Introduction to cost of production and its uses part 5
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Marketing is knowing the cost of production starts to really pay off for the operation. It can be described as when the farm sells its products to a consumer for a given price. The goal is to receive a high enough price that more than covers all costs the farm needs to pay. If the prices received are only enough to meet those needs, the farm is considered to have marketed at its break-even level.
Every farm wants to sell their products for more than break-even. They want to have additional dollars left over to use elsewhere. Without knowing the cost of production, there is no way to know that the market price being offered will provide a profit beyond the operation’s break-even.
It’s important to remember that break-even calculations should include not only the cash transactions in a year, but also pre-paid inputs or other inventory adjustments on the farm. These “accrual adjustments” give you the actual cost that needs to be covered for that input in a given year. When you have done these for all input purchases, you can then calculate what price is needed to cover the expected costs.
There are many types of break-even numbers that a farm business should think about when marketing their products. For purposes of this publication, we will focus on three of the most common:
- Net Return (Operating)
- Repayment Capacity (Cash Flow)
- Capital Retainment (Net Worth)
Net Return (Operating) Break-Even
Much of a growing season is focused on variable and fixed input costs. That is why the net return to operating tends to be the most common break-even that farm managers think about. To obtain a break-even price to cover operating costs, simply divide the total operating expenses by the expected production. To find the break-even for yield, divide the total operating expenses by the expected price. The formula for the net return (operating) break-even price is shown below:
| (Variable + Fixed Costs + Economic Depreciation) ÷ Expected Production Level = Net Return (Operating) Break-Even Price |
Economic Depreciation is added in this Break-Even as it focuses on covering all business costs.
Repayment Capacity (Cash Flow) Break-Even
The break-even for repayment capacity (or cash flow) is the number that your lender will want you to focus on. Cash flow is where the farm covers not only the variable and fixed costs, but also the non-operating or financial obligations for the year. This includes any family living cost, property taxes and term debt payments that the farm is expected to pay. The formula for the repayment capacity (cash flow) break-even is shown below:
| (Variable + Fixed Costs + Financial Obligations – Economic Depreciation) ÷ Expected Production Level = Repayment Capacity (Cash Flow) Break-Even Price |
Economic Depreciation is subtracted in this Break-Even as it focuses on actual dollars spent.
Capital Retainment (Net Worth) Break-Even
As a farm manager, you want your business to be worth more tomorrow than it is today. The increase of value or net worth of your business is a sign that it is doing well and considered a success. Increasing net worth is mainly accomplished through the generating of additional dollars or retained cash that the farm can use later. Reinvestments may be in the form of purchasing newer equipment, upgrading or adding facilities, or even the purchase of land. These dollars are also used to offset the depreciation in value of those same investments.
These capital activities make the net worth break-even one of the most important to calculate as a farm manager. What does the market price need to be to cover operating and financial costs as well as cover the lost value of depreciable assets? The formula for the capital retainment (net worth) break-even is shown below:
| (Variable + Fixed Costs + Financial Obligations + Economic Depreciation) ÷ Expected Production Level = Capital Retainment (Net Worth) Break-Even Price |
Economic Depreciation is added in this Break-Even as it focuses on changes in business value.
Knowing what the different break-even prices are is important in your role as a decision-maker on the farm. The cost of production will ultimately determine if your business is successful as a whole and can also be applied to individual enterprises within the business.
This is part of a six-part article series from the MSU Extension Beginning Farmer DEMaND series. The DEMaND series is a line of publications designed to help beginning farmers learn about financial and business management strategies that will assist them in developing into the next managers and decision-makers on the farm. For more information, check out the DEMaND series homepage on the MSU Extension’s Farm Management webpage.
