Cornhusker Economics June24, 2020
Farm and Ranch Enterprise Budgets: Return to What?

Budgets capturing the projected revenues and costs associated with producing and marketing a single commodity are generally called enterprise budgets or cost and return estimates but can also be referred to as profit center budgets. Two of the major purposes for developing enterprise budgets are to determine which enterprises are the most profitable and to determine breakeven prices for use in a marketing plan. Enterprise budgets produced by the University of Nebraska-Lincoln can be found at farm.unl.edu.

A typical enterprise budget estimates net return by identifying the value of production (gross returns) and categorizing costs as operating costs and ownership costs. Value of production includes the expected gross returns from all products produced by the enterprise. For example, a field corn enterprise budget would include gross returns from the actual grain harvested but could also include the value of baled or grazed cornstalks. Operating costs are incurred during the production of the enterprise. If the enterprise is not produced, these costs would not occur. Seed, fertilizer, fuel, and day labor are examples of operating costs. Ownership costs are generally costs the farm would be responsible for regardless of whether the commodity is produced or not. A proportion of the farm’s overhead costs, such as accounting fees, utilities and general pickup truck costs are included in ownership costs. Other ownership costs are costs associated with using capital or durable goods; goods that provide productive service over several time periods. Land, taxes, depreciation on machinery, equipment and buildings are examples of these ownership costs. Olsen (2011) provides a good discussion on how to determine ownership costs.

Economic Budgets

The majority of enterprise budgets developed and published by universities are what can be termed economic budgets; budgets that account for all costs, including opportunity costs. Opportunity costs attribute a return for inputs in the production process that do not have an identified cash or depreciation cost associated with them. Owner labor, owner capital and land are the most common examples. Frequently, the owner, and at times family members, do not draw a wage from the farm. The income they could have earned if they were not working on the farm is termed the opportunity cost of their labor contributions. This value is included as a non-cash expense in the enterprise budget. Likewise, if the owner did not finance the equity portion of a machinery purchase or the purchase of other inputs like fertilizer, for example, that equity could have been devoted to another investment, such as stocks or bonds, or could have been used to pay down the principal on a loan to forgo additional interest charges. The income that could have been earned by the owner’s capital in the next best investment would be included as a non-cash opportunity cost expense in the enterprise budget. The economic enterprise budget would then include a return to both borrowed and owned capital.

Similarly, the opportunity cost for owned land can be complicated by the equity position. However, it could simply be accounted for as what the land could be rented for if the land was not personally being farmed by the owner. This would be the opportunity cost of using the land regardless if the land was being financed by a bank or by the owner’s equity. Then, land ownership can be treated as a separate enterprise for which return on equity could be calculated. In this case, land taxes would be a part of the land ownership enterprise and not included in the crop or livestock enterprise budget.

Cash Enterprise Budget

There are times producers are interested in determining their breakeven cost of production on a cash basis. Specifically, what price would I need to receive for my commodity to cover all the cash costs associated with the farm for that year? To convert from an economic budget to a cash budget, all opportunity costs would be excluded as they are not cash payments that need to be made that year. Principal and interest payments for land and machinery, along with anticipated equity outlays for the year for capital purchases associated with the commodity (e.g., equity used in purchasing a new tractor that year) would be added to the budget in place of depreciation on machinery and opportunity costs on equity, including any opportunity costs charged for owned land (Hinman, 2002).

Return to What?

Whether you are using an economic budget or a cash budget, the important thing to realize is what the bottom-line or net return is telling you.  It is important to understand what inputs in the production process are receiving a fair market return for their use in the production process.  The net return is defined as the return to all inputs that have not had a fair market return attributed to them in the budget.  If the budget does not include a fair market value calculation for the owner-operator’s labor and management (opportunity cost), the bottom-line net return would represent a return to owner labor and management. In addition, if a calculated opportunity cost for owner’s equity was not included in the budget, the net return would represent a return to owner labor, management, and equity.

In economics, when all factors of production have a return attributed to them and the net return equals zero, the operation was actually profitable, because every input received a return for its use in the production process; owner management, labor and equity included. When the net return is greater than zero and all factors of production have a return attributed to them in the budget, an economic or pure profit is earned—a profit above the return to all inputs.

When a breakeven price per unit of a commodity is used to determine a target selling price, it is essential to understand what is and what is not being covered in that breakeven price. It may be prudent to have developed both an economic and cash enterprise budget so a breakeven price can be determined from each. Which breakeven price will be the largest? That depends on the equity and liability situation of the operation. If there are large principal and interest payments associated with the machinery, equipment and land used in the production process, the cash breakeven may actually be the larger number. However, typically the economic budget’s breakeven figure will be larger because it includes a competitive return to equity, all depreciation costs, and all management and owner labor contributions. 

There should be caution applied in using a cash-based enterprise budget and the associated breakeven price when high land payments exist. Land will rarely cash flow and economically is not designed to do so (see Van Tassell, 2015), so if land payments are high, rarely will commodity prices be high enough to cover a cash-based breakeven price.

Breakeven prices can be developed using returns above operating costs, ownership costs, or a combination. Developing and understanding the meaning of various breakeven prices (or breakeven yields) is a valuable tool in the financial management toolbox. The Department of Agricultural Economics is currently developing an Agricultural Budget Calculator that will aid producers in doing just that.

References

Hinman, Herbert R. “Understanding and Using WSU Crop Enterprise Budgets.” July 2002. https://s3.wp.wsu.edu/uploads/sites/2076/2014/09/EnterpriseBudgets.pdf

Olsen, Kent D. “Economics of Farm Management in a Global Setting.”  2011. John Wiley & Sons, Inc.

Van Tassell, Larry W. “Profitability vs. Feasibility and the Paradox of Purchasing Farmland.” Cornhusker Economics, Oct. 21, 2015.