Enterprise Budgets. How is it constructed?

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1 Enterprise Budgets An enterprise budget is an estimate of projected income and expenses associated with the production of a commodity. Most agricultural operations are made up of a combination of several crops and/or livestock. While the whole-farm income statements allow the producer to determine total farm profitability, analyzing the effects of changes within the operation should be done by examining the enterprise budgets. Enterprise budgets break the operation down into segments (profit centers) in order to tell which commodity is contributing to profitability and which commodity is losing money. An enterprise is a distinct part of the farm or ranch business that can be analyzed separately and is usually based on some production unit such as an acre of corn or one breeding cow. Enterprise budgets can be either historical or projected. Historical enterprise budgets are the same as income statements by enterprise and are created using actual income and expense information. Projected enterprise budgets attempt to estimate income and expenses in the future. These projected enterprise budgets are best started from historical enterprise income statements. Any estimates of changing costs or income should be conservative. If the budget is for a new enterprise, research on expected income and expenses should be the basis of the budget. How is it constructed? When enterprise budgets are developed for the first time, records from the whole farm or ranch are usually the starting point. The allocation of costs to the individual enterprise is an important step in the development of useful enterprise budgets. Some costs are easily allocated, but for certain fixed costs, it s not always clear how the allocation should be made. The key to allocating costs is to be realistic in allocating expense so a true price of profitability is expressed. An enterprise budget starts with the income potential of the commodity. The producer will need to estimate his production and price to generate what his expected revenue from the commodity will be. Costs are broken down into two groups, variable costs and fixed costs. The variable costs are those that can be directly tied to the enterprise and can be changed in the short run. Examples of variable costs are seed for wheat, veterinarian costs for cows, etc. Variable costs are the same on a per unit basis, and vary with the size of the enterprise (number of head, acres planted, etc.). Variable costs are usually already figured at the per unit rate, so those costs should simply be multiplied by the number of units to arrive at the variable cost portion of the enterprise budget. Fixed costs are those costs the business is committed to pay regardless of whether a crop is planted or livestock raised during the current planning period. Producers who have already invested in land, machinery and buildings are committed to owning these resources for the Duckworth, Brenda, Stan Bevers, Rob Borchardt, and Blake Bennett. Department of Ag Economics, Texas Cooperative Extension, Texas A&M University. May 2003.

2 upcoming production period or year. Fixed costs include depreciation and insurance on machinery, equipment and buildings, interest on machinery, equipment, buildings and land and land taxes, to name a few. For ease of daily recordkeeping, these costs are collected in support centers or cost centers. Fixed costs are constant as a total, but vary on a per unit basis. As an example, suppose the total property taxes of the business are $1,000. For simplicity, let s say the operation only raises calves. If the operation has 50 calves, the cost per calf would be $20 ($1,000 / 50 = $20). If the operation has 100 calves, the cost per calf is $10 ($1,000 / 100 = $10). If the operation has more than one commodity, an allocation criterion will have to be established, and the total cost allocated accordingly. (See the section on Allocation in this curriculum.) Both fixed and variable costs are considered when deciding whether to continue production. However, most producers will eventually face the problem of not covering all their costs for an enterprise in a production year. In the short run (when at least some costs are fixed), the producer should stay in production if it appears that revenue will at least cover variable costs. However, if variable costs cannot be covered, continued production, even in the short run, only makes things worse. In the long run, a farmer or rancher should continue production only if all costs can be covered. Anything short of that usually results in cash flow deficits and the erosion of net worth. Why do you need one? Once a producer has completed the enterprise budgets making up his operation, the commodities that are contributing to the business reaching its goals and those that are not can be determined. Decisions such as should you plant corn, can be made based on these budgets. Enterprise budgets can also be used to determine breakeven prices for the producer s commodities. This is calculated by dividing the production figure into the total cost per unit (Table 1, $2, / 150 bags = $7.62 per bag). By knowing the breakeven price for his commodities, a producer will know what market price he will need in order to cover his variable and fixed costs. What do I do with them once I have them? The primary focus of bookkeeping and reporting is so that a producer can make well-informed decisions. Enterprise budgets have the capacity to inform management about the feasibility of a new enterprise, as well as providing guidelines to spending limits. Just as with a personal budget, enterprise budgets can keep the only controllable part of financial planning (spending) within predetermined goals. A business-minded producer will evaluate each commodity within his operation to determine where he is making money and where he is not. Budgets can help identify this as well as areas where he could cut costs and become more efficient, breakeven prices for marketing, and the operations level of risk exposure within his enterprises. L9.2

