Making Money by Making Wine: West Coast and Eastern Comparisons V&WM 2: by Carl R. Dillon, Justin R. Morris and Carter Price

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1 Making Money by Making Wine: West Coast and Eastern Comparisons V&WM 2: by Carl R. Dillon, Justin R. Morris and Carter Price A considerable amount of worthwhile research has been conducted regarding vineyard management and the production of quality wine, but it can be argued that not enough analysis has been done on the economics of wineries. This is unfortunate because the success of the winery business depends on generating ample profits. In an attempt to help in the survival of wineries and to partially fill this void in the literature, research has been conducted at the University of Arkansas using computerized economic decision-making models to provide insight into business operations of the winemaking industry. While the insight and guidelines provided by such analysis can prove extremely helpful in comparative benchmarks and stimulating conscientious decision making, results are naturally dependent on the specifics in the situation in which the model is cast. Consequently, the particular circumstances of an individual existing winery need to be carefully considered because comparisons to the results provided by the specifics within this study may not apply. In attempting to help winery managers with their business operation decisions, this analysis focuses on the differences between conditions of Eastern wineries versus those that apply to the West Coast wine industry. For this study, "Eastern" is meant to identify the viticultural appellations of origin east of the Rocky Mountains. Additionally, the focus is upon four winery sizes in both regions, defined by annual fermenting capacity: 40,000 gal. (16,822 cases); 20,000 gal. (8,411 cases); 10,000 gal. (4,206 cases); 5,000 gal. (2,103 cases). Below is a description of the economic model and data used, followed by an analysis and results. At the end, general conclusions are offered for the reader's examination and consideration. The Economic Model The purpose of the economic decision-making model is to represent the economic and technological winemaking environments under which a West Coast or Eastern manager and operator of a small premium quality winery operates. Discussion of the method of modeling and data utilized assists in comprehending the procedures used, and it provides useful information for comparison to individual circumstances. Mathematical programming techniques are utilized to develop a computer model which can estimate what set of production and marketing decisions will lead to the greatest long run profit for a given set of circumstances. The objective of the economic model was to maximize profits. For the purposes of this study, the economic value of all expenses with the exception of inventory and income taxes are subtracted to calculate net returns. Therefore, the net returns which are maximized within the model already reflect, in addition to other expenses, a payment to capital (in the form of interest or personal return on investment) and a salary to all labor and management of the winery operation, even if the owner is also an operator. Table 1. Retail Wine Prices per 750 ml Bottle by Varietal for the West Coast and Eastern Wineries Varietal East West Coast Dollars ($) Chardonnay Sauvignon B1anc NA Vignoles 7.50 NA Vidal & Seyval 5.50 NA Riesling Cabernet Merlot NA Red/Red Blend 7.25 NA Note: Wine prices were determined from a survey of Eastern and Western winery managers. Wholesale prices are 50% of retail prices. Red/Red Blend refers to local red wines which may be varieties such as Baco Noir, Chambourcin, Chancellor, Cynthiana, DeChaunac, Foch, and others. NA refers to generally not applicable although isolated exceptions occur (e.g. Long Island does have some Merlot production). Since the economic model has already calculated payment to the owner plus a return on personal investment, any remaining positively valued net returns can be considered as profit. The economic model also represents a long run plan, one which the winery owner can work towards. In other words, the production and marketing decisions provided within the model solution reflect a plan which would be fully implemented only after about six years of operation. Profits and costs of operation also reflect those of a winery that is fully

