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ASAE Conference Proceeding

This is not a peer-reviewed article.

Economics of Successful Stall Barn Modernization

W. F. Lazarus, K. A. Janni and J. K. Reneau

Pp. 117-124 in Fifth International Dairy Housing Proceedings of the 29-31 January 2003 Conference, (Fort Worth, Texas, USA), ed. K. A. Janni. ,Pub. date 29 January 2003 . ASAE Pub #701P0203

Abstract

Many dairy producers in the Midwest have stall barns that could be remodeled to improve labor efficiency and increase income with modest investment. This presentation describes changes three dairy operations made over several years to upgrade and modernize their dairy operations. Their goals were to increase income and better manage labor and capital. Each operation remodeled a two-story stall barn to house either a walk-through step-up parlor or swing parlor and a holding area. They all added freestall barns and manure storage over a period of years. Projected financial analysis compared continuing to milk in a tie-stall barn, 50% expansion of a tie-stall barn, remodeling an existing barn to house a parlor, and a constructing an all-new dairy facility. The results indicated that a debt-free 58-cow operation with two operators would be able to generate a net farm income of $53,907. Expanding the tie-stall barn by 50 percent is unlikely to increase income if a third worker must be hired to handle the additional chores. If a retrofit parlor makes it possible to improve labor efficiency by roughly tripling the herd size with less than a doubling of labor requirements, net farm income would increase to $70,954. An all-new facility promises to generate three times that amount of net farm income, $156,714, but management and capitalization resources required for that 11-fold increase in herd size would be much greater. Return on equity depends on parlor throughput, milking time (hours per day), milk production per cow (kg per day), and herd size, as well as depending on the initial amount of equity capital available. Return on equity values ranged from 2.5% to 10.3% for $13 milk adjusted under the Farm Security and Rural Investment Act but turned negative at $11 milk. Remodeling projects can usually be done with substantially less initial equity. As with any major farm investment, the minimum amount of equity required will depend on the producer's risk preference and the lender's assessment of credit worthiness.

KEYWORDS. Remodeling, Dairy facilities, Financial analysis

Introduction

Many Minnesota dairy producers have stall barns and herds of less than 100 lactating cows. Their facilities are among the oldest in the United States, which contributes to the high cost of production compared to other regions. In Minnesota successful modernization projects need to improve output relative to the amounts of labor and equipment, without requiring investments that are beyond what the farm's equity capital base can support. Historically, dairies producing more than 600,000 pounds of milk were considered efficient and productive. Modern dairies set productivity goals of more than a million pounds of milk per full-time worker per year.

Stanchion and tie-stall barns with pipelines are the most common facility types in Minnesota, based on a 2000 survey of Stearns County (Rudstrom, 2001). Most operations milking in tie stall barns have less than 100 cows, and many are looking for ways to increase income without increasing the amount of physical labor required for milking. One approach is to remodel an existing building into a parlor. Two other approaches for expanding the herd size include adding more tie stalls and continue to milk in the existing stall barn, or build a large new parlor and freestall facilities.

All three of these approaches have their place, but the first (continuing to milk an expanded herd in a tie stall barn) is not usually very labor-efficient and involves more bending and stooping that may worsen the chronic back and leg problems that plague many dairy farmers. Building an all-new facility requires more capital than many producers have access to, and usually requires the producer to face the scary prospect of becoming a "people manager" in charge of a work force of a dozen or more hired workers.

There are examples of success and failure in both slow, gradual expansions and rapid transitions to all-new facilities. Both can be successful if two criteria are met: adequate capitalization and sound management. When the milking performance of the three expansion approaches is compared it boils down in the end to a question of how much improvement in labor efficiency can be attained in the larger, more capital-intensive, all-new facility compared to the cheaper options, and whether the savings in labor costs are sufficient to cover the additional capital servicing costs.

The purpose of this study was to describe the economic impact of alternative modernization strategies. Cases based on three dairy operations that started with stall barns were used. These operations were upgraded and modernized over several years.

Operation Descriptions

Table 1 summarizes select characteristics of three operations that modernized and upgraded their stall barn facilities. In general each operation

  • Built a new freestall barn for lactating cows

  • Remodeled a stall barn to house a parlor and holding area.

