Cost and Return Analysis PDF

Cost and Return Analysis DXP02705 —UN—23FEB11 INTRODUCTION DXP01785 —19—17SEP10 Cost and return analysis is the...

Cost and Return Analysis DXP02705 —UN—23FEB11 INTRODUCTION DXP01785 —19—17SEP10 Cost and return analysis is the primary tool for farm returns. Here we are defining costs to be inputs times and ranch managers to analyze profitability. For a farm their price, and returns to be outputs times their price. In business to survive, there must be a positive difference this chapter we will consider input-output relationships between returns and costs. In the process of analysis, and input-input relationships. We must first evaluate the there are relationships that exist between costs with physical relationships that exist and then consider the other costs, returns with other returns, and costs with prices involved. OUO1010,000166F -19-24FEB11-1/1 5-1 090117 PN=74  Cost and Return Analysis INPUT-OUTPUT RELATIONSHIPS PRODUCTION FUNCTION (INPUT-OUTPUT The budget is the primary decision-making tool for the RELATIONSHIP) farm or ranch manager. It compares the total estimated John Jones is an agriculture education student, His father costs to an expected return. Budgets can be prepared agrees to enter a joint venture with John to grow corn either pre-activity or post-activity. Projected (pre-activity) on 100 acres of the family farm. John has no resources budgets usually are used in planning, while actual except for his own labor. In exchange for his labor, John (post-activity) budgets are usually used in evaluation. will use his father's machinery and land. In whole farm, partial, or enterprise budgets there are two John must pay all of the variable inputs in the operation, types of costs. Fixed costs occur no matter what or how such as seed, gasoline, and fertilizer. From this enterprise much product is produced. Variable costs are expenses he will receive a percentage of the returns. John begins that occur only if a specific enterprise is undertaken. the project by obtaining a corn budget from his agriculture The materials that determine these fixed and variable education teacher (Figure 1a and 1b). The general costs are called inputs. The amount of the input used budget represents variable estimates and fixed inputs and in production can be varied to produce different results. outputs that he will need and can produce. These results are called outputs. John notices a number of interesting relationships from The basic relationship that allows analysis of an input and the budget. He asks, “What if I vary the amount of an output is called a production function. Research can fertilizer?” He also thinks about seeding rate, tillage, and sometimes give these relationships or at least give the weather. What effect will they have on the enterprise? basis for developing the relationships. John has begun the process of cost analysis. Figure 1a — Corn Budget Corn, Cash Rent Corn, Cash Rent Resource Information 17-Apr-10 0 2010 OPERATING INPUTS UNITS PRICE QUANTITY VALUE YOUR VALUE Seed 1000 Seed 0.98 26.000 25.48 ________________ Crop Chemicals 0 0.00 0.000 0.00 ________________ Nitrogen, Anhydrous Lb. 0.20 128.000 25.60 ________________ Phosphorus Lb. 0.26 74.000 19.24 ________________ Potassium Lb. 0.14 74.000 10.36 ________________ Lime Tons 11.00 0.500 5.50 ________________ Herbicide Per Acre 24.00 1.000 24.00 ________________ Insecticide 0 0.00 0.000 0.00 ________________ Drying Per Acre 8.00 1.000 8.00 ________________ Miscellaneous Per Acre 5.00 1.000 5.00 ________________ Custom Hire Per Acre 2.50 1.000 2.50 ________________ Cash Rent Per Acre 75.00 1.000 75.00 ________________ Annual Operating Capital Dollars 7.50% 94.425 7.08 ________________ Machinery Labor Hours 10.00 4.880 48.80 ________________ Irrigation Labor Hours 10.00 0.000 0.00 ________________ Other Labor Hours 10.00 1.500 15.00 ________________ DXP05215 —UN—09APR14 Machinery Fuel, Lube, Dollars 55.437 55.44 ________________ Repairs Equipment Fuel, Lube, Dollars 0.000 0.00 ________________ Repairs Irrigation