Prepare a contribution margin analysis and determine if he should keep the hens. A shift to sustainable farming practices (with a focus on animal welfare) is dependent on the consumers' willingness to pay more for that item and understand why it costs more. Organic farming has been a breath of life into small farms across the country. It creates an environment where the focus is on doing the right thing, not the cheapest thing. As a result the products cost more to produce and net more income that sustain this method of production. 1 Conventional caged eggs were a commodity and producer prices were sensitive to shifts in supply and demand. But specialty eggs were often grown under contracts that protected producers, and the current oversupply meant that consumer prices of conventional eggs had plummeted, while specialty egg prices remained high. This differential had gotten so large that consumers of specialty eggs were switching back to conventional cggs. Cox could not remember a time when prices for on-shelf conventional caged-eggs had fallen so low that they affected consumer demand for specialty eggs. Cox bemoaned his situation: This is the first time that a bad caged market has affected the specialty market. You go to the grocery store and you see 75-cent white caged eggs, you're going to buy those eggs, not our $5 eggs. White eggs have gotten so cheap that it's pulling our consumer base away.2 Until now, his margins on production had been largely protected by a key contract with CCF Brands, a wholesaler of packaged foods, including organic eggs. But that By 2016 , Cox was servicing these three contmats, as well as selling on the open market, with production from his own farms and from 25 contract growers in Arkansas and Missouri. His contract production in Missouri comprised 320,000 hens producing free-range eggs. His production on his own farms in Arkansas included 38,000 hens producing pasture-raised eggs and 130,000 hen that were producing organic cage-free eggs for the now expiring CCF Brands contract. CCF Brands contracted for the output of a certain number of hens (up to 150,000) at a set price. Although Cox could profit by achieving higher-than-average egg production with efficient feed conversion, he also risked losses if production was below average. While his contracts contained feed escalator clauses that largely protected Cox from changes in feed costs, to achieve expected profit margins of 68 percent, Cox had to keep costs low and production high. Cox elaborated on his approach and the costs: We use the Hyline Brown breed-commercial layers that will lay 26 to 28 dozen eggs in their lifetime. They're good layers, are hardy, calm, and have good feed conversion. We get them from the hatchery at 95 cents, 35 to 80 thousand chicks at a time. By 24 weeks, when they really start laying, we've got $6.35 invested in cage-free and $10.64 in organic cage-free. Over their life, cage-free hens will cost us about $1.10 a dozen and organic cage-free hens will cost us about $1.70 a dozen. That $1.70 includes the original investment, feed, compliance, transportation and other direct costs, as well as 16 cents longterm debt and overhead. On average, peak hen egg production occurred around week 31 and decreased thereafter. (Table 1 provides an approximation of the production pattern.) Generally Cox considered hens "productive" for 55 weeks beginning with week 24 and ending with week 78, when the hens were "spent." Hens were spent when they were not producing many eggs, but they were still consuming the same amount of food and thus it was no longer financially feasible to keep the hens alive and in production. of hens raised for meat, What we run into is that these are old birds-this is an 80 -week-old bird relative to a 35 - to 50 -day-old meat chicken you're getting from the store. The texture's different, the flavor profile's different, and it's not really something American consumers like. And from a cost standpoint, the yield of meat from a layer hen is minuscule compared to a meat bird, and considering the processing cost in a meat plant, you just can't justify it. At the end of the day you have i product that costs more per pound to create that visually looks worse and that tastes worse, to the American consumer. At the two layer farms in Arkansas (called Summers and Thomas) servicing the organic cage-free eggs contract for CCF Brands, Cox was operating 12 layer houses with about 130,000 hens (see Table 2). The contract specified that CCF Brands would accept the output of up to 150,000 hens at a set price. Cox aimed to produce at least 26.6 dozen eggs per hen over its productive life. If he produced 26.6 dozen, he could operate with a normal profit margin and recover costs. If he produced more, he could achieve greater profit on the remaining eggs produced (having recovered his costs). If he produced less than 26.6 dozen, he could potentially lose money. Without the