Partial Budgeting Kevin Bernhardt June 2016 Center for Dairy Profitability and UW-Extension Farm Management Specialist and UW-Platteville Professor of Agri-Business Questions: 608-342-6121 bernhark@uwplatt.edu

What is a Partial Budget A means to evaluate the expected impact on profit from relatively small changes (partial changes) in an operation compared to the current status. Including: Changes in input mix (amount, type, quality, etc.) That get more output Same output, but at a less cost for inputs New technology Own versus lease Changes in production mix Changes in size of enterprises And much more

Why a Partial Budget Like other types of budgeting it forces the planning function of management. And: It is fairly easy and straight forward to do! Yet it provides a process for thinking through the financial implication of operational changes

How to do a Partial Budget For any alternative, identify all changes associated with: Increases in profits from: Eliminated or reduced costs Additional revenue Decreases in profits from Eliminated or reduced revenues Additional costs Gives net change on profitability

Partial Budgeting Process Ask Four Questions

Process: Ask Four Questions What increases in profits will result from: Eliminated or reduced costs Additional revenues What decreases in profits will result from: Eliminated or reduced revenues Additional costs

Use “Partial Budget Case Study” spreadsheet Let’s Practice Use “Partial Budget Case Study” spreadsheet

Partial Budget Case Study Producer is thinking about converting his 500 acres of dryland cotton production to irrigation. Is this a good idea? Is it a profitable idea? What increases and decreases in profit will this change cause? Taken from “Kay, Edwards, and Duffy, Farm Management. 7th ed. Ch. 12

1. What Current Costs Will Be Reduced or Eliminated? Dryland Variable Costs of production that will be eliminated include: Fertilizer: $50,000 Fuel and chemicals: $35,000 Labor: 10,000 Interest on variable costs: (“Opportunity Cost” tab) $95,000 of variable costs Money tied up for 6 months 6% interest rate Record on “Partial Budget Worksheet” tab on the <Partial Budget Case Study> spreadsheet

2. What New or Additional Revenues Will be Received? Irrigated cotton is estimated to yield 800 lbs per acre and the price is estimated to be $.60 per lb 500 ac * 800 lbs/ac * $.60/lb = $240,000 Record on “Partial Budget Worksheet” tab on the <Partial Budget Case Study> spreadsheet

3. What Current Revenue Will Be Reduced or Eliminated? Currently, under dryland production, yield is 600 lbs and current price is $.60 per lb 500 ac * 600 lbs/ac * $.60/lb = $180,000 Record on “Partial Budget Worksheet” tab on the <Partial Budget Case Study> spreadsheet

4. What New or Additional Costs Will Be Incurred? Variable costs Fertilizer: 60,000 Fuel and chemicals: $50,000 Labor: $15,000 Opportunity Cost Interest on operating capital Total variable costs = $125,000 Money will be tied up for 6 months 6% interest rate “Opportunity Cost” tab

4. What New or Additional Costs Will Be Incurred? Use “Depreciation and Opportunity Cost” tab with the information below. Fixed costs Insurance: $600 Depreciation (straight line) Opp. Cost Interest (average value method) Information Purchase price = $300,000 Salvage value = $50,000 Useful life = 15 years Interest rate = 6%

So….. What are you going to do? Partial Budget shows that profits will increase by $1,333 per year. Is there anything else to consider before making this decision? Accuracy of the estimates What is the risk? Is a risk premium built into the estimates? Other alternatives (corn, SB, wheat, pasture, renting it out, different type of irrigation system, etc.)

Capital Recovery Method The depreciation cost ($16,667) plus the opportunity cost of the irrigation system investment ($10,500) added up to $27,167. If the capital recovery method had been used then the value would have been $28,741. One is not better than the other, just two ways to arrive at a reasonable estimate.

Opportunity Cost??? The inclusion of opportunity costs converts a strictly accounting or financial analysis into an economic assessment that quantifies the value of resource use against other alternatives for those resources. A negative result means that your money, your labor, etc. could get a greater return for you if employed in the alternative. In this case, the $300,000 used to purchase the irrigation system could have been put into an alternative investment and earned $10,500 on average. So, hopefully the use of that money for an irrigation system will at least return $10,500 or else the money would have been better spent elsewhere.

Opportunity Costs??? But, opportunity cost is not real money so why should I include it? Ahh, but it is real money! It is real money that is not in your pocket because you decided to invest in an irrigation system and not the alternative. That’s real money that is not in your pocket!

Opportunity Costs But, I’m not going to do the alternative! I’m investing in an irrigation system and that’s final! An argument can be made that if you truly are not considering any alternative then the opportunity cost is zero. Whether this is the reasoning or if you just want to evaluate an accounting/financial budget (that does not include opportunity cost) then set opportunity costs to zero. In this case the final value would then be $11,833. Note, in this case the opportunity costs on borrowed capital is a proxy for the actual interest costs so still must be included.

What if I Just Want To Know The Impact on Cash Flow for This Year Only??? Ask the same questions, but only include cash inflows and outflows for the next year. Depreciation, opportunity costs, payables, or receivables would not be included. But remember, you are no longer analyzing profitability or the best use of resources, just short-term cash flow. That is not a wrong thing to do, just don’t strive for cash flow and think it is profitability!

? Questions ?