Fuel, Lube, Dollars 0.000 0.00 ________________ Repairs TOTAL OPERATING COSTS 327.00 ________________ Figure 1a — Corn budget Continued on next page OUO1023,00040E3 -19-17JAN17-1/6 5-2 090117 PN=75  Cost and Return Analysis Figure 1b — Corn Budget FIXED COSTS AMOUNT VALUE YOUR VALUE Machinery Interest at 164.90 11.79 ________________ 7.15% Depreciation, 59.00 59.00 ________________ Taxes, Insurance Irrigation Interest at 0.00 0.00 ________________ 7.15% Depreciation, 0.00 0.00 ________________ Taxes, Insurance Equipment Interest at 0.00 0.00 ________________ 7.15% Depreciation, 0.00 0.00 ________________ Taxes, Insurance Land Interest at 0.00 0.00 ________________ 6.25% Taxes 0.00 0.00 ________________ TOTAL FIXED COSTS 70.79 ________________ PRODUCTION UNITS PRICE QUANTITY VALUE YOUR VALUE Corn Bu. 2.85 144.00 410.40 ________________ Net Gov't Payment Per Acre 23.74 01.00 23.14 ________________ TOTAL RECEIPTS 434.14 ________________ TOTAL RECEIPTS 434.14 TOTAL OPERATING COSTS 327.00 ________________ RETURNS ABOVE TOTAL OPERATING COSTS 107.14 ________________ TOTAL FIXED COSTS 70.79 ________________ RETURNS ABOVE ALL SPECIFIED COSTS 36.35 ________________ Cash Rent $75 per Acre Thompson/Jobes 4/17/10 2010-02 DEVELOPED AND PROCESSED By AFARM Consulting, L.C. PROGRAM DEVELOPED By Department of Agricultural Economics LAND GRANT UNIVERSITY Break-Even (B-E) Analysis B-E Yield at $/lb. 2.85 B-E Price at lb./acre 144 Above Operating Costs (lb.) 115 Above Operating Costs $2.27 Above Total Costs (lb.) 140 Above Total Costs $2.76 RETURNS ABOVE ALL SPECIFIED COSTS RISK ANALYSIS YIELD 101 122 144 166 187 PRICE $ 3.71 ($ 00.59) $ 79.44 $159.47 $239.50 $319.53 DXP05216 —UN—09APR14 $ 3.28 ($ 43.68) $ 27.12 $ 97.91 $168.70 $239.50 $ 2.85 ($ 86.77) ($ 25.21) $ 36.35 $ 97.91 $159.47 $ 2.42 ($129.86) ($ 77.54) ($ 25.21) $ 27.12 $ 79.44 $ 2.00 ($172.95) ($129.86) ($ 86.77) ($ 43.68) ($ 00.59) Figure 1b — Corn budget Continued on next page OUO1023,00040E3 -19-17JAN17-2/6 5-3 090117 PN=76  Cost and Return Analysis John continues his research by obtaining fertilizer response data from his county extension office. He plots this data on a graph. What he now has is a production function (Fig. 2). DIMINISHING RETURNS From this graph he sees that there is a particular point where yield begins to decline. He remembers the principle of diminishing returns that he learned from his agriculture education teacher. The principle states that as an input is added in production, DXP01783 —19—17SEP10 the output will increase at an increasing rate, then at a decreasing rate, and finally decline. John realizes that he can use this principle to fine-tune his enterprise budget for corn. As he looks at the production function (Fig. 2), he realizes that he can use other data to confirm his facts. He recalls the information he learned in school about yield Fig. 2 — Application rates can be plotted to show a relationship levels for corn. He knows corn yield peaks at about 150 bushels with approximately 125 units of fertilizer in his county. He also knows he can produce 25 bushels of corn With this information, he knows that anything more than without fertilizer. 125 units of fertilizer would be wasted. It would actually decrease the corn yield. OUO1023,00040E3 -19-17JAN17-3/6 From further research John finds another interesting fact. He remembers that there are three stages of production that can be applied to the production function graph (Fig. 3). Production is measured in three ways. Those three ways, then, can help identify the stages of production. First, we have total product (T.P.), which is the production (output) that can be achieved with the various levels of input. We apply one unit of fertilizer and we get an amount of output, two units of fertilizer gives an amount of output, 100 units of fertilizer gives an amount of output. When plotted, this gives the T.P. curve. Second, there is the average product DXP01784 —19—17SEP10 (A.P.), which is the total product divided by the amount of input and, third, marginal product (M.P.), which is