LECTURES
KHAFIRRUDDIN ALI
UiTM PAHANG
Chapter 1 MANAGEMENT AND DECISION MAKING
Changes in economic, technological, and environmental conditions affect managers’ decisions. New information about prices, weather, technology, public regulations, and consumers’ taste affects the manager’s decision in answering the following questions.
• What commodities should you produce?
• How do you produce them?
• What inputs to use?
• How much of each input to use?
• How do you finance the business?
• How, where, and when do you market the products?
New information is vital for making new decisions and will often cause managers to reconsider old management strategies.
Important changes can occur in climate, weather, government programs and policies, imports and exports, international events, and many other factors that affect the supply and demand situation for agricultural commodities. Managers must recognize the long-term trends and consider them.
Technological changes such as new seed varieties; new methods for weed and insect control; new animal health products and feed ingredients; and new designs, controls, and monitors for machinery are constant sources of new information. Other changes occur in labor laws, income tax rules, and environmental regulations. Managers must consider these changes when formulating strategies and making decisions. Management ability of the farm operators has an impact on the net farm income and return on assets.
Functions of Management
The functions of management - that distinguish a manager from a worker - are those that involve a considerable amount of thought and judgment. We can summarize the functions under the general categories of planning, implementation, and control.
Planning
Planning is the most fundamental and important function. It involves choosing a course of action, policy, or procedure. To formulate a plan, the manager must:
• Establish goals or understand clearly the business owner’s goals
• Identify the quality and quantity of resources available to meet these goals – resources include land, water, machinery, capital, and labor
• Allocate resources among several competing uses. Identify all possible alternatives, analyze them, and select those that will come closest to meeting the goals of the business
Implementation
Once a manager develops a plan, he or she must implement it. This includes acquiring the resources and materials necessary to put the plan into effect, plus overseeing the entire process. Coordinating, staffing, purchasing, and supervising are steps that fit the implementation function.
Control
The control function includes monitoring results, recording information, comparing results to standard, and taking corrective action when needed. It ensures the manager follows the plan and provides an early warning. Adjustments can be made - if it is not being followed or producing the desired results. Outcomes and other related data become a source of new and improved information to use for adjusting a current plan or improving new plans. For revising new plans, the manager can use information from the control function (Figure 1.1)
Strategic Farm Management
Strategic farm management consists of charting the overall long-term course of the business and is an on going process. This process can be broken down into a series of logical steps.
• Define the mission of the business
• Formulate the goals of the business
• Assess the resource of the business (internal scanning)
• Survey the business environment (external scanning)
• Identify and select strategies
• Implement the selected strategies
Defining the Mission of the Business
A mission statement is a short description of why a business exists. Mission statements should emphasize the special talents and concerns of each farm business and its managers.
Formulating the Goals of the Business
Goals provide a reference point for making decisions and measuring progress. For farms managed by hired managers, the owners may define the goals while the manager simply strives to achieve them. Not all farm managers will have the same goals, even when their resources are similar. This is because people have different values. Values influence the goals people set and the priorities they put on them. When more than one person is involved in setting goals, it is important to recognize differences in values and be willing to compromise, if necessary, to arrive at a mutual acceptable set of goals.
When we establish goals, it is important to keep the following points in mind:
1. Write them down. This allows everyone involved to see and agree on them and provides a record for review later.
2. Goals should be specific, measurable, and have a timetable.
Some of the common goals of farm operators include:
• Survive, stay in business, do not go broke, avoid foreclosure
• Maximize profits, get the best return on investment
• Maintain or increase the standard of living, attain a desirable family income
• Increase equity, accumulate assets
• Reduce debt, become free of debt
• Avoid years of low profit, maintain a stable income
• Pass the entire farm to the next generation
• Increase leisure and free time
• Increase farm size, expand, add acres
• Maintain or improve the quality of soil, water, and air resources
Goals should be more specific. Farm operators usually have multiple goals. When this occurs, the manager must decide which goals are the most important. Profit maximization is often a major goal of all business owners since achieving a profit plays a direct or an indirect role in meeting many other possible goals. Profit can pay family living expenses and taxes, increase owner equity, decrease debt, and expand production.
Assessing the Resources of the Business
The quantity and quantity of physical, human, and financial resources available vary from farm to farm. An honest and thorough assessment of these resources will help the manager choose realistic strategies for achieving the goal of the business. This process is internal scanning.
Physical resources
Land is probably the most critical physical resource to evaluate. Productivity, topography, drainage, and fertility are just a few of the qualities that determine the potential of land for agriculture use. The acreage available and their location are also important to consider. Other physical resources to evaluate include breeding livestock; buildings and fences; machinery and equipment; and established perennial crops such orchards, plantations, and pasture.
Human resources
Skills of the operators and other employees often determine the success or failure of certain enterprises. Some workers are talented with machinery, while others do better with livestock. The degree of a person to like or dislike certain jobs in an operation is also important. It is a good idea to conduct a thorough audit of personal skills and preferences before identifying competitive strategies for a farm business.
Financial resources
Even when physical and human resources are present to carry out certain enterprises, capital may be a limiting factor. Managers can evaluate financial resources by completing a set of financial statements and by exploring the possibility of obtaining additional capital from lenders or outside investors.
Surveying the Business Environment
Critically analyzing the business environment surrounding a farm is external scanning. Changing consumer tastes have led some customers to pay premiums for lean meat or high-protein grains, for example. Other trends affect the availability of new resources and the choices of technology. The prudent managers must be aware of these changes in the external environment and react to them early. If most producers adopt new production practices that lower costs per unit, then the operation that does not change will soon be at a competitive disadvantage.
Some trends may represent threats to the farm, which could decrease profits if managers do not take any corrective action. For example, decrease in consumption of a crop such as tobacco may require considering alternative crop. Other trends, such as a desire for diets lower in fat, may actually present opportunities for a farm that could help it reach its goal faster.
Identifying and Selecting Strategies
Everyone connected with the farm should brainstorm about possible plans for the future. By matching up the most promising opportunities with the strong points of the particular farm, the manager can formulate an overall business strategy with a high chance of success. Changes may have to be made, but will be the part of a deliberate, integrated plan, not just haphazard reactions. Several strategies identified include:
• A low volume, high value producer
• A high volume, low margin producer
• A special service provider
The number of alternatives for a farm limited resources (land for example) may increase - the number of possible strategies for a farm to reach its goals will also increase. This situation will also increase the complexity of the manager’s decision.
Implementing and Refining the Selected Strategies
The manager must formulate action steps, place them in a timetable, and execute them promptly. In some cases, a formal business plan will be developed and presented to potential lenders. Concrete, short-term objectives need to be set so that a manager can measure progress toward long-term goals. The manager needs to decide what information needed to evaluate the success or failure of the strategy, and how to collect and analyze the data.
Strategic management is an ongoing activity in which the manager is constantly alert for new threats or opportunities, ready to take advantage of new resources, and willing to adapt the farm’s strategies to changes in the values and goals of the individuals involved.
Tactical Decision Making
Once a manager develops an overall strategy for the farm, the manager must make tactical decisions about how to implement it. Management is a decision making process and follows several logical and orderly steps:
1. Identify and define the problem or opportunity
2. Identify alternative solutions
3. Collect data and information
4. Analyze the alternatives and make a decision
5. Implement the decision
6. Monitor and evaluate the results
7. Accept responsibility
The above steps will help a manager act in a logical and organized manner when confronted with choices.
Identifying and Defining the Problem or Opportunity
Many problems confront a farm manager – choosing what seed to use, selecting a livestock ration, deciding how to market production, and deciding how to obtain access to land. A manager must be alert to identify problems as quickly as possible. Once a problem is identified, it should be defined as specifically as possible.
Identifying Alternative Solutions
The second step is to begin listing potential solutions to the problems. Some may be obvious once we define the problem, while others may require tie and research.
Collecting Data and Information
The next step is to gather data, information, and facts about the alternatives. We may obtain data from many sources, including university extension services, bulletin and pamphlets from agriculture experiment stations, electronic data services, farm input dealers, salespersons of agriculture inputs, radio and television, computer networks, farm magazines and newsletters. The most useful source of data and information is an accurate and complete set of past records from the manager’s own farm. Decision making typically requires information about future events because we must make plans for producing crop long before the final products are ready to market.
Data is an unorganized collection of facts and numbers obtained from various sources-they may have very little use. We need to organize, sort, and analyze these data and facts. Information is the final product obtained from analyzing data in such a way that we obtain useful conclusions and results.
Analyzing Alternatives and Making a Decision
We should analyze each alternative in a logical and organized manner. We normally select the alternative that will best meet the established goals. If the primary goal were profit maximization, we choose the alternative resulting in the largest profit.
Implementing the Decision
The decision must be correctly and promptly implemented, which means taking some action. Resources need to be acquired, detailed budgets made, a timetable constructed, and expectations communicated to employees.
Monitoring and Evaluating Results
Managers must set up a system to assess the results of any decision, so that he can identify quickly any deviation from the expected outcome. This is part of the control function of management. Profit and loss statements summarize the economic impact of a decision; yield records measure the impact on crop production. Evaluating decisions is a way to “learn from your past mistakes.”
Accepting Responsibility
Responsibility for the outcome of a decision rests with the decision maker. A reluctance to bear responsibility may explain why some individuals find it so difficult to make decisions. Sometimes good decisions bring bad results due to uncertainties of markets and production.
Chapter 2 MICROECONOMIC PRINCIPLES AND DECISION MAKING
This function of management normally involves decision making in areas of production, marketing, and finance. Production decision involves answering the following questions:
1. How much to produce?
2. How do we produce? (combination of input)
3. What do we produce? (combination of output)
The above decisions must be integrated with basic marketing decisions as to where, when, and how to buy and sell inputs and products.
The manager must integrate the production and marketing decisions with the financial decisions: where to get the fund, the terms, the type of repayment, and for what use.
Successful managers of farm business must be prepared to deal with decision making in the above areas. Given the goals of the business, the manager can make decision following the steps in the decision making process.
• Define or identify the problem
• Collect relevant data, facts, and information
• Identify and analyze the alternative solutions
• Make decision – select the best alternative
• Implement the decision
• Evaluate the results and bear responsibility for the outcome
To perform the management functions, the decision maker needs some procedures and methods as a guide. Knowledge of economics provides the manager with a set of principles and rules for decision making (useful when making plan to organize and operate a farm business).
Economic principles are set of rules to ensure decision made will result in maximum profit.
In using economic principles the manager needs to
• acquire physical and biological data and process them into useful information
• acquire price data and process them into useful information
• apply the appropriate decision making rule to maximize profit
Decision Making Using Economic Principles
Input-output Relationship
How much do we produce? (Normally determine by the level of input)
The solution to the problem follows the following steps.
1. Obtain basic data / physical data. This is a relationship between different amounts of inputs used and the corresponding output (yield of that product). The relationship is a RESPONSE CURVE / YIELD CURVE / an INPUT-OUTPUT RELATIONSHIOP (Figure 2.1). This production function shows the amount of output produced by using different amount of variable inputs. We can express the production function in the form of TABLE, GRAPH, and MATHEMATICAL EQUATION.
2. Derive additional information from the basic data.
a. Average Physical Product (APP) – the average amount of output produced by each unit of input at each input level
APP =
b. Marginal Physical Product (MPP)-additional or extra TPP produced by using additional unit of input
MPP =
3. Understanding the production function to make decision
Law of diminishing returns
Diminishing returns relates to physical production TPP, APP, or MPP. When we use more variable-inputs, all the three values begin to diminish or decline after some points. As we use additional units of a variable input in combination with one or more fixed inputs, the MPP will eventually begin to decline.
4. The amount of input use to maximize profit is an important decision derived from the production function. We eliminate any input level in STAGE III because additional input causes TPP to decrease and MPP negative. Therefore, STAGE III is irrational. In STAGE I, adding additional unit of input causes APP to increase. This is reasonable because adding additional unit of input causes APP to increase. The manager may use input level that gives the greatest APP i.e. the boundary between STAGES I and II. However, we can further increase profit by using more input even when APP is declining. STAGE II is the logical stage of production to determine the PROFIT MAXIMIZING input level. However, we need more information and can eliminate APP.
Figure 2.1: The classical production function
Production stages (refer to Figure2.1)
STAGE I starts at the point where input level is zero and ends at the point where APP is at maximum. MPP reaches a maximum point where TPP increases at a decreasing rate. Production in this stage is irrational because we can make more profit if we use more input. However, if price data for both input and output are not available, production decision is at the point where APP is at maximum.
STAGE II starts at the point where APP is maximum and equal to MPP. It ends at the point where TPP is at maximum and MPP is zero. Stage II is the rational production stage because we can maximize profit at any point on the curve if price data for both input and output are available.
Stage III starts at the point where TPP is at maximum and MPP is zero. Production in this stage is irrational. A small change in input level neither increase nor decrease output (MPP = 0). Additional input cause TPP to decrease and MPP to be negative.
5. Obtain price data and process into useful information Additional information derived from price data:
a. MARGINAL VALUE PRODUCT (MVP) – is the additional or marginal income received from using additional unit of input
MVP = where TVP =
b. MARGINAL INPUT COST (MIC) – is the change in TIC (Total input cost) or the addition to the TIC caused by using an additional unit of input.
MIC =
6. Applying the appropriate decision making rule to maximize profit
When MVP > MIC, additional profit can be made by using more input. The INCOME received from using ONE MORE UNIT of INPUT exceeds the ADDITIONAL COST of that INPUT. Therefore, profit is maximized when MVP = MIC (additional income = additional cost). We maximize profit at MVP = MIC ( ), where MIC is the price of input. Therefore, where is the unit price of output and is the unit price of input.
How much should we produce to maximize profit?
We need to introduce:
• MARGINAL REVENUE (MR) – the change in INCOME or the additional income receive from selling one more unit of output.
MR = or the unit price of output,
• MARGINAL COST (MC) – the change in cost or additional cost incurred from producing one more unit of output
MC =
When MR > MC, additional unit of output increases profit and additional income is greater than additional cost.
When MR = MC, we maximize profit.
Graphical solution
1. Plot TPP against input
Find a straight line where units of X and Y have the same value (price). The point where the tangent of the straight line touches the curve is the profit maximizing input level.
2. Plot TVP against input
Find a straight line i.e. cost of input line. The point where the tangent of the straight line touches the curve is the profit maximizing input level.
PROBLEM 1.1 Determining profit maximizing input level
The table shows yield response of maize to nitrogen fertilizer on a Segat series.
N fertilizer (kg) Yield (kg)
0 764
9 1120
18 1400
27 1680
36 1909
45 2113
54 2265
63 2393
72 2469
81 2545
90 2545
99 2545
108 2469
i.
1. Find the profit maximizing input and output levels when the price of maize is RM 0.60 per kg and the price of N fertilizer is RM 4.50 per kg.
(USE DECISION RULE: MVP = MIC and MR = MC)
2. How much fertilizer would you use if the price of N fertilizer increases by 100%?
3. Solve the problem by graph. The prices are RM 4.50 per kg for N and RM0.60 per kg for maize.
Chapter 3 CHOOSING INPUT COMBINATION
The question of how to produce depends on factor-factor relation / input substitution / resource substitution. There are many ways of producing a given product. We can substitute input for one another or combine inputs to produce an output. For example:
• substitution of one type of feed for another
• substitution of herbicide for mechanical cultivation
• substitution of labor for machinery
Our interest is to determine the cheapest way to combine two or more inputs to obtain a given quantity of product.
Input combines with one another in different ways.
a. The tractor and operator combine in fixed proportion. Each addition of tractor is associated with the addition of specific number of operator. The inputs are not substitutable. The purchase of an extra tractor calls for an employment of an extra operator.
b. The rate of substitution is the same (constant ratio) irrespective of the proportion of each input used. For example, maize and paddy will often substitute at a constant ratio in livestock feed.
c. The rate of substitution is decreasing. More and more added input needed to substitute for one unit of input replaced. Substitution between grain and hay in cow feed is an example.
A farmer or producer is interested in determining the cheapest way to combine two or more inputs to obtain a given quantity of output.
Minimizing Cost of Input (Least Cost Combination)
When inputs are substitutable, it is possible to determine the input mix that will produce a given output at the least cost, provided we know the RATE OF SUBSTITUTION and INPUTS PRICES.
Substitution ratio, SR =
Price ratio, PR =
Example 3.1: Quantities of maize and paddy supplement in a livestock ration that will produce 20kg of milk daily if fed to a head of livestock in a week.
Maize (kg) Paddy (kg)
0 5.6
0.9 4.5
1.8 3.4
2.7 2.2
3.6 1.1
4.5 0
When inputs substitute at a constant rate, it will pay to use ALL of ONE and none of the other.
Maize (kg) Paddy (kg) SR
0 5.6
1.22
0.9 4.5
1.22
1.8 3.4
1.22
2.7 2.2
1.22
3.6 1.1
1.22
4.5 0
How do we produce? (Determine by combination of input)
Solution:
1. Obtain data on input and their relationship - paddy and maize combine at constant ratio
2. Determine the substitution ratio. Substitution ratio, = 1.22
3. Obtain price data – paddy RM 40/ton; maize RM 60/ton
4. Determine the price ratio. Price ratio, = =1.50
When the substitution ratio is equal price ratio (SR=PR), the combination of input has the least cost.