3 Table 1. Onion Budget Acres = 2 Y ield = 150 Quantity U nit $ / Unit Per Acre Total Ordinary Income/ Expense Income Crop Insurance Crop Revenues 150 B ags $ $3, $ 7, Total Income $3, $ 7, Expenses Chemicals 1 A cre $ $ $ Fertilizer & Lime 1 A cre $ $ $ Insurance 1 A cre $ - $ - $ - Labor (Hired) 1 A cre $ - $ - $ - Labor (Contract) 1 A cre $ - $ - $ - Professional Fees 1 A cre $ - $ - $ - Rent or Lease (Equip) 1 A cre $ - $ - $ - Rent or Lease (Land) 1 A cre $ - $ - $ - Seed 1 A cre $ $ $ Supplies 1 A cre $ - $ - $ - Other 1 Acre $ - $ - Total Variable Expenses $ $ $ Breakeven Price to Cover Variable Costs B ags $ 1.47 Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 A cre $ $ $ Allocation of Labor 1 A cre $ $ $ 1, Allocation of Finance 1 A cre $ $ $ Allocation of G&A 1 A cre $ - $ - $ - Total Other Expenses $ $ $ 1, Total Costs $ 1, $1, $ 2, Breakeven Price per pound B ags $ 7.62 Expected Net Income $2, $ 5, L9.3

4 Enterprise Budgets Lesson Plan I. Purposes A. Define enterprise budgets. B. Teach methods of compiling enterprise budgets. C. Explain uses of enterprise budgets. II. Highlights/descriptions A. What is an enterprise budget? An enterprise budget is the beginning of the financial planning process; it should have an historical basis (if it exists) and should be conservative in nature. Sometimes it takes several years to build up a good foundation of historical information from which to base future budgets. Budgets reflect projected income, based on projected yields and prices, and projected expenses. Since yields and prices fluctuate so dramatically in agriculture, they should be based on a very conservative estimate- lower than expected in an average situation. Expenses can be controlled somewhat, but should also be conservative- higher than expected in an average situation. B. Historical income statements by enterprise (covered in another section) provide an excellent start to an enterprise budget. Historical income and expenses can be adjusted to reflect an expected situation. C. Projected cash flow statements (covered in another section) can also be produced from enterprise budgets. When compiling projected cash flow statements, the producer would take the enterprise budgets, including projections for support center cost absorption, and follow the same process as with historical cash flow statements. It is important to compare a projected cash flow with an historical cash flow for reasonableness. Major deviations should be explained or adjusted. D. Projections of any kind are just that- PROJECTIONS. Budgeting and other projections are great planning tools, but should not be L9.4

5 completely relied upon because no projection is exact. As earlier stated, better foundations of historical data will improve the planning process, so it can be expected that if a producer is consistent in the accounting process, information will improve. Likewise, decisionmaking skills and planning will also improve. E. What will the enterprise budget tell the decision maker? Information is compiled so that educated decisions can be implemented. Enterprise budgets have the capacity to inform management about the feasibility of a new enterprise, as well as providing guidelines to spending limits. Just as with a personal budget, enterprise budgets can keep the only controllable part of financial planning within predetermined goals. Ultimately, producers are in business to make a profit. Most often, low-cost producers are the only producers left to tell the story. They achieve survival through good planning. III. Steps for compiling Enterprise Budgets. A. Historical Enterprise Budgets 1. Determine seed, fertilizer, & chemical rates of application (per acre). For cattle, determine the feed, vet & medicine, etc. per breeding cow. 2. Calculate cost per unit (acre, cow). 3. Determine projected allocated amounts of Machinery & Equipment, Finance, Labor, and General & Administrative for which the enterprise will likely be responsible. 4. Considering input rates, determine expected yield per unit. ** Historical Income Statements by Enterprise are an excellent source for steps 1 through 5 above. 5. Calculate totals for enterprise (rate per unit X # units). 6. Calculate breakeven price needed (total expected expenses divided by total expected yield). B. New Enterprise Budgets (Will it work?) L9.5