2 established and has been operating for at least six years. Discussion of the cashflow intensity of the earlier years of establishment will be discussed briefly in the results section later in this article, but without numerical presentation. The model incorporates estimates of factors that must be considered in making many key production and marketing decisions and also winemaking activities inherent to the operation of a winery. For example, embodied within the model are coefficients that simulate activities bearing upon the decision of how much of each wine varietal to produce and sell, how to exploit retail and wholesale markets, what type of winemaking equipment to investment in, and related decisions. The total amount of profits possible are restricted within the model by several technical requirements as well as marketing limitations. The production of quality wine naturally requires the timely presence and availability of sufficient equipment capacity, trained labor, and appropriate winemaking supplies. Also, several technical processing and time regulated stages must be properly performed before the wine can be sold. In addition to these and other technical winemaking constraints, estimates have been made to incorporate the realities of the economic environment within the model. These economic components combine to reflect the demand for the individual winery's products. A naturally important key factor in this demand for wine is the price of the product. The wine prices per 750 ml bottle for both West Coast and Eastern wineries are presented in Table 1. Note that not all varietals of wine are sold in both regions and that some simplifying assumptions were made (e.g. isolated production of some varietals were not considered). Wholesale prices were determined by discounting retail prices by 50%. Wine prices were estimated as being generally higher in the West Coast sales areas than in Eastern areas. Another important consideration in the demand for wine is the timing of sales. Table 2, which presents the estimated scheduling of wine sales by varietal and year, reflects the generally longer aging requirement of red wines. All prices are discounted using net present value techniques. The sales and revenue schedules reflect the costs of time in storage and foregone investment interest charged to inventory. From a retailing standpoint, the importance of a winery location is imperative to the profitability of an individual winery. The model estimated an "average-to-good" location by its restriction of the maximum and minimum percentages of individual wine varietals sold. The maximum and minimum limitations on sales percentages per representative variety, as outlined in Table 3, are included within the models. Furthermore, as more wine is produced, the need to utilize wholesale markets becomes more necessary. To introduce this reality into the model, maximum retail sales percentages were included, corresponding to increasing winery size inversely (Table 4). West Coast winemakers were estimated to be enjoying higher wine prices, but the capital requirements they face are also more substantial (Table 5). Despite reductions in the amount of investment capital resulting from the use of custom bottling for the smaller two winery sizes in the West Coast region, the reliance upon a greater percentage of French oak barrels and higher building and land costs results in total equipment and building capital costs that are generally twice what an equivalently sized Eastern winery would face. Table 2. Sales Schedule of Wine Production by Varietal and Year Years where Year 1 is Production Varietal Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Chardonnay NA* Sauvignon Blanc NA* NA* Vignoles NA* NA* Vidal & Seyval NA* NA* Riesling NA* NA* Cabernet Merlot NA* Red/Red Blend *NA means not applicable. In this model, wines are sold on either a four, five or six year cycle. Sales begin in either the second, third or fourth season after the grapes are produced, harvested, crushed, and the winemaking process is initiated. The West Coast wineries also must contend with paying generally higher prices to purchase grapes (Table 6). Notable differences between processing costs of the West Coast and Eastern Regions include the custom bottling common to smaller West Coast wineries and the more favorable state tax structure for wineries of the West Coast relative in general to that of eastern wineries (Table 7). The modeled estimates of the remaining nonlabor miscellaneous costs involved in winemaking are presented in Table 8. As shown, insurance, taxes, advertising, repairs and maintenance, laboratory and office supplies, accounting expenses, depreciation, and similar expenses are appropriately reflected. Based on opinion, it was assumed that the eastern wineries would possess a more favorable expenses structure for accounting activities, laboratory expenses, advertising expenses, and office supplies.

3 Table 3. Maximum and Minimum Sales of Varietals as a Percentage of Total Sales Volume in Gallons Eastern West Coast Varietal Maximum Minimum Maximum Minimum Chardonnay Sauvignon Blanc N/A N/A Vignoles N/A N/A Vidal & Seyval N/A N/A Riesling Cabernet Merlot N/A N/A Red/Red Blend N/A N/A Note: Marketing percentages were determined from a survey of winery managers. Different marketing conditions will prevail dependent on individual circumstances. Table 4. Maximum Wine Retail Percentages by Winery Size Maximum Winery Size Retail (Gallons) (% of Total Volume) 40, , ,

4 Table 6. Purchase Price for Grapes by Varietal East West Coast Purchase Purchase Price Price Varietal ($/Ton) ($/Ton) Chardonnay Sauvignon Blanc NA 649 Vignoles 500 NA Vidal-Seyval 400 NA Riesling Cabernet Merlot NA 1205 Cynthiana 650 NA Chambourcin 400 NA Other items of interest in the model are labor requirements and costs for the different regions and winery sizes. It was assumed that the labor required would be the same for equivalent winery sizes whether in the Eastern or West Coast Regions (Table 9). In addition, it should be noted that the model recognized the reality that different activities will at times be performed by all individuals within a winery. For instance, a winemaker or cellar worker will sometimes likely perform a retailing (sales room) function, especially at the 5,000 gallon winery. However, for purposes of simplicity and salary assignment, the tables reflect only the primary focus of an individual's job assignment. The higher costs of living of the West Coast are reflected in higher labor costs as depicted in Table 9. Regardless, total employee salaries modeled reflect a payment to owner/operators and personal labor and management as discussed previously. Study Results The estimated economic profitability of wineries in both regions is presented in Table 10. Wineries located on the West Coast demonstrated higher net returns than did comparable sized eastern wineries. In both regions, net returns increased with greater annual fermenting capacity, demonstrating economies of size. Profits for the eastern wineries range from $1,778 for the 5,000 gallon winery to $30,031 for the 40,000 gallon winery. West Coast winery profits range from $3,114 for the 5,000 gallon winery up to $81,460 annually for the 40,000 gallon winery. In this model, differences in tax structures ex plain most of the discrepancies in profits. For example, the eastern 40,000 gallon winery in the model paid $30,440 more in wine taxes than did the West Coast 40,000 gallon winery. This is because the Arkansas tax rate of $.75/gallon was included compared to the California rate of $.20/gallon. The 10,000 gallon winery in both regions displayed the greatest net returns to capital. Also of note, the 5,000 gallon winery of the East demonstrated higher returns to invested capital when compared to West Coast region wineries. The higher priced wines of the West Coast contribute to a greater average wine revenue than experienced in the East. With increasing winery size, average wine revenue per gallon decreases as a direct result of a greater reliance upon wholesale marketing techniques. The fixed cost proportion to total cost generally increase with increasing winery sizes for both regions. Because a greater degree of automation is required with increasing winery capacity, this result would be expected.

