seasonal changes in fertility by allowing sufficient gilts to be mated during the summer months to maintain constant farrowing numbers. On farms having gestation-space bottlenecks, we will breed and gestate gilts in the gilt development unit (GDU), as needed.

Born-alive litter size and %PWM can also be varied during the year, if changes in performance are predicted. The weaning weight of our pigs is predicted according to a growth rate algorhythm, such that weaning weight changes with changes in weaning age. As shown in Figure 2, the production budget module that we use for the growing pig herd is based upon the projected number of pigs produced from a sow farm each week. In addition the following production parameters are inputted as prime numbers and used to project the CWTs of pork sold:

  • % mortality
  • % cull pigs
  • ADG by days placed of survivors (interpolated from a growth curve)
  • number of nursery and finishing spaces
  • number of facility down days (days that barns or rooms in barns are not occupied by pigs).From the pigs placed per week into a production flow and the total spaces in the flow, the total growing days that a pig spends in a production facility are calculated.

The first-in/last-out (FILO) days are calculated from the total growing days less the down days. The market weight of each group of pigs is calculated from its ADG and FILO days. Seasonal changes in ADG, mortality, and % culls are also budgeted. The effects of planned interventions that change one or more of the prime numbers can also be scheduled in the budget.

Unit-use Budgets. Some line-items are influenced by the volume of pigs passing through the system. For these variable-cost and step-wise variable costs, increasing the number of pigs produced, increases the cost of the line item in either a linear or step-wise fashion, respectively. We have a separate budget for each variable use input, called a unit-use budget. These budgets relate the number of units of an animal product (e.g. pounds of pork; number of head of weaner, feeder, cull, and market pigs; number of replacement gilts or culled sows) passing through the production system to their projected rate of input use. For example, if we budget for a genetic improvement to be made in a breeding farm that would result in an increase in the average number of BA/L, the overall number of pigs born per week would increase and, therefore, the number of routine piglet treatments, such as fortified iron, would also increase accordingly. Our system uses seven unit-use budgets, including ones for:

  • feed
  • health products and services
  • semen
  • replacement gilts
  • labor
  • live haul
  • growing pig spaces

An example of our Unit-use Budget for feed consumed by the breeding herd is given in Table 3. Please note that projections of feed usage are driven by the daily feed consumptions of various subpopulations of animals in the breeding herd.

Linking Budgets to P&Ls. As most P&L reports do, our P&L statements report costs in terms of total dollars spent by line item during the time period (Figure 4) and by dollars per unit sold (e.g. $/weaned pig or $/CWT sold; Figure 5). Line item costs and revenues are reported relative to the budget, in terms of both a percent and dollar variance. This approach allows the reader not only to understand the cost opportunity in terms of dollars but also to determine the influence of production on the cost. For example, the total feed for a breeding herd may be under budget for a month, which at first glance appears to be a positive outcome. However, if the herd has not weaned the budgeted number of pigs, the cost on a weaned pig basis may be over budget.

The monthly as well as the year-to-date actual and budgeted production levels, revenues, and costs are reported on the P&L statement. This allows the user to understand information relative to the current month, but also discern whether costs are increasing or decreasing over time. When using accrual accounting practices, inconsistencies in the timing of expenditures may result in short-term fluctuations in a line item cost, which can lead to erroneous conclusions. For example, an unusually large sized gilt delivery into a breeding farm or extra gestation feed delivered in anticipation of a holiday or storm, can make “purchased animal” and “feed” costs, respectively, appear above budget, when they actually are not. Compliance Reports. We use a series of compliance reports to assist the user in determining if an overage in total dollars is due to increased number of units used or due to higher unit cost. Our managers receive these compliance reports monthly along with the P&L statement for their farm(s). We have the following compliance reports for breeding herds and their associated growing pig flows.

Semen Usage: As illustrated in Table 6, this compliance report indicates how much semen was delivered to the unit and subsequently used. It is based, in part, on the number of sows bred during a time period and the mating/service, both captured in PigCHAMPâ. Actual usage is then related to the budget in regards to total doses delivered, cost per dose, number of sows bred, number of doses used per female bred, and the % of doses that were delivered and not used (i.e. wasted). Therefore, variance in semen cost can be explained by increased semen usage due to: (1) breeding more females than budget, (2) having a higher number of matings/service than budget, 3) higher than budgeted semen wastage; or (4) higher than budgeted cost per semen dose.