contract, Cox would have to sell eggs on the open market where brown eggs were trading at around 30 cents per dozen.8 (See Exhibit 1 for additional cost and production information.) EGG INDUSTRY VIARKET DYNAMICS In the United States, the $6.6 billon, mature shell-egg industry was dominated by largescale, vertically-integrated producers of caged eggs. Sixty-four egg producers accounted for approximately 85% of the total production of 83 billion eggs from a domestic stock of about 302 million hens. About 88% of these hens supplied conventional eggs, and 12% produced specialty eggs, and most of the production supplied retailer and foodservice firms' demand.? Even given the current weak market for specialty eggs, Cox felt that it was poised to grow dramatically over the long term: More than 100 large-volume purchasers, including Walmart, McDonald's, Compass Foods, and Unilever, had recently committed to 100 percent cage-free eggs by 2025 . This was projected to affect over 50% of egg production in the United States. The egg market overall was cyclical and depended on multiple factors, including feed costs and the lead time required to bring hens into production. In addition, seasonal demand variation made life tough for producers. Cox described how demand changed over the year. The egg market is one of the most volatile commodity markets there is. Not only are there fluctuations with feed costs but there are significant demand changes over the year. Usually about the time school starts in August, demand hits. You've got cafeterias that are cooking eggs every morning and things like that. And then through the holidays, demand exceeds supply through Thanksgiving and Christmas, all the way to Easter. Then around May 1 st, demand falls until school starts again. However, the September 2016 market oversupply problem was related more to the ripple effects of an avian flu outbrenk that began in the U.S. during December 2014 and continued through the middle of 2015 . This outbreak had devastating effects on egg production; at least 35 million hens were lost by June 2015 from a base of nearly 310 million in January 2015.10 That loss, and the subsequent restocking, had sent prices spiraling upward in 2015, then crashing down again in 2016.11 (See Exhibit 2.) Cox described the dire impact of the situation on smaller producers and his optimism for a market rebound in the fall: through huge cycles, like seven-year cycles, but this is the worst that we've seen. By early spring of this year growers had their farms restocked, and basically the market flooded. A lot of small growers are going out of business. People hang on until they can't anymore. Part of what has me holding on is that historically the market turns around. So if you're looking at this in the summer you think, man, things stink now, but hey, the worse things are now, maybe the more likely they are to come back in the fall. Complicating things for Cox, competition also was heating up because the largest producers in the industry moved into the specialty market in response to the cage-free commitments by the retailers and foodservice firms. These producers operated large, integrated complexes (often with more than a million hens) and took advantage of that scale to lower their costs. Because the cage-free standards (with the exception of organic) did not require access to the outdoors, high-volume producers could easily convert their facilities to achieve this standard. At the same time, as larger conventional producers made this shift, they would either have to cut production or expand facilities. Cage-free hens required at least double the space of conventional hens. How this shift happened would influence the supply of both conventional and specialty eggs. Already, the U.S. cage-free hen inventory had doubled from 6 percent of the total flock in April 2015 to 12 percent in August 2016. in the fourth quarter? Market conditions usually improved in the fall and early winter as schools were in session and as holiday cooking required eggs. If market conditions improved, so would the possibility of contracts. Further, some of the largest food retail and foodservice companies were making commitments for procuring specialty eggs (cage-free). While these commitments were for the years 2020-2025, many large farms producing conventional eggs would need to cut production to meet the cage-free demand (barns that housed 10,000 hens in cages housed less than 5,000 cage-free). As supply of conventional eggs decreased, demand should be restored for Cox's organic eggs as the decreasing price differential drew consumers of organic eggs back. Holding on would mean selling on the spot market through Egg Clearing House Incorporated, where brown eggs were trading at around 30 cents per dozen. White eggs were even cheaper. He wondered if he should depopulate the flock; contractors would kill the hens humanely and dispose of them at the county