  • Purchased a total mixed ration (TMR) wagon and began feeding a TMR.

Operation 1

This operation began modernizing with a 46-stall stall barn. In 1990 a freestall barn was built adjacent to the stall barn to house the 46 cows. The stall barn was used for milking. An intergenerational transfer occurred in 1995. The herd was expanded to 111 lactating cow and a 110-stall three-row drive-by freestall barn was built. Switch milking continued in the stall barn. A tornado damaged the stall barn in 1998, which led to its remodeling. The space was remodeled to house a double-10 swing parlor, milk room, and transition cow housing. A portion of the original freestall barn served as the holding area. Approximately $33,000 was spent for the custom-built no-frills swing parlor. Additional herd expansion is planned so current parlor operation is below its potential capabilities. The operation has 110 cows with an annual RHA around 9,500 kg per cow (21,000 lb per cow).

Operation 2

This was a multigenerational operation that purchased an expandable farm with a 66-stall stall barn approximately 10 years ago. The structurally sound unique original two-story barn was built in 1951. It had a single-story addition. In 1995 a 198 stall, four-row freestall barn and an adjacent outdoor minipit manure storage unit were built for lactating cows. The stall barn was remodeled to house a new milkroom with a new milk tank, a double 6 step-up walk-through flat parlor, and holding area. The parlor cost was approximately $100,000 and included the new larger milk tank. The operation has 200 cows with an annual RHA around 10,700 kg per cow (23,500 lb per cow).

Operation 3

This operation began with an intergenerational partnership formed in 1993. The original stall barn housed 44 registered high producing Holsteins. The operation now has 143 lactating cows with an annual RHA of 12,200 kg per cow (27,000 lb per cow). Heifers were purchased and a four-row freestall barn with 108 stalls and an adjacent minipit manure storage unit was built in 1993. A total mixed ration (TMR) wagon was purchased and TMR feeding began. The stall barn and its attached milk house were used for switch milking until 1995 when the barn was remodeled. The stall barn was remodeled to house a double 4 step-up walk-through flat parlor and holding area. A bunker silos were added in both 1994 and 1995. In 1995 super calf hutches were built and a machine storage shed was remodeled to house heifers and transition cows. A commodity shed was built in 1996. A fabric covered calf barn was built in 1998 and an earthen manure storage unit was built in 1999.

Table 1. Description of three retrofitted parlor alternatives.

Parlor Description

Parlor Cost ($1,000)

Herd Size (cows)

Milk / Cow (lb)

Workers (FTE)

Milking Time (hr / day)

Cows Milked / Hour*

Cows Milked / Worker

Milk / Worker (1,000 lb)

Swing 2x10

$38

110

21,000

3.0

4

55

37

770

Step-up 2x6

$100

200

23,500

3.5

7

57

57

1,343

Step-up 2x4

$30

143

27,000

3.5

6

48

41

1,103

* Assumes 85 percent of the cows are in milk, 2X milking.

Results and Discussion

Economic Analysis of Expansion Alternatives for a Typical Dairy Farm

Many considerations are involved in analyzing the economic impact of modernization. Increased funds available for family living and increased return on equity are typical overall objectives. Other useful benchmarks include asset turnover, a measure of how well assets are being utilized, and leverage (debt-to-asset ratio) which describes debt management. Net farm income (cash farm income minus cash expenses, depreciation, and inventory adjustments) is a measure of operating profit margin. It is influenced by interest on debt, herd size, milk revenues per cow, direct expenses per cow, and overhead—all of which may be affected by modernization. The analysis presented here was based on the Dupont financial analysis equation (Brigham and Gapenski, 1997).

New Dairy Price Support Program Impacts Milk Price Projections

A recent policy change that affects the economics of dairy expansion is the direct dairy payment provided under the 2002 Farm Security and Rural Investment Act (FSRIA). The payment, currently projected to average $0.89/cwt over the 3.5 year life of the dairy program, will be paid on the first 2.4 million pounds produced on the farm, or the production from around 100 to 150 cows depending on production/cow that is achieved. Consequently, an analysis of dairy expansion alternatives needs to consider the government payment on expanded production up to the 2.4 million pound limit, and only the market price on any additional production. Also, the subsidy is expected to result in additional milk production nationally, which could depress the market price below what would have been expected otherwise.

