Introduction

Choosing what crops or livestock to produce is an essential decision of any farm business. One critical factor in making that decision is the cost of producing the “enterprises” being considered.

This is known as enterprise budgeting or “cost of production” budgeting. Enterprises are a single crop or livestock commodity that produces a marketable product. Cost of production (COP) budgeting consists of estimating the costs associated with an enterprise and the expected revenue. This fact sheet outlines the process and use of COP budgeting for farm-level decision-making.

What a cost of production budget is

While the format of cost of production budgets can vary, they typically include the following sections:

  • revenue — the gross revenue from crop or livestock sales before any expenses have been deducted
  • direct variable costs — expenses for the production of a specific commodity. These change depending on the level of production (for example, seed, fertilizer, pesticides and feed)
  • indirect variable costs — expenses used in producing all commodities on the farm (for example, fuel, labour and utilities). These also change depending on the level of production
  • fixed costs — expenses that remain the same regardless of the level of production (for example, property taxes, fire insurance and depreciation)
  • net profit (loss) — revenue minus all variable and fixed costs

How to use your cost of production

Knowing your cost of production is vital for making farm-level decisions.

Enterprise mix decisions

If possible, review your cost of production for each individual enterprise for the past 3 to 5 years. This shows how much each is contributing to the whole-farm financial picture, illustrating which enterprises are making money and which are not.

Purchasing and marketing decisions

Pricing targets for inputs and outputs can be set at different cost breakeven levels. Know your breakeven points. This information allows you to take advantage of buying or selling opportunities when they arise. Use the following formulas to determine breakeven points.

Breakeven price to cover variable costs

Total variable costs ÷ expected yield = $ per unit produced

This is the minimum price needed to cover variable costs.

Breakeven price to cover total costs

Total costs ÷ expected yield = $ per unit produced

This is the minimum price needed to cover all costs.

Breakeven yield

Total costs ÷ expected price = unit produced

This is the minimum yield needed to cover all costs.

Investment decisions

Making the right investments in capital assets such as land, machinery and buildings is critical to long-term success. COP information shows what the farm can afford to pay for those assets. Review investments in enterprises that fail to meet total costs in the long run, and redirect resources to more profitable enterprises.

Preparing a COP budget

Good cost of production information starts with good farm records. If your current recordkeeping system does not allow estimating costs on an enterprise level, change it. Many paper-based record books, including Ministry of Agriculture, Food and Rural Affairs (OMAFRA) Publication 540, Ontario Farm Record Book, provide space to record income and expenses by enterprise. Farm accounting software makes it easier to track this level of information.

Historical estimates vs. projections

Budgeting estimates use either historical estimates or projections. Historical estimates use actual farm results and provide a measure of past enterprise performance.

Projections are estimates for a future period. The projections will typically use the production systems approach. The quantities used of the different inputs (such as seeding rates, fertilizer rates, amounts of feed fed) are outlined. Labour requirements, facility and equipment investment needs are identified.

Input prices, labour rates and investment costs are then applied to arrive at the estimated annual cost of production for the production system. This approach is useful from a planning perspective in detailing the resources needed in the enterprise and potentially identifying areas to improve efficiency of input use or productivity.

Unit produced vs. production unit

There are 2 units of measurement to base costs on in preparing a budget — unit produced or production unit.

Unit produced is the output or yield that the commodity is commonly measured by, for example, bushels of corn, market hogs sold or tonnes of grapes.

Production unit is the base unit used to produce the output or yield such as a hectare of land, square foot of greenhouse space, sow, cow or ewe.

Since the production unit remains fairly constant throughout production, budgets are usually prepared on a production-unit basis.

First calculate the dollar per production unit, then test this with different yield levels to calculate your dollar per unit-produced costs.

Estimating enterprise revenue

Historical estimates use the average price received multiplied by the average yield to arrive at enterprise revenue.

