Chapter 11: Kay and Edwards Partial Budgeting Chapter 11: Kay and Edwards

Partial Budget It is an estimate of the changes in income and expenses that would result from carrying out a proposed change in the current farm plan. It compares the profitability of the current situation with a proposed change or new alternative. The emphasis of a partial budget is on change. It focuses its attention on changes in revenue and expenses.

Uses of a Partial Budget Analyze whether you should change the level of input usage between two inputs. Analyze whether you should increase or decrease your output. Analyze whether you should produce more of one good and less of another good.

Examples Uses of a Partial Budget Analyze whether to increase the size or eliminate a small herd of beef cows. Analyze whether to buy harvesting equipment or continue custom hire harvesting. Analyze whether to plant more barley and less wheat.

Partial Budgeting Procedure The following four questions must be answered when doing a partial budget: What new or additional costs will be incurred? What current cost will be reduced or limited? What new or additional revenue will be received? What current revenue will be reduced or lost?

Partial Budgeting Procedure Cont. Note that all physical changes that would result from the alternative being analyzed should first be identified before an economic value should be put on each.

Additional Cost These are all costs that do not exist at the current time with the current plan. Sources of additional costs: Additional inputs An increase in a current level of an input These additional costs can entail both variable and fixed costs.

Reduced Revenue This is revenue currently being received but will be lost or reduced should the alternative be adopted. Sources of a reduction in a revenue: Elimination or reduction in the size of an enterprise. A reduction in yields or production levels. Reduces selling price.

Reduced Revenue Cont. Estimating reduced revenue requires careful attention to information about yields, livestock birth and growth rates, and output selling prices.

Additional Revenue This is the revenue received by adopting the alternative practice. Sources of additional revenue: Adding a new enterprise. An increase in yields or production levels. An increase in the selling price.

Reduced Cost These are costs that are no longer incurred because the alternative plan is adopted. Sources of reduced costs: Eliminating or reducing an enterprise. Reducing input use. Being able to purchase inputs at lower prices.

Reduced Costs Cont. A reduction in fixed costs could occur if the proposed alternative reduces or eliminates the current investment in machinery, equipment, breeding livestock, land, or buildings.

Structure of Partial Budget Alternative: Description of Alternative Additional Costs: Additional Revenue: Reduced Revenue: Reduced Costs: A: Total of Additional Cost and Reduced Revenue B: Total of Additional Revenue and Reduced Cost $______ $______ Net Change in Profit (B – A) $______

Example of Partial Budgeting Suppose you are farming 600 acres in wheat and 400 acres of corn. Suppose you notice on the futures market that corn is selling relatively higher than wheat this year than in past years. You would like to figure out if is beneficial for you to switch 100 acres of wheat into corn.

Example of Partial Budgeting Cont. Suppose the price of corn on the futures market is $2.50 per bushel while the price for wheat is $4.00 per bushel. From your past experience, you notice that you on average tend to get 140 bushels of corn per acre and 45 bushels of wheat per acre.

Example of Partial Budgeting Cont. Also from past experience, you know that planting an acre of corn will cost you $300 per acre while planting wheat costs you $170 per acre. Would you plant more corn?

Example of Partial Budgeting Cont. Summary of what we know: Price of Corn = $2.50, Price of Wheat = $4.00 Cost of planting corn is $300 per acre, while the cost of planting wheat is $170 per acre. Looking at changing the acreage by 100 acres. Average yield per acre of corn is 140 bushels Average yield per acre of wheat is 45 bushels.

Example of Partial Budgeting Cont. Alternative: Switching 100 acres of wheat to corn Additional Costs: Additional Revenue: Producing corn: Selling corn: $300/AC * 100 AC $30,000 $2.50/BU * 140 BU/AC * 100 AC $35,000 Reduced Revenue: Reduced Costs: Selling Wheat Producing Wheat: $4.00/BU * 45 BU/AC * 100 AC $18,000 $170/AC * 100 AC $17,000 A: Total of Additional Cost and Reduced Revenue B: Total of Additional Cost and Reduced Revenue $48,000 $52,000 Net Change in Profit (B – A) $4,000

Factors to Consider in Partial Budgeting Non-proportional changes in costs and revenue. This is when an x percent increase (decrease) in the size of an enterprise or the use of a factor of production does not imply an x percent change in costs or revenue. Economies and diseconomies of size must be considered when estimating costs and revenue changes.

Factors to Consider in Partial Budgeting Cont. All opportunity costs should be considered when putting together a partial budget. When examining more than one partial budget, you can rank the alternatives using a cost benefit analysis.

Cost Benefit Analysis A cost benefit analysis is a way of examining the relative benefits you gain relative to each dollar of cost or detriment. It can de defined as benefit divided by cost. A number greater than one implies that the benefits outweigh the cost. A number less than one implies that the costs outweigh the benefits.

Cost Benefit Analysis Cont. When examining alternatives, you usually want to go with the ratio that is the largest.

Final Considerations What happens to the level of risk when going to the new alternative? Does the change in risk offset the change in revenue or costs? If any additional capital investment is needed, where will the funds for the new capital investment come from?