An Exploration Of Profit Measurement

G. Bright

Farm Management Vol 9, No 8 Winter 1996/7

Apart from Net Profit there are a number of other measures of farm profitability currently in use. Although they can be used for comparative purposes they can be criticised on a number of grounds. In this paper three alternative measures are proposed and these can then be converted to return on capital percentages for more appropriate comparisons. Finally, some adjustments to deal with inflation are suggested.

Introduction
Profit defined
Profit measures
Rate of return measures
Inflation adjustment
Conclusion
References
Biographical Notes
Appendix

Introduction

Profit is one of those terms that one seldom finds it necessary to define, since everyone seems to know what is meant by it. However, given the apparent confusion between measures of "profit", "cash" and "capital", (2) and the fact that there are a number of measures of profit in use in farming, it would appear that things are not as clear as they seem. The first section of this paper therefore seeks to establish what is meant by the term profit.

Although profit is generally compared to something, be it own past or budgeted performance or that of other businesses, how profit is measured depends upon what the measure is to be used for. Farmers are often concerned only with actual costs and the absolute amount of profit, whereas, policy makers, economists and business analysts may be interested in notional costs as well, in ratios and aggregation of results. Consequently, there are a number of different measures in use. The second part of the paper therefore outlines the most commonly employed measures, explains the underlying rationale, and shows the calculations for an example.

However, these measures can be criticised, either on the basis of non-comparability with other businesses or time periods, or because they are incomplete, showing a return to a mixture of resources rather than only one. In an attempt to overcome these shortcomings, alternative measures are presented, justified and illustrated.

Profit defined

Constructing a definition of how profit is measured is often easier and more helpful than finding a succinct form of words to describe it. Thus, as a description, Warren (11) suggests that profit is, "a reliable guide to the operational performance of a farm business" while Bent et al. (2) state that profit "indicates whether it is worthwhile doing business in any one period".

These writers go on to explain that net profit is measured as,"the difference between the output and input of value during a given period''(11) or "the surplus of financial benefits over financial costs" . (2) Emphasising the difference between profit and cash flow, Warren adds, "Profit is concemed with the revenues and expenses, cash or otherwise, arising from the productive activity of the business during that period", which mirrors closely the wording used by MAFF. (8)

This then is what most of those involved in farm management mean by the term profit and would be in agreement with the following accountant's definition which applies to the wider economy: "Net profit is the residual value arrived at after deducting all money costs (from total sales revenue)''. (1)

Even the economist's definition would concur: "A company's profit is the maximum value which a company can distribute during a period, and still expect to be as well-off at the end of the period as at the beginning". (3)

Profit measures

Profit measured using actual costs in the way outlined above is known as "net profit". This is the figure generally used by farmers and their accountants to assess performance by comparison with expected or previous figures.

However, if fair comparison of profitability between businesses is to be made, net profit is not the ideal measure. In farming the degree of ownership of the resources of land, labour, capital and management varies considerably, between businesses and, since owned resources are not normally costed, comparing net profits would not be comparing like with like. For instance, two farms with exactly the same resources and productivity might still show widely differing profit figures if one was tenanted while the other was owner-occupied: one would pay rent, while the other would pay no rent but incur ownership charges such as building depreciation. Table 1 provides a summary of how farm businesses might differ in terms of ownership of resources and the consequent costs:

Table 1: Ownership of resources and resulting costs

Resource	Owned	Actual Cost	Hired	Actual Cost
Land	owner occupier	ownership charges	tenant	rent
Labour	farmer, spouse and unpaid family labour	none	hire farm workers	wages
Capital	own funds	none	borrowed funds	interest
Management	own managerial input fee/salary	none	hired management

Furthermore, if profit is to be expressed in the form of a return on capital (profit divided by the value of capital) the profit measure must take account of the opportunity costs of all other owned resources in order to arrive at the residue to cover the cost of capital.

In order to address the perceived shortcomings of the accountant's measure of profit, official statistics present a number of alternative measures, particularly Occupier's Net Income (ONI), Net Farm Income (NFI) and Management and Investment Income (MII) (9) These are outlined in Table 2 below along with, by way of illustration, figures calculated from the 'Large Lowland Dairy Farms' category of the Welsh Farm Business Survey for 1 993/4. (4) [There are other measures in use including Family Farm Income, which differs from Farm Profit only in terms of excluding any interest received, Farm Surplus, a bankers' measure which is profit less income tax and private drawings, and Cash Flow from Farming The latter two are indicators of wealth change and cash flow respectively and should therefore not be used as profit measures.].