6 1. Research the new enterprise. Read research articles, and talk with extension professionals and producers with similar experience to determine application rates as in #1 above. Document findings in logical format for future reference. 2. Calculate cost per unit (acre, cow). 3. Determine projected allocated amounts of Machinery & Equipment, Finance, Labor, and General & Administrative for which the enterprise will likely be responsible. ** Go through allocation process with all planned enterprises (using historical support center amounts) to determine new allocations. 4. Considering input rates, determine expected yield per unit. (Consult research materials.) 5. Calculate totals for enterprise (rate per unit X # units). 6. Calculate breakeven price needed (total expected expenses divided by total expected yield). IV. Potential Speakers A. Extension Agents B. Extension Specialists V. Review Questions A. Enterprise Budgets only reflect the bare minimum of inputs while the maximum yield is considered. (True or False) False. Enterprise budgets should be conservative in nature. Inputs (expenses) considered should reflect the expected necessary inputs to achieve the expected yield. This consideration should be the middle to upper end of the range of expected expenses, and the middle to lower end of the range of expected revenues. It is also very important to include the expected allocated costs, like machinery, finance, and labor. L9.6

7 B. Why is it important to first figure the budget on a per unit basis? Most inputs are sold or described on a per unit (per acre) basis. For instance, the seed is purchased according to the number of acres planted. Yield is also easily described on a per acre basis. Producers can easily adjust the budget if the number of acres planted is changed. (The allocations as per the previous year may need to be adjusted since they are not usually figured on a per unit basis.) Likewise, the break-even price is specified on a per unit basis, which is one of the best indications of resource (land) uses. C. Why is the enterprise budget important? Enterprise budgets are guidelines to spending. They reflect a plan, with reasonable expectations that can be easily interpreted by all people involved in the business. If budget numbers are reasonable, credit risk can be reduced (by lenders), and less emotional management decisions can be made (and adhered to.) Also, enterprise budgets can test the feasibility of new enterprises. D. Enterprise budgets are an integral part of the planning process. (True or False) True. Enterprise budgets are the basis of the projected plan. All projected financial reports, like the Projected Cash Flow Statement and the Projected Income Statement, are based on the enterprise budgets. L9.7

8 Enterprise Budgets Overheads Introduction Enterprise budgeting is the basis for projected cash flow statements and projected income statements. Therefore, they are the basis for projected financial planning. Enterprise budgets are spending guidelines. Enterprise budgets can help test the feasibility of a new enterprise. Steps to compiling an historical enterprise budget: 1. Determine seed, fertilizer, & chemical rates of application (per acre). For cattle, determine the feed, vet & medicine, etc. per breeding cow. 2. Calculate cost per unit (acre, cow). 3. Determine projected allocated amounts of Machinery & Equipment, Finance, Labor, and General & Administrative for which the enterprise will likely be responsible. 4. Considering input rates, determine expected yield per unit. ** Historical Income Statements by Enterprise are an excellent source for steps 1 through 5 above. L9.8

9 5. Calculate totals for enterprise (rate per unit X # units). 6. Calculate breakeven price needed (total expected expenses divided by total expected yield). Steps to compiling a new enterprise budget: 1. Research the new enterprise. Read research articles, and talk with extension professionals and producers with similar experience to determine application rates as in #1 above. Document findings in logical format for future reference. 2. Calculate cost per unit (acre, cow). 3. Determine projected allocated amounts of Machinery & Equipment, Finance, Labor, and General & Administrative for which the enterprise will likely be responsible. ** Go through allocation process with all planned enterprises (using historical support center amounts) to determine new allocations. 4. Considering input rates, determine expected yield per unit. (Consult research materials.) 5. Calculate totals for enterprise (rate per unit X # units). 6. Calculate breakeven price needed (total expected expenses divided by total expected yield). L9.9

