May 4, 2018
Most people who have studied economics have been exposed to the term “production function.” And the majority have forgotten the concept, representing the loss of a valuable tool. At the most basic level, the production function maps what you get out for what you put in. I suppose most people would think this exemplifies a trite concept. However, if you really believe that a strong relationship exists between the inputs and the outputs, you should work hard to understand that relationship. Crucially, this places the control of your business into your own hands. Being able to control the process is about all you can really ask for in business.
Unfortunately, the “epsilon of life” means that every effort to measure the input to the output also has some level of error associated with it. Every real world model has an epsilon attached to it. This epsilon covers the unexplainable difference between what the model predicts and what we end up with. The sources of the “epsilon of life” are many and difficult to track, and they include measurement error and plain old randomness.
So, what does this have to do with agriculture? Well, agriculture is all about transforming some valuable inputs into some even more valuable outputs. When I started with Wells Fargo 18 years ago, I was struck by how many farmers claimed that their yields simply depended on the weather. Without a doubt, weather remains the number one uncontrollable input to the farming production function. A widespread drought and high temperatures will reduce grain and oilseed production no matter what farmers do, but how much it reduces production is a completely different issue. Farmers have the ability to tile their fields to mitigate wet weather, and irrigate to lessen the impact of drought, along with other things. Should they make these investments? Should they pay more or less for new varieties of seed? Should they spray that last application of fungicide? What is the right level of crop nutrients to maximize yield and minimize waste? All of these questions, and a host of others, are really the “Moneyball” question.
The movie Moneyball, and the book on which it was based, illustrates the production function in a way that is fun and easy to remember. A good story always beats a good statistic. The basic argument in the movie involves the difference between experience and statistics and models. Like the farmer who relies on their experience by remembering what produced great yields or bad ones, many baseball managers relied on the collective wisdom of baseball to make decisions. Along comes computers, and data collection kicks into overdrive. This data allowed people to go back and check if the outcome of the decision really matched what the experience expected. But, were they really getting the best bang for their buck?
Farming has changed from a “work hard” to a “think smart” business, and that change continues to accelerate. Over the last 25 years, University of Minnesota data from FINBIN shows that, on average, only 8% of the yield of corn and soybean ends up as payments to labor and management, and this share continues to shrink. Likewise, net profits after all expenses receives about 4% of the yield. So, that means that the other 88% of the yield goes to pay for the other inputs. Farmers and livestock producers succeed by understanding how the technology continues to change their agronomic production function. They need to forget “received wisdom” that might have made sense 15 years ago, but today, represents outdated information.
Just like Sabermetrics changed baseball by taking existing data and showing it in a different light, today’s farmers are collecting yield data and more and more detailed input data. The best performers ask statistically for proof that what they spend impacts what they grow. They understand that seed, fertilizer, and chemical can be mixed and matched in a wide variety of ways to control their yields. Plus, they accept the fact that some randomness will come along for the ride. They take control of what they can, and they know farming is a game of percentage points. The recently published data for 2017 shows, once again, the wide spread in performance.
The top 40% of the farmers played the “Moneyball” game better than the bottom 40% of the farmers. While the top performers only earned, on average, $23 per acre after all the expenses, they outperformed the bottom performers who lost an average of $178 per acre. This $201 gap will cause additional churning for the participants going forward. The weaker performers with almost $200 an acre losses will eat through their financial capital very quickly, and 2017 was not the first year of the discrepancy. I have no doubts that the top performers feel that the production function exists, and they are working with statistics and experts to get a better understanding of how it works. I also guess that the poorer performers are chalking up their poorer results to bad weather and poor prices. At the end of the day, everybody who manages a business had better be playing “Moneyball” if they want to succeed.
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