Existing Tie-stall Barn

For this analysis a "typical" dairy farm that remodeled an existing building into a parlor (referred to below as a "retrofitted parlor") was compared to expanding the tie-stall barn or building an all-new facility. The first column of Table 2 shows a typical tie-stall operation milking a herd of 58 cows twice/day. The costs and returns are based on a production level of 22,000 lb./cow/year, a $13.89/cwt. milk price (a $13 market price plus an 89 cent FSRIA payment), $4.50/cwt. for feed and $2.000/cwt for other direct expenses, $1,500/year for repairs and maintenance, $28,889/year for dairy replacements, and $10,000 in other overhead expenses including such items as property taxes and farm insurance. At a rate of 25 cows/hour, milking takes two hours. The labor force is the operator and spouse, with no hired labor. With the two people handling a herd of this size, their labor efficiency is 30 cows/worker. Net farm income calculates out at $53,907.

Expanded Tie-stall Barn

The second column shows the finances for the tie-stall barn expanded 50 percent, to 88 cows. The cost of the remodeling was estimated at $60,000, but by the time the cost of the extra cows is factored in at $2,000 each, the total investment comes to $129,000. If milking labor efficiency remains at 25 cows/hour, milking time will increase to three hours/milking. Feeding and other chores in the tie-stall barn are time-consuming enough that the overall labor efficiency of 30 cows/worker is not expected to change much. A third worker will be needed to handle the additional work. Factoring wages of $25,000/year for that extra person plus debt payments, and increasing feed and other direct expenses at the same amount per cow as before, the income nets out at $47,414, which is less than it would be without the expansion.

Retrofit Parlor

The third column in Table 2 depicts a retrofit parlor alternative. The experiences of three case farms described in Table 1 would suggest that a swing or step-up parlor operated for six hours/day should be able to handle around 45 cows/hour, for a capacity of 158 cows. A $50,000 investment in the parlor plus $1,000/herd cow for a free stall barn and $2,000/each for the additional cows would come to a total additional investment of $457,500. A midrange estimate of labor efficiency based on the case farms is around 50 cows/worker. At that rate, labor needs for this herd of 158 cows should be only a little more than for the tie-stall barn with 88 cows - that is, one additional full-time hired employee plus some part-time labor. The expansion would put production over the 2.4 million limit for the new government payment, so market revenue plus the payment is expected to average $13.61/cwt rather than the $13.89 used for the expanded tie-stall barn. Net farm income with the retrofit parlor is projected out at $70,954, or about 32 percent greater than for the tie-stall barn.

All-New Facility

Most producers with milking herds of less than 100 cows in tie-stall barns, would have difficulty financing an all-new facility for 500 cows or more. The all-new alternative is presented here not so much to represent a feasible course of action for the tie-stall operation, as to represent the competition that the modernizing tie-stall operation must be able to face in the future.

The final column shows a facility with a double-8 automated parlor capable of a throughput of 78 cows/hour. One way to minimize the initial investment required for the larger facility is to milk three times per day (3X) at least in the beginning, and then perhaps go back to milking two times per day (2X) later and increase herd size to keep the parlor operating near capacity. If this facility were operated for seven hours/milking (21 hours/day) and 3X milking, it could handle a 642-cow milking herd including those milked plus 15 percent dry cows. Milking 3X (21 hours/day) is usually expected to increase milk production/cow somewhat. The amount of the increase depends on nutritional management among other factors. For this analysis a nine percent increase was assumed, for a production level of 24,000 lb./cow/year. Total milk production would far exceed the 2.4 million pound limit for FSRIA payments, so the milk revenue would average only $13.14/cwt compared to $13.89 for the tie-stall scenarios and $13.61 for the retrofit parlor. Feed costs will also increase, but feed cost/cwt. for the additional 2,000 pounds of production should be less than the $4.50/cwt. assumed for the initial 22,000 pounds because maintenance requirements have already been met. A feed cost of $3.00/cwt. was assumed for the extra 2,000 pounds. Averaging feed costs of $4.50/cwt. for the first 22,000 lbs. together with $3.00/cwt. for the extra 2,000 lbs. resulted in an overall feed cost of $4.35/cwt. for all 24,000 pounds.