In the above problem, the substitution ratio is less than price ratio (SR
Example 3.2: Feed ration for cattle to increase weight by 2 kg per week.
Feed ration Hay (kg) Grain (kg) SR PR
A 1350 825
2.93 1.47
B 1130 900
2.60 1.47
C 935 975
2.20 1.47
D 770 1050
1.87 1.47
E 630 1125
1.47 1.47
F 520 1200
1.07 1.47
G 440 1275
Price of grain: RM 0.44 per kg Price of hay: RM 0.30 per kg
SR > PR MEANS COST OF NOT ADDING GRAIN IS HIGHER THAN COST OF ADDING GRAIN OR COST OF RETAINING HAY IS HIGHER THAN COST OF ADDING GRAIN.
COST OF RETAINING HAY = 220x0.30 = RM 66
COST OF ADDING GRAIN = 75x0.44 = RM 33
A least cost input combination is determined by finding the point where SUBSTITUTION RATIO and PRICE RATIO are equal. WHEN SR > PR MEANS SUBSTITUTING OR ADDING GRAIN IS CHEAPER THAN RETAINING HAY. SUBSTITUTION SHOULD CONTINUE UNTIL SR = PR.
PROBLEM 2:1: Least cost combination (INPUT – INPUT RELATION)
Two cows fed with the following combinations of quantities of hay and grain can produce 8500 kg of milk in a specified time.
Grain (kg) Hay (kg)
6154 5000
5454 5500
4892 6000
4423 6500
4029 7000
3694 7500
1. Plot these data.
2. Determine the rate of substitution.
3. Calculate the substitution ratio at all points along the curve.
4. Should we feed the two cows with 5000 kg hay and 6154 kg grain, if the price of a kg of hay equals the price of a kg of grain? Give your reasons.
Chapter 4 ENTERPRISE COMBINATION
A soil survey provides information on the possibilities of raising crops on certain soil types. We have choices of enterprises and choices on the combination of enterprises to maximize profit. What do we produce then? What are the combinations of enterprises that will maximize profit? Before we can decide, we have to understand the relationship between enterprises. With a limited amount of land, capital, or some other inputs, often we can only increase the production of one enterprise by reducing the production from the other. Strictly saying, the enterprises are competing for the use of the same limited resources at the same time – they are competitive enterprises.
Types of Competitive Enterprises
1. Competitive enterprises with a constant substitution ratio
Figure 4.1: Competitive enterprises with a constant substitution ratio
Groundnut and corn are competing for the use of the same 100 hectares of land (Figure 4.1). If we reduce one ha of groundnut and increase one ha of corn, we will lose 60 kg of groundnut and gain120 kg of corn. Substitution ratio = = 0.5, it means 0.5 kg of groundnut is given up to gain 1.0 kg of corn.
2. Competitive enterprise with increasing substitution ratio
Figure 4.2: Competitive enterprises with increasing substitution ratio
On the Production Possibility Curve (PPC) in Figure 4.2, total groundnut production increases at a slower rate as we use more land for groundnut (also true for corn). Substitution ratio of groundnut for corn increases from 0.2 to 0.7 – it means we have to give up more and more groundnuts for some increase in corn (Example 4.1).
Example 4.1
Selecting a profit maximizing enterprise combination with land the fixed input (the price of corn is RM 2.80/kg and the price of groundnut is RM 4.00/kg)
Combination Corn (kg) Groundnut (kg) SR PR
1 0 6000
0.20 0.70
2* 2000 5600
0.30 0.70
3 4000 5000
0.45 0.70
4 6000 4100
0.55 0.70
5 8000 3000
0.70 0.70
6 10000 1600
0.80 0.70
7 12000 0
*If substitution is made, income received is 2000kg x RM2.80 = RM 5600 and income lost is 400kg x RM 4.00 = RM 1600. If SR
From the table in Example 4.1, we give up more and more groundnut for an increase in corn i.e. increasing rate of substitution. The most profitable combination of two competitive enterprises can be determined by comparing substitution ratio, SR and price ratio, PR and we use the following equations to calculate them:
SR = PR =
Profit is maximized at SR = PR. When SR
Chapter 5 COST CONCEPTS IN ECONOMICS
Costs are important and useful in economics for making management decisions. Costs can be fixed or variable, cash or non-cash, and included or not included in a record book as an accounting expense. An opportunity cost is one that is not included as an accounting expense for a business, but it is an important economic cost.
Opportunity Cost
Opportunity cost is an important basic concept needed for making managerial decisions. We define opportunity cost in one of the two ways:
1. The value of the product not produced because an input was used for another purpose or
2. The income that would have been received if the input had been used in its most profitable alternative use
Equal Marginal Return Principle
We maximize the return from scarce or limited resource when we allocate the input to its most profitable uses and the value added by the last unit of the resource is the same in each alternative uses. We should allocate a limited input among alternative uses in a way that the marginal value product of the last unit equal to MVPs in all uses. The equal marginal return principle is the same as opportunity cost principle.
Table 5.1: Return per RM 1,000 of capital invested in each of the five alternative uses
RM 1,000 increment MVP (RM) from each RM 1,000 invested in
N
(soil A) N
(soil B) Chem
(soil A) Chem
(soil B) Feed
1 3150 3300 200 2250 1550
2 2475 3000 200 2250 1550
3 2475 2700 1600 2150
4 2025 2400 1100 1750
5 1800 2400 800 1150
6 1350 1800 500 850
7 1125 1800 150 450
8 675 1500 90
9 0 1500
10 900
In Table 5.1, the most profitable allocation of capital is – RM 5,000 for N in soil B, RM 3,000 for N in soil A, and RM 2,000 for chemical in soil B. If we were to invest each of the last RM 2,000 for feed, the opportunity cost of capital would be RM 4,800.
Costs
The costs used in economics are:
• Total fixed cost (TFC)
• Average fixed cost (AFC)
• Total variable cost (TVC)
• Average variable cost (AVC)
• Total cost (TC)
• Average total cost (ATC)
• Marginal cost (MC)
These costs are output related. Marginal cost is the additional cost of producing another unit of output. The other costs are either the total costs or average costs for producing a given amount of output.
Fixed Costs
Fixed costs are associated with owning a fixed input. The characteristics of fixed costs are as follows:
• The costs will still be incurred even if the input is not used
• Fixed costs do not change as the level of production changes in the short run, but can change in the long run as the quantity of the fixed input changes
• They exist regardless of how much or how little the resource is used - the manager cannot control them
Total fixed cost (TFC) is the summation of several types of fixed costs. Usual components of TFC include depreciation, insurance, taxes (property taxes, not income taxes), and interest. Repairs and maintenance may also be included as fixed cost.
Fixed cost can be expressed as an average per unit of output and the average fixed cost, AFC = , where output is measured in physical units such as kilogram, ton, or liter.
Computing the average annual TFC for a fixed input requires some methods of finding the average annual depreciation and interest.
Annual depreciation = where cost is equal to the purchase price, useful life is the number of years the item is expected to be owned, and the salvage value is its expected value at the end of that useful life.
Because capital invested in a fixed input has an opportunity cost, interest on that investment is included as part of the fixed cost. This interest is always included and always computed the same way, regardless of whether we borrow the money to finance the purchase.
Interest = x interest rate, where the interest rate is the opportunity cost of capital. As an example, assume the purchase of a machine for RM 20,000, with a salvage value of RM 5,000 and a useful life of 5 years. We estimate annual property taxes to be RM 250, annual insurance RM 150, and the opportunity cost of capital 10%.
Depreciation = = RM 3,000
Interest =
Taxes 250
Insurance 150
Annual TFC RM
TFC is a fixed or constant value, so the AFC will decline continuously as output increases (see Figure 5.2).To lower the cost of producing a given commodity, get more output from the fixed resource. Fixed costs can be either cash or non-cash expenses. Depreciation is always a non-cash expense. Repairs and property taxes are always cash expenses - interest and insurance may be either.
Variable Costs
Variable costs are costs that a manager can control. They can be increased or decreased at the manager’s discretion and will increase as production is increased. Feed, fertilizer, seed, chemicals, fuel, and livestock health expenses are example of variable costs. Total variable cost (TVC) is the sum of all variable costs. Each variable cost is the quantity of input purchased times its price. Average variable cost, AVC = and will initially decrease as output is increased and then will increase beginning at the point where average physical product begins to decline.
Total and Marginal Costs
Total cost (TC) is the sum of total fixed cost and total variable cost.
TC = TFC + TVC
Total cost will increase if TVC increase because TFC is a constant value.
Average total cost, ATC = AFC + AVC or
Marginal cost, MC is the change in TC divided by the change in output.
MC =
The Cost Curves
TFC is constant and unaffected by output level. TVC is always increasing, first at a decreasing rate than at an increasing rate. TC curve has the same shape as the TVC curve because TC = TFC + TVC, however it is always higher by vertical distance (Figure 5.1).
Figure 5.1: Typical cost curves
Referring to Figure 5.2, at a higher output level, AFC is always declining but at a decreasing rate. ATC and AVC are U shaped, declining at first, reaching a minimum, and then increasing. The vertical distance between them is equal to AFC that changes with output level. Marginal cost, MC is the change in TC divided by the change in output. It will generally be increasing (but it decreases over a short range before starting to increase). It crosses both average costs (ATC and AVC) at their minimum points.
Figure 5.2: Average and marginal cost curves
Application of Costs Concepts (Table 5.2)
We can apply the cost concept to determine the profit maximizing stocking rate for a pasture of fixed size.
We assume the TFC at RM 5,000 per year. It includes:
• Annual opportunity costs on land and any improvements
• Depreciation on fences and water facilities
• Insurance
We assume the VC at RM495 per steer (steers are the variable inputs). It includes:
• Cost of steer
• Transportation cost
• Health expense
• Feed
• Interest on investment in the steer
Because the size of pasture and the amount of forage available is limited, running more and more steers will eventually cause the average weight gain per steer to decline. The returns diminish and MPP declines when we place more than 30 steers in the pastures. Total hundred weights of beef sold off the pastures still increases, but at a decreasing rate as more steers compete for the limited forage. The cost figures in the table have the expected pattern as we increase output or production.
TFC remain constant. TVC and TC are increasing. AFC declines rapidly at first, and then continues to decline but at a slower rate. AVC, ATC, and MC decline initially, reach a minimum at different output levels, and then begin to increase.
The profit maximizing output level is where MR=MC (60 steers). When MC>MR, the additional cost per 100 wt of beef produced from additional 10 steers is greater than the additional income per 100 wt. The profit maximizing input and output levels will always depend on prices of both the input and output.
At selling price, SP RM 87.50 where stocking rate is 60 steers (MR=MC):
Total revenue, TR (420 hundred wt x RM87.50)
Total cost, TC
Profit
ATC is RM82.62 (less than SP)
At SP, RM 76.15 where stocking rate is 50 steers (MR=MC).
ATC is RM 82.64 – results in a loss of RM 6.49 per 100 wt (RM 76.15-RM 82.64)
Total loss is RM 2, 336 (RM6.49 x 360 hundred wt)
The question is – should any steers be purchased if the expected selling price is less than the average total cost (expected SP
We should not purchase the steers if it would result in a loss greater than RM 5000; we minimize the loss at $5,000 by not purchasing any. The variable cost, VC is under manager’s control and can be reduced to 0 by not purchasing any steers. No VC should be incurred unless expected SP is at least equal to or greater than minimum AVC (expected SP ≥ minimum AVC). This will provide enough total revenue, TR to cover TVC.
If expected SP > minimum AVC, but < than minimum ATC, TR will cover all VC with some left over to pay part of the FC. There would be a loss, but less than RM 5,000.
We should not purchase the steers when the expected SP is less than minimum ATC, but only if it is above minimum AVC. The action will result in a loss, but it will be the minimum loss possible.
If expected SP is less than minimum AVC, TR will be less than TVC – loss will be greater than RM 5,000. If NO steers purchased – we minimize loss at RM 5,000.
From the table:
• The MINIMUM AVC is RM 66.00. If expected SP < RM 66.00 – Do not purchase steers.
• The MINIMUM ATC is RM 82.62. If expected SP is between RM 82.62 and RM66.00. The output level that minimizes loss is at MR=MC.
Production Rules for the Short Run
1. Expected SP > Minimum ATC (TR > TC). We can make profit and maximize it by producing at MR=MC.
2. Expected SP < Minimum ATC (TR > TVC but less than TC). We cannot avoid loss but we will minimize it by producing at the output level where MR=MC. The loss will be somewhere between zero and TFC.
3. Expected SP < Minimum AVC (TR < TVC). We cannot avoid loss, but we can minimize it by not producing. The loss will be equal to TFC.
Table 5.2: Application of cost concepts in livestock production*
No.
of steers Output
(100 wt beef) MPP TFC
(RM) TVC
(RM) TC
(RM) AFC
(RM) AVC
(RM) ATC
(RM) MC
(RM) MR
(RM)
0 0 5000 0 5000
7.2 68.75 87.50
10 72 5000 4950 9950 69.44 68.75 138.19
7.6 65.13 87.50
20 148 5000 9900 14900 33.78 66.89 100.68
7.7 64.29 87.50
30 225 5000 14850 19850 22.22 66.00 88.22
7.0 70.71 87.50
40 295 5000 19800 24800 16.95 67.12 84.07
6.5 76.15 87.50
50 360 5000 24750 29750 13.89 68.75 82.64
6.0 82.50 87.50
60 420 5000 29700 34700 11.90 70.71 82.62 87.50 87.50
5.5 90.00 87.50
70 475 5000 34650 39650 10.53 72.95 83.47
5.0 99.00 87.50
80 525 5000 39600 44600 9.52 75.43 84.95
4.5 110.00 87.50
90 570 5000 44550 49550 8.77 78.16 86.93
4.0 123.75 87.50
100 610 5000 49500 54500 8.20 81.15 89.34
* Source: Kay et al. Farm Management 5th edition
Figure 5.3: Short-run production decision
Chapter 6 ENTERPRISE BUDGETING
One practical application of the cost concepts is their use in various types of budgets. Budgeting is often described as “testing it out on paper” before committing resources to a plan or to a change in an existing plan. It is a way to estimate the profitability or feasibility of a plan, a proposed change in a plan, or an enterprise, or before making the decision and implementing it. The combination of budgeting and economic principles provides some powerful, practical, and useful techniques for the manager when analyzing alternatives. A proper and correct analysis will lead to (making) the right decision.
Enterprise Budget
An enterprise budget provides an estimate of the potential revenue, expenses, and profit for a single enterprise (Example 6.1). Each crop or a type of livestock that can be grown or raised respectively is an enterprise. The base unit for enterprise budgets is typically one hectare for crops. For livestock it is on a per head basis or on a typical size operation (e.g. 30-head cow-calf operation) as the basis for a budget. Enterprise budgets for many enterprises are usually available from research institutions like MARDI or from the Ministry of Agriculture.
The primary purpose of enterprise budgets is to estimate projected costs, returns, and profit per unit for the enterprises. Once completed, the budgets have many uses. They help identify the more profitable enterprises to be included in the whole farm plan. A whole-farm plan often consists of several enterprises – enterprise budgets are the “building blocks” in a whole-farm plan and budget.
Basic Organization and Content
• On an enterprise budget, we show the name of the enterprise and the budgeting unit first. Most enterprise budgets cover a year or less, but for some enterprises, with a long production process, a multi-year budget is more useful. If the time is longer than a year, it is useful to state the period covered.
• Next, we show the income or revenue from the enterprise. Quantity, unit, and price should all be included to provide full information to the user.
• The cost section comes next and we divide them into two parts: variable (or operating) costs, and fixed (or ownership) costs.
• Income or revenue above variable costs is an intermediate calculation and shows the revenue remaining to apply to fixed costs. Income above variable costs is also the gross margin of an enterprise.
• Fixed costs in a crop enterprise budget include the fixed costs for the machinery needed to produce the crop, and a charge for the land use.
• The estimated profit per unit is the final value found by subtracting total costs from total revenue.
Most enterprise budgets are economic budgets. In addition to cash expenses, and depreciation, opportunity costs are also included. Typically, there would be opportunity costs for operator labor, capital used for variable costs, capital invested in machinery and possible for that invested in land. Therefore, the profit or return shown on an enterprise budget is an estimated economic profit.
In enterprise budgets, economic variable costs may be called operating or direct costs, emphasizing that they arise from the actual operation of the enterprise. These costs would not exist except for the production from this enterprise. Fixed costs may be called ownership or indirect costs .This term arise from owning machinery, buildings, or land and they would exist even if they were not used for this enterprise. They include property and liability insurance; legal and accounting fees; pickup truck expenses; and subscription to agricultural publications. These expenses are necessary and appropriate but not directly tied to any single enterprise. It is difficult to assign these expenses correctly when making enterprise budgets. We often prorate them on some basis to all enterprises to make sure we charge all farm expenses, direct and indirect, to the farm enterprises. For example, we prorate machinery expenses based on the number of hours a machine is used for a particular enterprise.
