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Information and discussions about cost of production are certainly nothing new to farmers. I have had the opportunity of giving presentations to farmers across Canada about cost of production. Given the price cycles of both inventory and inputs over the past couple years, there seems to be a bit of a renewed buzz and increased interest about cost of production in the industry. Helping farmers gain a better understanding of what their cost of production is and how it should factor into management decisions is important.
Cost of production per unit is the costs associated with production divided by the number of units produced – units being bushels, cwt, liters or pounds. The key words here are ‘per unit’. A large number of farmers tend to think about their cost of production in terms of acres. Rather than making this discussion a detailed review about cost of production theories, let’s take a look at some key points.
Allocation of revenue and expenses:
Allocating expenses is fundamental to calculating margins over costs of production. A grain farmer with only one crop will have a relatively straight forward calculation. However, most farmers have more than one crop and the calculations become complicated once you have livestock or other enterprises such as custom tracking or spraying. Unfortunately, most accounting statements are not presented in a format that provides much assistance when working through a cost of production exercise.
Revenue allocation can be fairly straight forward, until you have to consider government program allocations.
Expenses should be categorized in terms of how specific they can be allocated to any given enterprise or crop. Inputs such as fertilizer, seed and chemical can clearly be identified and allocated. Other operating-related costs such as fuel, repairs, custom work, supplies and labour tend to be in a greyer area. It becomes even more challenging to associate expenses related to overhead and administration of the farm, such as interest, amortization, professional fees, utilities and insurance. Some of these expenses, such as fuel, can be tracked accurately but it can be a painstaking process. Others expenses will always require a significant degree of estimation. Before embarking on a time consuming exercise of confidently allocating these expenses, determine the degree of accuracy desired and then design the processes accordingly.
Returns to management and ownership:
Farmers, who calculate their cost of production, often only analyze margins required to cover expenses for things which they write cheques for. How should you determine what margins would be required to provide an appropriate return to ownership and management? Returns, over cost of production, to management often equate to living cost withdrawals. The problem with this method is the adequacy of the withdrawals. Consider asking yourself what you would have to pay to have someone, with the appropriate skill set and experience, come and manage your farm. The cost will likely be more than what is taken as drawings.
After having factored your management expenses into your cost of production calculation, proceed to examine return to ownership. Most farmers do not include this expense when determining targets for margins over costs of production. But it is the return to ownership that compensates a farmer for the investment made and the risk endured.
Consider the following scenario: You spend the winters in the Caribbean and are golfing in the summer, so you have hired a manager to run your business. But every year, after paying the manager and all production expenses, the farm breaks even. Is this a business in which you would continue to invest in? Likely not. It can be virtually impossible to even cover production related costs, let alone provide any theoretical margin to management or ownership. But this is a good exercise, which can be helpful from a business management perspective, to determine what margins are required to cover the costs of production, including returns to management and ownership.
Terry Betker is a partner with Meyers Norris Penny LLP, working out of the Winnipeg, Manitoba office. He is director of practice development in Agriculture – Government & Industry.
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