the change in total product for a change in input. (The first four columns of Figure 5 also illustrate these curves with values for another example.) Fig. 3 — John can divide his production into three stages Continued on next page OUO1023,00040E3 -19-17JAN17-4/6 5-4 090117 PN=77  Cost and Return Analysis THE THREE STAGES OF THE PRODUCTION FUNCTION Stage 1 of production is an increasing average return for each added unit of input. The average product (A.P.) is the total yield (T.P.) divided by the number of units DXP01785 —19—17SEP10 of the variable input. Stage 2 begins when the marginal product (M.P.) equals the average product (A.P.). Diminishing returns begin to develop in stage 2. (In Fig. 3, line M.P. actually crosses line A.P. at 75.) Stage 3 begins when the marginal product (M.P.) becomes zero. In this stage, the total product actually decreases if the input increases. Fig. 4 — John uses the three stages of production to help determine corn production Like a rocket ship, production gets an initial boost upward by adding inputs. It gradually begins to level off, and then rapidly descends (Fig. 4). this question: What yield level gives me maximum income over variable costs? Remember, John must pay all HOW MUCH INPUT FOR MAXIMUM PROFIT? variable costs. To answer this question it is necessary to calculate the added cost of the fertilizer. John realizes market prices must be added to the production function in order to estimate the most profitable The fertilizer unit is made up of 25 pounds of nitrogen, combination. The exact point in stage 2 that is most 12 pounds of phosphate, and 12 pounds of potash. The profitable will depend on the relative price of the product prices per pound are 26 cents, 26 cents, and 13 cents (corn) and the cost of the input (fertilizer). for N, P, and K, respectively. This amounts to a cost of $11.18 per unit of fertilizer. If corn prices are high, then you will operate closer to stage 3. If corn prices are lower, then you will operate closer to Now that John has done all the computations, the new stage 1. The reverse holds true for the fertilizer price. A information will help him with his production decision by lower fertilizer price moves you closer to stage 3, and a letting him apply the profit maximizing rule. higher fertilizer price puts you closer to stage 1. You must The yield response data shows there are diminishing make your management decisions from the second stage returns (Col. 3). As another unit of fertilizer is added, the of production. This is the stage of highest profitability. additional yield response becomes smaller. Column 5 THE PROFIT MAXIMIZING RULE shows the value of the additional yield response (V.M.P.) from additional units of fertilizer (Col. 5 – Col. 3 x price Maximum profit will be obtained if you add the variable of corn). input to the point where the value of the marginal product (V.M.P.) equals the price of the added input or: John examines the table and applies the profit maximizing rule; V.M.P. = the price of input. This gives the profit V.M.P. = price of input maximizing point. John notes that the added cost of fertilizer is $11.18 per added unit. Also, John notes that the The V.M.P. is found by multiplying marginal product (M.P.) V.M.P. declines at a point due to the physical diminishing by the price of the product. returns from the addition of more fertilizer. John finds that John decides he wants to apply this rule to his corn maximum profit is obtained by applying between 3-1/2 enterprise. The yield response data he had obtained from and 4-1/2 units of fertilizer. The highest marginal product his county extension director shows responses achievable result shows the midpoint where negative change occurs. on John's father's farm. At 3-1/2 the value of the marginal product is $21.00 (I) and exceeds the cost of the added fertilizer of $11.18 cents Calculate the Profit by $9.82. When one additional unit of fertilizer is added John calculates the average product, the marginal (4-1/2 units), the added return is only one bushel at $3.00. product, and the value of marginal product, for the The added costs are $11.18. His total profit would then corn-fertilizer relationships he has obtained (see Figure decrease by $8.18 (J). (See Figure 5.) 