Constructing a Crop Enterprise Budget
The first step in constructing a crop enterprise budget is to determine tillage and agronomic practices (number and type of tillage operations), input levels (seeding rate, fertilizer levels, amount of herbicides), type of inputs (type of fertilizer and chemicals). We must make all the agronomic, production, and technical decisions before beginning work on the enterprise budget.
Revenue
This section should include all cash and non-cash revenue from the crop. We use the concept of opportunity cost to value any non-cash sources such as crop residue used by livestock. Both yield and price estimates must be as accurate as possible. We should estimate projected yield based on historical yields, yield trends, and the type and the amount of inputs to use. We should conduct a review of historical price levels, price trends, and outlook for the future before estimating price.
Operating or Variable Expenses
This section includes those costs incurred if we produce this crop. The amount of expenses in each case is under the control of the decision maker and if we do not produce the crop, the cost reduces to RM0.
Seed, Fertilizer, and Pesticides
Once we have selected the levels of inputs, we can contact input suppliers for their prices. Computation of the total per-hectare cost for each item is by multiplying the quantities and price.
Fuel and Lubricants
This expense relate to the type and size of machinery used and to the number and type of machinery operations performed for this crop. A way to obtain this value is to divide the total farm expense for fuel and lubricants by the number of crop hectares. A more accurate method is to determine the fuel consumption per hectare for each machine operation and then sum the fuel usage for all operations scheduled for this crop. The result multiplied by the price of fuel is the per-hectare cost. Another method is to compute fuel consumption per acre of tractor use and then determine the number of hours needed to perform the machine operation.
Machinery Repairs
Any methods discussed for estimating fuel expense can also estimate machinery repair expense.
Labor
Production operations including machinery used influence the total labor needed for crop production.
Interest
This interest expense is for the capital tied up in operating expenses. For annual crops, the interest charged is for a period of less than a year. We still charge the interest even if we do not borrow any capital, but there is still an opportunity cost on the farm operator’s capital. If we know the amount of borrowed capital and equity capital, we can use a weighted average of the interest rate on borrowed money and the opportunity cost of equity capital.
Income above variable Costs
This value, also the gross margin, shows how much an acre of this enterprise will contribute toward payment of fixed or ownership expenses. It also shows how much revenue could decrease before this enterprise could no longer cover its variable or operating expenses.
Ownership / Fixed Expenses
These costs would exist even if we do not grow the crop and incur due to the ownership of machinery, equipment, and land used in crop production.
Machinery Depreciation
The amount of machinery depreciation to charge depends on the size and type of machinery used and the number and type of machine operations. First, we compute the average annual depreciation on each machine using the straight-line depreciation method. Then we convert the value to a per-hectare or per-hour basis based on hectares or hours used per year. Next, we prorate to a specific crop based on use.
Machinery Interest
Interest on machinery is the average investment in the machine over its life and we compute the same way no matter how much money, if any, borrowed to purchase it. We prorate the interest charged to each enterprise using the same method used for depreciation.
Machinery Taxes and Insurance
There is a personal property tax for machinery owned and most farmers carry some type of insurance for their machinery. We compute the annual expense for these items and then allocate again using the same method as for the other machinery ownership costs.
Land Charge
We calculate the land charge by the following ways:
1. The cost to cash rent on similar land
2. The net cost of a share-rent lease for this crop on similar land
3. The opportunity cost of the capital invested i.e. the value of a hectare multiplied by the opportunity cost of owner’s capital.
Most enterprise budgets use one of the rental charges even if we own the land.
Miscellaneous Overhead
We can use this entry to cover many expenses such as a share of pickup truck expenses, farm liability insurance, farm shop expenses, and so on. These are expenses that cannot be directly associated with a single enterprise, but are necessary and important farm expenses.
Profit and Return to Management
Subtracting total expenses from total revenue gives the estimated profit. If a charge for management is not included in the budget, we consider this value as a return to management and profit. Management is an economic cost and we should recognize it in an economic budget either as specific expense or as part of the residual net return or loss.
Other Considerations
Establishment costs for perennial crops present a problem in budgeting. It is often useful to develop separate budgets for the establishment phase and the production phase. The latter budget must include an expense for a prorated share of the establishment costs and other costs incurred before receiving any income. We accumulate costs for all years before the onset of production and then determine the present value of these costs. This value determines the annual equivalent and included as the annual expense on the enterprise budget.
Enterprise budget format
Item Value (RM)
Revenue
Variable Costs
Interest on VC
Total VC
Income above VC
Fixed Costs
Machinery depreciation, interest, taxes, and insurance
Land charge
Total FC
Total costs
Estimated profit (return to management)
Interpreting and Analyzing Enterprise Budgets
We must interpret any economic enterprise budget correctly. An economic budget includes opportunity costs on labor, capital, land, and management as expenses. The resulting profit is the revenue remaining after covering all expenses, including opportunity costs. This is an economic profit and it is not the same as accounting profit. The latter would not include opportunity costs as operating expenses. Accounting profit is the revenue remaining to pay management, unpaid labor, and equity capital for their use.
We can use the data from an enterprise budget to perform several types of analyses. These analyses include calculating cost of production and computing break-even prices and yields.
Cost of Production
Cost of production is the average cost of producing one unit of commodity.
Cost of production =
Cost of production is a useful concept, particularly when marketing a product. When we sell the product for more than its cost of production, we make a profit. If opportunity costs are included in the expenses, the profit is an economic profit. The resulting accounting profit will be higher.
Break-Even Analysis
We can use the data in an enterprise budget to do a break-even analysis for prices and yields.
Break-even yield = This yield is necessary to cover all costs at a given output price. The output price is only an estimate, so it is often useful to compute the break-even yield for a range of possible prices.
The break-even price is the output price needed to cover all costs at a given output level.
Break-even price =
Break-even price is the same as the cost of production.
The calculation of break-even yields and prices can aid managerial decision-making. Managers can form their own expectations about the probability of obtaining a price and yield combination that would just cover total costs.
An example of an enterprise budget
An Enterprise budget for water melon
Item Value per hectare
REVENUE
22ton @ 250 per ton RM5500.00
Variable Cost
Seed RM140.00
Fertilizer 698.00
Pesticide 123.00
Machinery fuel, lube, and repairs 65.00
Transportation 125.00
Labor 950.00
Interest 10% for 6 months 105.05
Total Variable costs RM2206.05
Income above variable cost RM3293.95
Fixed Cost
Machinery depreciation, interest, and taxes 72.00
Land charge 85.00
Total Fixed Cost RM 157.00
Total Costs RM2363.05
Estimated Profit (Return to management) RM3136.95
Problem 6.1
From the following information, prepare an enterprise budget for watermelon for the year 2008.
Crop: watermelon
Yield per hectare: 18 ton - Price per ton: RM 220
Cost (in RM) per hectare for:
Seed RM 250
Organic fertilizer 220
Compound fertilizer 870
Chemicals 125
Labor (daily paid)
• Nursery preparation 120
• Land preparation 180
• Transplanting 170
• Irrigating 250
• Weed control 180
• Pest and disease 110
• Harvesting 250
Land charge 220
The farmer uses a tractor for land preparation and other operations. He bought the tractor in the year 2004 at a price of RM120, 000. The expected useful life of the tractor is 10 years and its expected salvage value is RM 9,000. The road tax and insurance of the tractor is RM 450 and RM 2400, respectively. The total crop acreage of the farm is 100 hectares (50 ha maize, and 50 ha watermelon). Total tractor-hour for a year is 700. The number of tractor hours required for land preparation and other operations on watermelon production is 90 hours. Fuel cost is RM 35 per tractor hour. The wage for the tractor operator is RM 1100 per month. The interest rate is 7% per annum.
From the enterprise budget:
1. Calculate the cost of production.
2. Determine the minimum amount of crop to be produced to avoid loss.
3. Can the business make profit if the price of watermelon is RM180 per ton
Chapter 7 PARTIAL BUDGETING
Analyzing possible change involving several enterprises and any interactions among them requires a different budgeting technique. We use a partial budget to analyze these types of problems using information obtained from enterprise budgets. Many day-to-day management decisions made by farmers are adjustments to, or fine-tuning of, an existing farm plan. These adjustments decisions often affect revenue and expenses. A convenient and practical method for analyzing the profit potential of these partial changes in the overall farm plan is the use of partial budget.
Uses of Partial Budget
We use partial budgets to analyze decisions on the following problems:
• To increase the size of, or to eliminate, a small herd of beef cows
• To own harvesting equipment or custom hire harvesting
• To plant more groundnut and less maize
Often by comparing two whole-farm budgets, we can evaluate most of these decisions, but time and effort would be wasted collecting and organizing information that will not change and affect the decision.
A partial budget provides a formal and consistent method for calculating the expected change in profit from a proposed change in the farm business. It compares the profitability of one alternative with a proposed change or new alternative. Only changes in revenue and expenses are included in a partial budget.
Partial Budgeting Procedure
Partial budgeting fits in the decision making process. It is capable of analyzing only two alternatives at a time: the current situation and a single proposed alternative.
We can identify the changes in costs and revenues needed for a partial budget by considering the following four questions.
1. What are the new or additional costs incurred?
2. What are the current costs to reduced or eliminated?
3. What are the new or additional revenue received?
4. What are the current revenue lost or reduced?
The Partial Budget Format
We organize the answers to the preceding questions within one of the four categories shown on the partial budget format (Table 7.1). For each category, only the changes in costs and revenues are included.
Table 7.1: A Partial Budget Form
PARTIAL BUDGET
Alternative:
Additional Costs:
Reduced Revenue: Additional Revenue:
Reduced Costs:
A. Total additional costs
and reduced revenue RM ____ B. Total additional revenue
and reduce costs RM _____
Net change in profit (B-A) RM _____
Additional Costs
A proposed change may cause additional costs because of the following reasons.
• A new or expanded enterprise requires the purchase of additional inputs.
• Increasing the current level of input use or substituting more of one input for another for an existing enterprise
Additional costs may be either variable or fixed, because there will be additional fixed costs whenever the proposed alternative requires additional capital investment. These additional fixed costs would include depreciation, interest (opportunity cost), taxes, and insurance for a new depreciable asset.
Reduced Revenue
The current revenue, but will be lost or reduced should the alternative be adopted. Revenue reduced because of the following reasons.
• If an enterprise is eliminated or reduced in size
• If the change causes a reduction in yields or production levels
• If the selling price will decrease
Estimating reduced revenue requires careful attention to information about yields, livestock birth and growth rates, and output selling price.
Additional Revenue
The revenue received if we adopt the alternative. Additional revenue can be received:
• If a new enterprise is added
• If there is an increase in the size of a current enterprise
• If the change will cause yields, production levels, or selling price to increase
Accurate estimate of yields and prices are important.
Reduced Costs
Reduced costs are those now being incurred that would not longer exist under the alternative being considered. Cost reduction can result from:
• Eliminating an enterprise
• Reducing the size of an enterprise
• Reducing input use
• Substituting more of one input for another
• Being able to purchase inputs at a lower price
Reduced costs may be either fixed or variable. A reduction in fixed costs will occur if the proposed alternative will reduced or eliminate the current investment in machinery, equipment, breeding livestock, land, or building.
The categories on the left-hand side of the partial budget are the two that reduce profit – additional costs and reduced revenue. On the right-hand side of the budget are the two categories that increase profit – additional revenue and reduced costs.
Entries on the two sides of the form are summed and then compared to find the net change in profit. Whenever opportunity costs are included on partial budget, the result is the estimated change in “economic profit”.
Example of a Partial Budget
The example in Table 7.2 is a simple budget analyzing the profitability of purchasing a combine to replace the current practice of hiring a custom combine operator to harvest 400 hectares of maize.
Purchasing the combine will increase fixed costs and incur additional variable costs associated with operating the combine.
Information on the combine:
1. Purchase cost: RM 120,000
2. Salvage value: RM 40,000
3. 8-year useful life
4. 10% opportunity cost on capital
Items in the partial budget:
Additional costs
Additional annual fixed costs = RM 18,400
Additional annual variable costs = RM 4,350
No reduced revenue
No additional revenue
Reduced cost = RM 20,000 (elimination of the payment for custom combining)
In this example, purchasing the combine instead of continuing to hire the custom operator would reduce annual economic profit by RM 2,750. It is more profitable to continue custom hiring.
TABLE 7.2: A partial budget for owning a combine
PARTIAL BUDGET
Alternative: Purchase combine to replace custom hiring (40 ha maize)
Additional Costs: Additional Revenue:
Fixed costs None
Depreciation RM 10,000
Interest 8,000
Tax 100
Insurance 300
Variable costs
Repairs 2,500
Fuel and lubricants 1,300
Labor 550
Reduced Revenue: Reduced Costs:
Custom combining charge
400 ha @ RM 50 per ha
RM 20,000
A. Total additional costs
and reduced revenue
RM22,700 B. Total additional revenue
and reduce costs
RM 20.00
Net change in profit (B-A) RM (2,750)
Problem 7.1: Partial budget
A vegetable producer, who owns a 6 ha vegetable farm, is deciding to replace manual irrigation with sprinkler irrigation system. With manual irrigation method, he has hired two workers and pays RM 20 per person daily for the job. The cost of irrigation water is RM 80 per crop. He produces 5 crops per year and one crop production cycle is 40 days. The income from one crop is RM 3500.
To replace the manual irrigation system, the producer needs to install a sprinkler system that will cost him RM 8,000 per hectare. The system is estimated to last for 10 years with a salvage value of RM 450 per hectare. No labor is required to turn on and turn off the system – it is computer control and works automatically. The system is so efficient such that the use of water is reduced to only RM 40 per crop. With the sprinkler system, he is able to produce 6 crops per year and the income is estimated at RM 4000 per crop. However, the sprinkler system requires the producer to bear costs on electricity and fuel which are estimated at RM 122 and RM 502 per crop, respectively.
Do you think the producer should switch to sprinkler irrigation system? Why?
Chapter 8 WHOLE FARM PLANNING
Once management has developed a strategic plan of a farm business, the next step is to develop a tactical plan to carry it out. Every manager has a plan of some kind – about what to produce, how to produce, and how much to produce – even if it has not been fully develop on paper. What is a whole farm plan? It is an outline or summary of the type and volume of production to be carried out on the entire farm, and the resources needed to do it.
It may contain sufficient detail to include fertilizer, seed, and chemical application rates, or it may simply list the enterprises to be carried out and their level of productions. When the expected costs and returns for each part of the plan are organized into detail projection, the result is a whole farm budget.
Enterprise budgets can be used as building blocks for the development of a whole farm plan and its associated budget. Partial budgets are particularly useful for making minor adjustments or fine tuning a previously developed whole-farm plan. The whole-farm plan can be designed specifically for the current year or upcoming year, or it may reflect a typical year over a longer time period.
The Planning Procedure
The development of a whole farm plan can be divided into six steps as shown in Figure 8.1. Often the farm plan is developed for one year, and resources such as land, full-time labor, breeding livestock, machinery, and buildings are considered to be fixed in quantity. The usual objective of a one- year plan is to maximize the total gross margin of the farm.
Review Goals and Specify Objectives
Most planning techniques assume that profit maximization is the primary management goal. Other goals that may be considered include:
• maintaining the long-term productivity of the land
• protecting the environment
• guarding the health of the operators and workers
• maintaining financial independence
• allowing time for social activities
Figure 8.1: Steps in developing a whole farm plan
After identifying goals, a manager should be able to specify a set of performance objectives. These can be defined in terms of crop yields, livestock production rates, costs of production, net income, or other measures.
Inventory Resources
The second step in developing a whole-farm plan is to complete an accurate inventory of available resources. The type, quality, and quantity of resources available determine which enterprises can be considered in the whole –farm plan and which ones cannot be considered or are not feasible.
Land
Land resource is generally the most valuable resource and one of the most difficult to alter. It is also a complex resource with many characteristics that influence the type and number of enterprises to be considered.
Important items to be included in the land inventory are:
1. total number of hectares available in cropland, pasture, orchards, timber, and wasteland
2. climatic factors including temperature and annual rainfall
3. soil types and factors such as slope, texture, and depth
4. soil fertility levels and needs - a soil testing program may be needed as part of the inventory
5. the current water supply and irrigation system or the potential for developing it
6. drainage canals in existence and any current potential surface and subsurface drainage problems
7. soil conservation practices and structures, including any current and future needs for improvement
8. the current soil conservation plan and any limitations it may place on land use or technology
9. crop bases, established yields, long-term contracts, or other characteristics related to government programs or legal obligations
10. existing and potential pest and weed problems that might affect enterprise selection and crop yields
This is also a good time to draw up the map of the farm showing field sizes, field layouts, fences, drainage ways and ditches, tile lines, and other physical features. If available, the cropping history of each field, including crop grown, yields obtained, fertilizer and lime applied, and pesticides used can be recorded on a copy of the field map or in a computer database. This information is very useful for developing a crop program where a crop rotation is desirable or herbicide carryover may be a problem.
Buildings
The inventory of buildings should include a list of all structures, along with their condition, capacity, and potential use. The potential for livestock production may also be affected by the location of the farm stead. Close proximity to streams, lakes, or nearby residents may restrict the type and volume of animals that can be raised. There should also be adequate land area for environmentally sound manure disposal.
