Economic Considerations for Grape Producers

Economic Considerations for Grape Producers

Roger Sahs

OSU Extension Specialist

Roger Sahs has been employed with the Oklahoma Cooperative Extension Service since 1985 and currently serves as an extension assistant with the OSU Department of Agricultural Economics.

Industry Overview

Over the past several years, Oklahoma’s wine industry has experienced a tremendous growth in both grape and wine production. Oklahoma’s grape and wine industry is based on the production from a number of grape cultivars from the American, Hybrid, and Vinifera groups. According to the Oklahoma Grape Growers and Wine Makers Association (OGGWMA), there are over 50licensed wineries. With more acres coming into production each year, the percentage of Oklahoma-grown grapes crushed at these wineries is expected to grow, resulting in more wine that is truly “Oklahoman” by nature.

Although established vineyards may generate per acre net returns substantially higher than conventional crops grown in Oklahoma, there are numerous challenges to be considered. Viticulture should be approached with a full understanding of what it takes to be successful, as it requires a significant investment of time, money, and knowledge. Oklahoma’s range of geographies, soil types, precipitation patterns, and overall climate presents many challenges to meeting the necessary quantity and quality of grapes demanded by local wineries.

While Oklahoma wines are beginning to distinguish themselves in regional competitions, they face ever present competition from home and abroad. California produces a majority of all wine consumed in the United States along with increased pressures from Chilean, Australian, and European imports. And Oklahoma Cabernet Sauvignon may not taste like its California counterpart or a French Bordeaux, which can create negative perceptions among local consumers.

By the same token, there is a great potential for continued growth in Oklahoma’s wine industry. As more research-based information is available and more producers are trained in the art of viticulture, producer profits will be enhanced. Agri-tourism and hospitality events are expected to increase demand and expand winery capacity. Wineries and grape growers will need to continue producing the best Oklahoma wine product possible with unique character and quality. If such challenges are met, the Oklahoma grape and wine industry will continue to prosper in the years to come.

Grower Considerations and Keys to Success

1. Markets. Be sure that the grape cultivars that you decide to invest in will be marketable when they bear fruit. Check with wineries and see what types of grapes they are interested in buying. Determine what cultivars will be in short supply or popular in the next five to ten years. It would be advisable to obtain a contract or firm commitment from wineries before you plant. Generally speaking, it takes 2.7 pounds of grapes to make a 750-ml bottle of wine. Therefore, one ton of grapes produces about 150 gallons, 62.5 cases or 750 bottles (750-ml) of wine.

1. Education. Better know what you are doing or growing grapes will be a painful lesson in the pocketbook. You will need to have an eye for detail, be able to follow set procedures, and understand the risks involved. Talk to local growers and Extension personnel. Other sources of information are: books/periodicals on grape production and industry, commodity organizations, and grape production websites on the Internet. Focus on financial management as much as production performance. Realize that alternatives that appear profitable for one producer may not work for another. Everyone’s experience levels, managerial abilities, and willingness to assume risk is different. Knowledge of budgeting (as discussed below) and the ability to use them will help make the right decision.

1. Investment. Investing in a vineyard is often an expensive undertaking and can be financially stressful. Land ownership in particular is costly. You will need sufficient capital and time to live for three years without any return from your vineyard while you still devote time to the enterprise. Preproductive expenditures can vary greatly, but expect over the first three years to exceed $9000 per acre exclusive of land costs with annual expenses over $1500 per acre (this includes placing a value on your labor). If financing is required, is it available? If so, educate your lender about marketing and production practices. Provide him with a detailed business plan along with current and pro-forma financial statements.

1. Start slow with a few acres at a time. Proceed with caution when trying new things. This is especially the case if you have limited knowledge of viticulture and/or farm machinery. It will help you learn about growing grapes without taking any unnecessary risks along the way. Don’t start too big!