5). After calculating the information, John must answer Continued on next page OUO1023,00040E3 -19-17JAN17-5/6 5-5 090117 PN=78  Cost and Return Analysis Figure 5 — John's Calculations of the Maximum Profit Level for His Corn Enterprise (Price of Corn is $3 per Bushel) Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Units of Yield Marginal Product Average Product Value of Marginal Added Cost of Contribution to Fertilizer Product Fertilizer Total Profit 0 89 XXXX 0 XXXX XXXX XXXX 1 115 26 115 $ 78.00 $ 11.18 $ 66.82 2 (B) 136 (A) 21 68 $ 63.00 $ 11.18 $ 51.82 3 (C) 148 (D) 12 49 $ 36.00 (D) $ 11.18 (E) $ 24.82 4 155 07 39 $ 21.00 (I) $ 11.18 $ 09.82 5 156 01 31 $ 03.00 $ 11.18 $ -08.18 (J) 6 156 00 26 $ 00.00 $ 11.18 $ -11.18 7 154 -2 22 $-06.00 $ 11.18 $ -17.18 DXP05217 —UN—17JAN17 8 149 -5 19 $-15.00 $ 11.18 $ 26.18 FORMULAS AND EXAMPLES (Data from the County Extension Director) D – A (Col. 2) Price of Corn x Col. 5 – Col. 6 C – B (Col. 1) Column 3 [D – E] [A ÷ B] Figure 5 — John's calculations of the maximum profit level for his corn enterprise The level that yields the highest profit will be between ranch business. Let's consider John's situation to see if 3-1/2 units and 4-1/2 units of fertilizer. That would be 4 a process can be developed to estimate values for these units of fertilizer. resource costs. FIXED COSTS John wants to develop a total cost of all inputs used in his corn project to help him make management decisions. The fixed expenses are not used in this analysis. They Since John provides all the labor for the corn enterprise, are not considered when analyzing input use and when he must decide what is the value of his labor. Only he can determining the production levels in an enterprise budget. realistically estimate this value. However, when farmers or ranchers create budgets, they must add fixed costs to their calculations. This can make Last summer John had an opportunity to go to work for the difference between a profit and a loss. John wondered another individual for $7.50 per hour on a construction what would be the fixed cost per acre for growing corn. job. John knows the offer is still available and he could Fortunately his father has a good set of computerized still receive $7.50 per hour for his labor. The rate of $7.50 records and is able to tell John that fixed costs per tillable per hour is common for that type of work. There are other acre for his farm are $55.00. In comparing this number jobs available that John could have at the same rate. with the number presented in the enterprise budget he He thinks that to obtain a realistic value for his cost in had obtained from his agriculture education teacher, he producing corn, he should use the value of $7.50 per hour is able to see that the fixed cost on his father's farm is in the calculations. This is the value he could receive for slightly less than what is shown in the enterprise budget. his labor if he were working at an alternative job. So, what level of yield should John strive for in this This is a very important concept for John to consider enterprise? He makes his decision from the analysis when looking at the resources he controls. Among these shown in Figure 5, and from the value of the marginal resources are such items as labor, capital, land, and product plus the added cost of the fertilizer. He decides to machinery. This concept is called opportunity cost. Simply apply approximately 4 units of fertilizer and plan for 155 stated, opportunity cost is the cost of using a resource in bushels of yield per acre. John reworks the enterprise one way based on the return that could be obtained from budget shown at the beginning of this section. He adds using it in the best alternative way. John's opportunity these values and recalculates his returns at the bottom cost for his labor is $7.50 per hour and that is the