landfill. That would probably also mean laying off the employees currently working in those houses. What if he got a contract opportunity, but had no chickens to fulfill it? He had to count on 6 months lead time to get back into production. Further, if he did depopulate, he gave up all possibility of recovering his initial investment. While depopulating hen houses was a fact of life for Cox, as a producer concerned with hen welfare, it was never easy to do. Exhibit 1. Arkansas Egg Company Cost and Production Information Arkansas Egg aimed to collect 26.6 dozen eggs from each hen over its productive laying cycle of 55 weeks. If that happened, based on the contract price, then AEC recovered the costs of bringing the bird to its productive cycle (about 40 cents/dozen) as well as fixed overhead (about 16 cents/dozen). The approximate contribution margin during this time was 7%. After the breakeven point, the only costs incurred were the variable production costs. \begin{tabular}{|l|l|} \hline \multicolumn{2}{|l|}{ point, the only costs incurred were the variable production costs. } \\ \hline Approximate life of hen & 78 weeks \\ \hline Pre-productive period of hen life cycle & First 23 weeks of life \\ \hline Productive period or laying cycle & Last 55 weeks of life \\ \hline Average age of laying hens at Summers' barns & 43 weeks \\ \hline Average age of laying hens at Thomas' barns & 48 weeks \\ \hline Minimum production target (PT) over which to allocate costs & 26.6 dozen \\ \hline \end{tabular} \begin{tabular}{|l|l|} \hline Approximate costs based on 26.6 dozen production target \\ \hline Total pre-production cost through week 23 & $0.40 per dozen or $10.64 per bird \\ \hline Fixed overhead cost (facilities, debt service, depopulation, ctc.) & $0.16 per dozen or $4.26 per bird \\ \hline Variable production costs (feed, transportation, labor, etc.) & $1.14 per dozen or $30.32 per bird \\ \hline \multicolumn{1}{|c|}{ Total cost for producing organic cage-free eggs } & $1.70 per dozen or $45.22 per bird \\ \hline Expected profit at 26.6 dozen (7\%) & $0.12 per dozen or $3.17 per bird \\ \hline \\ \hline Note:ArkansasEggCompany,asafamilybusinesswithlessthan$25millioninrevenue,usedcashbasisaccountingforbookandtaxpurposes.Forpurposesofthiscase,assumethatrevenuewasproducedaftereggsarelaid.Fixedandvariableproductioncostswereincurredevenlyacrossthehenproductioncycle. \end{tabular} hen production cycle. Exhibit 2. Trends in the Conventional Egg Market Prepare a contribution margin analysis and determine if he should keep the hens. A shift to sustainable farming practices (with a focus on animal welfare) is dependent on the consumers' willingness to pay more for that item and understand why it costs more. Organic farming has been a breath of life into small farms across the country. It creates an environment where the focus is on doing the right thing, not the cheapest thing. As a result the products cost more to produce and net more income that sustain this method of production. 1 Conventional caged eggs were a commodity and producer prices were sensitive to shifts in supply and demand. But specialty eggs were often grown under contracts that protected producers, and the current oversupply meant that consumer prices of conventional eggs had plummeted, while specialty egg prices remained high. This differential had gotten so large that consumers of specialty eggs were switching back to conventional cggs. Cox could not remember a time when prices for on-shelf conventional caged-eggs had fallen so low that they affected consumer demand for specialty eggs. Cox bemoaned his situation: This is the first time that a bad caged market has affected the specialty market. You go to the grocery store and you see 75-cent white caged eggs, you're going to buy those eggs, not our $5 eggs. White eggs have gotten so cheap that it's pulling our consumer base away.2 Until now, his margins on production had been largely protected by a key contract with CCF Brands, a wholesaler of packaged foods, including organic eggs. But that By 2016 , Cox was servicing these three contmats, as well as selling on the open market, with production from his own farms and from 25 contract growers in Arkansas and Missouri. His contract production in Missouri comprised 320,000 hens producing free-range eggs. His production on his own farms in Arkansas included 38,000 hens producing pasture-raised eggs and 130,000 hen that were producing organic cage-free eggs for the now expiring CCF Brands contract. CCF Brands contracted for the output of a certain number of hens (up to 150,000) at a set price. Although Cox could profit by achieving higher-than-average egg production with efficient feed conversion, he also risked losses if production was below average. While his contracts contained feed escalator clauses that largely protected Cox from changes in feed costs, to achieve expected profit margins of 68 percent, Cox had to keep