Although each of these measures does just as the definitions in Table 2 state, it is worth setting out what implicit assumptions are being made as to ownership of resources: this is presented in Table 3. Thus NFI, for instance, leaves management costs untouched, but puts all farms on a tenanted, hired family labour and own capital basis. To adjust for this, a notional rent is charged if the farm is in fact owner-occupied, unpaid family (not farmer and spouse) labour is charged for and if any interest is paid it is added back on the assumption that the farmer does not have to borrow at all.

Each of these alternative measures of profitability can be used for comparative purposes within farming. Nevertheless, these measures may be criticised, mainly on the grounds that they are incomplete since they only partially take account of the opportunity costs of own resources. Thus ONI makes no adjustment for own land, capital or management and only does so for some unpaid labour.

NFI is even more of a mongrel since it adjusts for owned land and some labour, but adds back interest. This latter would be acceptable for measuring return on capital if all other opportunity costs were to be included as it would then show the return on that one resource. However, as it stands, NFI shows a return on a mixture of resources: own management, some labour and all capital.

Similarly, MII adds back interest, but also charges for all unpaid labour, then adds back any management fees. Some might argue that this figure gives a return to one resource, namely enterprise. However, in most industries and projects the managerial cost is separated from the role of risk-taking by owners of capital, so should be charged for if a return on capital is to be arrived at. Furthermore, charging for owned land and so putting all farms on a common, "tenanted" basis, as occurs with NFI and MII, although covering its opportunity cost, is not realistic. Although the argument that inclusion of land can cause wide variations in performance indicators when land prices fluctuate is a valid one, as Sturgess (10) has pointed out, the majority of UK farmers are owner-occupiers and it may therefore be more appropriate to follow the practice elsewhere of looking at the return on all of the assets, rather than just the tenant-type ones.

Table 2: Official Profitability

Measure	Definition	example figure
Net Profit	"surplus of financial benefits over financial costs".	£93,282
less
imputed value of unpaid labour		£4,466
BLSA*		£2,664
equals
Occupier's Net Income	"return to the farmer and spouse for their manual and managerial labour and on all their investment in the business".	£86,152
less
notional rent		£11,423
plus
interest		£10,666
ownership charges (building depreciation, etc.)		£4,823
equals
Net Farm Income	"return to the farmers and spouse for their manual and managerial labour and on the tenant-type asset of the farm".	£90,218
less
farmer and spouse labour		£8,568
plus
paid management		£0
BLSA*		£2,664
equals
Management & Investment Income	"return to management and on the tenant-type assets of the farm".	£84,314

*BLSA refers to breeding livestock appreciation which will be dealt with in the latest section on inflation.

Table 3: Profitability measures - adjustment to actual costs

Measure		Land Labour		Capital Management
ONI	n.a.*	hired basis -family labour only	n.a.	n.a.
NFI	tenant basis	hired basis -family labour only	own capital basis	n.a.
MII	tenant basis	hired basis - all labour	own	own capital
	management		basis	basis

* n.a. = no adjustment made to actual costs.

All of this suggests that although profit and the alternative measures above can be used for comparative purposes, there may be better indicators, particularly for measuring return on capital. Table 4 presents some suggestions:

Table 4: Alternative profit measures

Measure	Definition	example figure
Net Profit		£93,282
less
imputed value of unpaid labour		£4,466
farmer and spouse labour		£8,568
imputed value of own management input		£4,284
equals
Farm Business Income	"return to the owners of the business on all their capital".	£75,964
plus
net interest		£10,666
equals
Farm Investment Income	"return to all of the assets of the farm business".	£86,630
Management and Investment Income		£84,314
less
imputed value of own management input		£4,284
equals
Tenant Investment Income	"return on the tenant-type capital of the farm".	£80,030

All three of these measures, Farm Business Income (FBI), Farm Investment Income (FII) and Tenant Investment Income (TII) perform similar functions in that they all measure return on capital in some form - the first on own capital, the second on all capital and the third on tenant-type capital. In doing this, they, unlike the currently used official measures, take account of all other costs including that of unpaid management. [Unpaid management is here estimated at 50% of farmer and spouse labour. This is based upon the fact that farm workers with supervisory responsibilities have a minimum wage premium of about one-third over general farm workers, and the manager's premium can be expected to be about 50%. Thee will of course be variations in the management input dependent upon the size of the business, but this has not been accounted for here.]. However, the calculation of this latter cost may not be as simple as has been implied here and further work needs to be carried out to ascertain how it might be measured.