1. Enterprise budgets. Lacking the information needed to make perfect decisions, specialty crop producers are forced to use the best information available and take calculated risks. Enterprise budgets are the foundation for risk-management decisions. An enterprise budget estimates the full economic costs and returns projected to accrue to an activity - raising livestock, producing grain, growing fruit - for some period, generally one year. They facilitate comparisons of profitability while documenting resources, management practices and technology used in production. Among the various uses for enterprise budgets are:

1. First step in developing business/marketing plan.
2. Evaluating options before a commitment of owned or controlled resources.
3. Estimating the size of vineyard needed to earn a specified return.
4. Uncovering costs that have not been previously considered.
5. Estimating potential income for a particular vineyard.
6. Comparing the profitability of two or more different systems of production.
7. Estimating the amount that can be paid for land or machinery.
8. Identifying production and financial risks and whether they may be managed.
9. Providing the documentation necessary to obtain/maintain creditworthiness.
10. Projecting cash flows for a specific period of time.

OSU software is available to develop a customized budget for an individual operation The Microsoft Excel-based software provides users access to important agricultural references during an “interactive” budget building process. Through a series of links and pop-up menus, users may override defaults with their own values to customize the budget if their experience and farm records indicate different values and production practices. Where possible, web-links are built into the spreadsheets to provide users important economic and agricultural science information on the Internet. In addition, information on break-even prices and yields plus sensitivity tables is presented.

Enterprise Budget Components and Concepts

Three general types of costs comprise the total cost of producing any type of farm commodity. They are variable (operating), fixed, and overhead expenses. Overhead expenses are difficult to allocate among individual enterprises. Examples include telephone, electricity and accounting services. Overhead expenses are included in whole-farm budgets, but are generally excluded (as shown in the grape examples) in enterprise budgets. Variable costs are illustrated in operating input section while fixed expenses are shown in the fixed cost section.

Variable Costs

Variable costs are those operating inputs that vary as the level of production changes. They are items that will be used during one operation year or one production period. They would not be purchased if production were not undertaken. Variable costs may also be classified as cash or non-cash in nature. No differentiation between owner supplied or hired labor is assumed. If the farm operator or a family member supplies labor, a wage rate or salary that represents earnings if employed elsewhere would be shown. This illustrates one of the most important concepts in economics – opportunity costs. Every resource used in the production process has one true cost, its opportunity cost. The opportunity cost of labor is the return the resource can earn when put to its best alternative. If the operator decides not to assign a charge to the labor item, residual earnings (as defined by Returns Above Total Operating Costs) includes labor income. The producer can then determine whether the return is adequate compensation for his/her labor efforts.

Fixed Costs

Fixed costs are those that do not change with the level of production. Generally, fixed costs are those ownership costs associated with buildings, machinery, and equipment that are pro-rated over a period of years. Fixed costs may also be cash or non-cash in nature. Real estate taxes, personal property taxes and insurance are examples of cash fixed costs. Non-cash costs such as depreciation and interest on capital investment result in foregone opportunities. A closer inspection of the fixed costs in a grape budget follows.

The interest charge for durable assets such as machinery, trellis system, and irrigation used in the operation is based on the average amount of capital invested over the ownership period, usage per year, and an interest rate. Money that is tied up in these capital assets could have earned a return in an alternative use. This foregone opportunity is what economists define as opportunity costs and reflects a payment to the farmer’s owned resources.

Depreciation represents an attempt to spread the investment costs or purchase price of durable assets over their productive lifetime. It is typically the largest cost associated with ownership. For example, when a tractor is worn out, it should be completely “paid for” by depreciation. A producer must, in effect, save this much every year or reinvest it in machinery and equipment, or he will eventually find himself with worn out items and no cash reserves to replace them.

Taxes vary by region but are generally a function of average value. In the illustrated budgets, the annual charge for taxes is based on 1% of the purchase price.

Insurance policies are usually carried on more expensive machines while the farmer generally assumes the risk of loss on the simpler, less expensive assets. The insurance costs are based on the average amount of capital invested times an insurance rate.