Investment requirements for this alternative are based on Wisconsin construction costs for actual operations (UW Dairy Team). The milking center and all other facilities such as feeding equipment and manure handling was estimated to cost $600,000. Adding in the freestall barn at $1,000/cow and an additional 765 cows at $2,000/cow brings the total investment for this alternative to $2,699,080.

The two original operators become largely "people managers" with this 642-cow operation, because quite a few hired workers are now required. Using a labor efficiency of 60 cows/worker, 9 full-time-equivalent workers will be needed plus the original two unpaid operators. Net farm income is projected to be $156,714/year with this all-new facility.

Capitalization Requirements and Return on Equity Capital

All three expansions alternatives were assumed to be financed through debt capital. Most lenders require the producer to have some level of initial equity capital (net worth) in the existing facility and land when seeking to add debt. If the producer does have substantial equity, is it wise to risk it in an expansion of the dairy, or would it be better to just liquidate the existing facility and put that equity in a savings account, the stock market, or some other nonfarm investment? Before undertaking any of these expansion alternatives, the producer would want to determine that the net farm income estimates discussed above provide a greater percentage rate of return on their equity capital as well as to their labor and management resources, compared to their next best alternative investment elsewhere. "Net farm income" is a measure of the return to all three of those unpaid resources - capital, labor, and management. We could add risk to that list of resources as well, but we will include return to risk together with labor and management here for the sake of simplicity. In order to calculate a percentage rate of return on equity, an opportunity cost of labor and management is subtracted first, in effect treating equity capital as the residual claimant on the farm's income. In the next section, labor and management are treated as the residual by subtracting an opportunity cost of capital.

If an opportunity cost of $40,000 for the unpaid labor and management was subtracted from the present tie-stall barn, the operation provided a return on equity of $13,907. The retrofit parlor increased the return on equity to $30,954, while the all-new facility generated $116,714. By this measure, the all-new facility was very profitable. Whether it provided a higher percentage rate of return depends on how much initial equity capital the producer began with, however. For example, suppose the retrofit parlor alternative was implemented with $300,000 in initial equity capital. For the purposes of this analysis, it was assumed that this $300,000 in equity was held mainly as cropland, cropping equipment, and working capital, but that was not important for the analysis. The most important consideration was whether any of the initial equity was available for use as a down payment to reduce the new borrowing required. It was assumed that the cropland, cropping equipment, and working capital was required so that none was available as a down payment. This issue is discussed in more detail below. Dividing the $300,000 in equity into the $30,954 return gives a percentage return on equity (ROE) of 10 percent per year.

Equity Capital as a Borrowing Reserve for Periods of Cash Flow Shortfalls, and Capitalization Requirements for the All-New Alternative

Could we finance the retrofit parlor with less than $300,000 in equity? The lender will likely demand sufficient equity that it can be drawn on to cover any additional borrowing needed to keep the operation going through any economic downturns without the prospect of insolvency (debts exceeding assets). Both the asset side of the farm's balance sheet and the debt side increase when the investment is made. Most lenders will not depend on being able to cash out the entire construction cost in the event of liquidation, however, because of considerations such as selling expenses. So, on a market value balance sheet the increase in assets is likely to be less than the increase in debts. In this scenario, the balance sheet is credited with 70 percent of the facility investment and 90 percent of the purchase price of the cows. At these rates, assets increase by $370,150 compared to an increase in debt of $457,500. This leaves produces a debt/asset ratio of ($370,150/$457,500) or 68 percent.

The original net farm income and return on equity discussed above were based on a milk market price of $13/cwt., because milk prices were expected to average at least that amount over the long run. The second panel of Table 2 shows how the three alternatives fare under a "worst-case" $11 milk price. Instead of earning $30,954 on the equity after subtracting a $40,000 opportunity cost of labor and management, the lower milk price leaves the producer with no return on equity and with only $23,034 return to labor and management, $16,966 less than its opportunity cost. If that was what the operator and spouse required for living expenses, they might be forced to take out an additional $16,966 loan for living expenses. The additional borrowing required in this scenario to cover one year's living expenses would increase the debt/asset ratio to 71 percent. With a volatile milk market, such a two-dollar swing in the average annual milk price is possible. The impact of depressed milk prices continuing for more than one year and its impact on debt/asset ratios is something the lender would wrestle with in deciding how much equity to demand of a producer. The lower milk price produces a negative return on equity capital for the three expansions. On a percentage basis, the retrofit alternative experienced losses amounting to around 6 percent of post-expansion equity/year with $11 milk.