value he of the budget. Now the enterprise budget represents his should use for labor in the enterprise budget. own situation and helps him make a profitable production decision. THE OPPORTUNITY COST Many times it is difficult to know how to calculate a value for resources controlled by the manager of the farm or OUO1023,00040E3 -19-17JAN17-6/6 5-6 090117 PN=79  Cost and Return Analysis PREPARING A BUDGET Figure 6a — John's Adjusted Budget Corn, Cash Rent Corn, Cash Rent Resource Information 17-Apr-10 0 2013 OPERATING INPUTS UNITS PRICE QUANTITY VALUE YOUR VALUE Seed 1000 Seed 0.98 26 25.48 ________________ Fertilizer, 25-12-12 100# 11.18 4 44.72 ________________ Nitrogen, Anhydrous Lb. 0.00 0 0.00 ________________ Phosphorus Lb. 0.00 0 0.00 ________________ Potassium Lb. 0.00 0 0.00 ________________ Lime Tons 11.00 0.5 5.50 ________________ Herbicide Per Acre 24.00 1 24.00 ________________ Insecticide 0 0.00 0 0.00 ________________ Drying Per Acre 8.00 1 8.00 ________________ Miscellaneous Per Acre 5.00 1 5.00 ________________ Custom Hire Per Acre 2.50 1 2.50 ________________ Cash Rent Per Acre 75.00 1 75.00 ________________ Annual Operating Capital Dollars 7.50% 94.425 7.08 ________________ Machinery Labor Hours 7.50 4.880 36.60 ________________ Irrigation Labor Hours 7.50 0.000 0.00 ________________ Other Labor Hours 7.50 1.5 11.25 ________________ Machinery Fuel, Lube, Repairs Dollars 55.437 55.44 ________________ Equipment Fuel, Lube, Repairs Dollars 0.000 0.00 ________________ Irrigation Fuel, Lube, Repairs Dollars 0.000 0.00 ________________ TOTAL OPERATING COSTS 300.57 ________________ FIXED COSTS AMOUNT VALUE YOUR VALUE Machinery Interest at 7.15% 164.90 11.79 ________________ Depreciation, 43.21 43.21 ________________ Taxes, Insurance Irrigation Interest at 7.15% 0.00 0.00 ________________ Depreciation, 0.00 0.00 ________________ Taxes, Insurance Equipment Interest at 7.15% 0.00 0.00 ________________ Depreciation, 0.00 0.00 ________________ Taxes, Insurance Land Interest at 6.25% 0.00 0.00 ________________ Taxes 0.00 0.00 ________________ TOTAL FIXED COSTS 55.00 ________________ PRODUCTION UNITS PRICE QUANTITY VALUE YOUR VALUE DXP05218 —UN—09APR14 Corn Bu. 2.85 155.00 441.75 ________________ Net Gov't Payment Per Acre 23.74 1.00 23.14 ________________ TOTAL RECEIPTS 465.49 ________________ Figure 6 — John's adjusted budget Continued on next page FB87413,000008C -19-10APR14-1/2 5-7 090117 PN=80  Cost and Return Analysis Figure 6b — John's Adjusted Budget TOTAL RECEIPTS 465.49 TOTAL OPERATING COSTS 300.57 ________________ RETURNS ABOVE TOTAL OPERATING COSTS 164.92 ________________ TOTAL FIXED COSTS 55.00 ________________ RETURNS ABOVE ALL SPECIFIED COSTS 109.92 ________________ Cash Rent $75 per Acre Thomp- son/Jobes 4/17/13 DEVELOPED AND PROCESSED By AFARM Consulting, L.C. PROGRAM DEVELOPED by Department of Agricultural Economics LAND GRANT UNIVERSITY Break-Even (B-E) Analysis B-E Yield at $/lb. 2.85 B-E Price at lb./Acre 155 Above Operating Costs (lb.) 105 Above Operating Costs $1.94 Above Total Costs (lb.) 125 Above Total Costs $2.29 RETURNS ABOVE ALL SPECIFIED COSTS RISK ANALYSIS YIELD DXP05219 —UN—09APR14 109 132 155 178 202 PRICE $ 3.71 $ 70.16 $156.30 $242.45 $328.59 $414.73 $ 3.28 $ 23.78 $ 99.98 $176.18 $252.39 $328.59 $ 2.85 ($ 22.60) $ 43.66 $109.92 $176.18 $242.45 $ 2.42 ($ 68.99) ($ 12.66) $ 43.66 $ 99.98 $156.30 $ 2.00 ($115.37) ($ 68.99) ($ 22.60) ($ 23.78) ($ 70.16) Figure 6 — John's adjusted budget John is now ready to evaluate his corn enterprise budget It shows that John's variable costs will be $300.57 per with his production function information and opportunity acre and his fixed costs will be $55.00 per acre. The total cost concept. This analysis includes the added fixed cost cost is $355.57 per acre. His return, as determined from information that has been provided by his father. the production function information and other information, When John got the budget from his agricultural education is $465.49 per acre. This gives a return above all costs, teacher, he also got