Labor
The labor resources should be analyzed for both quality and quantity. Quantity can be measured in months of hired labor currently available. The availability and cost of additional full-time or part-time labor should be noted, as the final farm plan might profitably use additional labor. Labor quality is more difficult to measure, but any special skills, training, and experience that would affect the possible success of certain enterprises should be noted.
Machinery
The number, size, and the capacity of the available machinery should be included in the inventory.
Capital
Capital can be another limiting resource. The lack of ready cash or limited access to operating credit can affect the size and the mix of enterprises that are chosen. Reluctance to tie up funds in fixed assets or to leverage the business through long term borrowing may also limit expansion of the farming operation or the purchase of labor saving technology.
Management
In this resource inventory, an assessment of the management skills available for the business is made. WHAT ARE THE AGE AND THE EXPERIENCE OF THE MANAGER? WHAT ARE THE PAST PERFORMANCE OF THE MANAGER AND HIS OR HER CAPACITY FOR MAKING MANAGEMENT DECISIONS? WHAT SPECIAL SKILLS OR CRITICAL WEAKNESSES ARE PRESENT?
If a manager has no training, experience, or interest in certain enterprise, that enterprise is likely to be inefficient and unprofitable. Past success and record s are the best indicators of future performance.
Other Resources
The availability of local markets, transportation, consultants, or specialized inputs is also important to consider when developing the whole- farm plan.
Identify Enterprises and Technical Coefficients
For some producers, the decision about which enterprises to include in the farm plan has already been determined by personal experience and preferences. Other managers will want to experiment with different enterprise combination by developing a series of budgets and comparing them (information from a soil survey can be used to identify enterprises).
The technical coefficients of an enterprise indicate how much of a resource is required to produce a unit of an enterprise. The technical coefficients or resource requirements are developed to correspond to the budgeting unit for each enterprise, which would be typically be 1 hectare for crops and 1 head for livestock. For almost all enterprise, technical coefficients will be needed for land, labor, and capital. For some enterprises, machinery time may also be critical and may need to be considered in the planning process. For example, the technical coefficients for a hectare of maize might be:
• 1 hectare of land
• 4 hours of labor
• RM 150 of operating capital
• 5 hours of tractor time
Estimate Gross Margin per Unit
Enterprise budgets are important tools for farm planning. An enterprise budget is required for every enterprise that might be chosen for the farm plan. It provides the estimate of gross margin needed in the farm planning process and also gives information that can be used to develop the technical coefficients.
Gross margin is the difference between income and variable costs. It represents how much each unit of an enterprise contributes toward fixed costs and profit after the variable costs of production has been paid. In the short run, maximizing gross margin is equivalent to maximizing profit.
Choose the Enterprise combination
With the following information known:
• Gross margins of the enterprises
• Amount of resources available on the farm
• Amount of each resource required per unit of each enterprise
The manager will attempt to find the combination of enterprises that provides the highest total profit for the farm. If there is more than little enterprise to consider or many resource restrictions, managers can use linear programming to aid them in decision making.
Prepare the Whole-Farm Budget
A whole-farm budget can be used for the following purposes:
1. To estimate the expected income, expenses, and profit for a given farm plan
2. To estimate the cash inflows, cash out flows, and liquidity of a given farm plan
3. To compare the effect of alternative farm plans on profitability, liquidity, and other considerations
4. To evaluate the effects of expanding or otherwise changing the present farm plan
5. To estimate the need for, and availability of, resources such as land, capital, labor, or irrigation water
6. To communicate the farm plan to lender, landowner, partner, or stockholder
The starting point of a whole farm budget is the income and variable costs used for computing gross margins. These values are multiplied by the number of units of each enterprise in the plan to get a first estimate of total gross income and total variable costs. Other farm income that does not come directly from the budgeted enterprise should then be added into the budget. Any costs not already included in the enterprise variable costs should now be added. Expenses such as building repairs, car and truck expenses, interest, utilities, insurance, and other overhead costs are very difficult to allocate to specific enterprise.
Graphical Example of Linear Programming
The basic logic for linear programming problem can be illustrated in a graphical form for a small problem involving two enterprises. The necessary information needed is shown below with land, capital, and labor as the limiting resources.
Resource requirement per hectare
Resources Resource limit Maize Groundnut
Land (hectare) 800 1 1
Capital (RM) 90,000 150 100
Labor (hour) 3,500 5 3
Gross margin / ha RM100 RM80
PROCEDURE
1. Using the information on the resource limit and resource requirement:
• Determine the total possible acreage for each of the enterprise for each resource
RESOURCE LIMIT POSSIBLE ACREAGE (Ha)
MAIZE GROUNDNUT
Land (ha) 800 800 800
Capital (RM) 90000 600 900
Labor (hr) 3500 700 1166
2. Using the information from the table in 1, mark the number of acreages possible for maize and groundnut [for each resource limitation] on the X and Y axes respectively.
3. On a graph paper, connect the point designating the value a resource on the Y axis to the point of the corresponding value of the same resource on the X axis with a straight line. Repeat the procedure for all resources. You now have a production possibility curve, PPC.
4. Construct a straight line on the graph connecting the values of both enterprises with the same gross margin.
5. The tangent of the gross margin line to the PPC is the point where the combination of enterprises results in maximum profit.
SOLUTION
MAIZE GROUNDNUT RHS Dual
Maximize 100 80
LAND (Ha) 1 1 <=800 40
OPERATING
CAPITAL (RM) 150 100 <=90000 0.4
LABOR (Hrs) 5 3 <=3500 0
Solution 200 ha 600 ha $68,000
Figure 8.2: Graph of groundnut-maize production
Problem 8.1: Whole farm plan
Use the information from the table to decide on the most profitable combination of enterprises by linear programming method.
Resource Limit Crop
Celery Cauli flower
Labor (hrs) 4000 30 35
Operating capital (RM) 6600 40 60
Land (hectare) 120 1 1
Gross margin (RM) 150 175
Chapter 9 CASH FLOW BUDGETING
Occasionally, most profitable farms find themselves short of cash. Anticipating these shortages and having a plan to deal with them is an important management activity. A cash flow budget is a financial analysis tool with application in both forward planning and the ongoing analysis of a farm business. After finishing the whole-farm plan and budget, preparing the cash flow budget is the next logical step. The preparing and analyzing of a cash flow budget will provide answers to some remaining questions below:
• Is the plan financially feasible?
• Will there be sufficient capital available at the specific times it will be needed?
• If not, how much will need to be borrowed?
• Will the plan generate the cash needed to repay any new loans?
Features of a Cash Flow Budget
A cash flow budget is a summary of the projected cash inflows and cash outflows for a business over a given period of time. This period of time is a future accounting period and is divided into months. As a forward planning tool, its primary purpose is to estimate the amount and timing of future borrowing needs and the ability of the business to repay these and other loans on time.
All cash flows must be identified and included on the budget. Cash flows into the farm business from many sources throughout the year and cash is used to pay many expenses and to meet other cash needs. Identifying and measuring these sources and uses is the important first step in constructing a cash flow budget. The concept of cash flow is shown in the figure below. It assumes that all cash moves through the business checking account, making it the central point for identifying and measuring the cash flow.
What makes a cash flow budget different from a whole-farm budget?
1. A cash flow budget contains all cash flows, not just revenue and expenses, and it does not include any non-cash items. For example, cash inflows would include cash from the sale of capital items and proceeds from new loans, but not inventory changes. Principal payments on debt and the full cost of new capital assets would be included as cash outflows, but depreciation would not.
2. It includes “when” cash will be received and paid out as well as “for what” and “how much”.
Structure of a Cash Flow Budget
The sources and uses of cash should be included on a cash flow form.
Sources of cash:
1. The beginning cash balance, or cash on hand at the beginning of the period
2. Farm product sales or cash revenue from the operation of the farm business
3. Capital sales, which is the cash received from the sale of capital assets such as land, machinery, breeding livestock, and dairy cattle.
4. Non-business cash receipts, which would include non-farm cash income, cash gifts, and other sources of cash
5. New borrowed capital or loans received (not included in the cash inflow section because borrowing requirements are not known until cash outflows are matched with the cash inflows)
General uses of cash:
1. Farm operating expenses, which are the normal and usual cash expenses incurred in producing the farm revenue
2. Capital purchases, which would be the full purchase price of any new capital assets such as land, machinery, and dairy or breeding livestock
3. Non-business and other expenses, which would include cash used for living expenses, income taxes, and any uses of cash not covered elsewhere
4. Principal payments on debt. Interest payment should also be included here, unless they were included as part of the operating expenses
From the simplified cash flow budget in Table 9.1, in the first time period, the total cash inflow of RM 3,000 includes the beginning cash balance. The total cash outflow is RM 14,000-leaving projected cash balance of (RM 11,000). This deficit will require borrowing RM 11,500 to provide a RM 500 minimum ending cash balance.
The total cash outflow of the second time period is estimated to be RM 18,000, resulting in a cash balance of RM 16,000 after subtracting a total cash outflow of RM 2,000. This large cash balance permits paying off debt incurred in the first time period, which is estimated at RM 11,700 when interest of RM 200 is included. The final result is an estimated RM 4, 300 cash balance at the end of the second time period. Following this same procedure for all subsequent time periods traces out the projected level and timing of borrowing and debt repayment potential.
Constructing a Cash Flow Budget
1. Develop a whole-farm plan. It is impossible to estimate cash revenues and expenses without knowing what crops and livestock to be produced.
2. Take inventory. This should include existing crops and livestock for sale during the budget period.
3. Estimate crop production and, for combination crop and livestock farms, estimate livestock feed requirements. This step projects crops available for sale after meeting livestock feed requirements. It may show a need to purchase feed if the production plus beginning inventory is less than what is needed for livestock.
4. Estimate cash receipts from livestock enterprise. Include both livestock included in the beginning inventory and those to be produced and sold within a year. Sales of livestock products such as milk should also be included.
Table 9.1: Simplified Cash Flow Budget
Time period 1 Time period 2
1. Beginning cash balance RM1,000 RM 500
Cash inflow:
2. Farm product sales RM 2,000 RM 12,000
3. Capital sales 0 5,000
4. Misc. cash income 0 500
5. Total cash inflow RM 3,000 RM 18,000
Cash outflow:
6. Farm operating expenses RM 3,500 RM 1,800
7. Capital purchases 10,000 0
8. Misc. expenses 500 200
9. Total cash outflow RM14,000 RM 2,000
10. Cash balance - 11,000 16,000
(line 5 – line 9)
11. Borrowed funds needed RM11,500 0
12. Loan repayments
(principal and interest) 0 11,700
13. Ending cash balance 500 4,300
( line 10 + line 11 – line 12)
14. Debt outstanding RM11,500 RM 0
5. Estimate cash crop sales. First, determine a desired ending inventory for feed use and sale next year. Next, compute the amount available for sale as beginning inventory plus production less livestock feed requirements less desired ending inventory.
6. Estimate other cash income. This may include revenue from custom work or government farm program payments. If the budget includes both business and personal cash flows, include rent, interest, or dividends on non farm investments plus any other non-farm sources of cash revenue.
7. Estimate cash farm operating expenses. This will also include property taxes, insurance, repairs, and other cash expenses not directly related to crop and livestock production.
8. Estimate personal and non-farm cash expenses. This will include cash needed for living expenses, income taxes, and any other non-farm cash expenses.
9. Estimate purchases and sales of capital assets. Include the full purchase price of any planned purchases of machinery, buildings, breeding livestock, and land, as well as the total cash to be received from the sale of any capital asset.
10. Find and record the scheduled principal and interest payments on existing debt. This will be primarily the non-current debt, where the amounts and dates of each payment are shown on a repayment schedule. Any carryover current debt from the previous year should also be included.
The data estimated and organized in these steps can be entered on a cash flow form. With few more calculations, the end result will be an estimate of borrowing needs for the year, the ability of the business to repay these loans, and the timing of each. Key assumptions about selling prices, input costs, and production levels should be well documented before the plan is presented to the lender.
Uses of a Cash Flow Budget
The primary use of a cash flow budget is to project the timing and amount of new borrowing that the business will need during the year and the timing and amount of loan repayment.
Other uses and advantages are:
• A borrowing and debt repayment plan can be developed to fit an individual farm business. The budget can prevent excessive borrowing and it shows how repaying debt as quickly as possible will save interest.
• A cash flow budget may suggest ways to rearrange purchases and scheduled debt repayments to minimize borrowing. For example, capital expenditures and insurance premiums might be moved to months where a large cash inflow is expected.
• A cash flow budget can combine both business and personal financial affairs into one complete plan.
• A bank or other lending agency is better able to offer financial advice and spot potential weaknesses or strengths in the business based on a completed cash flow budget. A realistic line of credit can be established.
• By planning ahead and knowing when cash will be available, managers can obtain discounts on input purchases by making prompt cash payment.
• A cash flow budget can help spot an imbalance between current and non-current debt and suggest ways to improve the situation. For example, too much current debt relative to non-current debt can create cash flow problems.
Investment Analysis Using a Cash Flow Budget
One other use of a cash flow budget is to know whether any new major capital investment such as the purchase of land, machinery, or building from borrowed capital is financially feasible, as opposed to economically profitable. In other words, will the new investment generate enough additional cash income to meet its additional cash requirement?
Suppose a farmer is considering the purchase of an irrigation system to irrigate 120 hectares. The following information is gathered to complete a cash flow analysis.
Cost of irrigation system RM 60,000
Down payment in cash 18,000
Capital borrowed (@ 12% for 3 years) 42,000
Additional crop income from yield increase (RM 140 per hectare) 16,800
Additional crop expenses from higher input levels (RM 30 per hectare) 3,600
Irrigation expenses (RM 25 per hectare) 3,000
Because this is a long-lived capital investment, it is important to look at the cash flow for a number of years (Table 9.2).
Table 9.2: Cash flow analysis for an irrigation investment
Year
1 2 3 4 5
Cash inflow:
Increase in crop income RM 16,800 RM 16,800 RM 16,800 RM 16,800 RM 16,800
Cash outflow:
Additional crop expenses 3,600 3,600 3,600 3,600 3,600
Irrigation expenses 3,000 3,000 3,000 3,000 3,000
Principal payments 14,000 14,000 14,000 0 0
Interest payments 5,040 3,360 1,680 0 0
Total cash outflow 25,640 23,960 22,280 6,600 6,600
Net cash flow (-8,840) (-7,160) (-5,480) 10,200 10,200
The new loan requires a principal payment of RM 14,000 each year of the three-year loan, plus interest on the unpaid balance. This obligation generates large cash out flow requirement during the first three years, causing a negative net cash flow for these years. Once the loan is paid off in the third year, there is a positive net cash flow in the following years.
This investment is obviously going to cause a cash flow problem the first three years. The irrigation system should last for more than five years and will continue to generate a positive cash flow in the later years. How to get by for the first three years? The purchase of the irrigation system should be incorporated into a cash flow budget for the entire farm. Other parts of the farm business may generate enough excess cash to meet the negative cash flow. If not, the farmer can negotiate with the lender for a longer loan with smaller annual payments. This solution would help reduce the cash flow problem, but would extend principal and interest payments over a longer time period and increase the total amount of interest paid.
Land purchases often generate negative cash flows for a number of years. New livestock facilities may require significant cash for construction, breeding stock, and feed before any additional cash income is generated. Orchards, oil palm, and rubber plantations take a number of years before they become productive and generate cash revenue. With these problems, managers should recognize the importance of analyzing a new investment with a cash flow budget.
PROBLEM 9.1: Cash flow budgeting
This problem involves working out a cash flow budget for 2008. The following information should be all that is needed to complete this problem. The information is in no particular order so carefully check to be sure you have used it all before finishing the problem. You should round everything to the nearest whole dollar.
Complete a cash flow budget on the form provided.
Beginning inventory (January 1, 2008): Paddy, 216 tons to sell in Jan of 2008
Beef cows, 140 head
Prices to use: Beef calves – RM 1.54 per kg Yields: 90% calf crop
Paddy - RM 180 per ton 10 tons per acre
Maize – RM 1.50 per kg 3 tons per acre
Additional Information
1. Sells all calves in August at average weight of 204 kg. (Assume no replacements kept.)
2. Will raise 300 acres of maize and 450 acres of paddy in 2008.
3. Plans to trade for a new pickup in March, paying RM18, 500 cash difference. There will be a new intermediate term loan of RM14, 000 to help pay for it.
4. The new intermediate loan on the pickup will have a semi-annual payment due in August of RM 2,300 for principal and RM750 for interest.
5. Will sell a bull in April for RM 800 and buy a replacement in May for RM 2,000.
6. Income tax of RM 15,200 due in March.
7. Family living expenses of RM 3,000 per month.
8. Personal life insurance premium of RM2, 000 due in April.
9. Cash on hand January 1, 2008, RM12, 000.
10. Assume all 2007 maize sold at harvest in October and all rice produced in 2007 is stored for sale in 2009.
11. Spouse's non-farm job nets RM1, 500 per month after all deductions.
12. All new borrowing will be "current" borrowing except as indicated in #3 above. To simplify calculations, borrow and repay loans in even RM100 units.
