Farm Management: Enterprise Budgets
An integral part of profitably managing agronomic crops is developing budgets for your individual crop enterprises. Budgets can be used to (1) estimate profitability, (2) project cash flows, (3) provide a basis for credit, (4) assist in farm planning, and (5) develop least-cost feed rations.
Types of Costs
Enterprise budgets contain several cost components, and it often can be difficult to determine which should be considered for a given decision, because production costs are unique to each farming situation.
One of the most common classifications divides costs into variable and fixed costs. Variable costs are those that vary with output within a production period. Examples include seed, fertilizer, chemicals, fuel, repairs, and labor. Other terms used to describe variable costs include cash costs (or expenses), direct costs, and out-of-pocket costs.
Fixed costs include depreciation, taxes, interest on investment, land charges, and insurance. Sometimes a management fee is included as a fixed cost. These costs are considered to be “fixed” because they generally remain the same within a production period and do not vary with the level of output. Indirect, noncash, and overhead costs are other terms used to describe fixed costs.
Total costs are calculated by adding variable and fixed costs. Ideally, you want to earn a profit above total costs every year. This is not always possible because income received is sometimes less than the total costs of production. Should you continue to produce under these circumstances? The answer may be yes if: (l) you are covering variable costs of production, and (2) it is a short-run condition. It is economical to continue production in the short run as long as income is higher than the variable costs of production. In other words, in the short run, you must receive a price that generates a return at least equal to variable costs. In the long run, however, market price and yield need to be high enough to cover total costs of production, including fixed costs. Otherwise, replacing machinery and equipment will become increasingly difficult, and as a result the enterprise will not be financially sound after a period of several years.
The variable/fixed cost concept is critical to most short-run and annual farm decisions. In Pennsylvania, for example, most farmers must decide whether to plant corn, soybeans, small grains, or forage. Most or all of the fixed costs associated with the farm will not be affected by the decision. Generally, these crops compete for the same land and labor and require much of the same machinery and equipment. The most desirable crop is the one that pays the highest return on these fixed resources and thus the great- est return above variable costs.
For lenders, variable costs can be used in a cash-flow analysis to arrive at a per- unit cost of production based on the “cash-flow cost” principle. Cash-flow costs include all variable costs plus debt payment, taxes, and family living. However, cash-flow costs do not include noncash items such as depreciation and interest on equity. The cash-flow costs of production may be more or less than the total of variable and fixed costs.
Application of the different classifications of cost may reveal large variations in per-unit costs of production. Each producer’s output and financial situation is unique. Individual farmers have to determine their costs of production in relation to their management decisions and income needs. For example, a farmer could compute costs on the basis of an income and loss statement to determine the profitability of the business. However, a cash-flow statement would be needed to determine whether all financial obligations can be met—that is, if the business can be made is liquid.