University of Wisconsin Center for Cooperatives
Rural Cooperatives, September/October 1998, pp. 24-25.
Published by the Rural Business and Cooperative Development Service
Dairy Co-ops vs. IOFs: New Measurement approach sheds light on performance
K. Charles Ling and Carolyn Liebrand
Ag Economists, USDA Rural Development
Do cooperatives perform as well as investor-owned firms? The two business types seem to have differing operational goals. The broader cooperative role in serving members leads some to argue that cooperatives in general are not as focused on the bottom line as are investor-owned firms (IOFs). This might lead some to assume, from a financial point of view, that IOFs would perform better. Research by Cooperative Services economists indicates such an assumption is not true.
Return on equity (ROE) is one of the most common measures of profitability used to evaluate a firm's financial performance. However, ROE may not adequately indicate a company's operating efficiency in generating value for its shareholders. ROE assumes equity capital is free. Thus, a firm may show that it is making money for the shareholders or members (a positive ROE), but in reality its operations cannot cover the cost of operating capital and therefore its alternative cost of equity capital. The firm actually loses value by operating.
So, while ROE is a worthwhile benchmark, it doesn't yield an unequivocal answer to the performance question. In the November/December 1996 issue of Rural Cooperatives, a new method for comparing cooperative performance was discussed. This new measure, the "extra-value index," provides dairy farmers with an objective tool to measure the performance of their cooperatives and to compare that performance with other firms.
Extra value is what a firm generates (or loses) for its stakeholders after the total operating cost, including a charge for the use of equity capital, is covered by earnings. The extra-value index (EVI) is created by dividing extra value by operating capital and thus is scale neutral. This way, firms of different sizes and with different types of operations can be compared fairly. (Please refer to RBS Research Report No. 166 for a detailed description of the EVI measure.)
EVI is a particularly meaningful tool for measuring a cooperative's operating efficiency because members typically supply equity capital through retained patronage earnings or capital retains and because stock-market valuation of its business worth is usually nonexistent. The relative performance of a cooperative or IOF, of course, depends upon what cost is assigned to equity capital. EVI does not favor using debt capital over equity capital, or vice versa, unless there is a difference between the cost of debt financing and equity financing.
To sum it up, ROE and EVI have different emphasis. ROE highlights the relationship of a firm's net earnings to the equity it employs, while EVI measures the efficiency of a firm's operation in adding value to the firm for the stakeholders or cooperative member-producers.
Who was compared?
There were 25 dairy cooperatives that were consistently on USDA's Cooperative Services' list of the nation's 100 largest agricultural cooperatives every year between 1986 and 1996. The performance of these dairy cooperatives, as measured by both ROE and EVI, were compared with IOFs for 3 years, 1994-1996.
Dairy Field magazine annually lists the top 100 dairy processing companies. IOFs from this list that also filed financial data with the U.S. Securities and Exchange Commission (SEC) for 1994 through 1996 were analyzed. Complete data for 12 IOFs were available from this source for 1994 and 15 were available for 1995 and 1996.
The 15 IOFs were primarily in the dairy business, although many were also involved in other enterprises. Seven of the companies processed and marketed fresh milk products and/or ice cream, three processed fresh milk products and nondairy products, two manufactured cheese and three were supermarket chains that manufactured and processed milk products.
Return on equity vs. extra-value index
The performances of dairy cooperatives and dairy IOFs are compared in Table 1, by ranking them together according to ROE and EVI (at selected costs of equity capital) for 1994-1996. Depending on a company's particular situation, the measures result in a different performance ranking when comparing the companies because the two measures have different emphasis.
But in other cases, the ranking converges. The relative performance of the companies also depends upon what cost is assigned to equity capital for the extra-value calculation and year-to-year differences in the companies' operations.
For instance, cooperative No.16 ranked second or third by each measure (ROE and EVI at 3 levels of assumed cost for equity) in 1996. Similarly, IOF No. F9 ranked first or second by the measures shown. However, differences in ranking between ROE and EVI are generally greater, as exemplified by cooperative No. 6 and IOF No. F6.
