Partial Budgeting AAE 320 Paul D. Mitchell

Goal 1.Explain purpose of partial budgets 2.Illustrate their structure and use 3.Give some examples

Partial Budget Purpose Analyze net return from small changes or refinements to farm operation Analyze net return from small changes or refinements to farm operation Partial Budget: focus only on parts that change, not budget each enterprise completely, but build on enterprise budgets Partial Budget: focus only on parts that change, not budget each enterprise completely, but build on enterprise budgets Fine tune current operation: Hold all else fixed to evaluate a small change Fine tune current operation: Hold all else fixed to evaluate a small change Marginal/incremental analysis: change input use, shift between inputs or between outputs Marginal/incremental analysis: change input use, shift between inputs or between outputs

Simple Examples Plant rootworm Bt corn or conventional corn with soil insecticide Plant rootworm Bt corn or conventional corn with soil insecticide Plant more corn and less soybeans Plant more corn and less soybeans Rent an additional 100 acres for corn Rent an additional 100 acres for corn Buy combine or continue custom hiring Buy combine or continue custom hiring Sell current tractor and buy a bigger one Sell current tractor and buy a bigger one Soil test for N or just use credits/guess Soil test for N or just use credits/guess

Partial Budget Basic Idea Benefits: 1) What will be the new or added revenues? 2) What costs will be reduced or eliminated? Costs: 3) What will be the new or added costs? 4) What revenues will be reduced or lost? Partial Budget: Answer these 4 questions and then calculate Net Benefit = Benefits – Costs

Partial Budget: Define the change analyzed BenefitsCosts Additional Revenues What will be the new or added revenues? Additional Costs What will be the new or added costs? Costs Reduced What costs will be reduced or eliminated? Revenues Reduced What revenues will be reduced or lost? Total Benefits Total Costs Net Benefit

Planter Example Look at buying a planter for 1000 acres of corn and soybean versus custom hire Look at buying a planter for 1000 acres of corn and soybean versus custom hire What will be the new or added revenues? What will be the new or added revenues? Increased yields due to more timely planting Increased yields due to more timely planting What costs will be reduced or eliminated? What costs will be reduced or eliminated? No longer pay for custom planting No longer pay for custom planting What will be the new or added costs? What will be the new or added costs? Fixed and variable costs of owning planter Fixed and variable costs of owning planter What revenues will be reduced or lost? What revenues will be reduced or lost? I can’t think of any I can’t think of any

Buy planter vs. custom hire for planting 1000 acres corn-soybeans (500 acres each) 1000 acres corn-soybeans (500 acres each) Additional Revenues What will be the new or added revenues? Higher yields with more timely planting Additional Costs What will be the new or added costs? Fixed and variable costs of owning a planter Costs Reduced What costs will be reduced or eliminated? No longer pay cost for custom hire Revenues Reduced What revenues will be reduced or lost? Can’t think of any Total Benefits Total Costs Net Benefit

Buy planter vs. custom hire for planting 1000 acres (500 each) corn-soybean 1000 acres (500 each) corn-soybean Additional Revenues 3 bu corn x $4.00/bu x 500 ac = $6,000 = $6,000 1 bu soybeans x $10/bu x 500 ac = $5,000 = $5,000 Additional Costs corn $19.11/ac x 500 ac = $9,555 = $9,555 soybeans $20.38/ac x 500 ac = $10,190 = $10,190 Costs Reduced Custom corn planting = $15/ac x 500 ac = $7,500 Custom soybean planting = $16/ac x 500 ac = $8,000 Revenues Reduced none Total Benefits $26,500 Total Costs $19,745 Net Benefit $6,755

Planter Example Only focused on costs and revenues that change Only focused on costs and revenues that change Made up numbers for illustration Made up numbers for illustration Estimate 3 more bu of corn and 1 more bu of soybeans due to more timely planting Estimate 3 more bu of corn and 1 more bu of soybeans due to more timely planting Corn = 1% loss/day in WI after May 8 Corn = 1% loss/day in WI after May 8 Soybeans: 0.25/bu/day in IA study Soybeans: 0.25/bu/day in IA study Estimate cost of owning and operating a planter: Use fast and simple method for 100 acres to get corn = $19.11/ac, soybeans = $20.38/ac Estimate cost of owning and operating a planter: Use fast and simple method for 100 acres to get corn = $19.11/ac, soybeans = $20.38/ac Custom rates: increased WI 2004 rates for increased fuel costs Custom rates: increased WI 2004 rates for increased fuel costs

Planter Example: What if “real” Look at your records: How late was your custom planter over the last several years? Look at your records: How late was your custom planter over the last several years? Estimate the average yield loss you suffered Estimate the average yield loss you suffered Several equations for corn and soybeans on web Several equations for corn and soybeans on web Cost to own and operate planter Cost to own and operate planter Used the fast and simple method Used the fast and simple method Lower cost if use economic engineering Lower cost if use economic engineering Is $6,755 ($6.76/ac) enough to justify the added hassle of owning and operating a planter? Is $6,755 ($6.76/ac) enough to justify the added hassle of owning and operating a planter?

