Follow Proper Procedures on Tank Clean Outs of Pesticide, Spill of Fertilizer and Clean Rotten Grain

Recently, I was contacted by the Consumer Protection division within the Department of Agriculture primarily because they are seeing several violations of pesticide clean out, fertilizer spills and boot pit clean outs. It is imperative that WE follow the label and dispose of pesticides, boot pit water and rotten grain and clean fertilizer spills up properly. They told me that it appears that some places have cleaned out tanks on top of or near area city water supplies. They have seen increasingly more piles of rotten grain and water being directly pumped out of a boot pit as well as an increasing number of piles of fertilizer that either clumped or was the very end of a load. I do believe they have your best interest in mind to contact us and lets us try to help them resolve it before they have to issue significant fines or EPA getting involved. 

They told me a story that in Oklahoma there was a clean out issue with a non-coop facility. EPA was involved in this case and they were issued a fine for the facility as well as the operators and manager getting charged criminally. The company was able to pay a much higher fine to keep the employees from being prosecuted. Please help ODA, our communities, and our industry by following the proper procedures. For example, on pesticide – follow the label and let it be your guide – it is the law. On grain clean out, dispose of the rotten grain and water appropriately, whether it be spreading it on an agreeable land owner or working out a deal with the landowner or local city for access to the sewer system. For fertilizer, apply the excess on a willing landowner if you must. 

Please contact the Oklahoma Department of Agriculture or your appropriate safety and compliance person for specifics.

Identifying Your Cooperative's Core Competencies

Phil Kenkel
Bill Fitzwater Cooperative Chair

A common aspect of the strategic planning process is to identify the core competencies of the organization.  When a cooperative, or other organization, is forced to downsize they are also advised to concentrate on their core competencies.  That raised the question of what constitutes a core competency.

C.K Prahalad and G. Hamel introduced the concept of core competencies in a 2014 Harvard Business Review article “The Core Competence of the Corporation.  According to the authors a core competency had three characteristics:  (1) Provides potential access to a wide variety of markets, (2) Should make a significant contribution to the perceived customer benefits of the end product and (3) Difficult to imitate by competitors.  Core competencies have also been described as “a specialized knowledge, technique or skill” and “collective learning across the organization”.  Regardless of the definition, experts agree that organizations need both tangible resources like property, plant and equipment and intangible resources like core competencies in order to be successful.

While identifying a core competency is complex, it is much easier to identify what is not a core competency.  Any product, skill or service that most firms can easily do is not a core competency.  Likewise, delivering the level of service or expertise that is expected does not create a core competency.  A service or activity that can easily be outsourced is not a core competency.  Similarly, any product or service with many close substitutes cannot be part of a core competency.

It is easiest to identify core competencies involving technical skills.  A tool and die company with the ability to machine to extremely high tolerances obviously has a core competency as would a company that can cut and weld thin wall aluminum pipe.  Some have suggested that Apple has a core competency in creating complex software that is easy to use while other view LL Bean as having a core competency in customer service.  When specialized knowledge relates to innovation, customer service or marketing it becomes difficult to ensure that it a competency that cannot be duplicated by a competitor.

In the context of a grain and farm supply cooperative defining, a core competency comes down to determining whether a knowledge base, skill set, product, or service creates a long-run competitive advantage.  In other words, does this activity impact member’s decision to patronize the cooperative.  For some cooperatives, fertilizer application might be a core competency.  For other firms it could be an important service or profit center but one that could be potentially outsourced.  To make the grade as a core competency the cooperative would have to be able to consistently provide superior accuracy and timeliness. 

At your next board meeting go around the room and describe your cooperative’s core competencies.  The discussion may help you as you manage human resources, assets and capital.

Cooperatives and Chopsticks

Phil Kenkel
Bill Fitzwater Cooperative Chair

I recently had the opportunity of presenting at an international cooperative education conference in Qingdao China.  In addition to representatives from China’s rapidly developing cooperative sectors there were presenters from Taiwan, Japan, Israel and Great Britain.  Just as using chopsticks gives you a new perspective on a formal dinner, it is always fascinating to see the various approaches to cooperative education around the globe. 

 The first thing that struck me when talking to cooperative leaders from other nations is how the cooperative business model over-arches nations and agricultural industries.  While the flavors differ, cooperatives provide the same unique benefits and have the same unique features problem around the world.  One of those unique features is the underlying cooperative principles.  No other business form that I know of has a foundation of independent and internationally accepted principles.  One of those principles is of course, “the duty to educate”.