Feed Usage: The total tons used of each diet during the time period and the cost per ton are reported in the Feed Compliance Report (Table 7), which helps the user identify if feed cost variance is due to unit use (tons of feed) or due to unit cost (cost per ton). Our compliance report lists feed usage (i.e. disappearance) by feed type. An understanding of how the different subpopulations of breeding females are moved among barns is required to interpret this report.

Animal Health: The total dollars spent per health product by generic class are compared to the budgeted amount in the Animal Health Compliance Report (Table 8). We also monitor the diagnostic costs relative to budget. Our staff veterinarian (CJR) works with farm staff to establish projected use rates of the different biologicals, pharmaceuticals, and diagnostic tests. Along with the farm management and service staff, he is expected to review monthly usages of all farms and flows monthly. He is also personally required to approve and justify to senior management any changes in our health management strategies and to continually look for ways to reduce health expenditures.

Utility Usage: In the Utility Compliance Report (Table 9), the total units (i.e. gallons of LP or kilowatt hours) along with the cost per unit are used to explain variances in total utility costs. We vary the amount of utilities budgeted with month of year toaccount for seasonal effects on farm consumption.

Labor: Manning levels, hours worked, and labor dollars spent relative to budget provide managers the diagnostic information that they need to manage the labor costs of their farms.

Opportunity Analysis. Understanding the number of units sold (i.e. weaned pigs or CWT pork sold) is key in explaining costs in terms of cost per unit sold. Our Opportunity Analysis Reports (Figure 10) focus on the production factors that drive the number of units sold or transferred to the next stage. For example, if more weaned pigs are produced than were budgeted, the overage in production will reduce cost/weaned pig. A manager can determine if the overage is due to the impact of the breeding department (e.g. more females serviced than budgeted, higher than budgeted farrowing rate) or the farrowing department (e.g. a higher BA/L than budgeted, lower than budgeted % PWM.) For each production parameter (e.g. %FR, BA/L, % finishing mortality), the Opportunity Analysis Report gives the relative contribution of each factor (positive or negative) on overall number of pigs weaned or CWTs or head of pork sold.

Empowering Staff. If the rate of use of inputs at the farm is to be controlled, the farm staff must be enrolled into active participation. As shown above, a key step in making them aware of the rate of input use is providing them with compliance reports. While providing them a benchmark is useful in getting their commitment to cost management programs, making them responsible for the multi-million dollar business that they manage is essential. We establish this responsibility by holding monthly meetings in which the managers of breeding farms and the service managers of growing pig flows are required to submit written summaries of the P&L for their farm(s), explaining significant variances in any line items.

For each line item expense, we ask them to explain the variance if one of the following criteria is met:

  • When a line item expense is $10,000 or less, determine which is greater: (1) 5% of the budgeted amount or (2) $1,000.

  • When a line item expense is greater than $10,000, determine which is greater: (1) 5% of the budgeted amount or (2) $2,500.

For both categories, when the variance in a line item expense exceeds the larger of the two, it must be explained. We require that managers explain a variance whether it is an underage or an overage. Any deviation from budget must be explained, regardless of whether it is positive or negative. Managers are asked to explain what contributes to (i.e. the sources of the variance). For example, when “feed cost” is above budget for a growing pig flow, the service manager must explain whether the variance was due to the tons of any diet fed to the group (i.e. unit use) or to a variance in cost/ton of any of the diets (i.e. unit cost). Managers must account for all of the variance; that is, the sum of the expenditures contributing to the variance in a line-item cost should add up to at least 90% of the entire variance in a line item. For example, if there is a variance in the “purchased animal” line item on a breeding farm P&L, the manager will be asked to explain the dollars of variance that are due to a higher than budgeted number of gilts entering the farm and the dollars that are due to a higher than budgeted cost/replacement gilt. In our system, a negative variance is as important as a positive variance, as it may indicate change in the production system. For example, if animal health costs are lower than budget, there may be a compliance issue, with farm staff failing to administer a vaccine.

The managers are asked to partition line-item variances, that qualify to be discussed, into that part that is due to production (i.e. higher or lower than budgeted levels of production) and that which is due to either an increased use of units of input or increased cost/unit. The second page of our P&Ls expresses costs and revenues on a weaned pig and cwt basis, and they delineate the proportions of variance due to production and cost management (Table 5).

