However, there are several ways to measure profitability, depending on the questions being asked. There are also published reports that include analyses of “profitability” that are not done correctly. Thus, this column is devoted to the proper assessment and interpretation of profitability measures and to a discussion of the types of hidden costs that are ignored too frequently.
Profitability, in its most general interpretation, measures whether the revenue generated by the business exceeds the total costs incurred by the business. Differences occur if the calculation is done for tax purposes, to measure “true” profits, or to estimate the profitability associated with a new capital investment. Additional problems arise when cost items are not included in the analysis. Reasons given for omitting cost items include: 1) they are assumed to already exist; 2) the item has already been paid for; or 3) it is something for which the business does not incur a direct expense.
For tax purposes, most aquaculture businesses hire an accountant who prepares a Schedule F for the farm business each year (in the U.S.). The Schedule F form includes sections to list all revenue and all expenses and results in a bottom line estimate of profit or loss for the year. However, tax codes in the U.S. provide various options for handling certain types of costs, and allow deductions and credits that can skew the measure of profit when filing income tax returns. For example, equipment can be depreciated quickly for tax purposes over fewer years than the equipment’s useful life. Since it is in the farm business’s interest to “write off” depreciation quickly, such “accounting profits” show that the farm business is less profitable than it is in reality.
True profit (also called “economic” profit) accounts for the value of all resources used in the production process. Thus, non-cash costs like depreciation, unpaid family labor, and all opportunity costs must be charged against the revenue received to measure “true” or “economic” profit. Economic profit is the best measure of whether a business is economically sustainable (i.e. profitable, over the long term). This is because: 1) the business must receive sufficient revenue to be able to replace its equipment and buildings when they wear out; 2) family labor must receive compensation greater than the value of their time and effort in other activities; and 3) the land must generate greater value in aquaculture than in other crops. The business will not be able to continue without replacing equipment; family members eventually will move to jobs that provide greater compensation; and farmers will plant more profitable crops at some point in the future. Costs for unpaid family labor and land that is already paid for are typically assigned as “opportunity costs.” Calculating economic profit is the only way to truly project the long-term economic feasibility of an aquaculture business.
Depreciation and opportunity
Depreciation and opportunity costs frequently are omitted from cost analyses. In some cases, those developing the analyses may not understand their importance. In other cases, their omission may be rationalized by saying that it is not a cash expense and thus is not relevant. Other cost analyses omit costs of equipment or land already owned. However, use of equipment, land, and labor in the aquaculture business means that it is no longer available for the uses for which it has been used in the past. Such costs must be included to be certain of the business’s profitability.
The bottom line estimates of costs of production that are calculated without opportunity costs and full costing of equipment, land, and labor needed can result in erroneous conclusions. The table illustrates such an example, with a negative value when accounting for all costs as compared to values that are seemingly quite profitable when fixed costs or unpaid family labor costs are ignored.
The profitability of a proposed investment requires a different type of analysis. Investing in new ponds, a processing plant, or new equipment will result in benefits and costs that accrue over a long period of time. A dollar of revenue to be received in the future does not have the same value as a dollar received today. This difference is not due to inflation, but rather due to the fact that a 2014 dollar can be invested and, by earning interest, be worth more than 1 dollar in the future. The proper analysis to be done is to estimate the revenues and costs for each year of the life of the investment, up to about 10 years (extending the analysis beyond 10 years rarely produces more accurate results). In this annual cash flow budget, all cash outflows are included in the year in which they incurred. Thus, if a new aerator will need to be purchased every 5 years, the total cost of a new aerator is included in Year 6.
Net Present Value (NPV) and the Internal Rate of Return (IRR) should then be calculated using a spreadsheet program like Microsoft Excel. Other metrics that have been used have important weaknesses that can lead to misinterpretation. To interpret the results, if NPV is greater than 0, the investment is profitable. If the IRR is greater than the interest rate that the capital could have generated in some other investment (opportunity cost of capital), then the investment is feasible.
Accurate and complete calculations of true economic profit and the long-term return on the investment (IRR) are a necessary foundation from which to make the best possible decisions for the aquaculture farm business.
Dr. Carole Engle is an Aquaculture Economist with more than 30 years of experience in the analysis of economics and marketing issues related to aquaculture businesses. She is the Editor-in-Chief of Aquaculture Economics and Management.