Since grapes are a multi-year crop, the establishment cost needs to be allocated over several years. Establishment cost is the sum of the costs for land preparation, planting, vines, and other production expenses for the years preceding the first marketable harvest (assumed to be the third growing season) year. The cost recovery method was utilized (AAEA Task Force) where annual preproductive costs are accrued to a future value at the end of the preproductive period. The total of these costs is then amortized over the life of the enterprise based on the vineyard’s useful or productive life.

Production

The total quantity of production is multiplied by the actual or expected price to determine a value for production. In the illustrated budgets, the expected yield is based on the full production potential of the vineyard, usually achieved by the fifth year of growth.

Returns Above Total Operating Costs

The returns to fixed costs, land, risk, and management is computed by subtracting total operating costs from total receipts. As long as returns are greater than total operating costs, production is economically rational for an enterprise already in production.

Returns Above All Specified Costs

In determining overall enterprise profitability, fixed costs also have to be part of the profit equation. Returns to management, land, and risk is calculated by subtracting total variable and fixed costs from operating revenues. This amount is residual earnings to the producer for management and to land (because land costs can have a large variation within a region, land costs are excluded). Each individual must decide whether this return is a sufficient reward for management skills, risk taking, and land devoted to the enterprise. It should be noted that since non-cash items may be included in fixed costs, profits as shown here are not the same as net cash or operating receipts as shown in a cash flow statement.

Preliminary budget estimates for vinifera grapes in Oklahoma suggest the following figures exclusive of land costs (Tables 1). Years 0-2 is the preproductive period (year zero is a “green crop” year prior to planting the vines in year 1) for the grape enterprise. By the 3rd leaf year, some marketable production is being harvested.

Having a positive return above operating costs indicates the operation is able to contribute to fixed costs associated with owning capital assets. By the time grapes are assumed to reach their mature yield in year 5, positive returns above all specified costs indicate that the operation is self-supporting and shows an amount available for reinvestment in the business or family living. In cases where operating costs are covered, but the return above all costs is negative, insufficient income is generated to cover all fixed costs. Losses may be a short-run problem depending on production or cost circumstances within any given year.

Table 1. Preliminary budget estimate summary for producing Cabernet Sauvignon grapes in Oklahoma.

Year / Operating
Cost ($/a) / Fixed Cost ($/a) / Total Cost ($/a) / Production (tons/a) / Price
($/ton) / Total Receipts
($/a) / Net All Specified
Cost ($/a) / Accumulated
Net
Investment
($/a)
0 / $ 241 / $ 7 / $ 248 / 0.00 / $ - / $ - / $ (248) / $ (248)
1 / $ 4,460 / $ 1,303 / $ 5,763 / 0.00 / $ - / $ - / $(5,763) / $ (6,011)
2 / $ 1,829 / $ 1,273 / $ 3,102 / 0.00 / $ - / $ - / $(3,102) / $ (9,113)
3 / $ 1,407 / $ 1,993 / $ 3,400 / 1.30 / $ 1,200 / $ 1,560 / $(1,840) / $ (10,953)
4 / $ 1,597 / $ 1,993 / $ 3,590 / 2.40 / $ 1,200 / $ 2,880 / $ (710) / $ (11,663)
5 / $ 1,787 / $ 1,993 / $ 3,780 / 3.50 / $ 1,200 / $ 4,200 / $ 420 / $ (10,243)

Building on budgets to view sensitivity analysis is helpful in evaluating the financial risk associated with an enterprise (Table 2 and 3). With sensitivity analysis, income variability due to price and production risk is demonstrated, typically with tables of numbers showing returns under different price and yield scenarios. This information helps the managers assess their willingness to assume the risk of these variations.

Table 2. Sensitivity of yield versus price on per acre net returns above total operating costs, Cabernet Sauvignon grapes in Oklahoma.