13. Interest rate is 12% per year or 1% per month on current borrowing. Repay oldest current borrowing first and pay interest only on the amount of principal repaid.
14. Maintain RM1000 monthly minimum balance (anything between RM950 and RM1050 is okay).
2008 Estimated Expenses
1. Hired labor RM18, 000 per year, equal amount each month.
2. Feed and grain 6, 000 per year, 1/2 in March, 1/2 in December
3. Chemicals 14, 400 per year, 1/2 in April, 1/2 in August
4. Machinery hire 2, 800 in October
5. Machinery repairs 6, 800 per year, half in May, 1/2 in September
6. Building repairs 4, 000 in November
7. Livestock expenses 4, 800 per year, equal amount each month
8. Fertilizer 14, 000 in February
9. Gas, fuel, oil 7, 200 per year, 1/2 in April, 1/2 September
10. Property taxes 1, 400 per year, 1/2 in June, 1/2 in November
11. Insurance for farm 3, 000 in February
12. Farm share of auto and pickup 4, 800 per year, equal amount each month
13. Utilities 3, 600 per year, equal amount each month
14. Miscellaneous 2, 400 per year, equal amount each month
15. Seed 5, 400 in February
Debt Situation as of 1/1/2008 Payment Due in 2008 (RM)
Balance Principal Interest Month due
Current loans 25,000 25,000 2,000 February
Non-current loans 205,000 15,500 16,400 May
Note
1. Use the form for cash flow budget to complete the assignment
2. Replace wheat by paddy and cotton by maize
Chapter 10 INVESTMENT ANALYSES
On a farm, capital is used to finance not only annual operating inputs such as feed, fertilizer, pesticides, and fuel, but capital assets such as land, machinery, buildings, and plantations. Investing in capital asset means a large capital expense, with the resulting returns spread over a number of future time periods. A proper analysis of these capital investments requires careful consideration of the size and timing of the related cash flows.
Time Value of Money
We would prefer to have a dollar today rather than a dollar at some time in the future. A dollar today is worth more than a dollar at some future date because a dollar today can be invested to earn interest and therefore will increase to a dollar plus interest by the future date. Besides, we prefer a dollar now based on some other reasons:
• Consumption - if the dollar were to be spent on consumer goods such as new auto, we would prefer to have the dollar now so we could enjoy the new item immediately.
• Risk – some unseen circumstance could prevent us from collecting the dollar in the future.
• Inflation – what a dollar can buy today can diminish in the future.
Future Values
The future value of money refers to the value of an investment at a specific date in the future. This concept assumes that the investment earns interest during each time period, which is then reinvested at the end of each period so it will also earn interest in later time periods. Therefore, the future value will include the original investment and the interest it has earned, plus interest on the accumulated interest. The procedure for determining future values when accumulated interest also earns interest is called compounding.
Future Value of a Present Value
Starting from a given amount of money today, a PV (Present Value), what will it worth at some date in the future? The answer depends on: 1) the PV 2) the interest rate it will earn 3) the length of time it will be invested
Example: you have just invested RM 1000 in a savings account that earns 8% interest compounded annually. The future value of this investment after 3 years will be
Year Value at beginning of year (RM) Interest rate (%) Interest earned (RM) Value at end of year (RM)
1 1000.00 8 80.00 1080.00
2 1080.00 8 86.40 1166.40
3 1166.40 8 93.30 1259.70
In this example, a present value of RM 1000 has a future value of RM 1259.70 when invested at 8% interest for 3 years.
The future value can be calculated by using the mathematical equation
FV = PV (1 + i)n
FV = RM 1000(1+0.08)3
= RM 1000(1.259)
= RM 1259.70
FV can also be found by multiplying the PV by the FV factor. For our example, the factor is 1.2597, and when multiplied by RM 1000 gives RM 1259.70.
Interestingly, we can know the approximate time it takes for the investment to double its value by dividing 72 by the interest rate.
Future Value of an Annuity
What is the future value of a number of payments (PMT) made at the end of each year for a given number of years? Suppose RM 1000 is deposited at the end of each year in a savings account that pays 8% annual interest. What is the value of this investment at the end of 3 years? It can be calculated in the following manner:
First payment RM 1000 = 1000(1+0.08)2 =1166.40
Second payment RM 1000 = 1000(1+0.08)1 =1080.00
Third payment RM 1000 = 1000(1+0.08)0 = 1000.00
Future value RM3246.40
The future value of annuity can be found by the equation
FV = PMT x (1 + i)n – 1
i
Multiplying annual PMT by the factor 3.2464 [from Table 3] gives the FV of RM 3246.40
Present Values
Present values are found using a process called discounting. Discounting is done because a sum to be received in the future is worth less than the amount available today. When used to find present value, the interest rate is referred to as the discount rate.
Present Value of a Future Value
The PV of a FV depends on the interest rate and the length of time before the payment will be received. The equation to find the PV of a single payment to be received in the future is
PV = or
A payment of RM 1000 to be received in 5 years using an interest rate of 8% has a present value of RM 680.58 or FV x 0.68058 from table 4. An investor should not pay more than RM 680.58 for an investment that will return RM1000 in 5 years if there are other alternatives that will pay 8% interest or more.
Present Value of Annuity
Suppose a payment of RM 1000 will be received at the end of each year for 3 years and the interest rate is 8%.
Year Amount (RM) Present Value Factor Present Value (RM)
1 1000 0.92593 925.93
2 1000 0.85734 857.34
3 1000 0.79383 793.83
Total 2,577.10
The PV of an annuity can be found by the equation PV = PMT x
Present values are more useful than future values when analyzing investments.
Investment Analysis
It refers to the addition of long-term or non-current assets to the business. A thorough analysis is required before investment decision is made. Investment analysis or capital budgeting is the process of determining the profitability of an investment or comparing the profitability of two or more alternative investments. A thorough analysis of an investment require four pieces of information: 1) the initial cost of the investment 2) the terminal or the salvage value of the investment 3) the annual net cash revenues realized 4) the interest or discount rate to be used
Initial cost of the investment should be the actual expenditure for its purchase.
Net cash revenues or cash flows must be estimated for each time period in the life of the investment. Cash receipts minus cash expenses equals the additional net cash revenues generated by the proposed investment.
Terminal value will need to be estimated and is the same as salvage value for depreciable asset. For non depreciable asset such as land, the terminal value should be the estimated market value of the asset at the time the investment is terminated. Whenever terminal values exist, they should be added to the net cash revenue for the last year, because they represent an additional cash receipt.
Discount rate is often difficult to estimate. It is the opportunity cost of capital, representing the minimum rate of return required to justify the investment. If fund will be borrowed to finance the investment, the discount rate can beset equal to the cost of borrowed capital. If a combination of borrowed an equity capital will be used, a weighted average of the interest rate on the loan and the equity opportunity cost should be used.
Net cash revenues (RM)
Year Investment A Investment B
1 3000 1000
2 3000 2000
3 3000 3000
4 3000 4000
5 3000 6000
Total cash revenues 15000 16000
Less initial investment 10000 10000
Net cash revenues 5000 6000
Average net revenue/yr 1000 1200
Payback Period
It is the number of years it would take an investment to return its original cost through the annual net cash revenue it generates.
Payback period, P = where C is the initial cost of the investment and E is the expected annual cash revenue. For investment A, the payback period is 3.33 years. When the annual net cash revenue are not equal, they should be summed year by year in which the total is equal to the amount of investment. For investment B, the payback period is 4 years because the accumulated net cash revenues reach RM 10000 in the fourth year. Investment A is preferred over investment B because it has a shorter payback period.
Simple Rate of Return
The simple rate of return expresses the average annual net revenue as the percentage of the original investment. The net revenue for investment A is RM 1000 and for investment B is RM 1200.
Rate of return =
Rate of return for investment A is 10% and for investment B is 12%. The simple rate of return method is a better indicator than the payback method because it considers an investment’s earnings over its entire life.
Net Present Value (discounted cash flow method)
An investment’s net present value is the sum of the present values for each year’s net cash flow (or net cash revenue) minus the initial cost of the investment. The net present value of an investment for each year is found by the net cash flow multiply by the present value factor of selected discount rate (normally the opportunity cost of capital). Total PV for 5 years less initial cost give the NPV (net present value). Investment with positive NPV would be accepted. For investment A, an investor could afford an initial cost of up to RM 11,370 and still receive at least a 10% return on invested capital. Both investments have NPVs greater than the opportunity cost of capital.
The equation for finding NPV [net present value] is
NPV = + +…+ – C where Pn is the net cash flow in the year n, i is the discount rate, and C is the initial cost of investment.
Internal Rate of Return
Both investments have positive NPV using the 10% discount rate, but what is the actual rate of return on these investments? It is the discount rate that makes the NPV just equal to zero. The actual rate of return on investment (with proper accounting for the time value of money) is IRR.
Calculation of IRR can be done by using the equation below, solving for i and equating NPV to 0
NPV = + +…+ – C where Pn is the net cash flow in the year n, i is the discount rate, and C is the initial cost of investment.
0 = + +…+ – C
C = + +…+
When both investments are discounted at 10% the NPV are positive – IRR must be greater than 10%. IRR for A is15.3% and for B is 13.9%. (Table 14.1) Any investment with IRR greater than discount rate would be a profitable investment.
Table14.1: Calculation of IRR for investment A and B
YR A B PV FACTOR PV(A) PV(B)
1 3000 1000 0.9091 2727.3 909.1
2 3000 2000 0.8264 2479.2 1652.8
3 3000 3000 0.7513 2253.9 2253.9
4 3000 4000 0.6830 2049.0 2732.0
5 3000 6000 0.6209 1862.7 3725.4
TPV 11372.10 11273.20
LESS INI. COST 10000.00 10000.00
NPV 1372.10 1273.20
YR A B PV (16%) PV(A) PV(B)
1 3000 1000 0.8621 2586.3 862.1
2 3000 2000 0.7432 2229.6 1486.4
3 3000 3000 0.6407 1922.1 1922.1
4 3000 4000 0.5523 1656.9 2209.2
5 3000 6000 0.4761 1428.3 2856.6
TPV 9823.2 9336.4
LESS INI. COST 10000.00 10000.00
NPV -176.80 -663.60
IRR (%) 15.3 13.9
INTERPOLATION OF IRR
IRR (%) = 16% +
Problem10.1: Investment Analysis
The table below shows cash income and expenses of an investment in the production of coconut palms on a 5 hectare coastal land for landscape purpose. The initial cost is estimated at RM 17,032. The farmer provides the capital required for the project and the opportunity cost of capital is estimated at 9%.
Analyze the information using payback period, simple rate of return, net present value [NPV], and internal rate of return [IRR]. Decide whether the investment is profitable.
Year Cash Income (RM) Cash Expenses (RM)
1 0 1,100
2 0 1,356
3 0 1,445
4 0 1,768
5 0 2,201
6 10,630 3,000
7 35,000 6,785
8 30,000 5,356
Chapter 11 CAPITAL
Capital includes cash, balances in checking and saving accounts, other types of liquid funds - and money invested in livestock, machinery, buildings, land, and any other assets that are bought and sold. Credit, the ability to borrow money with a promise to return the money in the future and pay interest for its use, is important to capital acquisition. The use of credit allows farmers to acquire productive assets and pay for them later with the income they generate.
Economics of Capital Use
Broadly defined, capital is the money invested in the physical inputs used in agricultural production. It is needed to purchase or rent productive assets, pay for labor and other inputs.
Total Capital Use
The figure above is a graphical presentation of MVP and MIC, where MVP is declining, as occurs whenever diminishing marginal returns exist. The MVP is the additional net return, before interest payment, that results from an additional capital investment and is calculated in a manner similar to the return on assets (ROA), except a factor of 1 is added. Marginal input cost is equal to the additional dollar of capital invested plus the interest that must be paid to use it. Therefore MIC is equal to 1+i, where i is the rate of interest on the borrowed funds, or the opportunity cost of investing the farm’s own capital. In the above example, profit is maximized by using the amount of capital represented by a, where MVP is equal to MIC.
Allocation of Limited Capital
How to allocate limited capital among its alternative uses? This problem can be solved by using the equal marginal principle where capital is allocated among alternative uses in such a way that the marginal value product of the last dollar is equal in all uses.
Sources of Capital
Because capital consists of cash and assets purchased with cash, it is easy to mix capital use from different sources. The ability to obtain capital and combine it in the proper proportions in various uses is an important part of farm financial management.
Owner Equity
The farmer’s own capital is called owner equity or net worth. It is calculated as the difference between the total assets and the total liabilities of the business. An operator can secure or accumulate equity through several ways. Most farmers begin with a contribution of original capital acquired through savings, gifts, or inheritances. As the farm generates profits in excess of what is withdrawn to pay personal expenses and taxes, retained earnings can be reinvested in the business. Some operators may have outside earnings, such as non-farm job or other investment income, which they can invest in their farming operation. Assets that are already owned may increase in value through inflation or changes in demand. Additional cash can be obtained by selling the assets or using them as collateral for loan.
Outside Equity
Some investors may be willing to contribute capital to a farm without being the operator. Under some types of share lease agreements, the land owner contributes operating capital to buy seed and fertilizer, or even provides equipment and breeding livestock. Larger agriculture operations may include limited or silent partners who contribute capital, but do not participate in management. Farms that are incorporated may sell stock to outside investors. These arrangements increase the pool of capital available to the business, but also obligate the business to share earnings with the investors.
Leasing
It is often cheaper to gain the use of capital assets by leasing or renting rather than owning them. Short-term leases make it easier for the owner to change the amount and the kind of assets used from year to year.
Contracting
Farmers who have restricted access to capital may contract their operation to agricultural investors. Examples include crop harvesting, weeding, and pest control. Typically, the investors will provide the labor, equipment, and transportation for certain operations such as harvesting. For other operation such as weeding the operator provides chemicals - the investors provide labor for the job. The investor receives a fixed payment per operation. Potential returns per unit for contract operations may be lower than for a well-managed owner-operated business.
Credit
Capital obtained through credit can provide a means to:
• Quickly increase business size
• Improve the efficiency of other resources
• Spread out the purchase of capital asset over time
• Withstand the temporary period of negative cash flow
Types of Loans
Loans can be classified based on their length of repayment, use of the funds, and type of security pledged. A prospective borrower needs to be familiar with these terms to communicate effectively with the lenders.
Length of Repayment
Classifying loans by the length of repayment period is widely used when preparing balance sheets. Three types of loans classified by length of repayment are common.
Short-Term Loans
These loans are generally used to purchase inputs needed to operate through the current production cycle. Operator purchase fertilizer, seed, feeder livestock, feed and pay wages and rent with capital from short-term loans. Repayment is due when crop is harvested and sold or when feeder livestock are sold. Short-term loans (also known as production or operating loans) are listed as current liabilities on the farm balance sheet.
Intermediate-Term Loans
When a loan is repayable over more than one year, but less than ten years, it is classified as an intermediate loan. Operators normally used these loans to purchase machinery, breeding and dairy livestock, and some buildings. These assets are used in production for several years and cannot be expected to pay for themselves in one year or less.
Long-Term Loans
A loan with a term of ten years or longer is classified as long-term loan. Operators purchase assets with longer or indefinite life, such as land, with these loans. Annual payment is required through the loan period. Both intermediate and long-term loans are shown as non-current liabilities on the balance sheet.
Use
Another common criterion for classifying loans is the use of the funds.
Real Estate Loans
These loans are made available for the purchase of real estate such as land and buildings - they are long-term loans. Real estate assets serve as security for the loans.
Non-Real Estate Loans
These are short-term or intermediate-term loans which include all business loans other than real estate loans. Crops, livestock, machinery, or other non-real estate assets may be pledged as security.
Personal Loans
These are non-business loans used to purchase personal assets such as homes, vehicles, and appliances.
Security
The security for a loan refers to the assets pledged to the lender to ensure loan repayment. The lender has legal right to take possession the mortgaged assets if the borrower is unable to pay the necessary principal and interest on the loan. These assets can be sold by the lender – the proceeds used to pay off the loan. Assets mortgaged or pledged as security are called loan collateral.
Secured Loans
Asset is mortgaged to provide collateral for the loan. Lenders favor secured loans because they have greater assurance the loan will be repaid. Intermediate and long-term loans are usually secured by specific asset, such as land or machinery.
Unsecured Loans
A borrower with good credit and a history of prompt loan repayment may be able to borrow money with only “a promise to repay,” or without pledging any specific collateral. This unsecured loan or signature loan (borrower’s signature is the only security provided to the lender) is discouraged by lending practices or banking regulations.
Repayment Plans
Lenders try to fit repayment plans based on the purpose of the loan, the type of collateral used, and the borrower’s projected cash flow. When a loan is negotiated, the borrower and the lender should agree about when it is to be repaid. The total interest paid will increase if the money is borrowed for a longer time period.
Cost of Borrowing
Interest can be thought as the ‘RENT’ paid for the use of the borrowed money. Interest can be a major expense of a farm business. Borrowers are advised to shop around for the best combination of interest rate and loan terms or repayment schedule.
