Knowing your cost of production is the bedrock of modern farm management, so you’d think that it would be the one calculation that we would always have all the answers for. Indeed, most farmers probably feel they do know the answers. Probably you do too.
So you shouldn’t have any trouble with these questions.
It’s a no-brainer to add in all your variable costs, including fertilizer and chemicals, fuel, seed and custom work. Some costs are a little harder to assign, but even with items such as repairs we can usually make at least a stab at injecting some kind of guesstimate.
But then it gets a bit more difficult. How much do you add in for machinery depreciation? And how much for interest costs, and what about land taxes?
And what, if anything, do you add in to reflect the opportunity or paper cost of owning assets such as land and buildings? After all, if your capital wasn’t tied up in those assets, it could be earning three or four per cent interest without any appreciable risk by simply investing it in GICs at the bank.
Then there’s your own time and effort. What is it worth, and where do you account for it?
There can be subtle differences to the answers to some of these questions depending on the specifics
of your farm and depending on your accounting system. Sometimes, even the experts disagree.
But the two things they don’t disagree about are that an accurate cost of production is vital for developing an effective marketing plan, and the more accurate your cost of production, the better your marketing plan can be.
Dan Caron is a business development specialist who works out of the Starbuck office of the Manitoba Agricultural Services Corporation. He works directly with producers in his area, dealing with issues that can range from economics to agronomics. It’s a job that he has held for 12 years since he completed his degree in agricultural economics from the University of Manitoba.
Caron also heads the team of provincial government experts that is tasked with coming up with representative budgets for 23 Manitoba crops on an annual basis.
“When I work with producers, I try to use cost of production as a starting point, especially with the volatility in the markets that we have seen recently,” Caron says. “The biggest marketing driver for many of them is what they think the markets will do. But I try to get them to think in terms of profit, and that profit has two sides: costs and total returns.”
Producers can usually tell him their variable expenses right off the top of their heads, Caron says. They are particularly aware of fertilizer and chemical costs, which isn’t surprising given that fertilizer represents 30 to 35 per cent of the cash cost of producing a crop.
Fuel and repair costs are often ball-parked in Caron’s experience, with fuel coming in around the $15 to $17 per acre mark.
Fixed costs, according to Caron, are much more difficult to define.
“On the provincial budgets,” Caron explains, “we take a pretty by-the-book approach where we try to account for depreciation, interest and investment costs. We tell farmers not to take these figures to the bank but to use them as a guide and plug their own figures in. But when I’m working with individual growers, I’ll often simplify things by getting them to look at rent and principal and interest payments on land and machinery. Then they know what their payments are and how much they have to generate.”
Debt servicing is also front-and-centre when the Sanford Credit Union reviews credit applications from producers. Harold Froese, a producer who sits on the board of directors of the Egg Farmers of Manitoba, works at the Oak Bluff branch of the credit union, just west of Winnipeg, as an agriculture loans officer.
Froese says that when it comes to machinery, the credit union isn’t so concerned about colour, make and model but they do want to see a marketing plan that covers the payments that the equipment purchases entail.
“The Credit Union Central has a figure of $250 per acre for machinery investment that it considers a benchmark,” Froese explains. “When you’re up around $400 per acre, we’re going to be checking on whether or not you’re pushing the upper boundary of what the farm can afford.”
The problem with depreciation, says Froese, is that it is often quite subjective, depending on maintenance and resale value. As a loans officer, he is more interested in seeing a plan that covers the payments associated with the asset than the paper cost that is depreciation.
Dan Caron sees similar challenges with establishing the cost of ownership of land. “We’ve tracked the price of land in Manitoba since 1971,” Caron says, “and we’ve found that it has appreciated somewhere between eight and nine per cent per year on average. In light of this, it’s hard to say that the money a producer has tied up in land is costing him or her anything.”
So while both acknowledge that repayment of principal on land, building and machinery loans is not an expense per se, they see real benefit in including it as part of the calculation of a farmer’s cost of production.
How about owner labour and management? Some producers will work it in as a labour charge in the variable cost section of the budget, especially on incorporated farms where owners, management and staff take a wage from the farm. But many others do not.
“Everyone knows that, over time, they have to be able to draw money from the farm,” Caron adds. “But in the short term, if margins are really tight, personal withdrawals will often be deferred or put aside entirely as producers make do on savings or outside income.”
The challenge of accurately determining fixed costs is at least partly responsible for the fact that many farmers do not know their cost of production. But there are other factors at work as well.
Mark Lepp is the co-founder and business manager of FarmLink Marketing Solutions. FarmLink works with grain producers throughout Western Canada and offers several different levels of service, ranging from basic marketing information to complete financial analysis and benchmarking services.
Lepp says that when the company started operations back in 2004, it only provided the complete package it markets today as its Premium service. But it became evident, at a certain point that there was a clientele that FarmLink was missing.
“There are producers who feel they have no need for the financial analysis, including the breakeven analysis, that we can provide,” Lepp says. “All they want is market information. When producers have 100 per cent equity and they’re getting $14 per bushel for their canola as they were a couple of years ago, they aren’t really worried about covering either their costs or their payments.”
Dan Caron agrees. “It’s hard to get some of those high prices that we saw a couple of years ago out of people’s heads.”
But Caron and Lepp agree there is renewed interest in cost of production now that the markets have become so volatile. It is a tendency that is also being driven by younger producers who have cash flow and payment requirements that surpass those of their better-established peers.
Regardless of how or why they come to calculate it, producers can get a lot of mileage out of their cost of production when it comes to articulating a sound marketing plan. Combined with some sense of where prices may be headed overall, it provides a general framework for a lot of the detailed decisions a producer has to make over the course of the year.
“We’ll often look at marketing crops as a two-year undertaking,” says Mark Lepp. “Throughout that period, we’ll be comparing people’s cost of production with pricing opportunities and recommending that they sell, usually in 20 per cent increments.”
In developing these recommendations, however, FarmLink cannot focus solely on cost of production. The run-up of prices in the fall of 2007 is a good example. Based on a comparison of breakeven prices and those available in the marketplace, every bushel of grain would have been sold that fall long before prices topped out in the late winter. Although no one can know with absolute certainty how high prices will climb or when they will turn around, some sense of market fundamentals must be brought into the equation.
Caron suggests a similar approach. “In the pre-plant period, we’ll tell producers to look at pricing a small percentage of their crop — maybe 10 or 20 per cent — when available prices are at least above a level that covers their variable costs.”
“Overall, I’m not a big fan of pricing too much too early,” Caron says. “As the season progresses, you have to be able to take advantage of pricing opportunities that guarantee a profit. The problem is when nothing at all pencils out above the cost of production, like in 2005 and 2006.”
But Caron also suggests keeping a close eye on costs, like fertilizer. “Fertilizer should be seen as a commodity,” he says. “It should be bought strategically at prices that fit into the farm`s cost structure and enable it to make a profit.”
The bottom line is that knowing what it costs to grow a crop, raise a hog or finish a steer takes a lot of the guesswork out of marketing, especially in the context of today’s volatile markets. It does so by defining what a good price is — not compared to where the markets were last year or where they might be in three months’ time.
Instead, it shifts the emphasis to where it needs to be, on selling for more than it cost to produce.
That, says Caron, is a very good place to start.CG