Cooperative No.6 ranked fourth according to ROE, but ninth according to EVI at an equity charge of 0 percent in 1996. And in 1995, cooperative No. 6 ranked sixth based on ROE, but eleventh, tenth and eighth based on EVI at interest charges of 0, 10, and 25 percent. IOF firm No. F6's ranking differed more dramatically between ROE (sixth) and EVI (twentyninth, when there was no charge for equity capital) in 1996.
Furthermore, while cooperative No.16 was the highest ranking cooperative by all measures in 1996, in 1995 it ranked fifth based on ROE and on EVI when equity cost 25 percent. It dropped to ninth place when EVI assumed equity was cost-free and seventh by EVI if equity cost 10 percent.
Perhaps the more marked difference between 1995 and 1996 in the relative ranking of cooperative No. 16 by EVI at the different interest charges reflects a change in its mix of equity capital versus debt capital in financing its operations. Thus, cooperatives No. 16 and No. 6 had the highest ROE of all the cooperatives in 1995, but were not necessarily the most efficient users of operating capital as reflected by their EVIs.
Dairy cooperatives vs. IOFs
While an IOF (F10 or F9 in 1996, F9 in 1995, and F8 in 1994) ranked first by all measures for the 3-year period, the top rankings were not dominated by dairy IOFs. In 1994, except for the number one position, dairy cooperatives filled all of the top seven places by either ROE or EVI.
Table 2 shows the composition of the ten highest ranking companies by firm type. The number of cooperatives in the top 10 rankings by all measures in 1995 and 1996 was 6, making up 60 percent of the top 10 firms. Of the 40 firms in the comparison, 25 were cooperatives (63 percent). Thus, in terms of profitability (ROE) or extra value created (EVI), cooperatives performed as well as IOF dairy companies.
Because ROE measures the return shareholders' or members' equity earns by being employed by the company, and EVI measures the earning ability beyond covering all operating cost—including the cost of equity—a company could show positive returns to equity but actually be losing value as a going concern. Thus, in terms of ROE, most cooperatives and IOFs had positive earnings and few lost money.
But, many companies' operations— both cooperative and investor owned— could not cover their imputed cost of equity capital and lost value as a business concern (as indicated by a negative EVI). Not unexpectedly, the number of companies with a negative EVI increased as the imputed cost of equity increased.
Very significantly, however, over the 3year period 1994-1996,11 to 13 companies (7 of which were cooperatives) each year were able to generate value while "paying" a charge of 25 percent on the equity capital employed (Table 1).
Table 3 shows the percentages of cooperatives and IOFs that had negative ROE or EVI. A smaller proportion of the cooperatives had negative ROE each year than did the IOFs. (In fact, in 1996, none of the 25 dairy cooperatives incurred losses in terms of ROE.) And, when a cost for equity capital was not charged, fewer cooperatives than IOFs lost value by operating When equity was assumed to cost 10 or 25 percent, a higher proportion of cooperatives lost value than did IOFs (except for in 1994 when about equal proportions showed negative EVI at equity cost of 10 percent).
In summary, the performance of dairy companies examined in this study showed cooperatives to be competitive with IOFs. While an IOF took top billing all three of the years looked at, by all measures, an IOF also held the bottom position all three years (except when EVI is measured at 25 percent in 1996 and 1994). The EVI performance measure indicated that dairy cooperatives did just as well in creating value for their members as did dairy IOFs for their shareholders. This is significant because detractors perceive cooperatives as being unable to generate earnings for member-producers.
The EVI measure can be a tool for measuring and gruding a cooperative's operating performance. Cooperatives may wish to calculate their extra value figure by following the formula presented in USDA/PBS Research Report 166. In doing so, the cooperative must decide what is the opportunity cost of the equity members have invested in their cooperative (i.e., the interest rate that should be charged on equity capital).
If a cooperative's extra value is negative, members will have to ask whether the negative extra value is caused by inefficient operations, or by other factors (assuming their valuation of the opportunity cost of equity capital is correct).
Ling, K Charles and Carolyn Liebrand, A New Approach to Measurirzg Dairy Cooperative Performance. USDA, Rural Business-Cooperative Service, Research Report 166, September 1998. This report illustrates the use of extra-value index in comparing operational performance among dairy cooperatives and dairy companies. The concept and the method are equally applicable to other commodities and businesses. To order this report, call (202) 7208381.
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