 In my opinion, the duty to educate comes from the unique structures of the business model.  Members have roles as customers but are also involved in governance and build ownership.  Directors face the conflicting challenges of distributing benefits to members while protecting the cooperative.  Managers and employees faces multiple goals of efficiency, profitability and service.

My other observation was that Asia, and perhaps other countries, place more emphasis on cooperative principles in their educational efforts.  In the U.S, we tend to worry whether our agricultural cooperatives are successful agribusinesses.  In Asia, the concern is whether their cooperative agribusinesses are operating as successful cooperatives.  Their educational programs focus on the ICA cooperative principles while industry educational programs in the U.S. tend to be more pragmatic, mixing in operational and technical training.  Just like knives, forks and chopsticks, we may just have different approaches to the same problem.

One aspect of the “Duty to Educate” appears to be a universal challenge.  Cooperatives everywhere struggle to educate members and the public about the about the visible and invisible benefits that cooperatives are providing.  We can never lose sight of the need to develop the next generation of cooperative members.

Just as using chopsticks makes one appreciate silverware, seeing other cooperative industries makes one appreciate the success of U.S. cooperatives.  I am sure that we could learn from cooperatives in other countries but I never appreciated the extent to which other countries look to the U.S. as a model of cooperative success!  In any case, our cooperative family is bigger than we may realize!

While we are waiting for world peace maybe we should visualize building cooperatives!

The Cooperative's Role in Pooling Tax Deductions

Phil Kenkel
Bill Fitzwater Cooperative Chair

In my last newsletter article I discussed the revised Section 199A deduction.  As you may recall Section 199A now creates a deduction at the cooperative level which can be retained or passed on to the producer.  Producers marketing to a cooperative potentially face a reduction in a farm level deduction.  My analysis based on “typical” grain cooperatives and grain producers indicated the cooperative needed to pass on 75% of their Section 199A deduction to hold the member harmless, not considering patronage or 40% if patronage is factored in.  That conclusion is highly dependent on the level of the producer’s W-2 wages.

On a more general level, Section 199A is institutionalizing the structure of pooling producer’s tax deductions at the cooperative level.  That structure really began with the previous Section 199 (Domestic Production Activities Deduction) which began in 2005.  Marketing cooperatives were able to use DPAD because they were assumed to be collectively producing (manufacturing) their member’s commodities.  The structure of the revised Section 199A brings this concept of tax deduction pooling into sharper focus.  Cooperative producers will see the balancing act between any possible loss of farm level deduction and possible pass through of the deduction calculated at the cooperative level.

The cooperative business model is formulated around the concept of pooling.  Members of a marketing cooperative decide to collectively handle, store and market their commodities.  The cooperative business model has also long recognized the need to balance the need for resources at the cooperative level and the member’s need for returns.  The balance of cash and retained patronage reflects those competing needs.  Cooperative boards, and one would hope, cooperative members, understand the need to keep a portion of the profits in the cooperative.  Those retained profits are funding the cooperative’s ability to collectively handle and market the member’s commodities.  There is no one size fits all answer for the balance of cash and retained patronage.

Board members and CEOs of marketing cooperatives now have the additional challenge of balancing the retention of distribution of the Section 199A deduction.  Many have been doing this for some time, but that aspect of the cooperative’s role in pooling tax deductions has flown beneath the radar for many producers.  Just like patronage, there will be no one size fits all solution.  Passing on more deduction benefits producers in the short run (assuming they have taxable income) while retaining a greater share of the deduction allows the cooperative to invest to benefit the members later.  A familiar balancing act but perhaps a new communication challenge.

I’ll expand on this issue in my next newsletter.  If you would like a copy of my latest fact sheet “Impact of Section 199A on Grain Producers” drop me an email at [email protected]

A Realistic Look at the Revised Section 199A

Phil Kenkel
Bill Fitzwater Cooperative Chair

The 2017 Tax Cuts and Jobs Act created a number of changes impacting farmers and agribusinesses.  The top tax rate for corporations was reduced from 35% to 21%.  In recognition of the fact that the corporate tax rate change provided limited gains for entities with pass through taxation, a new deduction was added. Section 199A provided tax benefits for pass through entities including agricultural cooperatives. The original Section 199A language in the TCJA became controversial because it raised the possibility that a producer who marketed commodities through a cooperative might receive greater tax benefits relative to one who sold to an investor owned corporation.  Due to that issue, which was often described as “The Grain Glitch” a revision to the Section 199A Deduction was included in the March 23, 2018 omnibus spending bill.