Yield (ton/ac) / Price ($/ton)
$ 1,000 / $ 1,100 / $ 1,200 / $ 1,300 / $ 1,400
2.00 / $ 472 / $ 672 / $ 872 / $ 1,072 / $ 1,272
2.75 / $ 1,092 / $ 1,367 / $ 1,642 / $ 1,917 / $ 2,192
3.50 / $ 1,713 / $ 2,063 / $ 2,413 / $ 2,763 / $ 3,113
4.25 / $ 2,333 / $ 2,758 / $ 3,183 / $ 3,608 / $ 4,033
5.00 / $ 2,953 / $ 3,453 / $ 3,953 / $ 4,453 / $ 4,953

Table 3. Sensitivity of yield versus price on per acre net returns above total costs, Cabernet Sauvignon grapes in Oklahoma.

Yield (ton/ac) / Price ($/ton)
$ 1,000 / $ 1,100 / $ 1,200 / $ 1,300 / $ 1,400
2.00 / $ (1,521) / $ (1,321) / $ (1,121) / $ (921) / $ (721)
2.75 / $ (901) / $ (626) / $ (351) / $ (76) / $ 199
3.50 / $ (280) / $ 70 / $ 420 / $ 770 / $ 1,120
4.25 / $ 340 / $ 765 / $ 1,190 / $ 1,615 / $ 2,040
5.00 / $ 960 / $ 1,460 / $ 1,960 / $ 2,460 / $ 2,960

Financial Measures and Where to Get Help

Occasionally I get questions about evaluating investments in terms of how long will it take for a vineyard to pay for itself or in other words, the results of the payback method. The principal advantage is its simplicity, but that’s also the main downfall. It does not consider the time value of money and often fails to consider earnings over the entire vineyard’s useful life. Finally, there is no logical basis for establishing a meaningful payback period. Should the maximum be 5 years, 10 years, or whatever is really a matter of guesswork.

The overall financial performance of a vineyard as a business or within a larger diversified farm operation should be evaluated through measures of liquidity, solvency, repayment capacity as well as the rate of return on assets (or equity). No single measure is sufficient for evaluating financial position as several measures must be tracked over time to provide a true perspective.

Oklahoma farmers and ranchers can call on the Intensive Financial and Management Planning Support (IFMAPS) program to receive free, confidential assistance in farm business planning, including analyzing the potential for a new or expanded vineyard. Trained financial specialists work with families one-on-one to develop financial statements and evaluate alternative plans. The plans typically include budgets for the farm enterprise(s), a cash flow plan, income statement, balance sheet, debt worksheet, and financial measures. Contact your local agricultural Oklahoma Cooperative Extension Educator or call the IFMAPSCenter at 1-800-522-3755.

Summary

Budget preparation is time consuming and hard work, but it can pay major dividends. It is important to remember that “best estimates” are influenced by production and price uncertainty. Revenues losses do occur from unexpected freeze damage and other adverse weather events. It’s a probability game since everything doesn’t always go according to plan. Identifying potential sources of risk will result in fewer unpleasant surprises.

Note that the budget illustrations are for vinifera cultivars and are supplied for planning purposes only. Hybrid and American varieties may have lower price per ton, but also experience lower disease pressures and are more dependable producers. Since every producer’s experience levels and managerial abilities vary as well as vineyard site location, budgets need to be tailored to fit individual situations.

The bottom line is – make sure your operation is as cost effective as possible. And don’t settle for “average” in terms of grape quality or overall yields. Identify new technologies/cultural practices that help lower costs. Find the leverage points that can generate the most bang for the buck. Benchmark the competition and become a real partner with your wineries.

Grapes may produce high rewards, but do involve high risks and require high levels of management. Successful managers discover that life is a whole lot easier controlling risks and saving money through budget planning. A vineyard operator interested in being profitable should expect to do no less.

References

AAEA Task Force. “Commodity Cost and Returns Estimation Handbook.” February 2000.

Stafne, Eric. “Report of the 2006 Oklahoma Grape Growers Survey.” Oklahoma Cooperative Extension Service, 2006