Know your cost of production
This article originally appeared in Grainews.ca on December 22, 2020
Is there a right way to calculate farm cost of production? It depends on whether you’re budgeting or performing an investment analysis.
“Know your cost of production” is an annual farm advisor’s rallying cry. This is still good advice with ever-rising costs and uncertain revenue. How exactly should you calculate cost of production when there seems to be different approaches throughout the industry? More specifically, what should you include and not include?
To answer that question, it depends on what problem you are solving. For many farm managers, it will be to compare annual cropping options. For others, it will be evaluating overall profitability, and for some it might be looking at new machinery, technology or land investment opportunities. It all depends on whether you are preparing a budget or investment analysis.
Why it matters: Some farms and advisors have a hybrid way to complete cost of production budgets, which might include principal payments, depreciation and reinvestment. There is no way to compare this budget with actual results.
Cost of production is best defined by the accounting and economics disciplines. One difference is economics considers opportunity cost. Most farm managers intuitively consider opportunity cost when they are making an investment decision. One choice prevents you benefiting from another.
For example, do I invest profits in land or machinery, or maintain working capital? Whether to maintain both a livestock and grain enterprise would be another example of opportunity cost. Another applicable economics concept is marginal cost. For example, at what point will increasing fertilizer application diminish profitability?
Some cost of production budgets include an investment amount for land or machinery. At this point, farm managers should consider if they are preparing a budget or an investment analysis. If preparing an annual budget, consider timing — when will cash for reinvestment be available? A rolling cash flow forecast can help solve this problem. Also, if budgeting for reinvestment, managers need to consider how they can compare the budget to final results.
Accrual or cash
If you are budgeting or reviewing profitability, accounting concepts are most useful. For example, the matching principle’s goal is to match up expenses with revenue generated each year. This is the most accurate way to compare results from year to year. With accrual accounting, inputs are expensed with the crop they grew, regardless if they were bought the prior year.
Many farmers complete their cost of production budgets on a cash basis. This means if it enters or leaves the bank account, it is included in the budget. This is synonymous with a cash flow forecast or projection.
An alternative way to complete a cost of production budget is using accrual accounting. Accrual accounting includes interest costs as an expense, but not principal payments. Principal payments reduce your debt, rather than profitability. Depreciation is also included in a cost of production budget based on accrual accounting, even though no cash left the bank account.
Depreciation accounts for the estimated loss of value for depreciable assets like farm machinery. Depreciation turns into cash when machinery gets traded. Budgeting based on accrual net income measures profitability, which along with cash flow are two important dials for farm managers to watch.
Pre-seed or post-harvest
Most farmers think of chemical applications when they hear pre-seed or post-harvest. However, these are also important cut-offs for cost of production budgets. Cost of production budgets are either estimates completed with an unharvested crop or based on actual results post-harvest. For improved budgeting and financial performance, farmers should compare budgeted cost of production with actual results. This closes the loop of farm budget planning. The best way to do this is with final financial results completed using accrual accounting or a cash flow statement.
Caution, hybrid cost of production budgets
Some farms and advisors have a hybrid way to complete cost of production budgets. These hybrid budgets might include principal payments, depreciation and reinvestment. I caution there is no way to compare this budget to actual results. If your bank and accountant are using accrual financial information, are you using a hybrid system for your budgeting?
Improved cost of production budgets can improve management decisions like precision farming improves agronomy. Hybrids in crop genetics are a good thing, but not in cost of production budgets. Farmers should look to the accounting discipline and consider using both cash and accrual cost of production budgets while keeping in mind economics concepts like opportunity cost and marginal cost.
Contact your trusted Stark & Marsh Advisor or an office close to you today.