costs low and production high. Cox elaborated on his approach and the costs: We use the Hyline Brown breed-commercial layers that will lay 26 to 28 dozen eggs in their lifetime. They're good layers, are hardy, calm, and have good feed conversion. We get them from the hatchery at 95 cents, 35 to 80 thousand chicks at a time. By 24 weeks, when they really start laying, we've got $6.35 invested in cage-free and $10.64 in organic cage-free. Over their life, cage-free hens will cost us about $1.10 a dozen and organic cage-free hens will cost us about $1.70 a dozen. That $1.70 includes the original investment, feed, compliance, transportation and other direct costs, as well as 16 cents longterm debt and overhead. On average, peak hen egg production occurred around week 31 and decreased thereafter. (Table 1 provides an approximation of the production pattern.) Generally Cox considered hens "productive" for 55 weeks beginning with week 24 and ending with week 78, when the hens were "spent." Hens were spent when they were not producing many eggs, but they were still consuming the same amount of food and thus it was no longer financially feasible to keep the hens alive and in production. of hens raised for meat, What we run into is that these are old birds-this is an 80 -week-old bird relative to a 35 - to 50 -day-old meat chicken you're getting from the store. The texture's different, the flavor profile's different, and it's not really something American consumers like. And from a cost standpoint, the yield of meat from a layer hen is minuscule compared to a meat bird, and considering the processing cost in a meat plant, you just can't justify it. At the end of the day you have i product that costs more per pound to create that visually looks worse and that tastes worse, to the American consumer. At the two layer farms in Arkansas (called Summers and Thomas) servicing the organic cage-free eggs contract for CCF Brands, Cox was operating 12 layer houses with about 130,000 hens (see Table 2). The contract specified that CCF Brands would accept the output of up to 150,000 hens at a set price. Cox aimed to produce at least 26.6 dozen eggs per hen over its productive life. If he produced 26.6 dozen, he could operate with a normal profit margin and recover costs. If he produced more, he could achieve greater profit on the remaining eggs produced (having recovered his costs). If he produced less than 26.6 dozen, he could potentially lose money. Without the contract, Cox would have to sell eggs on the open market where brown eggs were trading at around 30 cents per dozen.8 (See Exhibit 1 for additional cost and production information.) EGG INDUSTRY VIARKET DYNAMICS In the United States, the $6.6 billon, mature shell-egg industry was dominated by largescale, vertically-integrated producers of caged eggs. Sixty-four egg producers accounted for approximately 85% of the total production of 83 billion eggs from a domestic stock of about 302 million hens. About 88% of these hens supplied conventional eggs, and 12% produced specialty eggs, and most of the production supplied retailer and foodservice firms' demand.? Even given the current weak market for specialty eggs, Cox felt that it was poised to grow dramatically over the long term: More than 100 large-volume purchasers, including Walmart, McDonald's, Compass Foods, and Unilever, had recently committed to 100 percent cage-free eggs by 2025 . This was projected to affect over 50% of egg production in the United States. The egg market overall was cyclical and depended on multiple factors, including feed costs and the lead time required to bring hens into production. In addition, seasonal demand variation made life tough for producers. Cox described how demand changed over the year. The egg market is one of the most volatile commodity markets there is. Not only are there fluctuations with feed costs but there are significant demand changes over the year. Usually about the time school starts in August, demand hits. You've got cafeterias that are cooking eggs every morning and things like that. And then through the holidays, demand exceeds supply through Thanksgiving and Christmas, all the way to Easter. Then around May 1 st, demand falls until school starts again. However, the September 2016 market oversupply problem was related more to the ripple effects of an avian flu outbrenk that began in the U.S. during December 2014 and continued through the middle of 2015 . This outbreak had devastating effects on egg production; at least 35 million hens were lost by June 2015 from a base of nearly 310 million in January 2015.10 That loss, and the subsequent restocking, had sent prices spiraling upward in 2015, then crashing down again in 2016.11 (See Exhibit 2.) Cox described the dire impact of the situation on smaller producers and his optimism for a market rebound in the fall: through huge cycles, like seven-year cycles, but this is the worst that we've