The true or actual interest rate is called the effective rate or the annual percentage rate. When loan is available from several sources, they should be compared on the basis of their annual percentage rate.
The fundamental equation for calculating interest is
Single payment
A single payment loan has all the principal payable in one lump sum plus the interest when the loan is due. It requires good cash flow planning to ensure sufficient cash available to pay the loan when it is due. Interest paid for single payment loan is simple interest.
If RM 10,000 is borrowed for exactly one year at 12 percent annual interest, the single payment would be RM 11,200. With discount interest, the borrower will only received RM8,800 after deducting the interest of RM1,200. The effective rate or annual percentage rate of this borrowing is 13.6% which is actually higher than the stated rate of 12%.
Annual percentage rate, APR =
Installment loans
Loans to finance the purchase of automobiles and machinery use add-on interest.
Example: RM 40,000 is needed to finance the purchase of an automobile, with an interest of 5%, and the loan will be repaid in 5 years.
1. Interest calculation: RM 40000 x 5% x 5 years = RM 10000
2. Interest add on to the amount of loan: RM40000 + RM 10000 = RM 50000 [total amount to be repaid]
3. Monthly payment: RM 50000/60 months or payment = RM 833.33/month.
The APR for this loan can be calculated by: APR =
Amortized
An amortized loan has periodic principal and interest payment and is also known as installment loan. As the principal is repaid, the loan balance decline, and the interest payment also decline. Example: RM 10,000 is borrowed with a 12% annual interest. RM 5,000 is scheduled to be paid in 6 months and the remaining RM 5,000 at the end of one year.
Interest calculation: First payment RM 10000 at 12% for year = RM 600
Second payment RM 5000 at 12% for year = RM 300
Total interest = RM 900
Total payments would be RM 5,600 and RM 5,300
They are two types of amortization plans:
1. EQUAL PRINCIPAL PAYMENT which has the same amount of principal due each payment date, plus interest on the unpaid balance. Borrowers often find the first few loan payments difficult to make. For this reason, many long-term loans have an amortized repayment schedule with equal total payment.
2. EQUAL TOTAL PAYMENT which has all payments of the same amount.
The following tables demonstrate an amortization of a RM 100,000 loan for 10 years at 8% annual interest.
TABLE 11.1: Equal principal repayment method
EQUAL PRINCIPAL PAYMENT
Year Principal
paid Interest
paid Total
payment Principal remaining
1 RM 10000 RM 18000 RM 18000 RM 90000
2 10000 7200 17200 80000
3 10000 6400 16400 70000
4 10000 5600 15600 60000
5 10000 4800 14800 50000
6 10000 4000 14000 40000
7 10000 3200 13200 30000
8 10000 2400 12400 20000
9 10000 1600 11600 10000
10 10000 800 10800 0
TOTAL RM100000 RM44000 RM144000
TABLE 11.2: Equal total repayment method
EQUAL TOTAL PAYMENT
Year Total
payment Interest
paid Principal
paid
Principal remaining
1 RM 14903* RM 8000 RM 6903 RM 93097
2 14903 7448 7455 85642
3 14903 6851 8052 77590
4 14903 6207 8696 68895
5 14903 5512 9391 59503
6 14903 4760 10143 49360
7 14903 3949 10954 38406
8 14903 3073 11830 26576
9 14903 2126 12777 13799
10 14903 1104 13799 0
TOTAL RM149030 RM49030 RM100000
*The annual payment is calculated by multiplying RM 100000 by the amortization factor of 0.14903
Sources of Loan Funds
Money can be borrowed from many different sources. Among them are the commercial banks which also provide other financial services such as checking and savings accounts beside loans. In Malaysia, Bank Pertanian provides most of the financial services related to agriculture production including loans and credit. Loans for the purchase of vehicles can be obtained from finance companies.
Establishing and Developing Credit
What does a lender consider when making decision on loan application? Why can one business borrow money more than another? A borrower should be aware of the need to demonstrate and communicate credit worthiness to lenders. Some of the more important factors considered by lenders in financial decision for loan approval include:
• Personal character Honesty, integrity, judgment, reputation, and other personal characteristics of the loan applicant are always considered by lenders. Credit can be quickly lost by being untruthful in business dealings and slow to meet financial obligation. To maintain good credit record, borrowers should promptly inform lenders of any changes in their financial condition or farming operation that might affect loan repayment.
• Management ability A lender will try to evaluate a borrower’s management ability. Established farmers may be judged on their past records, but beginners can be judged only on their background, education, and training. Lenders often rate poor management ability as the number one reason for borrowers getting into financial difficulty.
• Financial position Accurate, well prepared balance sheets and income statements are needed to document the current financial position of the business and its profitability.
• Repayment capacity Repayment capacity is best measured by the cash flow generated by the business. A cash flow budget projected for one or more years should be completed before borrowing large amount of money and establishing rigid repayment schedules.
• Purpose of the loan Money can be borrowed for many purposes – borrowers as well as lenders should identify the more profitable alternatives.
• Collateral The amount and type of collateral available may be important factors in a loan request.
Chapter 12 LAND
Land is the basic resource that supports the production of all agricultural commodities including livestock. Livestock farmers depend on land to produce the forage and grain that their livestock consume.
The Economics of Land Use and Management
The many characteristics of land greatly influence the economic of land use and management. The potential profit per hectare from crop production determines the market value of agricultural land.
Characteristics of Land
Land is a permanent resource that does not depreciate or wear out, provided soil fertility is maintained and appropriate conservation measures are used. Land is productive in its native state – producing stands of timber and native grasses, but the management effort of farmers and ranchers have improved the productivity of land. This has been accomplished through land clearing, drainage, good conservation practices, irrigation, the introduction of new and improved plant species, and the use of limestone and fertilizer. These improvements often change land use.
Each tract of land has a legal description which identifies its particular location, size, and shape. Land is immobile – it cannot be moved to combine with other resources. Machinery, seed, fertilizer, water, and other inputs must be transported to the land and combined with it to produce crops and livestock. Soil types, topography, drainage, organic material, and the existence of natural hazards such as flooding and rock outcrops are factors that make land resources different from farm to farm.
Planning Land Use
A complete inventory of the land including soil types, drainage, slope, and fertility provide information to develop the whole farm plan. The potential livestock and crop enterprises, yields, fertility requirements, and necessary conservation practices are related directly to the nature of land resources available. Whole farm planning often involves maximizing return to the most limited resources. The fixed nature of land in the short run makes it the beginning of most farm planning effort.
Land use is affected by regional differences in land productivity – the principle of comparative advantage. The most profitable use of land depends on relative commodity prices and production technology – both can change over time and bring about changes in land use.
Rice production is concentrated in the northern part of peninsular Malaysia – MADA and KADA areas. On the other hand, rubber and oil palm production is widespread in the states of Negri Sembilan, Pahang, Perak, Trengganu, Johor, and some parts of Selangor. A substantial rubber producing areas have been transplanted with oil palm. Some portion of agricultural land has been transformed into real estate and industrial areas. These changes can be traced to changes in relative price of products and inputs, marketed products, new technology, and competing uses for land.
Controlling Land
A farmer has to decide on how much land to control and how to acquire it. Too little land may mean the business is too small to utilize other resources fully. At the other extreme, too much land may require borrowing a large amount of money, cause serious cash flow problems, and overextend the operator’s management and machinery capacity. Either situation can result in financial stress and eventual failure of the business. Land acquisition should be thought of in terms of control and not just ownership. Control can be achieved by either ownership or leasing.
Ownership
Owning land is an important goal for many farmers, regardless of the economics involved. A certain amount of pride, satisfaction, and prestige is derived from owning a land. It also provides a tangible estate to pass on to one’s heirs.
Owning land has the following advantages:
1. Security of Tenure Landownership eliminates the uncertainty of losing a lease and having the size of the business reduced unexpectedly. It also ensures that the operator will receive the benefits of any long-term improvements made to the land.
2. Loan Collateral Accumulated equity inland provides an excellent source of collateral when borrowing money. Increasing land values over time have provided substantial equity for land owners.
3. Management Independence and Freedom Landowners are free to make their own decisions about enterprise combinations, conservation measures, fertilizer levels, and other choices, without consulting with a land lord or professional farm manager.
4. Hedge Against Inflation Over the long run, land provides an excellent hedge against inflation. Because increase in land values have tended to equal or exceed the rate of inflation.
5. Pride of Ownership Owning and improving one’s own property is a source of pride. It assures a future benefit from years of labor and investment.
Owning land also has the following disadvantages:
1. Cash Flow Large debt load associated with purchasing farmland can create serious cash flow problems. The cash earnings from the land may not be sufficient to meet the required principal and interest payments, as well as the other cash obligations of the business.
2. Lower Return on Capital Where capital is limited, they may be alternative uses for it than investing in land. Machinery, livestock, and annual operating inputs such as fertilizer, seed and feed, often produce a higher rate of return on investment than land.
3. Less Working Capital A large investment or heavy debt load on land may restrict the amount of working capital that is available, severely limiting the volume of production, choice of enterprises, input levels, and profits.
4. Size Limits A combination of limited capital and a desire to own all the land to be operated will limit the size of the business. A small size may prevent the use of certain technologies and result in higher average costs.
The disadvantages of land ownership are more likely to affect the beginning farmer with limited capital.
Leasing Land
Beginning farmers are often advised to lease land. With limited capital, leasing is a mean of controlling more acres. Other advantages of leasing land are:
1. More Working Capital When capital is not tied up in land purchases more is available to purchase machinery, livestock, and annual operating inputs.
2. Additional Management A beginning farmer may be short of management skills. Management assistance can be provided by a knowledgeable landlord or professional farm manager employed by the landlord.
3. More Flexible Size Lease contracts are often for only one year or, at most, several years. Changes in business size can be easily accomplished by giving up old leases or leasing additional land.
4. More flexible Financial Obligations Lease payments are more flexible than mortgage payments, which may be fixed for along period. The value of share rent will automatically vary with crop yields and prices. Cash rent are less flexible but can be negotiated each time the lease is renewed, taking into account current and projected economic conditions.
Leasing land also has disadvantages, especially when all the land operated is leased. These disadvantages are:
1. Uncertainty The land being farmed can be lost on short notice. This possibility discourages long-term investments and contributes to a general feeling of uncertainty about the future of the business.
2. Poor Facilities Some landlords are reluctant to invest money in buildings and other improvements. Thus family housing, livestock facilities, grain storage, fences, and machinery housing may be obsolete, in poor condition, or nonexistent.
3. Slow Equity Accumulation In period of rising land values, tenants may have to pay higher rents without accumulating any equity.
The proper combination of owned and leased land is the one providing enough land to fully use the available labor, machinery, management, and working capital without creating excessive financial risk.
Buying Land
The purchase of land involves large sums of money and will have long-run effects on both liquidity and solvency of the business. Income potential is the most important determinant of land value. Other factors that contribute include: soil topography and climate, buildings and improvements, size, markets, location, and competing uses.
1. Soil, Topography, and climate affect the crop and livestock production potential and there fore the expected income stream.
2. Buildings and improvements The number, size, condition, and usefulness of buildings, fences, storage structures, and other improvements will affect the value of a parcel of land.
3. Size Small and medium-sized farms may sell for a higher price per hectare than large farms – a smaller total purchase price puts the farm within the financial reach of a larger number of buyers.
4. Markets Proximity to a number of markets will reduce transportation costs, increase competition for the farm’s products, and possibly raise net selling price.
5. Location with respect to schools, masjid, towns, recreational facilities, paved roads, and farm input suppliers will also affect value.
6. Competing uses Land that is close to urban or recreational areas, or has mineral deposits, may have a higher value than other agriculture land due to its other potential uses.
Land Appraisal
An appraisal is a systematic process which leads to the estimate of a value of a piece of a real estate. Two methods are used to determine the value of income-producing property such as land: the market data method and the income capitalization method.
The market data method compares the characteristics of the land which was sold recently with the land being appraised. Sale prices for the comparable land sales are used to estimate value for the subject property after adjusting for differences in factors such as soil types, productivity, location, size, buildings, and time of sale.
The income capitalization method uses investment analysis methods to estimate the present value of the future income stream from the land.
This method involves:
1. an estimate of the expected annual net income
2. the selection of a discount rate
3. computing the present value of annuity
The present value equation for land appraisal purpose:
Chapter 13 HUMAN RESOURCE MANAGEMENT
Human labor is one of the most important inputs in agriculture. The introduction of mechanization requires labor input operating, supervising, and monitoring these mechanical activities and less on physical effort. Changes in tasks performed by agriculture labor have required both employees and managers to increase their education, skills and, training.
The availability of new technology such as larger machinery, mechanical feed, manure handling systems, and computers does not alone explain their rapid and widespread adoption. There has to be economic justification for the use of new technology or it will simply “sit on the shelf”. Most labor saving technology has been adopted for one or more of the following reasons:
• It is less expensive than the labor it replaces
• It allows farmers or producers to increase their volume of production and total profit
• It makes work easier and more pleasant
• It allows certain operations such as planting and harvesting to be completed on time, even when weather is unfavorable or labor is short in supply
• It does a better job than could be accomplished manually
Input substitution occurs because of a change in the marginal physical rate of substitution and/or a change in the relative prices of inputs. Both factors have been important in the substitution of capital-intensive technology for labor in agriculture. Marginal rates of substitution have changed as new technology altered the shape of the relevant isoquants, making it profitable to use less labor and more capital.
Characteristics of Agriculture Labor
Labor is a continuous-flow input – the service it provides is available hour by hour and day by day. It cannot be stored for later use – it must be used as it becomes available or it is lost.
The human factor is another characteristic that distinguishes labor from other resources. If an individual is treated as an inanimate object, productivity and efficiency suffer. The hopes, fears, ambitions, likes, dislike, worries, and personal problems of both the operator and employees must be considered in any labor management plan.
Planning Farm Labor Resources
The first step is to assess the farm’s labor needs, both the quantity and quality, and the condition under which workers will function. Figure 13.1 illustrates the process.
Figure 13.1: Farm labor planning process
Quantity of Labor Needed
Most managers judge the quantity of labor needed by observation and experience. Labor requirement for a new enterprise can be determined by a published enterprise budget. The seasonality of labor needs must also be considered. Labor requirement may exceed available labor in certain months where production operations involve more work. Sometimes addition of full time employee results in large amount of excess labor during other months. Therefore, longer workdays, temporary help, or hiring custom operator [contracting] may be necessary to perform the required tasks on time. A more permanent solution may be to increase the capacity of field machinery or processing equipment, or to shift to different enterprise. The amount of labor to be utilized to maximize profit depends on its availability, its costs, and whether it is a fixed or variable input.
Labor as a Fixed Cost
The total labor supply of the full-time employee may be fixed but not fully utilized. If this labor is being paid a fixed salary regardless of the hour worked, there is no variable or marginal cost for utilizing another hour. In this situation labor can be treated as fixed cost. In an enterprise budget labor cost neither affects the gross margin, nor the choice of enterprises. In a partial budget, labor costs are neither included in added costs nor in reduced costs.
Labor as a Variable Cost
When labor is hired on a part-time or ‘as needed’ basis, it should always be treated as variable cost. The cost of such labor, including the benefit and payroll taxes, should be included in any budgeting decisions as well as marginal cost, marginal revenue analysis.
Quality of Labor Needed
New agricultural technologies require more specialized and sophisticated skills. Some activities, such as application of certain pesticides, may even require a special training and certification. An assessment of labor needs requires identification of special capabilities needed, such as operating certain type of machines, performing livestock health chores, balancing feed rations, using computers or electronic control devices, or performing mechanical repairs and maintenance. If skill workers are not available, then certain jobs may be contracted to outside consultants, repair shops, or custom operators. Training programs may also be available to help farm workers acquire new skills.
Management Style
Some employers prefer employees who can work independently with a minimum amount of supervision and instruction. Other employers prefer to work closely with workers, and give specific instructions about how a job is to be performed. Both management style can be effective, but a good manager recognizes his or her own style and seek out workers who can function effectively under it.
Once the quantity and the quality of labor needed by the farm have been analyzed, tentative job description should be developed. Larger operations will allow for much more specialization of duties than smaller ones. Then the skills of the workers currently available should be compared to the job descriptions. Some duties may have to be rearranged to match the skills and the interests of certain employees. Needs that cannot be met by current work force will have to be filled by providing job training, securing additional workers, or contracting with outside services.
Developing an organizational chart is especially useful where several employees and managers are involved. It should be made clear whether some employees are expected to take directions from other employees. An organizational chart should show the lines of communication that need to be maintained among managers and employees.
Measuring the Efficiency of Labor
Labor efficiency depends not only on the skills and training of the labor used but also on the size of the business, enterprises, degree of mechanization, type of organization, and many other factors. Measures of labor efficiency should be used to compare and evaluate results only on farm businesses of approximately the same size and type.
Measures of labor efficiency often use the concept of person-years or full-time equivalents of labor employed. A 12 month, 4 month, and 5 month labor provided by operator, family, and hired worker respectively is equivalent to 1.75 person-years or 1.75 persons working full time during the year. Measures of labor efficiency convert some physical output, cost, or income total into a value per person-year.