a spreadsheet that contained the except overhead, risk, and management, of $109.92. A budget as it was printed. He can now make the changes further discussion on how to analyze and change the to that budget to reflect his estimated costs and his enterprise budget is presented in chapter 4, “Budget expected returns (see Figure 6). This will also allow all Analysis.” totals to be recalculated and the break-even analysis and risk management sections to be updated. FB87413,000008C -19-10APR14-2/2 INPUT-INPUT RELATIONSHIPS of John's labor in exchange for the use of his machinery, John's dad plans to expand the hog enterprise. Many times, inputs have individual and combined impacts on the final product. For example, profit levels among John has worked with least-cost ration formulas in his farmers can be due to the fact that inputs were not study of animal nutrition. combined in a least-cost manner to produce a given level of output. John had determined that the “best” John discovers there is a trade-off or substitution of corn combination of nitrogen, phosphate, and potash was and soybean oil meal in the production of 100 pounds of 25-12-12 per unit. If that relationship was different, such gain for 60-pound hogs. This is the usual weight of pigs as, only nitrogen, then the results or yield would not be purchased for the finishing floor. These two inputs are the same and a different production function would result. cheap and readily available. John shares this information This is the reason that the input-to-input relationships with his father and goes through the details of finding must be analyzed. the least-cost ration formulation of these two main feed ingredients. John's father has asked him to be a part of the hog enterprise on the family farm. Because of the availability OUO1010,0001672 -19-24FEB11-1/1 5-8 090117 PN=81  Cost and Return Analysis THE LEAST-COST RATION FORMULA There are two methods that can be used to determine the least-cost ration formulation: Graphics Mathematical THE GRAPHICS APPROACHJohn takes the information found in Table 1 and plots it on graph paper (Fig. 7). The “same production” line occurs when all points are connected into a line segment. The line shows the combination of soybean oil meal and corn for 100 pounds DXP01786 —19—17SEP10 of gain for the pigs. Fig. 7 — John plots his feed combinations OUO1023,00040D6 -19-21JUL16-1/3 John's dad wants the least-cost combination of the two feedstuffs. To do this, John combines market price information with the physical feed conversion information (the same production line).Corn is selling for $0.05 per pound and soybean oil meal for $0.13 per pound. John puts this on a graph in a usable form. John calculates a same ration cost line by assuming he has $5.00 to buy the two feedstuffs. Five dollars will buy 100 (point B) pounds of corn or 38.97 pounds of soybean oil meal (point A). John plots these two points (Fig. 8). He connects the two points with a straightedge and gets a $5.00 same ration cost line. Any point on this line gives a combination of DXP01787 —19—17SEP10 soybean oil meal and corn that costs $5.00. Fig. 8 — John plots the same ration cost line Continued on next page OUO1023,00040D6 -19-21JUL16-2/3 5-9 090117 PN=82  Cost and Return Analysis John now combines the two bits of information (the same ration cost line and the same production line) (Fig. 9). To find the least-cost combination of the two feedstuffs, John moves the same ration cost line in a parallel manner until it just touches the same production line. This is point C. It is the least-cost combination. This point is about at the point of ration 7 (40 pounds of soybean oil meal and 195 pounds of corn) (Table 1). Table 1 — Feed Combinations to Produce 100 lb. of Gain for 60 lb. Hogs Ration Soybean Oil Corn Number Meal DXP01788 —19—17SEP10 (1) 10 421.7 (2) 15 336.5 (3) 20 286.7 (4) 25 253.1 (5) 30 228.7 (6) 35 209.8 Fig. 9 — John moves line A-B parallel to find the least-cost combination (7) 40 194.8 (8) 45 182.4 of the feedstuff. This gives the quantity that a given (9) 50 172.0 amount of money will purchase. Do the same for the (10) 55 163.1 other feedstuff. This gives the amount of the feedstuff (11) 60 155.4 if all money is spent on it. Connect points A and B with a straightedge. This is the same ration cost line. In summary, let's trace back through the steps John followed: 3. To determine the least-cost combination, move the same cost line parallel to itself until it touches the 1. Identify the same production line. This is generally same production line at one point only (point C). determined from research information. 