 Under the revised Section 199A agricultural producers operating in any structure other than a C corporation receive a 20% deduction on their income from commodity sales subject to taxable income limits.  Producers who market commodities through a cooperative face both a possible reduction in their 20% deduction and a possible pass through deduction distribution from the cooperative.  The advantage or disadvantage of marketing commodities through a cooperative depends on the balance of those effects.  Because of the complexity of the Section 199A calculations it is possible to come up scenarios involving both large advantages and large disadvantages for marketing commodities through a cooperative.

A more realistic comparison can be made by using the best information on a “representative cooperative” and “representative producer”.  The most recent (2016) USDA Agricultural Cooperative Statistics can be used to determine the sales, margin, labor expense, local savings and potential Section 199A pass through for the “average” grain marketing cooperative.  The most recent (2013) Economic Research Service report on wheat production costs can be used to determine the total revenue, W-2 wage expense, and yield of an “average” wheat farm in the Southern Plains.  That data makes it possible to make all the necessary calculations for the Section 199A deduction and patronage at the cooperative level and the possible tax deduction offset at the producer level. The effects can be summarized on a “per bushel” basis which provides a very simple and understandable comparison.

The “average” wheat cooperative has a labor expense of just under $.15/bushel which means that the 50% of W-2 wages is the binding constraint on their Section 199A deduction.  The cooperative would generate a $.073/bushel total Section 199A deduction which could be retained at the cooperative level or passed on to the producer.  The cooperative would also generate $.072/bushel of patronage which would translate to $.036/bushel cash patronage assuming a 50% cash/qualified stock distribution. The “average” producer’s reduction in their 20% deduction is also limited by their W-2 wage level and is $.061/bushel.

The cooperative needs to distribute 75% of their Section 199A deduction to offset the producer’s reduction. In that case the cooperative delivering producer is equivalent with the independent delivering producer before patronage and $.036/bushel better off if cash patronage is considered. The cooperative would only need to distribute 40% of its Section 199A deduction to keep the cooperative delivering producer and independent delivering producer equivalent if the cash patronage is factored in.  The worst case scenario for the cooperative delivering producer is 0% Section 199A distributed and 0% patronage which results in a disadvantage of $.061/bushel and the best case scenario for the cooperative delivering producer is 100% Section 199A and 50% cash patronage which results in an advantage of $.05/bushel.

Historically producers have not known the eventual patronage distribution at the time that they make the decision to deliver grain to a cooperative elevator.  Those patronage benefits are part of being an owner in the cooperative and ownership benefits are always dependent on profitability.  The tax reform process created another distribution, the Section 199A pass through, which also cannot be determined at the time that grain is delivered.  These results suggest that the tax difference between delivering to a cooperative or independent elevator is likely to be relatively small.  Cooperative boards of directors are likely to make decisions on Section 199A pass through such that most cooperative members will be equivalent or better off by continuing to patronize the cooperative.  Producers should consider the entire value package as they make decisions on where to market commodities.  It does not appear that the Section 199A tax effect should be a major factor in that decision.

The Sustainable Growth Rate of a Cooperative Firm

Phil Kenkel
Bill Fitzwater Cooperative Chair

In many strategic planning sessions the board and CEO develop a vision of what the cooperative will look like ten years in the future.  That vision invariably brings up a conversation about growing the cooperative. While there are cooperatives that remain small and stay successful most cooperative organizations have a desire to grow.  As producers grow their operations there is a need for the cooperative to grow in order to remain relevant.  All of the agribusiness input industries are becoming more concentrated which requires cooperatives to have a larger scale in order to compete.  Cooperative boards also want their cooperative to be of a size and scale that they can compete for talent at both the CEO and mid-level management positions.  A vision for growth of a cooperative leads to the next question.  Is the desired growth achievable?

The sustainable growth rate for a cooperative, or any other business, is the maximum growth rate a business can achieve while maintaining its financial leverage (debt/equity ratio) at the desired level.  Another way to look at the sustainable growth rate is the maximum growth that can be achieved given the cooperatives sales volume, profitability, asset utilization, member payments and debt ratios.  One formula for the sustainable growth rate is that growth is equal to the return on equity times the retention ratio.  The retention ratio is simply the percentage of profits that are not being distributed to members through cash patronage and equity retirement payments. 