Value of Farm Production per Person
This measures the total value of agricultural products generated by the farm per person-year equivalent. It is affected by business size, type of enterprise, and the amount of machinery and other labor-saving equipment used.
Labor Cost per Crop Acre
The cost of labor per crop acre is found by dividing the total crop labor cost for the year by the number of acres in crop and fallow.
Crop Acres per Person
The number of crop acre per person is found by dividing total crop acres by the number of person-years of labor used for crop-related activities.
Improving Labor Efficiency
Labor efficiency can be improved by:
1. More capital investment per worker, the use of large scale machinery, or adopting less labor intensive technology. Increasing the capital investment per worker will increase profit only if:
• Total cost is reduced, while revenue increases, remains constant, or at least decrease less than cost
• The labor that is saved can be used to increase output value elsewhere by more than the cost of the investment
2. When the labor supply is increased by adding a full-time worker, some additional units of an enterprise may be needed to fully utilize the available labor.
3. Simplifying working procedures and routines can increase labor efficiency. Considerable time can be saved by having all necessary tools and supplies at the work area, keeping equipment well maintained, and having spare parts on hand.
4. Making changes in the farmstead layout, building designs, field size and shape, and the storage sites for materials relative to where they will be used can also save time and increase labor efficiency
5. Carrying radios or portable telephones in vehicles or tractors makes timely communication possible, allows coordination of activities over a wide geographic area, and reduces trips.
6. Production data can be entered into small notebook or hand-held computers, rather than transferred from paper records – additional costs of any changes must be weighed against the value of labor saved.
7. Labor efficiency can also be improved by making sure workers have safe and comfortable working conditions whenever possible.
8. Workers should be provided with suitable clothing and other safety equipment when working with agricultural chemicals or performing other hazardous jobs.
9. The simple procedure of planning and scheduling work in advance will help reduce wasted time. Tasks that must be done at a specific time must be scheduled first. Those that are not specific, such as building repairs and other maintenance can be planned for months of slack labor. Keep a list of jobs to be done and assign a priority and deadline to each one. Exhibit or place the list where all workers can see it, add to it and cross off tasks that have been completed.
Improving Managerial Capacity
In any business managers are the most important labor resources. Management skills must continually be reinforced and upgraded. A successful farm manager must understand the principles behind technology, such as plant physiology, soil science, crop protection, and farm mechanics or engineering. Farm magazines, seminars, continuing education course are excellent sources of information about new technology. The manager must realize that delegating responsibility to others or hiring outside consultants is a useful way of accessing additional expertise.
Developing an efficient office or business center is also a sign of good manager.
• The physical facilities should be comfortable and functional, and allow the use of up-to-date communications and information management technology.
• The flow of bills, receipts, reports, and correspondence should move quickly and frequently.
• Records should be sorted and filed for easy retrieval.
The manager must adopt the principles of immediacy and impact to decide what jobs will have the most effect on the business and/or need to be completed first. Making monthly and weekly lists helps identify and prioritize tasks to be done.
Many successful managers are active in professional and volunteer organizations outside their own businesses. Through this participation, managers can develop their organizational skills and human relations. Some of the best ideas and philosophies are often generated by interacting with other highly capable people. Agriculture manager needs to develop a ‘world view’ of agriculture production and the demand of agriculture products which can be achieved through:
• Traveling abroad
• Hosting international visitors
• Reading about other cultures
Obtaining and Managing Farm Employees
Acquisition, training, and retention of hired workers are part of a manager’s job. Skills in human relations and personnel management are valuable assets to managers.
Recruiting
The process of hiring an employee starts with recruiting, including announcing the job opening, publicizing it, and receiving applications.
Placing newspaper ads, contacting college placement offices and employment agencies are ways to inform individuals about job opening and identify potential candidates to fill it. The job announcement should clearly state the academic qualification, skills, and experience desired. It is generally helpful to provide application form to each applicant. Basic information about the applicant’s background, work experience, training, personal goals, and other factors should be obtained.
Interviewing and Selecting
Completed application forms can be used to select a number of candidates for interview. The interview should be planned carefully to efficiently acquire more information. Sufficient time and opportunity should be allowed for the applicant to ask questions about the job, its duties, and responsibilities. Interview also provides information to the applicant so they can assess their own interest in and the qualifications for the job. A skill test may be needed for certain technical jobs. It is good to provide a tour of the work location. The information obtained about each job applicant through the application form, the interview, and references must be evaluated. Many factors, including personal compatibility, must be considered in selecting a candidate.
The Employment Agreement
Once a job offer is made and accepted, a written employment agreement should be developed. The purpose of the agreement is to clarify the work expectations of both employer and employee, and to serve as a reference for evaluating performance later on.
The employment agreement should contain:
• Job description, including duties and responsibilities, lines of authority, and the job title
• Wages and benefits, working hours and days, vacation , sick leave and personal leave policy, safety rules, allowable uses of farm property, training opportunities, bonus or incentive plans
• Procedures for evaluation and promotion or termination
Compensation
A competitive compensation package is essential in a successful labor hiring program. The total value of take home-pay, benefits, and bonuses should be compared against comparable figures in other employment.
Wages and Salaries
The actual cash wage or salary paid is the most important item. Positions in which the duties and hours worked will be fairly constant through out the year usually received a fixed weekly or monthly salary. Other positions with highly variable hours, such as those found on fruit and vegetable or cash grain farm, are often paid by the hour, as are most part time positions. Workers who are employed in harvesting activities are sometimes paid on a piece-rate basis.
Fringe Benefits
Fringe benefits are often a large part of the total compensation of the farm employees. Prospective employees should be made aware of the value of their benefits so they can fairly evaluate a job offer. Fringe benefits such as retirement plan, insurance, housing, utilities, farm produce, and the use of vehicle will make a lower cash wage for farm work competitive with non-farm employment that has a higher cash salary but fewer benefits. Fringe benefits are most useful when the employer can provide them for less than it would cost the employee to obtain them elsewhere.
Incentive Programs and Bonuses
Bonuses are often used to supplement base wages, improve labor productivity, and increase employee retention. However, bonuses help increase labor efficiency only if they are tied closely to performance. If not, employees soon come to expect the bonus and consider it part of their basic cash salary. When the size of the bonus is tied to annual profit, an employer may fin d it difficult to decrease the bonus in a poor year after employees have experienced several years with a larger bonus.
Most bonus plans are based on several factors:
• Volume – It can be measured by amount of crop harvested. The employee’s wages increase when the work load increases, and a modest incentive for efficiency is provided.
• Performance – It can be measured by crop yield per acre. The bonus is often based on how much the actual performance exceeds a certain base level.
• Longevity – A bonus is paid based on the n umber of years the employee has worked for the business. This recognizes the value of experience and worker continuity to employer, and rewards loyalty.
• Profitability – Bonuses are usually based on the gross or net income of the business. They allow the employees to share the risks and rewards of the business.
Following several basic principles will increase the effectiveness of any incentive program.
• The program should be simple and easily understood by the employee.
• The program should be based on factors largely within the control of the employee.
• The program should reward work that is in the best interest of the employer.
• The program should provide a cash return large enough to motivate improved performance.
• The incentive payment should be made promptly or as soon as possible after the completion of the work.
• The incentive payment should not be considered as a substitute for a competitive base wage and good labor relation.
A good bonus plan not only reward employees financially, but also provides recognition for their accomplishments. Total compensation packages offered to employees should have internal consistency i.e. they should be fair among employees of the same business.
Training Hired Labor
Hired workers will need some instruction on the practices and routines to be followed for a particular operation. Employees with lesser skills should receive complete instructions and proper supervision during a training period. Periodic retraining may be necessary even for long-term employees. The adoption of new technology in the form of different machinery, new pesticides, feed additives, seed varieties and electronic data gathering, or introduction of a new enterprise may require training for all employees. Extension short courses, bulletins, farm magazines, DVD, internet sites, field days, and seminars can be used for employee training. Participation in these activities will improve not only employees’ skills, but also their self-esteem. The cost of training should be borne by the employer.
Motivation and Communication
Hiring and training new employees is costly in terms of both time and money. If labor turnover is high, these costs can become excessive, and labor efficiency will be low. Employers should be aware of the reasons for poor employee retention and take action to improve the situation. High labor turnover is often due to:
1. Long working hours with little time off
2. Early-morning or late-evening work
3. Uncomfortable working conditions
4. Poor personal relationship with their employer
Hired workers are motivated if:
1. They have adequate vacations and time off
2. They have the opportunity to work in good working environment
3. They job titles that can boost their personal satisfaction and self-image. For example, replacing the title laborer with group leader or machine operator.
4. The employers practice good human relations – such as friendly attitude, loyalty, trust, mutual respect, the ability to delegate authority, and willingness to listen to employee suggestions and complaints
5. Criticism and suggestion for improvement is communicated in private
6. More responsibilities are given to employees who have increased their abilities and experience
Chapter 14 MACHINERY MANAGEMENT
Mechanization affects cost of production, efficiency levels, energy use, labor requirements, and product quality in agriculture. Mechanization in agriculture does not only include farm tractors and other crop production machinery, but also power and equipment in livestock production and materials handling. Others include small engines and electric motors, conveyors, computers, sensors, and timers. Automation adopted in farms to reduce labor costs and requirements, and improve performance in grain handling, manure collection and disposal, livestock feeding, feed grinding and mixing, accounting, and data collection are other examples. Good machinery management strives to provide reliable service to various crop and livestock enterprises at minimum cost.
Estimating Machinery Costs
The ownership costs (also called overhead, indirect, or fixed costs) are fixed with respect to the amount of annual use. Operating costs or variable costs or direct costs vary directly with the amount of machinery use.
Ownership costs
Generally, ownership costs is about 15% to 20% of the total cost of the machine depending on the type of machine, its age, expected useful life, and the cost of capital.
Depreciation
Depreciation is a non-cash expense that reflects a loss in value of machinery due to age, wear, and obsolescence. It is an accounting procedure to recover the initial purchase cost of an asset by spreading this cost over its entire ownership period. Annual depreciation can be estimated by the straight-line, declining balance or the SOYD methods.
Interest
Interest is calculated based on the average value of the machine over its ownership period or its value at mid-life. This value is then multiplied by the interest rate, which is the opportunity of capital.
Average value =
Interest = average value x interest rate
Taxes
The charge depends on the value of the machine and the tax rate.
Insurance
It is an annual charge to cover damage to the machine from collision, fire, theft, and for any liability coverage.
Operating costs
They are directly related to use and have a value of zero if the machine is not used – the costs will increase with the amount of use. Operating costs include repairs, fuel and lubrication, and labor operating the machine.
Calculating Machinery Cost
Step 1: List basic data
The machine: New tractor 200-hp diesel engine:
Purchase cost
Salvage value
Average value
Ownership life
Estimated annual use
Interest
Step 2: Calculate ownership cost
Depreciation
Interest
Tax and insurance
Total ownership costs
Ownership cost per hour
Step 3: Calculate operating costs
Repairs
Diesel fuel
Lubrication and filters
Labor
Total operating costs
Operating cost per hour
Step 4: Calculate total cost per hour
Ownership cost per hour
Operating cost per hour
Total cost per hour
Step 5: Calculate cost per acre
Factors in Machinery Selection
Selecting the machinery required with a proper capacity depends on:
• Types and sizes available
• Capital availability
• Labor requirements
• Crop and livestock enterprises in the farm plan
• Tillage practices
• Climatic factors
The objective is to select a machine that will satisfactorily perform the required task within the time available for the lowest possible total cost.
Calculating the Field Capacity of a Machine
A one meter Cane Commander operated at 12 km per hour with a field efficiency of 80% would have a field capacity of: 12000 m2 per hr / 10000 m2 per ha x 80% = 0.96 ha per hour.
If a producer wants to harvest 10 ha canes in two days and operates 6 hours per day; the minimum capacity needed: 10 ha / 2 days x 6 hrs = 0.83 ha per hour.
Put it differently, a producer who owns a harvester with an effective capacity of 0.83 ha per hour, harvests cane 6 hours per day, only requires 2 days to completely harvest 10 ha of canes.
Example of Machinery cost calculation
Step 1: List basic data
New combine, 7-meter header, 240-hp diesel engine
List price RM 175,000
Purchase price 160,000
Salvage value (22% of new list price) 38,500
Average value (purchase price + salvage value)/2 9,920
Ownership life 10 yrs
Annual use 300 hrs
Interest rate 8%
Step 2: calculate ownership costs
Depreciation RM 12,150
Interest 7,940
Taxes and insurance (1.5% of average value) 1,489
Total Ownership Costs (TOC) RM 21,579
Ownership cost per hour (TOC/300 hrs) RM 71.93
Step 3: Calculate operating costs
Repairs
6,983
Diesel fuel
2,693
Lubrication and filters (15% of fuel costs) 404
Labor (300 hrs x RM 10.8 per hr 3,240
Total Annual Operating Costs (TAOC) RM 13,320
Operating cost per hr
RM 44.40
Step 4: Calculate total cost per hr
Ownership cost per hr 71.93
Operating cost per hr 44.40
Total cost per hr RM 116.33
Step 5: Calculate cost per hectare
Performance rate/Field capacity: 8 ha per hr
RM 14.54
Chapter 15 MEASURING MANAGEMENT PERFORMANCE
After planning the farm business and acquiring resources to operate the business, the next step is to measure profit and other financial characteristics of a farm business. The results of the measurement allow the manager to determine how well and to what degree this goal is being attained.
This discussion is related to the control function of management. Control is a monitoring system to see whether the farm’s business plan is being followed and how close the farm is towards meeting the goal(s) of the plan. Many of the same records needed to measure profit and the financial status of the business are also needed to perform the control function of management. They provide a method of measuring the performances of both the business and the manager or management.
Acquiring and Organizing Management Information – Farm Record System
A business with poor or no records is like a ship in the middle of the ocean that has lost its rudder and navigational aids. It does not know where it has been, where it is going, or how long will it take to get there. From records the manager can know where the business has been - whether it is now on the path to making profits and creating financial stability or otherwise. They also show the results of management decisions over past time periods and can provide considerable information to correct or amend past decisions and to improve future decision making – they influence the future direction of the business. However, for a number of reasons, farm records have been poorly kept.
Purpose and Use of Records
The manager uses farm records for the following reasons:
1. To measure profit and assess financial condition
2. To obtain data for business analysis
3. To assist in obtaining loans
4. To measure the profitability of individual enterprises
5. To assist in the analysis of new investments
6. To prepare income tax returns
Other possible uses include establishing insurance needs, planning and valuing estates, monitoring inventories, reporting to partners and shareholders, and developing marketing plans.
Measuring Profit and Assess Financial Condition
Profit is estimated by developing an income statement and financial condition of the business is shown on a balance sheet.
Provide Data for Business Analysis
The information from the balance sheet and the income statement can be used to do an in-depth business analysis. Is the business profitable? How profitable? A financial analysis of the business can provide information on the results of past decisions, and this information can be very useful when making current and future decisions.
Assist in Obtaining Loans
Lenders need and require financial information about the farm business to assist them in their lending decisions.
Measure the Profitability of Individual Enterprises
A record system can be designed to show revenue and expenses for each individual enterprise. With this information, the unprofitable or least profitable enterprises can be eliminated, and resources can be redirected for use in the more profitable ones.
Assist in the Analysis of New Investments
A decision to commit a large amount of capital to a new investment can be difficult and may require a large amount of information to do a proper analysis. The records from the past operations of the business can be an excellent source of information to assist in analyzing potential investment. For example, records on the same investments can provide data on expected profitability, expected life, and typical repairs over its life.
Prepare Income Tax Returns
Internal Revenue Authorities (IRA/LHDN) regulations require keeping records that permit the proper reporting of taxable income and expenses. A detailed management accounting system can produce income tax benefits. It may identify additional deductions and exemptions and allow better management of taxable income from year to year.
Farm Business Activities
The farm accounting system must be able to handle transactions relating to production, investment, and financing activities of the business.
Production Activities
Accounting transactions for production activities are those related to the production of crops and livestock. Revenue from their sales and other farm revenue such as government program payments and custom work done for others would be included. Expenses incurred in producing that revenue – such as feed, fertilizer, chemicals, fuel, interest, and depreciation – need to be recorded in the accounting system.
Investment Activities
These activities are those related to the purchase, depreciation, and sale of long-lived assets, such as land, buildings, machinery, orchards, plantations, and breeding livestock. Records for each asset should include: purchase date, purchase price, annual depreciation amount, book value, current market value, sale date, sale price, and gain or loss when sold.
Financing Activities
Financing activities are all transactions related to borrowing money and paying interest and principal on debt of all kinds. This includes money borrowed to finance new investments, operating money borrowed to finance production activities for the year, and accounts payable at farm supply stores.
A good accounting system must be able to record all transactions and to assign them to appropriate activity and enterprise of the operation.
Basic Accounting Terms
Some knowledge of basic accounting and accounting terminology is useful to keep and analyze a set of farm records. It is needed:
• to fully understand and use any accounting system
• to accurately communicate accounting information to others
Some important basic accounting terms that a manager should know include the followings:
• Account payable is an expense that has been incurred but not yet paid. Typical account payable are for items charged at farm supply stores where the purchaser is given a certain period of time to pay the amount due.