2. Determine the same ration cost line. Take a given amount of money and divide by the cost per pound OUO1023,00040D6 -19-21JUL16-3/3 5-10 090117 PN=83  Cost and Return Analysis THE MATHEMATICAL APPROACH To calculate, divide the change in one input by the change This approach is less time-consuming than the graph of the other input among different rations. Table 2 shows approach. The first step is to find the rate at which one this first step. Note that soybean oil meal changes from input substitutes for another along the same production ration to ration in 5-pound increments. Corn requirements line. This rate is referred to as the marginal rate of among the different rations change at varying rates. substitution. Table 2 Ratio No. X Change X Change Marginal Rate of Substitution: Soybean Oil Meal Corn (lb.) Change of Corn ÷ Change in (lb.) Soybean Oil Meal 421.7 (1) 10 5 85.2 17.04 336.5 336.5 (2) 15 5 49.8 9.96 286.7 286.7 (3) 20 5 33.6 6.72 253.1 253.1 (4) 25 5 24.4 4.88 228.7 228.7 (5) 30 5 18.9 3.78 209.8 209.8 (6) 35 5 15.0 3.00 194.8 194.8 (7) 40 5 12.4 2.48 182.4 182.4 (8) 45 5 10.4 2.08 172.0 172.0 (9) 50 5 8.9 1.78 163.1 (10) 55 5 163.1 7.7 1.54 (11) 60 5 155.4 Least-Cost Ration Math Formula Ration 6: 35 # x $0.13 = $04.55 Change in Corn Price of Soybean Oil Meal 209.8 # x $0.05 = $10.49 = Change in Soybean Oil Meal Price of Corn $15.04 total ration cost Ration 7: 40# x $0.13 = $05.20 The math formula for the least-cost ration (where the 194.8 # x $0.05 = $09.74 same cost ration line hits the same line) is the ratio of: $14.94 total ration cost The price ratio is constant among all rations at a value of Ration 8: 45 # x $0.13 = $05.85 2.6 ($0.13 divided by $0.05). 209.8 # x $0.05 = $09.12 To find the least-cost ration, one merely moves down the $14.97 total ration cost rations until the marginal rate of substitution ratio equals the relative price ratio in the above formula. They are not John finds that ration 7 is the least-cost, but only by a exactly equal at 2.6 at any one ration, but they would be margin of $0.03 ($14.97 – $14.94). equal at approximately ration #7. So to check which ration number is most cost efficient, John computes the cost of In summary, to use the math approach you must: each ration: 1. Determine the rate that one input substitutes for another. This is the marginal rate of substitution. 2. Compute the price ratio. This should be the price at the point of use. In John's case it is the family farm. 3. Find the ration for which the two rations are equal. This is the least-cost combination of the two inputs. OUO1023,00040D9 -19-21JUL16-1/1 5-11 090117 PN=84  Cost and Return Analysis BREAK-EVEN ANALYSIS returns (refer to chapter 4, “Budget Analysis” for additional discussion of yield-dependent costs and returns). Break-even analysis can provide price and/or yield targets that can be beneficial in planning. When considering John Break-even prices can also be calculated using the same Jones’s personal budget as shown in Table 3, break-even approach. Total operating costs of $300.57 divided by yields and prices are shown toward the bottom of the the yield of 155 bushels gives a break-even price for budget. If the price as shown in the budget ($2.85 per operating costs of $1.94. The break-even price to cover bushel) is divided into the total operating costs of $300.57, all costs when considering the 155 bushel yield is $2.29. a break-even yield of 105 bushels is needed to cover the The additional factors also