Cost creep.

Right now, it’s relentless. For the year ended Dec-21, the Consumer Price Index (CPI) was 5.9%, the biggest change since the year to June 1990. The quarter to Sept-21 was 2.2%, and Dec-21 quarter was 1.1%. Then came the oil shock.

The CPI is made up of the theoretical cost of a bunch of staple goods and services that a household will need to purchase. It includes, food, utilities and services, energy, transport and housing among other things.

The biggest culprit referenced in the December numbers were, unsurprisingly, housing related costs. Within that bundle were rents (up 3.8%) and Housing construction (up 16%). Drivers for this increase in construction costs were cited as supply-chain disruption, higher labour costs, and higher demand.

The second largest contributor was transport related costs, lead by increases in petrol (up 30%) and second-hand cars (up 12%).

And then, there’s of course the Russian Ukraine conflict. Ukraine, known as Europe’s bread-basket. And Russia with its countless litres of oil. These are significant economic changes happening right before our eyes.

So what?

Farmers have long known about the connection between inflation and interest rates. Particularly our farming clients that started their careers in the early 2000s and experienced inflation and rising interest rates over this time. Pre-GFC, the Official Cash Rate (OCR) got as high as 8.25% before Lehmann Brothers fell, bringing the world’s financial system with them. Up until then, at every OCR announcement, I remember Allan Bollard clutching the Lectern and adding yet another 25 basis points to the OCR, knowing that meant another corresponding lift to floating rates.

After the GFC, from July 2008 until July 2009, the OCR fell from 8.25% to 2.50%. Since then, and ignoring a few false starts, we really haven’t had inflation and we haven’t had rising interest rates. In fact the opposite has happened, credit has ballooned and the price or credit has only dropped. I remember thinking how good a 5-year fixed rate of 6.99% was at the time. Then a few years later, how good a 5-year rate of 4.99% was. There have been many times since 2009 when it looked like inflation was going to take off and fixing rates should be seriously considered as a hedge, only for another disaster to come along to force the central bank to take a dovish tone.

That being said, a headline inflation rate of 5.90% cannot be ignored. It is here in the flesh and farmers are living and breathing it. Not so much in the interest rate area (yet), we are still at historically low costs of funding, but certainly in the input costs.

You see it everywhere. Meetings with clients, when it comes to expenses, “There’s a sea of red” in the expense lines. The typical places are fertiliser, wages, fuel, feed and grazing and compliance.

And in the last 3 weeks, the OCR has hit 1.00% and Russia has invaded the Ukraine. Neither of which are beneficial to business cost structures.

Inflating Costs and Mindset

Here are some observations:

1. Inflation is self-fulfilling

When farmers think prices will increase, there is a strong desire to beat the system. They will pre-purchase or “inventory build” a lot of their inputs – i.e. fertiliser, spray, feed etc. This creates more perceived demand and further drives inflationary pressure on supply chains. Fear creeps in and decisions are made quickly and probably in a lot of cases, without proper analysis.

2. Inflation is an opportunity for suppliers to reprice

Constant messaging around inflation gives an excellent pretext for supply businesses to reprice their goods and services. Farmers are seeing it and hearing it constantly and therefore, when the servicing bill is a little higher, there is a greater rate of acceptance without question.

3. High commodity pricing can quickly erode cost-management

Despite the international backdrop, times are good right? It’s easy to let the cost creep occur due to the ballooning top line.

4. Be mindful of System Creep

System Creep occurs when the perceived answer to rising costs is lifting production. Marginal increases in production can result in structural changes to the business model lifting fixed costs. These costs become embedded and are hard to unwind.

5. Credit metrics can become quickly “outdated”

Bankers have a really tough job right now. They will have to try and fit your current (and likely inflated) cost structure into their credit-decisioning tools, which are likely to be based on product prices around 40% lower than the current high-prices you are receiving.

Is it all bad or are we missing the big picture?

Right now, we are facing one of the greatest periods of agricultural profitability we have ever seen. If handled well, we have an opportunity for many farming businesses to set themselves up as excellent business for the next 10 -20 years.

But how do we capture it?

1. Understand your Business – What does it really cost?

Understand what it really costs you to produce a milk solid, a ton of grain, or a kg of beef. What discretionary spending have you undertaken this year, that aren’t actually costs of production? What about last year? Have you got it recorded?

2. What-if Analysis – Hope for the best, plan for the best, but what can you change if you have to?

What would you change if the payout dropped by 20%? What about if it dropped by 40%? Would you drop cow numbers? Reduce a labour unit? Mine your soil fertility? Present this strategy to your bank so they can understand your true running costs, and how you would react to a changing environment. This will give them confidence in you and your business.

3. Are you getting the best deal?

Review your suppliers. Should you reprice some of your supply arrangements or could you negotiate better terms with your existing suppliers? Could you increase your business with them to become more valuable to them? Where are their cost pressures coming from and are those longer term issues or shorter term ones? Can you work with other farming businesses to create buyer groups, or pooled buying?

4. Innovation

The answer isn’t always the same. What are your competitors doing? Break the norm and challenge your thinking. If you do what you’ve always done, you’ll get what you have always got. Only, it will cost you more.

5. Changing up (or down) your business

Understand your own business’ value chain. Could you diversify up or down your supply chain? Should you look at support land to fulfil your grazing needs? Or a dairy farm so you own the cows you currently winter graze? Or a cropping business supplying you grain? Or do you expand to spread overheads, or sell the poorest performing blocks that require significant fertility improvement?

6. Understand how your bank is dealing with how they assess your mid-term creditworthiness.

Your bank is still going to be using a payout of $6.50-7.00 to “stress test” any lending decision they make with your business. Your current costs, whether due to price rises or one-off discretionary items, might look a bit ugly against that payout.  

Learn how to present and validate your numbers at this lower payout bringing in historical numbers and other narrative to support.   All banks have different processes here for how they look at your current and past data to make their lending decisions.

Build a Strategy Now

These are massive topics, that require lots of thought and good robust discussion amongst your governance team. The current landscape really is a wonderful opportunity to create outstanding businesses and set them up for years to come.

Let’s not let this opportunity pass us by.

Who is NZAB? 

Farming’s very complex and you can’t be an expert in everything. That’s why the best farmers gather a specialist team around them. Our specialty is better banking outcomes for our clients.

There’s no one better to work alongside you and your bank. With a deep understanding of your operation and our considerable banking expertise, we can give you the confidence and control to do what you do best.

We’ve been operating for five years now and we’re right across New Zealand, For an introductory no cost chat, pick up the phone and talk directly to one of our specialists on 0800 NZAB 12.    

Or if you prefer, Visit us at our website  or email us directly on info@nzab.co.nz