Running through similar calculations for the all-new facility, indicated that more than $300,000 in initial equity would be required as collateral for the $3 million loan that would be required for the facility construction and cattle purchases. For illustrative purposes, the calculations were done for the all-new facility based on $1.8 million in initial equity. This level of initial equity was selected because it leaves the operation with the same 68 percent debt/asset ratio as for the retrofit alternative. The rate of return on initial equity is lower for the all-new facility, at 6.5 percent. The all-new facility's debt/asset ratio would rise to 72 percent after a year of $11 milk prices.

Varying Levels of Equity Capital Before the Expansion

Another term for an increase in the debt/asset ratio is "leverage". For simplicity, the scenarios discussed above were assumed to begin with zero debt and $300,000 in equity before the expansion, except for the all-new alternative which was assumed to start with $1.8 million in equity. Starting with a given initial level of equity capital, the producer leverages that equity by borrowing and investing in additional assets. Leverage is a "two-edged sword" because if the business opportunity appears profitable, increasing volume and debt can increase profitability. Increased leverage can increase losses just as quickly in a downturn, however, because the larger fixed debt payments take a bigger bite out of a shrinking revenue stream. For example, if the retrofit parlor started with $1 million in equity rather than $300,000, it would not risk as much by making the investment. It would earn an ROE of only 8 percent even with $15 milk, but could also weather a year of $10 milk with only a 4 percent loss. On the other hand, percentage returns could be quite attractive for an operation with only $200,000 in equity. It would earn a 4 percent annual ROE with $15 milk, but could lose 20 percent of its equity with $10 milk. An all-new facility that is less well capitalized would also experience wider swings in ROE.

The increase in the debt/asset ratio is a concern mainly in the early post-expansion years. Principal payments would be expected to reduce the debt side of the ratio in later years, and inflation-related asset market value increases over time will also reduce the ratio. The case farms discussed above tended to make their investments in housing, manure storage, and milking facilities over a period of years. Spreading out the investments over time makes it more feasible to pay some of the cost out of cash flows and minimize borrowing and the risk associated with it.

Financing New Investments Out of Operating Cash Flows

The expansion alternatives discussed above were assumed to be financed entirely by new borrowing that was needed because the operation's initial equity capital was tied up in assets that cannot be turned into cash without adverse impacts. It is fairly common, however, in a modernization situation to spread out the investments over a period of years and finance at least some of them with cash accumulated out of operating cash flows. This scenario was not analyzed here, but would minimize the amount of new debt required and its associated financial risk. The downside is that depending on operating cash flows as a source of investment capital might slow down the farm's expansion path and reduce future income potential, and/or may require unacceptable reductions in family living expenditures.

Capital Efficiency

The asset turnover ratio of 59 percent for the present tie-stall barn shows that the efficiency of capital utilization was fairly good in this scenario compared to other dairy farms - the average for 404 dairy farms in the FINBIN database was 40 percent in 2000. Part of the difference between this farm and the averages may be because both production/cow and the milk price were higher than the averages. Expanding the tie-stall barn resulted in an increase in the asset turnover rate to 67 percent, indicating that capital efficiency had improved, but adding the debt for the investment had also increased the debt/asset ratio to 32 percent. The retrofit parlor increased the asset turnover ratio to 71 percent, along with improved labor efficiency. It is interesting that if the all-new facility was undertaken with sufficient initial equity to leave it at a post-expansion debt/asset ratio of 68 percent, its capital efficiency calculates out at an asset turnover ratio of 51 percent, a level no better than for the original tie-stall barn.

