Getting your costing right

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There’s an ongoing debate between farmers, agro-processors and agricultural economists about the correct way to calculate the cost of a specific farm enterprise. Items bought and used directly in the production process, such as fertiliser and bought feed, pose no problem. The price paid for the product is regarded as the cost. Problems arise with farm-produced inputs, such as maize used in livestock enterprises. And the situation gets even more complicated with livestock on planted pastures.

Farmers generally believe that the cost of the maize used in a beef enterprise is equal to the market price of the maize, while processors generally believe the cost of maize used in beef enterprises must be taken as the direct cost of producing the maize. Various arguments are used to defend these different viewpoints.Actually, both methods are correct, but for different reasons. The method of calculating costs depends on the question being asked.

If you want to know whether your operation is profitable, then only actual costs are taken into account. If you want to compare one enterprise with another, then the real cost of farm-produced or ‘intermediate’ inputs are considered.
Remember to distinguish between accounting cost and full economic cost. The first is used in a whole-farm setup to determine the profitability of the total farm. The second is used when studying and comparing enterprises. When you’ve decided on a farming system, don’t make any alterations based on short-term changes in prices.

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Some years, the livestock enterprise may be profitable; in other years, the crop enterprises may do better. The ability to cross-subsidise between enterprises provides stability to a farming system. Full economic cost includes opportunity cost. This is the income forfeited by a specific action. If your wife bakes cupcakes for a party and you steal one cupcake out of the kitchen, the cost of that cupcake is the cost of the flour, other ingredients and electricity used to produce it. However, if your wife bakes for a shop, then the real cost is the price she would have been paid for that cupcake.

Use long-term data for analysis
When deciding on the optimal combination of farming enterprises, it’s important to take opportunity cost into account.
Some years ago, I was asked by a Free State farmer to evaluate the profitability of his sheep-fattening enterprise on pasture under pivot irrigation. While the cost analysis showed that the enterprise was profitable, a full economic analysis using long-term data showed that he could increase his total profitability by switching over to a feedlot production system and using the irrigated land for cash-crop production. Any drastic changes in enterprise combinations must be based on long-term price and yield information and not on data from the past two years.

Fixed and variable costs
Farmers are frequently advised to sell low-producing animals. This only makes sense if the income from these animals is less than the variable cost of the production. As long as the income covers the variable cost it doesn’t make sense to cull the animals. Farmers who follow this advice frequently find that their total income decreases, while total cost doesn’t decrease to the same extent.

The same principle applies when crop yields are too low to cover full production cost. As long as the value of the maize or wheat covers the harvesting and marketing cost, the correct decision is to harvest it.

Combined enterprises
The analysis of farm enterprises, based on full economic cost, provides a tool for the comparison of enterprises. It can help a farmer to identify aspects in his own enterprise where he can improve their management. But these enterprise analyses must not be used as the basis for decisions about the combination of enterprises. If the beef enterprise analysis shows that the beef enterprise barely covered cost at high grain prices, this must not be taken as an indication that the beef enterprise must be sold.

Analysis of the total farm financial statements is important to determine whether the farm is creating wealth. Bear in mind that this only shows the position at the end of a single financial year. Don’t take long-term decisions without looking at the longer-term results. In-depth analysis can easily lead farmers astray if long-term decisions are based on short-term data. Consultants who advise farmers should also heed this warning.

Dr Koos Coetzee is an agricultural economist at the MPO. All opinions expressed are his own and do not reflect MPO policy.