Projections can use average historical price/yield or expected price/yield, depending on the purpose of the budget. To obtain a good planning estimate, use either:

  • the past 5-year average for prices and yields, or
  • a season-adjusted market price for the month of the expected time of sale

Example

Average vidal grape yield per hectare
× average market price
= vidal enterprise revenue

23.8 tonnes per hectare
× $674.00 per tonne
= $16,007.50 per hectare

Estimating enterprise costs

The difficulty many farmers have in COP budgeting is allocating costs to the specific enterprise. And the more enterprises there are, the more difficult the allocation process.

First identify your enterprises. Include them all, even those used by other enterprises, such as hay fed to livestock. Calculating home-grown feed enterprise costs is useful in determining if it is cheaper to grow feed on the farm or to purchase it from off-farm sources.

Assign costs to the individual enterprises. Use the three main approaches to estimating enterprise costs: using on-farm records, market value information and formula based.

Using on-farm records

The on-farm records approach can be further broken down into direct costing and allocating whole-farm expenses.

Direct costing

Direct costing uses the actual amount paid for each cost item by enterprise. This requires commodity-specific records. Direct costing is the preferred cost estimation method for direct variable costs because it uses actual prices and quantities, providing the best estimate of your farm’s COP.

Allocating whole-farm expenses

Allocating whole-farm expenses distributes each item to a commodity according to an allocation scheme. It can be difficult to allocate whole-farm expenses as they are not directly attributable to a single enterprise, but all enterprises share the cost.

Whole-farm expenses include items such as:

  • advertising
  • utilities
  • memberships/subscription fees
  • office expenses
  • professional fees
  • motor vehicle expenses
  • small tools
  • property taxes
  • fire and liability insurance premiums

You must allocate whole-farm expenses to arrive at a total cost of production for an enterprise. But this should have no effect on enterprise selection decisions. Your enterprise choices should be the same after allocating whole-farm expenses as it was before they were added.

Common allocation methods of whole-farm expenses

  • Percent of enterprise contribution margin (refer to the section “Interpreting a COP Budget” for information on contribution margin) — this is the recommended method. For example, if a commodity accounts for 30% of the whole-farm contribution margin, the commodity is charged 30% of the overhead costs. Use one of the other methods below if there are objective reasons to do so.
  • Percent of sales — expenses are allocated according to how much the enterprise contributes to the gross sales.
  • Percent of total expenses — expenses are allocated according to how much the enterprise contributes to the whole-farm expenses.
  • Number of hectare (acre)-trips — for example, no-till field operations require fewer machinery passes, so the machinery cost is less than conventional tillage.
  • Hours spent — allocating labour costs across the enterprises. If machinery hours are tracked by enterprise this can be an effective way to allocate these costs.
  • Self defined — based on experience and unique to site or farm.

No one allocation method is right for every farm business or every enterprise or for all expenses; it may take a variety of methods. Use the method that makes the most sense for your farm and each expense.

Once allocations are developed, provided there are no significant changes to the enterprise mix, keep them consistent. This will make for better year-to-year comparisons.

Market value

Market value uses current market prices to determine the cost estimate. This is commonly used for costs such as land, labour and machinery.

The preferred estimate for land costs is the cash rental rate, since cash rental rates are assumed to cover all costs associated with owning agricultural land and are the best reflection of the agricultural value of the land.

Labour requirements on the farm can be supplied by a combination of paid and unpaid labour. To estimate costs for all labour, multiply the total number of hours needed (paid and unpaid) in an enterprise by the current hourly wage rate.

Machinery costs can be difficult to estimate on an enterprise level. A common approach is to use the custom farmwork rates for the operations involved in the enterprise to arrive at the enterprise machinery cost.

The downside to using market values is that they may not accurately reflect what is happening on your farm. There can be large differences between market prices and your own costs. Use your records to provide the most accurate measure of costs.

Formula-based

A formula-based approach is particularly useful for estimating capital costs associated with farm machinery and buildings. This method takes fuel use and repair rates, replacement costs and years of expected life to insert into formulas that calculate annual variable and fixed costs.

Refer to the OMAFRA fact sheets on budgeting farm machinery costs and lease agreements for farm buildings for detailed information and tables to calculate machinery and building costs using the formula-based approach.