High Initial Debt Before the Expansion

If the farm has significant existing term debt before the expansion, the interest on that debt would be included in overhead expenses which could then exceed the $10,000 assumed here. Interest on term debt is an overhead expense. For example, 8.5% interest on $300,000 of initial debt (50% debt/asset ratio) would add $25,500 to overhead and would cut net farm income to less than half of the level shown for the debt-free situation. The bottom panel of the table shows that the tie-stall scenarios with this much existing debt would fall short of covering the opportunity cost of labor and management, let alone providing a return to the capital invested. A 50 percent debt load would also present problems for the two parlor alternatives as well. Neither would generate a positive return on equity. Any of the alternatives would require either greater profitability and cash flow generating potential, or lower debt loads, for financial feasibility.

Conclusion

The trend in the dairy industry seems to be in the direction of larger facilities of 500 to 1,000 cows or more, with the western states leading the way with many operations with thousands of cows. There is little sign of these trends reversing themselves in the near term. The rates of return on capital can be quite attractive, as the financial projections above show. Still, this analysis shows that a more gradual expansion path can also offer attractive returns, and may offer another way to prosper in the dairy industry for producers with suitable existing farm structures and who are not ready to make the commitment required for totally new facilities.

REFERENCES

Rudstrom, M.2001. Dairy Farming in Stearns County: Summary and Analysis of the 2000 Dairy Farm Survey, Staff Paper P01-5. Department of Applied Economics, University of Minnesota, http://agecon.lib.umn.edu/cgi-bin/pdf_view.pl?paperid=2923&ftype=.pdf

Brigham and Gapenski. 1997. Financial Management Theory and Practice, 8th Ed. Dryden Press.

UW Extension Dairy Team, 2001. Low Cost Parlor Options.

Table 2. Projected Dairy Enterprise Budget Under Three Expansion Alternatives

Present Tie Stall Barn

Expand Tie Stall Barn

Retrofit Parlor

All-New Facility (Double-8)

Milking time desired, hrs/day

4

6

6

21

Milking center throughput, cows/hr

25

25

45

78

Herd size including dry cows

58

88

158

642

Milking center investment required, $

$ -

$ 60,000

$ 50,000

$600,000

Total investment required for facility and cows

$ -

$ 129,000

$ 457,500

$2,699,080

Labor efficiency, cows/worker

30

30

50

60

Total milk price expected from market & FSRIA, $/cwt

$13.89

$13.89

$13.61

$ 13.14

Milk revenue expected

$ 177,236

$ 268,910

$ 473,240

$2,024,400

Initial equity capital, $

$ 300,000

$ 300,000

$ 300,000

$1,800,000

Total asset market value after expansion

$ 300,000

$ 404,100

$ 670,150

$3,980,772

Asset turnover ratio

59%

67%

71%

51%

Debt/asset ratio after expansion

0%

32%

68%

68%

Net farm income, $/yr

$ 53,907

$ 47,414

$ 70,954

$156,714

Less opportunity cost of operator labor and management

$ 40,000

$ 40,000

$ 40,000

$ 40,000

Return on equity capital, $/yr

$ 13,907

$7,414

$ 30,954

$116,714

Percentage return on initial equity capital (ROE)

4.6%

2.5%

10.3%

6.5%

Low milk price:

Return on equity capital at milk price of $11.89

$ (129)

$ (13,882)

$(16,966)

$(169,846)

Percentage return on initial equity capital (ROE) @ $11.89

0.0%

-4.6%

-5.7%

-9.4%

Debt after expansion

$-

$ 129,000

$ 457,500

$ 2,699,080

Debt after one year's low milk price if negative ROE is borrowed

$129

$ 142,882

$ 474,466

$ 2,868,926

Debt/asset ratio after initial lost capital and one year's low milk price

0%

35%

71%

72%

The viability of expansion when there is existing debt

Initial debt/asset ratio

50%

50%

50%

50%

Initial debt, $

$ 300,000

$ 300,000

$ 300,000

$1,800,000

Interest on existing debt, $/yr

$ 25,500

$ 25,500

$ 25,500

$ 153,000

Return on initial equity capital, $/yr

(11,593)

(18,086)

5,454

(36,286)

Percentage return on initial equity capital (ROE)

-3.9%

-6.0%

1.8%

-2.0%