The last post, I focused on some tips and tricks at the 30,000 foot level. In this post I want to bring it down to the 10,000 foot level. I will outline the basic financial definitions, and focus on knowing our cost of production. I always look at my cost of production on a per acre basis, and then I take it down to the cost of production per unit (bushel, cwt, or tons per acre)
- Fixed Cost-Costs that remain the same regardless of activity level. Examples include farm payments, machinery equipment, depreciation, irrigation equipment and other hard physical assets (shops, offices, warehouses, misc crop storages). An easy way to tell a fixed cost is if the cost remains the same regardless of what crops or livestock are raised. It is important to divide your total fixed costs by the total number of acres being farmed or livestock produced. This makes it much easier to see the big picture, and much easier to manage and make decisions.
- Variable Cost-Costs that change depending on activity levels. Examples include seed, fertilizer, cost of electricity, planting and harvesting costs. Just as the fixed costs are broken down to cost per acre, so should the variable costs. Farmers and Ranchers are in the business to make a profit, it does not matter how much you sell your crops for, if your expenses exceed your income, you will not be in business very long.
- Differential Costs-Costs that influence a specific decision and will change depending upon which decision is chosen. Examples include cost difference between different crop inputs, such as seed, fertilizer and chemicals. Once a crop is decided upon it is hard to change our mind until the following year.
- Total Cost=Fixed costs +(Variable cost per unit *Production level)
- Contribution Margin- The difference between sales revenue and variable costs. Contribution margin looks at your net proceeds before taking into account the fixed costs. To begin with we are going to stick with this assumption. However, sometimes depending upon the situation we assign a higher percentage of fixed cost to certain crops. For example, a potato farm may allocate a higher percentage of their fixed costs to potatoes because that is their primary crop. For starters let’s not go down that road yet, when we discuss overhead allocations this will come into play.
- Break-Even Point- Is the point where total costs = total revenue. All of our analysis should center on this point and which crop will provide the highest net return. If we just break-even all we are doing is completing an exercise and heaven knows there is too much work and worry involved for just an exercise.
Since these definitions took up more space than I planned on, I will write two posts for today. The next post will introduce the formulas and equations for break-even analysis.
Work Hard, Be Patient, Never Quit, Always be Honest and Have Fun!