6 The wine production and sales volumes for eastern and West Coast wineries are presented in Table 11. For the East, Cabernet and Vignoles were relatively the most profitable wines and were therefore selected by the model to be marketed at the maximum allowable percentage. All other wines with the exception of Chardonnay were estimated as being marketed at the minimum percentage allowed at eastern wineries. The exception of Chardonnay demonstrates intermediate profitability because of lower production costs relative to revenue considerations in the model. In the sales estimated by the model, white wines accounted for 60% of the total wine volume with the remaining in Cabernet at 30% and local red wines at 10% at eastern wineries (Table 11). Notably, the production decisions were proportionally constant across the different winery sizes (i.e. the percentage in a given wine varietal remain constant with only the total volume changing). Interestingly, the West Coast wine varietal sales was much more concentrated in that red wine production accounted for 75% of the volume (Table 11). Cabernet was again one of the most profitable and was marketed at 50% of total wine sales volume the maximum allowed in the model. Merlot, which was an intermediately profitable wine varietal because of the cost/revenue relationship, accounts for 25% of sales volume. All three white wines for the West Coast region model were selected as being produced and sold at the minimum allowable percentages, accounting for the remaining 25% of wine production and sales. Wine production decisions and sales volume by varietal were again proportional and constant across winery sizes. These combined results demonstrate that both eastern and West Coast wineries are potentially profitable when properly managed and operated. However, in a word of caution it must be remembered that conditions were modeled to reflect a winery which has been in operation for at least six years. Nonetheless, the initial years of establishment can be extremely demanding in terms of negative cash flow. Overcoming the severity of cash requirements during this establishment phase is a major obstacle in achieving the long run economic profits which were estimated as possible in the winemaking industry. While the specific results of this study can not be directly applied to any given individual winery, several economic considerations for small wineries can be raised from these results. A lucrative location is essential to the successful operation of a winery. Location is intricately intertwined into several economic components contributing to the success or failure of the winery. Customer flow, percentages of wine sold at retail versus wholesale markets, pricing levels, and other important considerations are directly dependent on winery location. Cost of product marketing and grape or raw product acquisition is also directly tied to the location of the winery. Both West Coast and eastern wineries can be profitable after several years of operation. Wine taxes can play a substantial role in explaining profit differentials between states. Differences between West Coast and eastern sales potentials for wine varietals indicates a distinct need to pay close attention to the marketing strategy utilized. For the firms modeled, the West Coast region wineries were estimated to market 75% of total wine volume under red varietals while the model for the East selected had white wine production estimated at 60% of total volume (Table 11). These differences can be accounted for by both profitability of wine varietals and the maximum/minimum sales volumes mandated by the model (Table 3). The significant point to remember from the results is that it is imperative to pay close attention to the desires of consumers. In terms of operating a winery for profit, it is best to consider the demands of the customer base and accordingly adjust production and winemaking strategies. The economically successful winery is likely to try to make what

it can market rather than try to market what it has already made. The final key result of the study is to emphasize economic decision making in conducting winemaking operations.

7 it can market rather than try to market what it has already made. The final key result of the study is to emphasize economic decision making in conducting winemaking operations. While the importance of quality wine production can not be disputed, it is not the entire story. While detailed attention to planning and management may not as exciting or sexy as concentration on the production of an award winning wine, it can be possibly even more rewarding monetarily. Without adequate concentration on business operations the winery business can fail. If the need for good management practices is not sacrificed, this study indicates that there is lucrative potential economic profits to be earned for small premium quality wineries on both the West Coast and in the East. Ed. note: The reader will bear in mind that this is a model for predicting ways to winery profitability, not, as the authors themselves pointed out, illustrative of any actual situation. In practice, the numerous variables a winery owner manipulates, from grape selection to methods of marketing, will give running a winery a very different feel from this-intentionally-simplistic model which was designed to help newcomers to the business understand how their planning decisions will effect final profitability.

Results from the First North Carolina Wine Industry Tracker Survey

Results from the First North Carolina Wine Industry Tracker Survey - 2009 Dr. Michael R. Evans Director and Professor of Hospitality and Tourism Management and Dr. James E. Stoddard Professor of Marketing