Estimation approaches summary

There is nothing wrong with using different methods for different individual costs. The American Agricultural Economics Association (AAEA) recommends several methods on an individual cost basis. Choose an estimation method that requires information you have available. It is better to use your own commodity-specific information as this will provide the best estimate of your farm’s COP.

AAEA recommended estimation approaches by enterprise expense

Direct
  • commodity purchases (seed, livestock, feed grain)
  • fertilizers and soil supplements
  • pesticides and chemical treatments
  • prepared feed, minerals and salts
  • custom feeding
  • veterinary fees, medicine, breeding fees
  • insurance premiums (crop or production)
  • other crop and livestock supplies 
Allocate whole farm expenses
  • motor vehicle expenses
  • small tools
  • containers and twine
  • soil testing
  • office expenses/legal and accounting fees
  • advertising and promotion costs
  • memberships/subscriptions/licences/permits
  • motor vehicle interest and leasing costs
  • utilities (electricity, telephone, heating fuel)
  • other insurance premiums
  • property taxes
Market value
  • labour
  • agricultural contract work
  • freight and shipping
  • commissions and levies
  • storage/drying
  • rent (land, buildings, pastures)
  • machinery lease/rental
Formula-based
  • machinery (gasoline, diesel, fuel, oil)
  • machinery (repairs, licenses, insurance)
  • building and fence repairs
  • depreciation (buildings and machinery)
  • interest (operating)
  • interest (real estate, mortgage, term loans)

AAEA has guidelines for COP budgeting available in their publication Commodity Cost and Returns Estimation Handbook.

Other cost considerations

Establishment costs — perennial crops only produce after an “establishment” period. The costs associated with this non-productive time must be recovered during the crops’ productive life. Include an estimate of the annual cost to recover establishment costs in the annual budget of the years in full production. Spread these costs over the expected productive life of the crop.

Depreciation is a non-cash cost that measures the loss of value of machinery or buildings over time. It is the portion of the cost of the machinery or building that is counted as an expense each year. Costs are spread over their expected useful life.

The depreciation rate used for tax purposes typically does not reflect the expected useful life of the asset. A rate that better reflects the life of the asset is more appropriate for business management purposes.

Interest

Interest paid on loans is the actual cash paid in interest for existing loans. This gives a good estimate for cash flow purposes but fails to account for the cost of having your money invested in the operation.

Interest on investment accounts for the money you have invested in the operation in the form of equity. This is also referred to as the opportunity cost; it is what you could have earned with that money if you had invested it in the next best alternative.

The interest rate used should reflect conservative rates of return for money that could be obtained in the current market, for example, GIC rate, T-Bill rate or the current lending rate for operating credit. This assigns an interest cost to the portion of the business operation that is financed with your own equity.

To illustrate, consider an example farm with assets valued at $1,000,000, of which 25% is financed with bank debt and 75% financed with their own equity.

Example

$1,000,000 farm assets × 25% of asset value
= $250,000 in loans

$1,000,000 farm assets × 75%
= $750,000 in equity

Interest paid on loans (cash cost)
= $250,000 × 5% (interest rate on loans)
= $12,500 per year (interest paid on loans)

Interest on investment (non-cash cost)
= $750,000 × 3% (interest on investment rate)
= $22,500 per year (interest on investment)

Total annual interest cost for the farm
= $12,500 + $22,500 = $35,000.

Livestock replacement and death loss costs

Factor in the cost to replace breeding livestock, whether raised on the farm or purchased. Market value is typically used to estimate these costs. Replacement cost is the net value between the estimated market value of replacements and the estimated cull value multiplied by the replacement rate. The replacement rate incorporates a culling rate and a death loss rate.

Example

Sow replacement cost:

Culling rate = 35%

Death loss rate = 5%

Replacement value = $300.00

Cull value = -$150.00

Net value = $150.00

Replacement cost
= net value × (culling rate + death loss rate)
= $150 × 40%
= $60.00 per sow per year

Not all animals being raised for sale make it there, so consider death loss in your market livestock. Use a reasonable death rate to reduce the number of expected market livestock. Then the market livestock bears the cost that went into the livestock that were lost along the way.

