Cost Concepts—Key Questions
Chapter 9, pp. 129-134
Ø What is an opportunity cost?
Ø How do operating and ownership costs differ?
Ø How are ownership costs calculated?
Ø In the short run?
Ø In the long run?
Ø How do cash and noncash costs differ?
Opportunity Cost
n The amount a certain resource could have earned in another use.
n Amount given by using a resource in farming.
n Examples:
n Labor
n Capital
n Home grown feed
Operating Costs (variable)
n Cost of goods or services that are used up in one production cycle
n Seed, fertilizer, fuel, wages, rent, repairs, feed, veterinary, etc.
Ownership Costs
Costs of goods that last more than one production cycle
n Machinery
n Equipment
n Breeding livestock
n Land
n Buildings
Ownership Costs (fixed costs)
n Depreciation: loss in value due to wearout or obsolescence
n Interest on investment: cost of a loan or opportunity cost on your own capital
n Insurance: casualty, theft, etc.
n Taxes: property (on some items)
n Repairs and maintenance: just buildings
They are an operating cost for machinery.
Machinery Example (pages 403-405)
Current Year Costs
n Current value of tractor = $50,000
n Depreciation: take 10% of current value
$50,000 x 10% = $5,000
n Interest: current value x interest rate $50,000 x 7% = $3,500 / year
n Insurance and taxes: est. 1% of current value
$50,000 x 1% = $500 per year
q Total ownership cost = $9,000 / year
What Interest Rate to Use?
n Use weighted average cost of capital
n Example:
n $30,000 is owed on the tractor, at 9 % interest (60% debt capital)
n $20,000 of equity capital that could earn 4% in a savings account (40% equity)
n Cost of capital = (.60 x 9%) + (.40 x 4%) = 5.4% + 1.6% = 7.0%
n 7% x $50,000 = $3,500
Interest Cost on Capital Assets
n Or:
n Loan: $30,000 x 9% = $2,700
n Equity: $20,000 x 4% = 800
n Total interest = $3,500
Ownership Costs for Buildings
n Use slower depreciation (5% of current value)
n Include repairs and maintenance
Building Ownership Costs
Estimated value of building is $60,000
n Interest (on current value)
7% x $60,000 = $4,200 / year
n Depreciation
5% x $60,000 = $3,000
n Taxes and insurance (current)
1% x $60,000 = $600
n Repairs.& maintenance: 2 - 4% of value
3% x $60,000 = $3,000
q Total ownership costs = $10,800 per year
Average Ownership Costs over the Entire Ownership Period
n Depreciation =
(purchase cost – salvage value)
years owned
See page 399 for estimated salvage values for machinery.
Tractor: salvage value after 10 years is 32% of original list price
Tractor Example—Average Costs
n New value = $100,000
n Salvage value = 32% x 100,000 =$32,000
n Total depreciation =($100,000 - $32,000) = $68,000
n Average annual depreciation is:
$68,000 / 10 years = $6,800 per year
Interest Expense
n Interest is charged against the average value of the machine
n Take average of new value and salvage value
Average value =(100,000 + 32,000) / 2= $66,000
Interest = 7 % x $66,000 = $4,620 per year
Insurance and Taxes
n Assume 1% of the average value of the machine.
Insurance & taxes = 1% x $66,000 = $660
Total = $6,800 + 4,620 + 660
= $12,080 per year
Ownership Costs Over Ownership Life for Tractor
Economic Principle
n If gross revenue exceeds variable costs, profit will be increased (or losses decreased) by producing.
n That is, when gross margin > 0 go ahead and produce
Example:
Finishing Feeder Pigs
Variable costs: feeder pig $40.00
feed 50.00
operating 10.00
labor 3.00
=total variable costs $ 103.00
Fixed costs (bldg, equip) $ 13.00
Total costs $ 116.00
Profit (250 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.
Higher Cost Facilities, Perm.Labor
Variable costs: feeder pig $40.00
feed 45.00
operating + labor 8.00
total v.c. $ 103.00
Fixed costs (bldg, equip) $ 23.00
Total costs $116.00
V.C. breakeven = $93 / 270 lb. =$.34
Economic Principle
n If a higher proportion of a farm’s costs are fixed, it will continue to produce even at a lower price.
In the long run all costs are variable.
n Before an investment is made
n Fixed resources could be sold
Cash and Noncash Costs
Cash Costs
n Seed, fertilizer, pesticides
n Fuel and repairs
n Hired labor
n Cash rent
n Interest on loans
n Etc.
Noncash Costs
n Depreciation
n Opportunity Costs
n unpaid labor
n net worth capital
n feed produced on the farm
Sunk Costs
n As the production cycle progresses,more and more costs become sunk.
n Sunk costs no longer affect decision making in the short run (within the production cycle)
Sunk Costs
n Should you harvest a poor crop even if you expect to not cover total costs?
Diminishing Returns
Chapter 7 (pages 113-124)
n In an agricultural production process, how does adding more units of input change the units of output?
n How is the most profitable level of input use determined?
Corn Yield Response to Nitrogen
Law of Diminishing Marginal Returns
n As more units of input are used, output will increase.
n The rate of increase in output will eventually decline.
n It may even become negative at high levels of input.
n This response is due to biological limitations.
Yield Response to Nitrogen
Example: Add N to Corn
n Increase N application from 0 to 40 lbs/ac
n Cost of N is $.20 per lb.
n Marginal cost = 40 lb. X $.20 = $8
n Corn yield increases from 103 to 128 bu/a
n Marginal product = 128 – 103 = 25 bu.
n Price of corn is $2.00 per bu.
n Marginal Revenue = 25 bu. X $2.00 = $50
Definitions
n Marginal Product--Amount of added product for each unit of added input. Depends on biological factors.
n Marginal Revenue--Value of the marginal product. Depends on product selling price.
n Marginal Cost--Cost of additional input. Depends on purchase price of input.
Profit Maximization Rules
n As long as MR > MC, use more input.
n If MR < MC, do not use more input.
n Where MR = MC, profit is maximized.
Optimum N Rates at Increasing N Prices
Corn after Soybeans
Nitrogen Rate Calculator
http://extension.agron.iastate.edu/soilfertility/nrate.aspx
Diminishing Marginal Returns: Cattle Feeding