Farm Business Income (FBI) has a further value in that it involves an adjustment to Net Profit to make it more comparable to profits of companies, which will be paying for all management and labour.

Rate of return measures

Although these alternative profit measures are useful indicators, comparisons between companies and even between years are not that helpful if not related to the size of the business. A profit of 50,000 means something very different to a 50 cow dairy farm in West Wales than it does to a 5,000 hectare estate in Eastern England. But to what should profit be related?

The return measures identified above (FBI, FII and TII) refer to capital and so to calculate a percentage return the profit figure should be divided by own capital, all capital or tenant-typecapital respectively. There is some confusion as to whether the capital figure should be the value at the start of the year, the end of the year or the average of the two. Although any of these can be used for comparative purposes, the opening value is the only one which stands up to economic reasoning. (3) The formulae and the terminologies, together with the calculations for the example, are given in Table 5 below.

Table 5: Rate of Return Measures

Name of measure	Formula
(and alternative names)	(general and example)
Return on all capital(ROAC)	FBI / £989,269 = 7.68%
Return on all capital(ROAC)	FII / Opening Total Assets x 100%
Accounting Rate of Profit (ARP)
Return on Assets (ROA) or
Return on Capital Employed (ROCE)	£86,630 / £1,129,447 = 7.68%
Return on tenant's capital (ROTC)	TII / Opening Tenant's Capital x 100% £80,030 / £262,520 = 30.49%

These rates can be compared to those of other businesses or previous figures for the same business (bearing in mind the adjustments suggested in the next section). But what about comparisons with the rate of interest? After all, one should be interested in checking whether the investment has been worthwhile compared with the opportunity cost of capital. Strictly speaking, unless valuations have been made according to a complex set of decision rules, comparing the rate of return with the opportunity cost rate of interest is not valid. (3) Pragmatically, however, it can be done, as long as the next problem has been overcome.

Inflation adjustment

Despite the experiences of double-figure inflation in the 1970s many farrners and accountants continue to ignore its effects, hoping that they will cancel themselves out. Nevertheless, without adjustment the figures contain distortions, and even in the current circumstances of low inflation erroneous conclusions may be reached.5 6 7 The fact is, even if one calculates profit on an historical basis, inflation of values is still included in some of the figures. Thus land, buildings and machinery values might be kept at their historic level, while the valuations of live and dead stock and cash flows are expressed in inflated terms.

This is not the place to delve far into the intricacies of inflation accounting. Suffice it to say that to produce a profit figure attributable to the trading, rather than holding, activities of the business, adjustments need to be made to valuations, depreciation, costs of production and interest charges. As the Appendix indicates, at low rates of inflation, the degree of error is acceptable. However, at rather higher rates, judgements about profitability could be seriously affected.

Conclusion

The decision as to what profit measures to employ is really a case of "horses for courses": it depends what the measure is to be used for. However, one must be clear as to what the particular indicator is measuring, whether it really does have a meaning and with what it should be compared.

In the light of the previous paragraph, both farm profit and the alternative of official indicators may be useful, although it is suggested that the alternative measures FBI, FII and TII outlined here would be preferable in certain respects, particularly when used to derive rate of return values. More research does need to be done to derive a straightforward and accurate means of estimating management costs, but the same might be said of notional rents, which have a major impact on NFI and MII.

Any of these profit indicators will be inaccurate if measured on an historical basis and will give increasingly misleading signals if we return to higher inflation rates. Steps therefore need to be taken now to enable inflation to be dealt with, not only by government but also by accountants.

Finally, if improved understanding and further debate on appropriate profit measurement arises as a consequence of this article, it will have served its purpose.

References

1 Bannock, G., Baxter, R. E. and Rees R. 1972. The Penguin Dictionary of Economics. Penguin Books, Harmondsworth, Middlesex.