For example if a cooperative has equity retirement payments averaging $80,000/year and profit before patronage averaging $8.00,000, then equity retirement represents 10% of profits before patronage.  If that cooperative paid 50% cash patronage then  total member payments are 60% of profits (10% of profits go to equity retirement and 50% go to cash patronage).  The cooperative’s retention ratio is 40%. 

That 40% of the profits which are retained in the cooperative determine the rate at which the cooperative can grow.  If the cooperative has an average return on equity of 15% it can growth at 40% of that rate implying a sustainable growth rate of 6%.  If the cooperative was able to avoid drought and other challenges and maintain a constant 6% growth rate it would be roughly a third larger at the end of five years.  Growing any more rapidly than that would require increasing the debt to asset ratio and thus the risk level of the firm.

This first stab at the sustainable growth rate provides the initial answer to the question as to whether the desired or envisioned growth of the cooperative is achievable.  The sustainable growth rate concept also allows the board and CEO to dig deeper into the possible future of their cooperative.  All of the components of the sustainable growth ratio, the return on equity, the desired amount of leverage and cash patronage and equity redemption payouts are determined directly, or indirectly by decisions of the board and management.

I’ll dig deeper into how cooperative leaders can change their sustainable growth rate in my next newsletter.

Can Cooperatives Seize the Moment?

Phil Kenkel
Bill Fitzwater Cooperative Chair

The Tax Reform and Jobs Act of 2017 (tax reform) created the Section 199A deduction for cooperatives and their members.  You don’t need me to tell you that a least on provision of Section 199A is controversial.  The tax reform process has greatly raised the profile of the cooperative business model.  Agricultural cooperatives were one of the few sectors that received a special provision in the tax reform act.  There has been debate as to whether the provisions, as originally passed, will give cooperatives an unfair advantage.  Popular press articles have suggested that investor owned businesses will convert to cooperatives and producers will form new cooperatives.

As they say in Hollywood, any publicity can be good publicity.  The challenge for cooperatives is to seize the moment and tell the cooperative story.  There are many great talking points.  Agricultural cooperatives distribute their profits to their producer members rather than to investor members.  We need to point out that essential difference when people suggest that investor owned firms will re-organize as cooperatives.  The difference between cooperatives and investor owned corporations is not some incorporation technicality; it is the essence of the objective of the firm.  Now is our time to promote and communicate the principle of “user benefit”.

Producers, and perhaps the rest of us, are always looking for a tax angle.  Farmers always have an eye on taxes when they consider the timing of input purchases or commodity payments.  Perhaps that mindset contributes to predictions that producers will form new cooperatives to align with tax provisions. The opportunity for the cooperative industry is to shift the conversation from the mechanics of tax legislation (which may or may not change after legislative clarification and rule writing) to the basic economic rationale for agricultural cooperatives.  Cooperatives allow members to achieve economies of scale and reduce costs.  Cooperatives expand the producer’s access to the market place.  Cooperatives also help producers share and manage risk. It would be great to have a new wave of cooperative start ups. The more important point is that it would be great to have more producers consider the benefits of patronizing a user owned business regardless of whether it’s one they started or one they have been driving by all these years. 

I had a cooperative manger tell me that he never criticized a competitor.  He felt that he had so little time in front of the producer that he didn’t want to waste it by mentioning another firm.  That is good advice as we try to seize the moment in communicating the cooperative advantage. We should concentrate on promoting our business model and leave any comparisons up to the producer.

It’s a great time to be a cooperative member!  Let’s seize the moment and tell our story!   

An Update on the Impact of Tax Reform on Agricultural Cooperatives

Phil Kenkel
Bill Fitzwater Cooperative Chair

Economics has been termed “the dismal science.”  It therefore goes against my training to write anything positive.  That makes it a struggle to describe the impact of tax reform on agricultural cooperatives, because it is basically all good!  The outcome is a tribute both to our state and national cooperative councils and the apparent positive reputation of agricultural cooperatives among legislators. 