need to be evaluated when total operating costs. Total costs of $355.57 ($300.57 + calculating the break-even prices. $55.00) divided by the price of corn gives 125 bushels needed to cover all specified costs. Two factors that need The calculated break-even values are too high because to always be evaluated when calculating break-even the budget has a government payment specified in the prices are, first, additional receipts that might have been budget. If the government payment is not yield dependent, included such as grazing, government payments, or baled then the break-even yields would decrease by 8.33 straw. The second, yield-dependent costs and other bushels ($23.74/$2.85) or the break-even prices would decrease by $0.15 per bushel ($23.74/155). OUO1010,0001674 -19-24FEB11-1/1 RISK MANAGEMENT ANALYSIS The information presented at the bottom of Table C gives Risk management analysis in enterprise budgets can some basic analysis about the risk involved in producing be useful when completing the financial analysis. The corn under the conditions as specified in the budget information may already be presented to you, or you may shown in (Table 3). The value in the center cell (shaded have to do the calculations. This analysis also may have to gray) in the bottom portion of Table 3 should equal the make adjustments because of yield-dependent costs and Returns Above All Specified Costs shown in the budget. returns (refer to discussion in chapter 4, “Budget Analysis” The other values should reflect the decrease (increase) in about yield-dependent costs and returns). A table price or yield shown. showing the impact on either returns above total operating Crop insurance is now offered for many products produced costs or returns above all specified costs, where price in agriculture. Crop insurance is designed to remove and yield are varied by a set amount, can provide much the lower yields from the table. Levels of insurance are insight to the risk of an enterprise. How much of the table selectable by the producer (with an associated cost). This shows negative values, and how much of the table shows type of crop insurance has been designed to help reduce positive values? How great a range exists in the table? yield risk to the producer. OUO1010,0001675 -19-24FEB11-1/1 SUMMARY Stage 2 begins when the marginal product equals the average product. Diminishing returns begin to develop Cost and return analysis is critical for the survival of farm in stage 2. and ranch businesses. Stage 3 begins when the marginal product (M.P.) The basic relationship that allows analysis of an input and becomes zero. In this stage, the total product actually an output is called a production function. The production decreases if the input increases. function, when combined with prices, provides information Maximum profit will be obtained if you add the variable to be able to analyze profitability. input to the point where the value of the marginal product Budgets provide a systematic way to analyze cost and (V.M.P.) equals the price of the added input. return information. Input-input relationships are analyzed by finding the rate The principle of diminishing returns states that as an at which one input substitutes for another along the same input is added in production, the output will increase at production line. This rate is referred to as the marginal an increasing rate, then at a decreasing rate, and finally rate of substitution. decline. The relationships between the inputs and outputs and The three stages of the production function are: their prices are important if a goal of management is to maximize profits. It is difficult to accomplish a thorough Stage 1 of production is an increasing average return analysis because of data constraints and time constraints, for each added unit of input. The average product is but that still does not diminish the importance of these the total yield (T.P.) divided by the number of units of concepts in maximizing profits. the variable input. OUO1010,0001676 -19-24FEB11-1/1 5-12 090117 PN=85