The limits of gross margins

Gross margins are a great tool. But they don't tell you everything, and choosing an enterprise on gross margin alone can go wrong. NSW DPI says gross margins "should be by no means the sole determinant of enterprise mix". Here's what else to weigh up.

Overheads

A gross margin leaves out overheads. That works when a change doesn't add any. But some changes do. A new enterprise might need new yards, a shed, more fencing, a bigger ute or more insurance. Add these to the comparison.

Labour

Permanent labour is left out of a gross margin too. Some enterprises take far more work than others. Lambing, shearing and a piggery's daily routine all take time. If you'd need to hire help, that's a real cost. If you'd do it yourself, ask whether you have the hours.

Capital

Capital is the money tied up in the business, such as stock, sheds and gear. Two enterprises can have similar gross margins but need very different amounts of capital. The one that needs less ties up less money, so there's less interest to pay. DPI suggests checking the return on any extra capital before a big change.

Risk

Some enterprises swing more than others. Trade cattle depend on the gap between the buying and selling price. A piggery depends heavily on grain prices. A gross margin built on one set of prices hides that. Test each option at lower prices and in a dry year. Ask what you'd do if feed ran out.

Time and cashflow

A new enterprise can take years to reach full production. A breeding herd built from scratch won't sell its first weaners for well over a year. Meanwhile the costs keep coming. DPI also lists cashflow and the time to reach steady production as things to check before a major change.

A simple checklist

Before you change your enterprise mix, ask:

1. Does it add any overheads?
2. Who will do the extra work, and what will it cost?
3. How much capital does it tie up, and at what interest?
4. What happens in a dry year or at lower prices?
5. How long before it pays, and can the cashflow carry it?

Our new enterprise go or no-go checklist takes you through these questions. Our guide to adding a new enterprise goes into more detail. This is general information, not advice for your situation. Talk to your accountant about any tax effects before you make a change.