Interpreting a cost of production budget

Your COP budget measures three different margins:

  • gross margin
  • contribution margin
  • profit margin

Start with the gross margin, then move to the contribution margin and end with the profit margin. Each margin provides information to make farm level decisions. Appendix 1 will help you through this process.

Gross margin

Gross margin is revenue minus direct variable costs or production-related costs. For crops, this includes seed, fertilizer, pesticides, crop insurance and marketing. For livestock, this includes feed, livestock purchases, custom feeding, health, breeding and marketing. This is the simplest margin to calculate since you are dealing with costs directly related to growing crops or raising livestock.

Gross margin is a measure of how well the farm is converting the direct production inputs into marketable products. Low gross margin can indicate problems in productivity in terms of yield or in marketing, resulting in lower prices received or direct input cost control.

Use gross margin as a quick reference point in making short-term cropping decisions. If a new crop does not require additional labour or machinery, the direct variable costs of your crop choices will change the most from one crop to the next. The gross margin tells you whether the enterprise is contributing to the other indirect costs and by how much, compared to other enterprises.

Contribution margin

Contribution margin is revenue minus all variable costs. This involves allocating whole-farm costs that all enterprises must share. Use the contribution margin to decide if it makes sense to invest in capital assets for this enterprise. Capital assets are long-term assets with a useful life longer than a year. These include land, buildings, machinery and quota.

If the contribution margin is low, determine if anything can be realistically done on the cost or revenue side to improve this measure. A positive contribution margin indicates that the enterprise does contribute to paying some or all of its fixed farm costs.

If, for example, the enterprise covers all variable costs and only a portion of fixed costs, you could continue with the enterprise in the short run, while looking at either cost reductions or revenue increases to have it cover all costs in the future.

Profit margin

Profit margin is revenue minus all variable and fixed costs. Without long-term profit, a farm business is not sustainable. Sustainability depends on every enterprise covering all costs and providing a return to management.

Risk and the cost of production budget

Farming is a risky business, and profit is a return to risk. To make a profit, you must take risk. The goal is to learn to manage it. It is necessary to develop reasonable expected yield, cost and price estimates in decision making. However, expected outcomes are not enough for effective decision making. A producer must also consider the consequences of outcomes other than those expected or are considered most likely. Think of these other outcomes as the “what ifs” of decision making. What if weather is less favourable than expected? What if market prices are lower than expected? What if insects or disease reduce yields or increase death losses for livestock? What if a crop is wiped out by hail or flood?

Since a wide variety of “what ifs” can affect yield, price and cost, it is highly unlikely that actual net returns will match your estimated net returns. Understanding and anticipating these unpredictable risks is critical to budgeting.

The Budgeting Tools of the Ontario Enterprise Budgets on OMAFRA’s Agriculture Business Management website allow you to assess the potential impact of production and marketing risk factors and risk management strategies. In each commodity budget, expected as well as optimistic and pessimistic outcomes for key risk variables are submitted. Based on these entries, the tool then calculates an assessment of how much risk is involved in this enterprise.

Summary

Cost of production information is an essential ingredient for farm-level decision making. Knowing your costs of production is the first step in controlling them. Good cost of production information starts with good farm records. If your current recordkeeping system does not lend itself to estimating your costs on an enterprise level, start making changes today.

Download the PDF for the appendix.

References

Commodity Costs and Returns Estimation Handbook, American Agricultural Economics Association, February 2000

OMAFRA fact sheets

Other OMAFRA business resources

Fact sheets:

Internet resources

Crops and livestock budgeting in Ontario — OMAFRA Business Management. Enterprise budgets for crop and livestock enterprises in Ontario available in Excel format.

Budget Library – University of Minnesota. The Budget Library includes current enterprise budget information and software from throughout the U.S.

This fact sheet was written by John Molenhuis, business analysis and cost of production specialist, OMAFRA.