• Account receivable is the revenue for a product that has been sold or a service provided for which no payment has yet been received. Examples would be custom work done for a neighbor who has agreed to make payment by the end of next month, or grain sold on a deferred payment contract.
• Accrued expense is an expense that accrues or accumulates daily but has not yet been paid because the due date is still some time in future. Examples are interest on loans and property taxes.
• Asset includes any item of value, tangible or financial such as machinery, land, bank accounts, buildings, grain, and livestock.
• Credit in accounting is simply an entry in the right-hand side of a double-entry ledger. A credit entry is used to record a decrease in value of an asset or an increase in a liability, owner equity, or an income account.
• Debit is an entry in the left-hand side of a double-entry ledger. A debit entry is used to record an increase in an asset or expense account, and a decrease in a liability or owner equity account.
• Expense is a cost or expenditure incurred in the production of revenue.
• Inventory is the physical quantity and financial value of products produced for sale that have not yet been sold. Farm or ranch examples would be grain in storage, or livestock that are ready for sale or could be sold at the time the inventory is taken.
• Liability is a debt or other financial obligation that must be paid at some time in the future. Examples would include loans from a bank or other lending institution, accounts payable, and accrued expenses.
• Net farm income is revenue minus expenses - the same as profit.
• Owner equity is the difference between business assets and business liabilities. It represents the net value of the business to the owner(s) of the business.
• Prepaid expense is payment made for a product or service in an accounting period before the one in which it will be used to produce revenue.
• Profit is revenue minus expenses- same as net farm income.
• Revenue is the value of products and services produced by a business during an accounting period. Revenue may be either cash or non-cash.
Options in Choosing an Accounting System
A manager must make several decisions on the type of accounting system to be used. Decisions must be made on the following options:
1. What accounting period should be used? An accounting period is that period of time used to summarize revenue and expenses and estimate profit. It can be a calendar year or a fiscal year. If a calendar year is used, it starts from January 1 to December 31 each year. A fiscal year is any 12 month period that begins on some other date other than January 1.
2. Should it be cash or an accrual system? In CASH ACCOUNTING system, no transaction is recorded unless cash is spent or received. REVENUE is recorded only when cash is received for the sale of products produced or services provided. Revenue is recorded in the accounting period when cash is received regardless of when the product is produced or the service provided. Example: a crop produced in one year, placed in storage, and sold in the following year. Any accounts receivable at the end of an accounting period also result in cash being received in an accounting period after the product was produced. EXPENSES are recorded in the accounting period during which they are paid. The accounting period in which the product is purchased is not considered. Expenses can be recorded in different years than those years the product is purchased and has generated revenue. Examples are prepaid expenses, account payable, and accrued expense – an item (borrowed money) is being used in one year, the cost of that item (interest) will not be paid until the next year when the annual payment is due. Exception: depreciation is non cash expense, but is considered as cash expense in cash accounting. ACCRUAL ACCOUNTING is the standard of the accounting profession. It requires more entries and accounting knowledge than cash accounting. However, it provides a much more accurate estimate of annual profit than cash accounting. REVENUE is recorded for all values of products produced or services provided during the year. Accrual accounting emphasizes that the value of a product or service should be counted as revenue in the year it was produced, no matter when the cash is received. The handling of inventories is the major difference between cash and accrual accounting on farms. Accrual accounting records inventories as revenues. Example: a crop produced in one year and placed in storage the following year. Accrual accounting includes an estimate of the value of the crop in storage as revenue in the year it was produced. This is done by adding an inventory increase from the beginning to the end of the year to other revenue. An inventory decrease is deducted from the other revenue. The result is an estimated profit that more accurately describes the financial results of the production activities for the year. EXPENSES incurred in the production of that revenue in one year should be recorded in the same year. Therefore, 1) prepaid expenses must show up as expenses in the year after the item is purchased 2) accounts payable must be entered as expenses, although no cash has yet been expended to pay for the items 3) accrued expenses at year-end must be entered as expenses, although no cash has been expended.
3. Should it be a single- or double-entry system? Single-entry system makes only one entry in the books to record a receipt or expenditure. A double-entry system records changes in the values of assets and liabilities as well as revenues and expenses. This system will result in more transactions being recorded during an accounting period, but it has two important advantages:
• Improved accuracy, because the accounts can be kept in balance more easily
• The ability to produce complete financial statements, including a balance sheet, at any time, directly from data already recorded in the system
The improved accuracy of double-entry accounting comes from two offsetting entries, which means that debits must equal credits for each transaction recorded. It also means that the basic accounting equation of Assets = Liabilities + owner equity will be maintained.
4. Should it be a basic or complete accounting system? The most basic and simple accounting system would be one which is manual and uses cash accounting only. A complete system would be computerized with capabilities for both cash accounting for tax purposes and accrual accounting for management purposes. It would also be able to track inventories, compute depreciation, track loans, perform enterprise analysis, and handle all employee payroll accounting.
The completeness of an accounting system for a farm depends on the answers to the following questions:
• How much accounting knowledge does the user have?
• How large and complex is the farm business and its financial activities?
• How much and what kind of information is needed or desired for management decision making?
Output from an Accounting System
Any accounting system should be able to produce some basic financial reports. The possible products from an accounting system are shown in the Figure 15.1. The two most important and common reports from an accounting system are the balance sheet and the income statement.
Depreciation
Machinery, buildings, and similar assets are purchased because they are required in the production of farm products, which in turn produce revenue. Their use in the production process over time causes them to grow old, wear out, and become less valuable. This loss in value is considered as business expense, because it is a direct result of the asset’s use in producing revenue and profit. Depreciation is the annual loss in value due to use, wear, tear, age, and technical obsolescence. Depreciation is an expense that reduces annual profit and reduces the value of asset. To be depreciable, an asset must have the following characteristics:
• a useful life of more than one year
• a determinable useful life but not an unlimited life
• a use in business in order for the depreciation to be a business expense
There are several methods to compute annual depreciation. These are only estimates of the actual loss in value. We can determine the true depreciation by finding the asset current market value and comparing it to the original cost. We must define several terms before reviewing the depreciation methods. Cost is the price paid for the asset, including taxes, installation, and any other expenses directly related to placing the asset into use. Useful life is the expected number of years of the asset’s use in the business. Salvage value is the expected market value of the asset at the end of its assigned useful life. Therefore, the difference between cost and salvage value is the total depreciation or loss in value expected over the useful life. A salvage value will generally have some positive value. However, it may be zero if we use the asset until completely worn out. Book value is the assets cost less accumulated depreciation. This value will always lie between cost and salvage value.
Depreciation Methods
We can use several methods to compute annual depreciation. The correct choice of the methods depends on the type of asset, its pattern of use over time, how rapidly or slowly its market value declines, and other factors.
Straight Line
Annual depreciation = or Annual depreciation = (cost – salvage value) x R where R is the annual straight-line percentage rate found by dividing 100 percent by the useful life.
Sum-of-the- Year’s Digits (SOYD)
Annual depreciation = (cost – salvage value) x
RL = remaining years of useful life as of the beginning of the year for which depreciation is being computed. SOYD = sum of all the numbers from 1.0 to the estimated useful life. Example, SOYD = 15 for a 5-year useful life asset.
Declining Balance
Annual depreciation = (book value at beginning of year) x R where R is a constant percentage value or rate. The declining balance uses a multiple of the straight- line rate, such as 200 (double), 175, 150, or 125 percent, for the R-value.
Partial-year depreciation
An asset purchased during the year should have the first year’s depreciation prorated according to the length of time actually owned.
Valuation of Assets
Several evaluation methods of business assets can be used, and the choice will depend on the type of asset and the purpose of evaluation. We should keep in mind the accounting concept of “conservatism” (placing too high a value on asset) and “consistency” (using same evaluation method over time).
Market Value
Asset is valued using its current market price (also known as fair market value or net market price method). We subtract any normal marketing charges such as transportation, selling commissions, and other fees to find the net market value. Grain is valued using this method.
Cost
Items purchased can be valued at their original cost. Land is generally valued at cost for a conservative valuation. Feed, fertilizers, supplies, and purchased feeder livestock are often valued at cost.
Lower of Cost or Market
An item is valued at both cost and market value and use whichever value is lower. This is a conservative method because it minimizes the chance of placing an overly high value on any item.
Farm Production Cost
Grain and raised livestock can be valued at their farm production cost, the accumulated costs of producing the item. Established but immature crop growing in the field is valued this way.
Cost Less Accumulated Depreciation
This method is used to value depreciable asset such as machinery, buildings, and purchased breeding livestock. Assets estimated value will be the same as its current book value.
The Balance Sheet and its Analysis
A balance sheet summarizes the financial condition of the business at a point in time, Balance sheet estimates net worth or owner equity by valuing and organizing assets and liabilities.
A balance sheet is a systematic organization of everything “owned” (asset) and “owed” (liability) by a business or individual at a given point in time.
ASSETS = LIABILITIES + OWNER EQUITY
Normally, a balance sheet is prepared at the end of the accounting period (December 31). This procedure allows a single balance sheet to be both an end-of-year statement for one accounting period and a beginning-of-year statement for the next accounting period. We measure the financial position of a business primarily using the concepts of SOLVENCY and LIQUIDITY.
An example of a balance sheet
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash/checking A/C RM 5000 A/C payable RM 6000
Marketable securities 1000 Notes payable within 1 yr 15000
Inventories Current portion of term debt 28000
Crops 40000 Accrued interest 15700
Livestock 52000 Income tax payable 8000
Supplies 4000 Current-portion deferred taxes 15020
A/C receivable 1200 Other accrued expense 900
Prepaid expenses 500 Total Current Liabilities 88620
Investment in growing crops 7600 Non-current Liabilities
Other current assets 0 Notes payable
Total Current Assets 111300 Machinery 20000
Non-current Assets Breeding livestock 40000
Machines and equipment 67500 Real estate debt 175000
Breeding livestock (purchased) 48000 Total Non-current Liabilities 235000
Breeding livestock (raised) 12000 Total Liabilities 323620
Buildings and improvements 27000 Owner Equity
Land 288000 Contributed capital 50000
Other non-current assets 0 Retained earnings 180180
Total Non-current Assets 442500 Total Equity 230180
Total Assets 553800 Total Liabilities and Owner 553800
Equity
Balance Sheet Analysis
We use a balance sheet to measure the financial condition of a business – solvency and liquidity.
Analyzing Liquidity
Current ratio
Current ratio =
A value of 1.0 means current liabilities is just equal to current assets. The larger the ratio, the more liquid is the business, and vice versa.
Working capital
Working capital = current assets – current liabilities
Working capital is the dollar value that would remain after selling all current assets and paying all current liabilities.
Analyzing Solvency
Solvency is the relative relations among assets, liabilities, and equity.
Debt/asset ratio
Debt/asset ratio = It measures what part of total assets is owed to lenders. A value of less than 1.0 is preferred.
Equity/asset ratio
Equity/asset ratio = It measures what part of total assets is financed by the owner’s equity capital. Higher values are preferred. A negative value means an insolvent business.
Debt/equity ratio
Debt/equity ratio = It compares the proportion of financing provide by the lender and the business owner. Smaller values are preferred.
Other Measures
Net capital ratio
Net capital ratio = It measures solvency. A net capital ratio of 1.0 result from zero equity and higher values indicate a greater degree of solvency. A value of 2.0 is often considered the minimum safe value.
Debt structure ratio
Debt structure ratio = It measures the proportion of current liabilities to total liabilities and can be converted to percentage. Since all current liabilities must be paid within the next year, smaller numbers are preferred.
Statement of Owner Equity
The balance sheet shows the amount of owner equity at a point in time. This statement shows the sources of changes in owner equity and the amount that came from each source.
The Income Statement (Operating Statement/Profit and Loss Statement)
The income statement is a summary of revenue and expenses for a given accounting period. Its purpose is to measure difference between revenue and expenses. A positive difference indicates a profit or a positive net farm income, and a negative difference indicates a loss or a negative net farm income for the accounting period. Therefore, an income statement answers the question: Did the farm business have a profit or loss during the last accounting period, and how large was it?
All revenue and expenses identified should be included in the income statement for the computation of net farm income.
Revenue
An income statement should include all business revenue earned during the accounting period. Revenue received from the sale of commodity produced in the same accounting period is easy and straightforward. Inventories of commodity ready for sale at some other time and changes in inventories (ending value minus beginning value) are included on an accrual income statement. Accounts receivable and any change in their value from the beginning to the end of the year must be included as revenue.
Gain or Loss on Sale of Capital Assets
For depreciable assets such as machinery, orchards, and purchased breeding livestock, it is the difference between the selling price and the asset’s book value. They will only be a gain or loss when we sell an asset.
Expenses
Expenses can be either cash or non-cash. Cash expenses would include purchases of and payment for feed, fertilizer, seed, market livestock, and fuel. Non-cash expenses would include depreciation, accounts payable, accrued interest and other accrued expenses. There is also an adjustment for prepaid expenses. Depreciation is a non-cash expense. Accounts payable, accrued interest, and other accrued expenses such as property taxes are expenses incurred during the last accounting period, but not paid. To match these expenses with the revenue they produce, they must be included on this year’s income statement. We will subtract them from the next year’s income statement, when we make the payment.
The basic structure of a condensed income statement format is:
TOTAL REVENUE
Less TOTAL EXPENSES
EQUALS NET FARM INCOME FROM OPERATIONS
Plus or minus gain/ loss ON SALE OF CAPITAL ASSETS
EQUALS NET FARM INCOME
Analysis of Net Farm Income
From the income statement, we can extract the net farm income from the operation. However, the net farm income cannot tell whether the business is profitable or not, but it is a good starting point for analyzing profitability.
Rate of Return on Assets (ROA)
It is also known as return to capital, or return on investment (ROI)
ROA (%) = x 100
The return on assets is the dollar return to both debt and equity capital.
From the income statement used as example, the calculation of ROA is as follows:
Net farm income from operation 46,800
Plus interest expense 29,500
Equals adjusted net farm income from operation 76,300
Less opportunity cost on unpaid labor* -20,000
Less opportunity cost on management* -5,000
Equals return to assets 51,300
*assuming opportunity cost on unpaid labor is 20,000 and 5,000 on management
ROA = = 0.0707 or 7.07%. The average assets value is the average of total assets value from the balance sheets of the beginning year and ending year of the accounting period. We can compare the ROA with those of similar farms, the returns from other possible investments, the opportunity cost of farm’s capital, and the past ROAs from the same farm.
Rate of Return on Equity (ROE)
This is the return on the owner’s share of the capital invested. It is calculated as follows:
Net farm income from operation 46,800
Less opportunity cost of unpaid labor 20,000
Less opportunity cost of management 5,000
Equals return on equity 21,800
Rate of return on equity (%) = x 100
ROE = = 0.0608 or 6.08%
If the return on assets is less than the interest rate on borrowed capital, the ROE will be less than the ROA.
Operating Profit Margin Ratio
This ratio computes operating profit as a percent of total revenue. A higher value means the business is making more profit per dollar of revenue.
Net farm income from operation
Plus interest expense
Less opportunity cost of unpaid labor
Less opportunity cost of management
Equals operating profit
Operating profit margin ratio = x 100
= = 0.256 or 25.6%
For every dollar of revenue, 25.6 cents remained as profit after paying the operating expense necessary to generate that dollar.
Return to Labor and Management
Adjusted net farm income from operation
Less opportunity cost of capital
Equals to return to labor and management
Opportunity cost on capital is 8% (assumption)
Capital (average asset value) 725,750
Opportunity cost on capital is 58,060
Return to labor and management 76,300 – 58,060 = 18,240
Return to Labor
Return to labor and management 18,240
Less opportunity cost of management 5,000
Equals return to labor 13,240
Return to Management
Return to labor and management 18,240
Less opportunity cost of labor 20,000
Equals return to management - 1,760
In this example, net farm income was not sufficient to provide labor, management, and capital with a return at least equal to their opportunity costs.
An example of an income statement
REVENUE
Cash crop sales RM 133100
Cash livestock sales 68400
Inventory changes
Crops (8000)
Market livestock 1700
Livestock product sales 0
Government program payment 3400
Change in value of raised breeding livestock 0
Gain/loss from sale of culled breeding livestock 600
Change in A/C receivable 1200
Other farm income 0
Total Revenue RM 200400
EXPENSES
Purchased feed and grain 12000
Purchased market livestock 28000
Other operating cash expenses
Crop expenses 44500
Livestock expenses 6500
Fuel and oil 3200
Labor 8400
Repairs and maintenance 3600
Property taxes 2800
Insurance 2000
Other: Utilities 2400
Adjustments
A/C payable 1000
Prepaid expenses 1500
Accrued expenses 0
Depreciation 8200
Total operating expenses 124100
Cash interest paid 30000
Change in interest payable (500)
Total interest expense 29500
Total Expenses RM 153600
Net Farm Income from Operations RM 46800
Gain/loss on sale of capital assets
Machinery 1100
Land 0
Other 0
Total Gain/loss on sale of capital assets 1100
Net Farm Income RM 47900
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