Introduction to cost of production and its uses part 3
Part 3: Direct vs variable and fixed costs
Direct or “operating” costs are those that vary in proportion to the size or scope of each farm’s enterprises (i.e. every type of crop or livestock produced on the farm). This is important as a farm manager begins to think about each production area and which costs are associated to them.
For every acre grown or added animal raised, the costs associated with a production activity will change. These include a combination of variable and fixed cost items as they are used specifically or more often for one enterprise or another. Examples include livestock feed, irrigation costs and land rent.
Consider a vegetable farm that raises zucchini and yellow squash. They have annual labor costs of $14,000 or an average of $35 per acre on 400 acres. This amount covers their full and part-time employees who work for the farm. This past year, approximately 60% of work hours were spent in the fields of yellow squash. Heavy rains led to increased weed pressure and also higher than anticipated production. The remaining 40% was spent in the zucchini fields. This meant that $8,400 of the total labor costs were directly tied to yellow squash while $5,600 was tied to zucchini. If each enterprise had 200 acres, then the direct cost of hired labor for yellow squash would be $42 dollars per acre and $28 for zucchini.
|Table 3: Labor Cost Example
|Labor cost to Yellow Squash||$8,400||÷ 200 = $42/acre|
|Labor cost to Zucchini||$5,600||÷ 200 = $28/acre|
|Total Annual Labor Cost||$14,000||÷ 400 = $35/acre|
Farm managers use this process of “enterprising” to determine each production areas’ specific costs of production. This allows them to evaluate the success of each component of the business on an individual basis separate from the whole farm. Frequently, they will learn that one production area is more effective and profitable compared to another.
This process can then be taken to the next level by comparing the whole farm and cost of production against other farm operations. Using national benchmarking databases, such as FINBIN, managers gain valuable information about best practices, areas of improvement and overall performance. Producers that enterprise and utilize benchmarking information often discover ways to improve profitability and long-term sustainability.
For more information on enterprising, check out bulletin E-3410 Understanding Enterprise Budgets and Economic Profit.
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.