10 Enterprise Budgets Case Application Profitability has been identified as the most serious problem for the Doe farming operation. Historical enterprise budgets are the most effective way of determining which commodities are contributing or draining to that profitability. However, as mentioned throughout this curriculum, the enterprise budgets need to encompass all the costs of the operation including depreciation and family living expenses. Five enterprises make up the farming operation. Enterprise budgets for each of the five are listed below. These budgets identify which commodity is making money and which is not. As shown, the cattle operation lost approximately $13,800 (Table 5). Productivity is low and costs are high. The current breakeven price per pound of weaned calf needed to cover all costs is $3.10 per pound. This price will never be attained from any market. The Does need to address this situation by improving the weaning weights of the calves and reducing the costs associated with the cattle enterprise. Of the four vegetables grown and marketed, the onions (Table 3) are contributing positively to the business. However, only two acres were grown. The sweet corn (Table 2) resulted in a loss, but not as much as the tomatoes (Table 4) and cantaloupes (Table 1). The breakeven price for the sweet corn was $0.59 per pound. Mr. Doe received $0.33 per pound. If the market will bear a higher price, Mr. Doe could turn the corn into a profitable enterprise. The cantaloupes and tomatoes need to be considered from the consumer standpoint. Do the consumers expect Mr. Doe to have these commodities at this stand? The Does need to seriously consider what vegetables will be grown in the coming year and how much of each will be grown. All commodities covered their variable costs. However, when the fixed costs were added, only the onions covered total costs. The total operational variable costs were $7,508 while the fixed costs totaled $26,371. The fixed costs are too high for an operation of this size. After breaking down the fixed costs into components, we can see that $5,619 was spent for machinery & equipment, $18,394 was spent for all labor, and $2,358 was spent on financing (interest.) Notice that labor is by far the greatest expense. The personal withdrawals, charged to the labor support center, make up the largest portion. Changes could be made in the allocation of the personal costs. Allocating ½ of the expenses to the farming operation would still result in a loss for the operation. The profit margin (revenue less variable costs) needs to be wider. Production needs to be increased (cow-calf), higher prices need to be obtained (all enterprises), or costs need to be lower. Generally, producers are price takers and cannot change prices received for their products. Therefore, they must focus on costs. All costs should be utilized efficiently to produce the highest amount of output. The Does should research the efficiency of the farming input costs. Also, the fixed costs should be examined. It is possible that the Does could reduce family consumption or vehicle expense (fuel and repairs). L9.10

11 Table 1. Cantaloupe Budget Acres = 2 Yield = 10,000 Quantity Unit $/ Unit Per Acre Total Ordinary Income/ Expense Income Crop Insurance Crop Revenues 10,000 Lbs $ 0.17 $ 1, $ 3, Total Income $ 1, $ 3, Expenses Chemicals 1 Acre $ $ $ Fertilizer & Lime 1 Acre $ $ $ Insurance 1 Acre $ - $ - $ - Labor (Hired) 1 Acre $ - $ - $ - Labor (Contract) 1 Acre $ - $ - $ - Professional Fees 1 Acre $ - $ - $ - Rent or Lease (Equip) 1 Acre $ - $ - $ - Rent or Lease (Land) 1 Acre $ - $ - $ - Seed 1 Acre $ $ $ Supplies 1 Acre $ - $ - $ - Total Variable Expenses $ $ $ 1, Breakeven Price to Cover Variable Costs Lbs $ 0.06 Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 Acre $ $ $ Allocation of Labor 1 Acre $ 1, $ 1, $ 2, Allocation of Finance 1 Acre $ $ $ Allocation of G&A 1 Acre $ - $ - $ - Total Other Expenses $ 1, $ 1, $ 3, Total Costs $ 2, $ 2, $ 5, Breakeven Price per pound Lbs $ 0.26 Expected Net Income ($882.98) ($1,765.95) L9.11

12 Table 2. Sweet Corn Budget Acres = 4 Yield = 1,000 Quantity Unit $/ Unit Per Acre Total Ordinary Income/ Expense Income Crop Insurance Crop Revenues 1,000 Lbs $ 0.33 $ $ 1, Total Income $ $ 1, Expenses Chemicals 1 Acre $ $ $ Fertilizer & Lime 1 Acre $ $ $ Insurance 1 Acre $ - $ - $ - Labor (Hired) 1 Acre $ - $ - $ - Labor (Contract) 1 Acre $ - $ - $ - Professional Fees 1 Acre $ - $ - $ - Rent or Lease (Equip) 1 Acre $ - $ - $ - Rent or Lease (Land) 1 Acre $ - $ - $ - Seed 1 Acre $ $ $ Supplies 1 Acre $ - $ - $ - Total Variable Expenses $ $ $ Breakeven Price to Cover Variable Costs Lbs $ 0.13 Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 Acre $ $ $ Allocation of Labor 1 Acre $ $ $ 1, Allocation of Finance 1 Acre $ $ $ Allocation of G&A 1 Acre $ - $ - $ - Total Other Expenses $ $ $ 1, Total Costs $ $ 2, Breakeven Price per pound Lbs $ 0.59 Expected Net Income ($258.18) ($1,032.71) L9.12