The Tax Reform and Jobs Act of 2017 had several provisions that impacted agricultural cooperatives.  First, it reduced the corporate income tax from 35% to 21%.  That reduces the cooperatives tax on non-member profits.  It also means that a cooperative does not have to reduce the cash patronage rate as much, if it wished to issue non-qualified stock while maintaining its cash flow.  Tax reform also gives members a 20% deduction on qualified (cash and qualified stock) distributions.  Finally while the Domestic Production Activities Deduction (DPAD or Section 199) was repealed a new Section 199A was created.

Section 199A provides two potential tax credits, one for cooperative member, and one for the cooperative which are determined separately.  The cooperative credit cannot be passed through to the member.  Unlike the previous treatment under DPAD, Section 199A appears to apply to both marketing and farm supply cooperatives and can offset potential taxes on both member and non-member based profits.

What does this mean for cooperative members?  Consider Cooperative A, a cooperative that did not use DPAD and retained patronage as qualified stock. They can continue to issue cash and qualified equity while increasing the cash patronage rate slightly because of lower non-member based taxes.  They can further increase member return by retaining profits as non-qualified equity.  There members are potentially better off under tax reform.

Cooperative B previously used DPAD to eliminate the taxation from member profits.  The can use the new Section 199A and increase member return.  The member benefit comes indirectly from the reduced corporate tax rate and directly from the 20% deduction on their cash patronage. Again the best choice for the member is to retain funds as non-qualified equity but the members benefit regardless of the profit distribution choice. Again, their members are better off under tax reform.

Finally Cooperative C, did not use DPAD but now chooses to take the Section 199A at the cooperative level.  Their members of are much better off, particularly if their cooperative distributes profits in a combination of cash and non-qualified stock.

All of those positive conclusions come without even considering the member’s potential benefit from the Section 199A deduction at the member level.  That farm level benefit only accrues to producers patronizing a cooperative so there has never been a better time to be a cooperative member!

More details of the impact of Tax Reform on agricultural cooperatives are available in a newly revised fact sheet which describes the research from my financial simulator. You can access the fact sheet on the OACC website or email me at [email protected]/edu.  If your board would like a presentation on tax reform and profit distribution alternatives, give me a shout.  Note that you always consult a tax professional on the implications for your specific situation.

 I am continuing to analyze this issue and if I can find any dismal aspects, I promise to highlight them in future newsletters!

Tax Reform and the Cooperative Balance Sheet

Phil Kenkel
Bill Fitzwater Cooperative Chair

As I discussed in my last newsletter, tax reform eliminated the Section 199 deduction, changed the corporate tax rate and created new deductions for both the cooperative and the member. These changes have implications for profit distribution choices which in turn impact the cooperative balance sheet.  Simulation modeling which held the cooperative’s cash flow constant across choices found that member return was highest when profits were retained as nonqualified stock, followed by unallocated retained earnings and qualified stock. Tax return has reduced the differences between the effective tax rate of the cooperative and the member which results in less difference in member return across profit distribution choices. The choices do have drastically different impacts on the cooperative’s balance sheet.  A cooperative starting with 45% allocated equity would have less than 5% allocated equity in 10 years if it retained profits as unallocated equity.  Retaining profits as nonqualified stock would increase the allocated percentage to 75% while qualified stock retention would result in 68% allocated equity. Clearly, one of the most important considerations for profit distribution under tax reform is the board’s goals for the portion of allocated equity on the balance sheet.

Unallocated retained earnings, also called unallocated equity, are an interesting part of the cooperative business model.  In an investor owned firms retained earnings is really just an accounting measure.  The value of the firm is based on the stock price and the categories of stock and retained earnings have no impact on the stockholders return from investing in the firm. In the cooperative firm stock is issued to members are revolving equity and is held at face value. Unallocated retained earnings are never redeemed and individual members never receives the profits which are retained as unallocated retained earnings.  While the member is active they have a collective claim on the unallocated retained earnings.  However, once the member stop using the cooperative their claim on the unallocated retained earnings disappears.  While some unallocated equity is necessary for a cushion fund, unallocated equity violates the cooperative principles of “profits distributes as patronage” and “ownership by users”.  At extreme levels, unallocated retained earnings provide the members and incentive to liquidate the cooperative.  Tax reform provides a good opportunity to revisit our profit allocation choices.  Maybe that would make a good new year’s resolution!

More information the impact of tax reform on agricultural cooperatives is available in a new fact sheet which Dr, Brian Briggeman, KSU Arthur  Capper Cooperative Center Director, and I have just published.  Drop me an email at [email protected],edu if you would like a copy.