2 Bent, M. J., Bright, G. A., Cain, P., Dawson, B., Schofield, J. and Young, C. 1995. Budget Builder 1 v 1. 0. MERTaL Courseware, (Ed.) S. B. Heath, University of Aberdeen, Aberdeen.

3 Edwards, J., Kay, J. and Mayer. C. 1987. The Economic Analysis of Accounting Profitability. Clarendon Press, Oxford.

4 Farm Business Survey in Wales 1995. Statistical Results for 199314. Department of Agricultural Sciences, The University of Wales, Aberystwyth.

5 Hill, B. 1982. Concepts and the Measurement of the Incomes, Wealth and Economic Well-being of Farmers. Journal of Agricultural Economics. Vol. 33, no. 1, pp: 311-324.

6 Hill, G. P. 1984. Measuring Farm Income under Conditions of Inflation: The Gains from Borrowing. Journal of Agricultural Economics. Vol. 35, no. 1, pp: 51-60.

7 Lewis, R. W. and Jones, W. D. 1980. Current Cost Accounting and FarmBusinesses. Journal of Agricultural Economics. Vol. 31, no. 1, pp: 45-54.

8 MAFF. 1978. Definition of Terms Used in Farm Business Management. HMSO, London.

9 MAFF. 1992. Farm Incomes in The U.K 1991. HMSO, London.

10 Sturgess, I. 1996. Interpretation and Execution of Measures of Farm Income. A.E. S. Annual Conference, Newcastle. Discussion Group Guidelines.

11 Warren, M. 1992. Financial Management for Farmers. Stanley Thornes, Cheltenham.

Biographical Notes

Geoff Bright has lectured in farm management and agricultural economics at the
University of Wales, Bangor for the past 11 years. Prior to that he worked at the
University of Gezira in Sudan and ESCA in Edinburgh. He is currently part of the team involved in producing Budget Builder, a CAL package for farm management.

Appendix

To adjust for inflation the following steps need to be taken:

1. Stock appreciation (like BLSA, but concerned with all stocks) is calculated for each stock category as: Stock appreciation = (average of opening and closing valuation) x percentage price inflation of that item over the year.

2. Depreciation charges should be inflated by the inflation rates applying to machinery and buildings, whose opening values have been updated.

3. Costs of production should be inflated, again by an appropriate rate, up to the time of sale of the product or year-end if still in store. (6) (7) A simplification is to inflate costs by the average period between purchase of input and sale of product or year-end.

4. Interest charges are in nominal terms, but need to be converted to real terms, (6) thus:

real interest payment = nominal interest payment x i - f

where i is the average interest rate paid over the year; and f is the average inflation rate of non-money assets held over the period. This measure can be compared with those for previous years by inflating figures for earlier years by the general rate of inflation for the period concerned.

To measure the percentage return on capital, whether own, all or tenant's, the rate should be adjusted, thus:

                        (1 +  g ) 
                      	100

where g is the general rate of inflation over the previous year.

This figure can then be compared to real interest rates elsewhere, although remember that there are misgivings amongst economists about doing so. (3)

In the example above, adjustments are estimated as follows:
1. BLSA is given as 2664, to which may be added an estimated 725 for trading livestock, giving a total of 3389.
2. FBS statistics already involve inflation adjustment.
3. Costs of production are 178,708. With a CoSt inflation rate of approximately 3% and period of say two months, the adjustment would be 894.
4. The interest charge is 10,666.

Assuming interest averaged about 7% and inflation 3%, the real interest charge becomes:

        10,666 x (7-3) 7 = 6,095

The adjusted profit indicators then become:

         FBI = 75,964 - 3,389 - 894 + ( 10,666 - 6095) = 76,252
         FII = 86,330 - 3,389 - 894 = 82,047
         TII = 80,030 - 3,389 - 894 = 75,747 

The rates of return are:

         ROOC = 76,252 98,927 x 100% = 7.7%
         ROAC = 82,047 1,129,447 x 100% = 7.
         ROTC = 75,747 262,520 x 100% = 28.9% 

and the real rates of return, using a general inflation rate of 3% are:

         Real ROOC = (7.7 - 3) (1 + 0.03) = 4.6 %
         Real ROAC = (7.3 - 3) (1+ 0.03) = 4.2 %
         Real ROTC = (28.9 - 3) (1+ 0.03) = 25.1% 

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