By: Carole R. Engle, Ph.D.* Engle-Stone Aquatic$
Is now the right time to expand or diversify your aquaculture business? Is it time to move into new markets, produce new products or increase production? If the primary reason for considering expansion or diversification of the business is: 1) the owner is tired of what he/she is doing; 2) the business is not doing well; 3) other people are changing; or 4) there appear to be new opportunities for the business, then the next step is to devote the time to thorough planning and analysis.
The first step is to conduct a careful financial analysis of the current financial performance of the business. Previous columns discussed the three components of a successful aquaculture business: adequate cash flow, moderate financial position, and acceptable level of profitability. What “adequate” means will vary from farm to farm but should be based on whether the farm is meeting the specific short and long-term goals established for the business. It is critical to spend time setting these very specific goals for each upcoming year. These goals and a detailed understanding of the financial performance of your business provide the platform from which to make decisions related to expanding or diversifying your business.
Under what conditions does it make economic/financial sense to expand the business? One good reason to expand is if the business model and plan include goals of becoming the primary and preferred supplier to a profitable segment of the market. An often related reason to expand the business is to take advantages of economies of scale. However, under no circumstances should a business undertake a major expansion without a great deal of certainty and proof that the additional volume can realistically be sold at an acceptable price.
Economies of scale typically exist in industries with high fixed costs of production such that expanding output results in spreading the fixed costs over a greater amount of production. As long as fixed costs of production remain “fixed” and do not increase, then greater production will reduce the fixed costs per pound of production.
It is important to understand that there also are diseconomies of scale. There are many examples of businesses growing too large to be managed in an efficient manner. For example, a seafood processing plant that adds too many additional processing lines may find that coordinating the delivery of live fish on trucks becomes difficult, backlogs develop, and overall efficiencies of the plant decrease.
While fixed costs per pound of fish will decrease with an expansion of the quantity of product sold, variable costs will also increase as production increases. The feed bill, fingerling costs, total costs of harvest, labor, and other costs will increase because more inputs are needed. If the expansion involves investing in new ponds, trucks, or processing lines, then total fixed costs will also increase. The key question that requires careful analysis is what effect will the entire set of changes have on the bottomline cost per pound of production.
If the cost analysis shows that the overall cost per pound of production would go down with an expansion, the second step in the analysis is to evaluate the effect on cash flow. For example, a farmer may recognize that a new technology would increase profits on the farm, but the farm is experiencing cash flow problems. Expanding production would require the farm to spend more cash to purchase more feed, fingerlings, and other inputs that would likely create even greater cash flow problems that could lead to even more serious financial consequences for the farm. Such a farm would need to first resolve the cash flow problems this year and then begin the expansion process at a later date. The rate of expansion should be determined through careful and realistic projections of what the farm’s cash flow will allow.
The final step in the analysis of whether to expand or not in the near future is to examine the effect on the farm’s financial position. For example, if a farm with a debt-to-asset ratio of 55% borrowed additional capital to invest in new ponds, equipment, or increased operating expenses that drove the debt-to-asset ratio to 85%, the farm would end up in a position of very high financial risk. Such a farm business would be better off taking the necessary steps this year to first decrease the debt-to-asset ratio to, perhaps 25% to 30%. Then, even with the 30% projected increase in the debt-to-asset ratio from the new investment, financial risk in the business would remain at a moderate level.
The analysis of whether to diversify into a new crop, new product, or new market should also include the following steps: 1) careful financial analysis of the farm’s current profitability, cash flow, and financial position; and 2) careful financial analysis of the effect of diversification on profitability, cash flow, and financial position. Additional investment in distribution or marketing equipment and facilities must be accounted for. As with the expansion decision, the market analysis done to justify diversification must provide a great deal of certainty that any new products can be sold at the volume and price necessary to cover the additional costs.
There are three important reasons to consider diversification. One is to spread overall economic risk. For diversification to successfully reduce economic risk, the new products produced or the new markets targeted must have prices that vary in the opposite direction of prices of the existing products sold or existing markets sold into. In other words, the new product’s price would tend to be high when the primary product’s price is low. A second reason to diversify production is to improve cash flow. If a foodfish grower who sells into a market with the greatest demand in the spring Lenten season can identify a product that can be sold in the fall holiday season, cash flow in the business may improve. A third reason to diversify may be to adjust, over time, to the product’s life cycle. Most products do not last forever in the market place. There comes a time when sales of that particular product begin to wane, and the successful business must be prepared to introduce and develop new products.
Expansion and diversification of an aquaculture business can be advantageous. However, such decisions must be preceded by careful and thorough financial and market analysis to chart a successful path for growing the aquaculture business.
Carole Engle holds a B.A. degree in Biology/Rural Development from Friends World College and M.S. and Ph.D. degrees from Auburn University where she specialized in aquaculture economics. Dr. Engle is a past-President of the U.S. Aquaculture Society and the International Association of Aquaculture Economics and Management. She is currently a Principal in Engle-Stone Aquatic$ LLC, and can be reached at firstname.lastname@example.org