When the majority of the cost variance is not due to production but to cost control, they must explain whether there is a problem in unit use or unit cost. For example, when there is a positive variance in “labor costs” for a breeding farm, the manager is asked to explain how much of the variance is due to the staffing level of the farm and how much is due to labor rates (i.e. average payroll cost/hour).

At the end of their write-ups, managers and/or service staff are required to prepare an “Opportunities” section, focusing on the production and financial opportunities in their farm. They are required to present their ideas for fixing or improving their farm(s) using the following format:

  • The primary areas of opportunity existing for improvement. Opportunities must be quantifiable; in other words they are defined as either a production or financial number. An opportunity can exist if less than budgeted performance occurs or if the farm/flow is experiencing less than industry-leading levels of performance. Examples of opportunities that we have dealt with in some farms and flows recently include: BA/L, high finishing mortality, high “Animal Health” costs, high “Repairs and Maintenance” expense, and high sort loss.

  • The risk factors (causes) of each opportunity area. For example, if BA/L is proposed as an opportunity for a breeding farm, parity distribution, lactation length, sow genotype and other similar risk factors might be discussed in quantitative terms as to their relative potential contribution to the problem.

  • The solution for each risk factor proposed to contribute to the area of opportunity. For example in the BA/L example, managers would be expected to state, in detail, a plan on how they propose to establish a long-term plan for correcting the parity distribution problem on the farm.

  • Solutions are written up as an action plan for addressing each cause of an opportunity. They often can be presented in terms of short- and long-term actionable steps. When CAPEX expenditures or additional costs are incurred in implementing an action plan, managers must include a cost justification for the intervention.

After editing, written reports are turned in along with other financial information to our bankers and to any business partners. All farm management and service staff receive copies of the P&Ls and write-ups for all farms and flows. The farm managers are expected to discuss their written reports with the department heads and, in some instances, with their farm staff. A work-up of potential risk factors contributing to an opportunity is expected. Data analysis is required whenever feasible. If data analysis cannot be done, we expect the manager to list the risk factors according to the following likelihood that they contribute to the opportunity.
  • “Horses” are those risk factors that potentially have a substantial effect on the opportunity (e.g. effects of lactation feed intake on subsequent litter size).

  • “Ponies” are those risk factors that have a modest effect on an opportunity (e.g. seasonal effects on born-alive litter size).

  • “Zebras” are those factors that are unlikely to significantly influence the opportunity. Zebras often include “old wives tales” and “industry dogma” that are perceived to influence an endpoint, but scientific research has either (1) failed to prove a cause and effect relationship or (2) has, in fact, proven that there is not a relationship between the risk factor and the endpoint.

  • “Draft Horses” are those factors perceived as having a huge effect on a production or financial endpoint (e.g. effects of parity distribution on litter size).

At the monthly financial meeting, managers and production staff are required to give a formal oral report in which they not only explain the direction (positive or negative) and the magnitude of variances for all line items in the P&L report. Other farm managers and service staff are encouraged to understand and critique the plan as it is being presented. The peer pressure that comes from oral presentation of results compels all good farm managers to understand their costs and apply rigor to the creation of their action plans. At subsequent meetings, the manager is expected to give a progress report on the segments of the action plan that they have initiated.

Budgets and Targets. The management team should ”live and die” by the budgets of their farms and pig flows. We interpret all measures of financial and production performance relative to the budget. Budget values are what we expect to achieve. They are what we will use to forecast financial performance. We also have targeted levels of performance. Targets are what we could achieve if things went well. They are a “stretch” for the farm to achieve, but are within the grasp of the farm staff if events unfold as desired. In most instances, our management team chases targets but rely on achieving budget.

Summary
In order for cost management strategies to be effective, a “low cost culture” must be created. This usually requires that biological endpoints, at least initially, be de-emphasized at the expense of financial endpoints. When breeding farm managers talk among themselves about their labor costs/weaned pig rather than the number of pigs weaned/sow/year (PWSY), you know that you have created the culture. When they are more proud of their break-even or their weaned pig cost than they are of their ADG or farrowing rate, you have been successful in making them business people. We are not saying that biological endpoints are not important, just that they are less important than cost indicators. We are striving to not just make our managers good caretakers of our stock and our employees, but that they become some of the best business minds in animal agriculture.

Source - Prairie Swine Centre - June 2004

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