seen. By early spring of this year growers had their farms restocked, and basically the market flooded. A lot of small growers are going out of business. People hang on until they can't anymore. Part of what has me holding on is that historically the market turns around. So if you're looking at this in the summer you think, man, things stink now, but hey, the worse things are now, maybe the more likely they are to come back in the fall. Complicating things for Cox, competition also was heating up because the largest producers in the industry moved into the specialty market in response to the cage-free commitments by the retailers and foodservice firms. These producers operated large, integrated complexes (often with more than a million hens) and took advantage of that scale to lower their costs. Because the cage-free standards (with the exception of organic) did not require access to the outdoors, high-volume producers could easily convert their facilities to achieve this standard. At the same time, as larger conventional producers made this shift, they would either have to cut production or expand facilities. Cage-free hens required at least double the space of conventional hens. How this shift happened would influence the supply of both conventional and specialty eggs. Already, the U.S. cage-free hen inventory had doubled from 6 percent of the total flock in April 2015 to 12 percent in August 2016. in the fourth quarter? Market conditions usually improved in the fall and early winter as schools were in session and as holiday cooking required eggs. If market conditions improved, so would the possibility of contracts. Further, some of the largest food retail and foodservice companies were making commitments for procuring specialty eggs (cage-free). While these commitments were for the years 2020-2025, many large farms producing conventional eggs would need to cut production to meet the cage-free demand (barns that housed 10,000 hens in cages housed less than 5,000 cage-free). As supply of conventional eggs decreased, demand should be restored for Cox's organic eggs as the decreasing price differential drew consumers of organic eggs back. Holding on would mean selling on the spot market through Egg Clearing House Incorporated, where brown eggs were trading at around 30 cents per dozen. White eggs were even cheaper. He wondered if he should depopulate the flock; contractors would kill the hens humanely and dispose of them at the county landfill. That would probably also mean laying off the employees currently working in those houses. What if he got a contract opportunity, but had no chickens to fulfill it? He had to count on 6 months lead time to get back into production. Further, if he did depopulate, he gave up all possibility of recovering his initial investment. While depopulating hen houses was a fact of life for Cox, as a producer concerned with hen welfare, it was never easy to do. Exhibit 1. Arkansas Egg Company Cost and Production Information Arkansas Egg aimed to collect 26.6 dozen eggs from each hen over its productive laying cycle of 55 weeks. If that happened, based on the contract price, then AEC recovered the costs of bringing the bird to its productive cycle (about 40 cents/dozen) as well as fixed overhead (about 16 cents/dozen). The approximate contribution margin during this time was 7%. After the breakeven point, the only costs incurred were the variable production costs. \begin{tabular}{|l|l|} \hline \multicolumn{2}{|l|}{ point, the only costs incurred were the variable production costs. } \\ \hline Approximate life of hen & 78 weeks \\ \hline Pre-productive period of hen life cycle & First 23 weeks of life \\ \hline Productive period or laying cycle & Last 55 weeks of life \\ \hline Average age of laying hens at Summers' barns & 43 weeks \\ \hline Average age of laying hens at Thomas' barns & 48 weeks \\ \hline Minimum production target (PT) over which to allocate costs & 26.6 dozen \\ \hline \end{tabular} \begin{tabular}{|l|l|} \hline Approximate costs based on 26.6 dozen production target \\ \hline Total pre-production cost through week 23 & $0.40 per dozen or $10.64 per bird \\ \hline Fixed overhead cost (facilities, debt service, depopulation, ctc.) & $0.16 per dozen or $4.26 per bird \\ \hline Variable production costs (feed, transportation, labor, etc.) & $1.14 per dozen or $30.32 per bird \\ \hline \multicolumn{1}{|c|}{ Total cost for producing organic cage-free eggs } & $1.70 per dozen or $45.22 per bird \\ \hline Expected profit at 26.6 dozen (7\%) & $0.12 per dozen or $3.17 per bird \\ \hline \\ \hline Note:ArkansasEggCompany,asafamilybusinesswithlessthan$25millioninrevenue,usedcashbasisaccountingforbookandtaxpurposes.Forpurposesofthiscase,assumethatrevenuewasproducedaftereggsarelaid.Fixedandvariableproductioncostswereincurredevenlyacrossthehenproductioncycle. \end{tabular} hen production cycle. Exhibit 2. Trends in the Conventional Egg Market