VinPro survey - The cost of grape production and producer profitability

A Technical Guide
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VinPro survey - The cost of grape production and producer profitability

Gert van Wyk

Gert van Wyk, VinPro Agricultural Economist
Introduction
Over the past few years, including 2007, VinPro has undertaken financial analyses in the various South African wine districts to ascertain the probable financial situation of primary wine producers. This survey, better known as the Production Plan, is conducted in collaboration with Winetech, with the aim of providing an economic support service to producers and industry organisations. At the core of the survey lies the calculation of average grape production cost, which may be used as the norm or guideline for decision making in the industry.
There are basically three important determinants that impact on the profitability of wine grape cultivation, namely:

Income per ton
Yield per hectare
Cost per hectare

Worldwide surpluses, which contributed directly to decreasing wine and grape prices, together with increasing input costs, were some of the most important factors that had a negative impact on producers’ cash flow and financial position, especially from the 2005 vintage onwards. Additional obligations such as land/municipal taxes, increased minimum wages, ongoing increases with regard to fuel prices, water levies, the impact of steep increases in excise tax, etc can hardly be accommodated and in many instances income levels realised below the cost of producing the grapes. Especially as far as cellars are concerned, large capital expenditure and increased costs due to power outages will exert even greater pressure on producers’ financial situation.
Grape prices
According to preliminary indications from the SA Wine Industry Information and Systems (Sawis), grape prices paid out by Producer Cellars with regard to red cultivars decreased by 54% from 2003 to 2006 - there were no increases up to and including the 2007 harvest. White grape prices showed slight increases for certain cultivars, but indications are that the average price of all cultivars decreased by at least 22% for the period under review. Grapes that are sold outside the Producer Cellar system followed the same trend and decreased by 42% and 27% per ton respectively for red and all cultivars (see Figures 1 and 2).

Figure 1 (NB: 2005 and 2006 preliminary prices)
Figure 2
Results
Production cost
The 2007 harvest analyses - the poll comprising approximately 18% of the total wine industry surface - found that the industry’s average production cost increased by 18% from 2004 to R22 125 per ha in 2007. Since 2006 the cost increase amounted to less than 4%.
Labour currently represents 43% of the industry’s average annual operational cash expenditure, mechanisation 20%, direct costs 16%, general expenses 17%, and running costs related to improvements of fixed assets 4% (see Figure 3).

Figure 3
Although it is generally accepted that the cost per hectare remains more or less the same, there are certainly differences among vineyards - everything depends on the desired viticultural practices and requirements, as well as the product and "price point" for which production takes place, in other words market-driven grape and wine production.
There are also significant differences in the various geographical areas or districts in the industry as regards the factors that influence total cost, the most prominent being labour costs and yield per hectare.
The cost related to the production of grapes - excluding interest, tax and the entrepreneur’s remuneration - consists of the following components:

Cash expenditure / Annual running expenses
All cash expenditure incurred in the year under review

Provision for replacement / Capital maintenance
During the production process expenses are not limited to prerequisites for the actual production process, in view of the fact that machinery and implements are also required. In due course tractors, machinery and other tools have to be replaced. Even vineyards and buildings deteriorate and have to be replaced. The "deterioration" and "depletion" of these items form part of the cost in the production process.
Sufficient provision has to be made for the fact that the purchase value of an item has to be recovered in its lifetime, as well as for fluctuating inflation. By using the principle 'provision for replacement', a larger amount is covered than in the case of 'depreciation'. This addresses the problem of rectilinear depreciation to a certain extent and ensures that the business is maintained as a running concern.
When calculating provision for replacement, items are written off against replacement value over different terms:
Buildings - 60 years
Vineyards - 20 years
Moveables / means of production - 5 - 15 years

The average production cost with regard to the participants in the 2007 vintage was calculated as follows:
(CLICK TO ENLARGE)
Profitability
There are two approaches to calculating the profitability of wine grapes, viz:

The profitability of a specific production year
The profitability of a specific vintage

The results and findings in this report refer to the profitability of a specific vintage.
Time value of money and deferred payments to producers undoubtedly represent one of the most important factors that cause serious cash flow problems in the current economic climate. It is impossible to calculate the impact thereof in this survey, seeing that participants realise their income at different stages.
In determining the production structure the following factors are taken into account: total surface planted to vines, age distribution, expected payout per ton, production per hectare and the expected income per hectare.
Profit or Net Farming Income (NFI) is calculated as the difference between the total income and total production cost, i e:
PROFIT (NFI) = TOTAL INCOME - TOTAL EXPENSES (Before interest, tax and entrepreneurial remuneration).
The industry average NFI of participants over the past four years was calculated as follows (see Figures 4 and 5):

Figure 4

Figure 5
A cause of concern, judging from the 2007 analyses, is the fact that in the 2004 analyses the industry’s average annual cash expenditure and total expenditure amounted to 46% and 61% of the total income respectively. These ratios have weakened to such an extent that they amounted to 58% and 80% respectively of the income according to the 2007 analyses. This implies that 80% of the income is spent on production cost, which leaves only 20% for interest, tax and the entrepreneur’s remuneration.
As a guideline for economically sustainable production the average gross income and NFI for the 2007 vintage should have realised R35 125 and R13 000 per hectare respectively.
A record crop of 1 352 040 tons was realised in 2007, which can be partly ascribed to the producers’ focus on increased productions for lower and medium priced products. Producers are making a concerted effort to manage costs down by aligning viticultural practices with the wine goal and by not overspending on vineyards with lower profitability. Unfortunately many are involved in a struggle for survival and the necessary capital maintenance - inter alia the replacement of old and non-profitable vineyards - cannot be done.
Judging from Sawis statistics, it is clear that the industry as a whole uprooted more vines than it planted during 2006. Of greater concern is the fact that since 2005 the industry has been unable to replace 5% of existing vineyards annually (20 years serve as a guideline for economic lifespan). In years to come this may have a negative influence on the industry as a whole (see Figure 6).

Figure 6
There are nevertheless several positive signals, such as the good growth in sales during 2007, and one can only hope that the wine industry has reached the turning point at the bottom of its current economic cycle. It is critical that the producers’ income flow be increased.
With thanks to Standard Bank, Nedbank and Absa for financial support.
Summary
From the analysis of the 2007 harvest it was found that the wine industry’s average production costs increased by 18% from 2004 to R22 125 per hectare in 2007. It was also striking that the increases in costs were less than 4% since 2006. Producers actively strive towards managing costs down by aligning vineyard practices with the end use of the wine and not to overspend on vineyards with lower profitability. Unfortunately many producers are currently struggling to survive financially and necessary capital maintenance, such as the replacement of old and unproductive vineyards, cannot be done. It is critical that the producers’ income flow be increased.

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