Know your cost of production for better decision making

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When getting a clear financial picture for your operation, basic record keeping isn’t often enough. That’s why it’s essential to know how to calculate your historical cost of production. Getting there isn’t always straightforward, but you should know your variable and fixed costs with certainty. Your accounting software program and financial statements should give you most of the information you need.

Variable vs. fixed costs

Variable costs can be divided into two types - direct and indirect. On a grain farm, direct variable costs are likely to change for each crop since the cost of seed, fertilizer and crop protection products will be different for each.

Indirect variable costs change depending on the level of production, but it may be difficult to assign different amounts to different crops. Examples include fuel and utility costs. Often the cost of these per acre will be assigned to all crops equally.

Fixed costs are expenses that stay the same, regardless of your level of production. These include interest on land loans, property taxes and machinery depreciation. They include the expenses you pay, regardless of putting in a crop or calving cows. Some are easy to pin down - you know what they are. Others are open to interpretation, like the full cost of machinery ownership or a land investment cost.

For farms with multiple enterprises (like grain and livestock), it’s often necessary to allocate fixed costs between enterprises. You could allocate based on the gross margin percentage that an enterprise contributes or use a percentage of total expenses.

Determining cost of production is even more challenging if you’re projecting for the future. You must estimate production, related expenses and what prices you expect for commodities. However, costs and returns from the previous year can help make this easier.

Even if you can’t always be precise, calculating cost of production is essential because it helps you:

Know what’s a profitable price for appropriate marketing decisions
Understand how much cash to withdraw from the business for personal use
Compare different cropping options for profitability
Determine your fixed costs and whether they can be reduced
Make informed decisions about equipment upgrades and repairs
Evaluate government and private insurance programs, farm expansion, diversification and land rentals
Set prices for consumer food products sold directly to consumers
Benchmark with comparable farms

Contribution margin as a tool

A cost of production analysis can also be useful without getting into the intricacies of fixed costs. For instance, when comparing cropping options, you can consider the variable costs for seed, fertilizer and crop protection products. These are the expenses that vary from one crop to another.

Deducting these variable expenses from the gross income expected for what each crop generates is often called a contribution margin. This can be useful when comparing crops. But to know whether a crop or an enterprise will make a net profit, all costs, including fixed expenses, must be considered.

Calculating fixed costs for machinery

For machinery, the capital cost allowance used for calculating income tax is a starting point for figuring out fixed costs. Still, it may not reflect the real depreciation or what it will cost when it’s time to upgrade.

If you’ve borrowed money to buy equipment, the loan payments are considered a fixed cost. But you should also include it as an opportunity cost. If that money was invested elsewhere, it could be earning a return.

A useful exercise for grain farms is to tally the total value of machinery and divide by the number of seeded acres to generate machinery investment per acre. Large differences often exist from one farm to the next, and this has a direct impact on fixed costs.

Assume the annual machinery depreciation rate is 10.7%. Additionally, a machinery investment cost of 7.5% is assumed for a total of 18.2%. The machinery investment cost accounts for the value of money you’ve invested in equipment, plus when you eventually go to upgrade equipment, it’s likely to be more expensive.

Based on these assumptions and using a total of 18.2%, a farm with $300 per acre invested in machinery would incur a fixed cost of $54.60 per acre, while a farm with $600 per acre invested in machinery would have a fixed cost of $109.20.

This example would change, depending on province.

Calculating land costs

If you’re cash renting land, the rental cost (and land loan payments) are obvious expenses to include in your cost of production analysis. But what about your equity in the land? Although it doesn’t come out of your cash flow, there’s an opportunity cost associated with land investment. For that reason, it’s common to apply a land investment cost compared to what the money could be earning in a low-risk investment.

Alberta Agriculture and Forestry has an AgriProfits Business Analysis and Research Program that generates financial performance reports based on producer surveys. Their analysis of cow-calf production takes a different approach to land costs.

Land costs for pasture are based on prevailing pasture lease costs. Feed and bedding costs are based on the value of the feed and bedding in the marketplace, even if these were produced on the same farm.

Alberta Agriculture and Forestry uses the same approach for its annual Dairy Cost Study. In most cases, dairy operators use homegrown feed in conjunction with purchased feed. The study examines only the dairy enterprise. Costs of production for homegrown feed are allocated to the crop enterprise portion of the farm.

Analyzing in this way separates the livestock enterprise from the grain farming enterprise that may or may not exist within the same farm.

Consider your living costs

Cost of production is sometimes calculated without any allowance for the owner’s living expenses. That might be reasonable if the owners have other sources of income and don’t need to draw income from the farm, but if withdrawals are going to be made, this should be included in the calculations.

Withdrawals for incorporated farms are often delineated, but this may not be the case for sole proprietorships or partnerships. Using the same bank account for farming and personal use makes it difficult to track your cost of living. Separate accounts and a disciplined approach to personal withdrawals are highly recommended.

There can be a wide variation in living costs from one family to the next. Education expenses, sporting activities, vacations, recreational equipment, retirement savings and entertainment expenses can be dramatically different. A farm’s gross income might seem like a large number, but net income might not. Personal expenses need to be factored in as they can have a significant impact on a farm’s viability. On the other hand, farms sometimes use unpaid labour. To generate a true cost of production, unpaid labour should be assigned an appropriate value.

Benchmarking

It’s beneficial to monitor how your farm is doing year-to-year, and to know how your cost of production compares to other farms in your region. And this is getting easier as more benchmarking information becomes available.

Many provincial departments of agriculture survey producers and publish cost of production studies. Crop planning guides, like the ones published by provincial governments, are not based on producer surveys, but still provide useful information and approaches for your analysis.

If your accounting firm has a significant number of farm clients, it may be able to share how your costs and returns stack up against others.

Resources and options

Not everyone uses the same method for analyzing cost of production, but there’s a lot to be gained from viewing how others do it. Some of the provincial agriculture departments have cost of production calculators for a wide range of commodities where you can plug your numbers.

Cost of production analysis can be useful for both big and small farm management decisions. For example, what piece of equipment should be leased or purchased? And it all starts with good farm record keeping and updating your projections regularly as cost and revenue assumptions change.

Cost of production