13 Table 3. Onion Budget Acres = 2 Yield = 150 Quantity Unit $/ Unit Per Acre Total Ordinary Income/ Expense Income Crop Insurance Crop Revenues 150 Bags $ $3, $ 7, Total Income $3, $ 7, Expenses Chemicals 1 Acre $ $ $ Fertilizer & Lime 1 Acre $ $ $ Insurance 1 Acre $ - $ - $ - Labor (Hired) 1 Acre $ - $ - $ - Labor (Contract) 1 Acre $ - $ - $ - Professional Fees 1 Acre $ - $ - $ - Rent or Lease (Equip) 1 Acre $ - $ - $ - Rent or Lease (Land) 1 Acre $ - $ - $ - Seed 1 Acre $ $ $ Supplies 1 Acre $ - $ - $ - Other 1 Acre $ - $ - Total Variable Expenses $ $ $ Breakeven Price to Cover Variable Costs Bags $ 1.47 Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 Acre $ $ $ Allocation of Labor 1 Acre $ $ $ 1, Allocation of Finance 1 Acre $ $ $ Allocation of G&A 1 Acre $ - $ - $ - Total Other Expenses $ $ $ 1, Total Costs $ 1, $1, $ 2, Breakeven Price per Bag Bags $ 7.62 Expected Net Income $2, $ 5, L9.13

14 Table 4. Tomato Budget Acres = 2 Yield = 15 Quantity Unit $/ Unit Per Acre Total Ordinary Income/ Expense Income Crop Insurance Crop Revenues 15 Cwt $ $ $ 1, Total Income $ $ 1, Expenses Chemicals 1 Acre $ $ $ Fertilizer & Lime 1 Acre $ $ $ Insurance 1 Acre $ - $ - $ - Labor (Hired) 1 Acre $ - $ - $ - Labor (Contract) 1 Acre $ - $ - $ - Professional Fees 1 Acre $ - $ - $ - Rent or Lease (Equip) 1 Acre $ - $ - $ - Rent or Lease (Land) 1 Acre $ - $ - $ - Seed 1 Acre $ $ $ Supplies 1 Acre $ - $ - $ - Other 1 Acre $ - $ - $ - Total Variable Expenses $ $ 1, Breakeven Price to Cover Variable Costs Cwt $ Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 Acre $ $ $ Allocation of Labor 1 Acre $ 1, $ 1, $ 2, Allocation of Finance 1 Acre $ $ $ Allocation of G&A 1 Acre $ - $ - $ - Total Other Expenses $ 2, $ 2, $ 4, Total Costs $ 2, $ 5, Breakeven Price per Cwt. Cwt $ Expected Net Income ($1,978.54) ($3,957.08) L9.14

15 Table 5. Cow-calf Budget Cows = 25 Quantity Unit $/Unit Per Cow Total Ordinary Income/ Expense Income Calf Sales 234 Lbs $ $4, Culls 48 Lbs 0.40 $19.20 $ Total Income $ $4, Expenses Feed 1 Hd $ $3, Freight & Trucking 1 Hd 0.00 $0.00 $0.00 Labor (Contract) 1 Hd 0.00 $0.00 $0.00 Rent or Lease (Land) 1 Hd 0.00 $0.00 $0.00 Supplies 1 Hd 5.00 $5.00 $ Vet & Medicine 1 Hd $15.00 $ Other 1 Hd 0.00 $0.00 $0.00 Total Expenses $ $ $4, Net Ordinary Income $29.44 $ Other Income/ Expense Other Expenses Allocation of Support Centers Allocation of M&E 1 Hd $ $3, Allocation of Labor 1 Hd $ $10, Allocation of Finance 1 Hd $51.88 $1, Allocation of G&A 1 Hd 0.00 $0.00 $0.00 Total Other Expenses $ $ $14, Total Costs $ $ $18, Breakeven Price per Pound of Weaned Calf Lbs $3.10 Expected Net Income ($550.73) ($13,768.24) L9.15