Cost Concepts Key Questions Chapter 9, pp

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1 Cost Concepts Key Questions Chapter 9, pp How do operating and ownership costs differ? How are ownership costs calculated? In the short run? In the long run? How do cash and noncash costs differ? What is an opportunity cost?

2 Operating Costs Cost of goods or services that are used up in one production cycle Seed, fertilizer, fuel, wages, rent, repairs, feed, veterinary, etc. Also called variable costs (vary directly by acres, head, etc.

3 Rate used per acre x cost per unit Seed corn: 30,000 seeds per acre x $3.50 per 1000 seeds = $105 per acre Milk hauling: 24,000 lbs. per cow per year x $.30 per cwt. x 1 cwt./100 lbs. = $72 per cow per year Watch your units!

4 Ownership Costs Costs of goods that last more than one production cycle Machinery Equipment Breeding livestock Land Buildings Capital Assets

5 Also called Fixed Costs (occur regardless of use) Depreciation: loss in value due to wearout or obsolescence Interest on investment: cost of a loan or opportunity cost on your own capital Insurance: casualty, theft, etc. Taxes: property (on some items) Repairs and maintenance: just for buildings They are an operating cost for machinery.

6 Machinery Example (page 426) Current Year Costs Current value of tractor = $50,000 Depreciation: take 10% of current value $50,000 x 10% = $5,000 Interest: current value x interest rate $50,000 x 7% = $3,500 / year Insurance and taxes: est. 1% of current value $50,000 x 1% = $500 per year Total ownership cost = $9,000 / year

7 What Interest Rate to Use? Use weighted average cost of capital Example: $30,000 is owed on the tractor, at 9 % interest (60% debt capital) $20,000 of equity capital that could earn 4% in a savings account (40% equity) Cost of capital = (.60 x 9%) + (.40 x 4%) = 5.4% + 1.6% = 7.0% 7% x $50,000 = $3,500

8 Interest Cost on Capital Assets Or: Loan: $30,000 x 9% = $2,700 Equity: $20,000 x 4% = 800 Total interest = $3,500

9 Opportunity Cost The amount a certain resource could have earned in another use. Amount given up by using a resource in farming. Examples: Labor Capital Home grown feed

10 Ownership Costs for Buildings Use slower depreciation (5% of current value) Include repairs and maintenance

11 Building Ownership Costs Estimated value of building is $60,000 Interest (on current value) 7% x $60,000 = $4,200 / year Depreciation 5% x $60,000 = $3,000 Taxes and insurance (current) 1% x $60,000 = $600 Repairs.& maintenance: 2-4% of value 3% x $60,000 = $3,000 Total ownership costs = $10,800 per year

12 Average Ownership Costs over the Entire Ownership Period Depreciation = (purchase cost salvage value) years owned See page 421 for estimated salvage values for machinery. Tractor: salvage value after 10 years is 32% of original list price

13 Tractor Example Average Costs New value = $100,000 Salvage value = 32% x 100,000 =$32,000 Total depreciation =($100,000 - $32,000) = $68,000 Average annual depreciation is: $68,000 / 10 years = $6,800 per year

14 Salvage value of tractor $100,000 $80,000 $60,000 $40,000 $20,000 $0 Average value Age

15 Interest Expense Interest is charged against the average value of the machine Take average of new value and salvage value Average value =(100, ,000) / 2= $66,000 Interest = 7 % x $66,000 = $4,620 per year

16 Insurance and Taxes Assume 1% of the average value of the machine. Insurance & taxes = 1% x $66,000 = $660 Total = $6, , = $12,080 per year

17 Ownership Costs Over Ownership Life for Tractor $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Depreciation Interest Ins & txs Ave. Age

19 Economic Principle If gross revenue exceeds variable costs, profit will be increased (or losses decreased) by producing. That is, when gross margin > 0 go ahead and produce

20 Example: Finishing Feeder Pigs Variable costs: feeder pig $40.00 feed operating labor 3.00 =total variable costs $ Fixed costs (bldg, equip) $ Total costs $

21 Profit (270 lb. pig) Price Revenue Produce Do not $.50 $135 $19 -$13 $.40 $ 108 -$ 8 -$13 $.30 $ 81 -$35 -$13 Variable cost breakeven = $103 / 270 lb. = $.38 per lb.

22 Higher Cost Facilities, Perm.Labor Variable costs: feeder pig $40.00 feed operating + labor 8.00 total v.c. $ Fixed costs (bldg, equip) $ Total costs $ V.C. breakeven = $93 / 270 lb. =$.34

23 Economic Principle If a higher proportion of a farm s costs are fixed, it will continue to produce even at a lower price.

24 In the long run all costs are variable. Before an investment is made Fixed resources could be sold

25 Cash and Noncash Costs Cash Costs Seed, fertilizer, pesticides Fuel and repairs Hired labor Cash rent Interest on loans Etc. Noncash Costs Depreciation Opportunity Costs unpaid labor net worth capital feed produced on the farm

26 Sunk Costs As the production cycle progresses,more and more costs become sunk. Sunk costs no longer affect decision making in the short run (within the production cycle)

27 Sunk Costs Should you harvest a poor crop even if you expect to not cover total costs?

Farm Business Analysis Ch.18

Farm Business Analysis Ch.18 What are the strengths and weaknesses of the farm business? How can we measure how well the farm is doing? Which farm would you prefer? Farm A Net worth $400,000 Total acres