Think Break #20 Suppose you are a corn-soybean farmer who currently custom hires all combining. You are thinking of buying a combine. Suppose you are a corn-soybean farmer who currently custom hires all combining. You are thinking of buying a combine. Do a partial budget analysis of a Combine Purchase vs. Custom Hire decision Do a partial budget analysis of a Combine Purchase vs. Custom Hire decision Needed assumptions/information and questions are given in the next slide Needed assumptions/information and questions are given in the next slide

Think Break #20 Combine Purchase vs. Custom Hire Corn acres = 2,000; Farm crop acres 4,000 Corn acres = 2,000; Farm crop acres 4,000 Custom Rate = $25/ac Custom Rate = $25/ac Scale Factor = (33.026/acres) Scale Factor = (33.026/acres) 1% yield increase with more timely harvest 1% yield increase with more timely harvest Average yield = 150 bu/ac; Price = $4/bu Average yield = 150 bu/ac; Price = $4/bu 1) What will be the new or added revenues? 2) What costs will be reduced or eliminated? 3) What will be the new or added costs? 4) What revenues will be reduced or lost? 5) What’s the net benefit?

Another Example Add 50 beef cows to your cow-calf herd Add 50 beef cows to your cow-calf herd Convert 100 acres from grain to forage Convert 100 acres from grain to forage 1) What will be the new or added revenues? 2) What costs will be reduced or eliminated? 3) What will be the new or added costs? 4) What revenues will be reduced or lost? 5) What’s the net benefit?

Revenue Benefits 1) What will be the new or added revenues? Sell more steers, heifers, and cull cows Sell more steers, heifers, and cull cows 46 calves (92% efficiency) 46 calves (92% efficiency) Save 5 heifers as replacements (10% cull rate) Save 5 heifers as replacements (10% cull rate) 23 steer calves: 500 lbs x $0.85/lb = $9, steer calves: 500 lbs x $0.85/lb = $9, heifer calves: 460 lbs x $0.80/lb = $6, heifer calves: 460 lbs x $0.80/lb = $6,624 5 cull cows $500 each = $2,500 5 cull cows $500 each = $2,500 Total = $18,899 Total = $18,899

Cost Benefits 2) What costs will be reduced or eliminated? Variable inputs used for grain production Variable inputs used for grain production Fertilizer, seed, pesticides, etc.: $5,350 Fertilizer, seed, pesticides, etc.: $5,350 Labor: $1,500 Labor: $1,500 Variable machinery costs: $1,000 Variable machinery costs: $1,000 Interest on variable 6% = $470 Interest on variable 6% = $470 Total = $8,320 Total = $8,320

Cost Costs 3) What will be the new or added costs? Fixed costs Fixed costs Interest on cows and bulls = $2,500 Interest on cows and bulls = $2,500 Bull depreciation = $300 Bull depreciation = $300 Variable costs Variable costs Labor = $600, Vet and health = $500 Labor = $600, Vet and health = $500 Feed/Hay = $2,000, Pasture fertilizer = $1,500 Feed/Hay = $2,000, Pasture fertilizer = $1,500 Hauling and Miscellaneous = $500 Hauling and Miscellaneous = $500 Interest on variable 6% = $300 Interest on variable 6% = $300 Total = $8,200 Total = $8,200

Revenue Costs 4) What revenues will be reduced or lost? Grain production from 100 acres Grain production from 100 acres Corn: 110 bu/ac x $2.00/bu x 100 ac = $22,000 Corn: 110 bu/ac x $2.00/bu x 100 ac = $22,000 Soybeans: 30 bu/ac x $5.00/bu x 100 ac = $15,000 Soybeans: 30 bu/ac x $5.00/bu x 100 ac = $15,000 Use half of each, since 2 year rotation Use half of each, since 2 year rotation Total = ½ ($22,000 + $15,000) = $18,500 Total = ½ ($22,000 + $15,000) = $18,500

Partial Budget: Add 50 cows to cow-calf operation and convert 100 acres to forage BenefitsCosts Additional Revenues 23 Steer calves, 18 heifer calves and 5 cull cows = $18,899 Additional Costs Fixed and variable costs for 50 more cows and needed bulls = $8,200 Costs Reduced Variable inputs for grain production = $8,320 Revenues Reduced Revenue from corn-soybean production = $18,500 Total Benefits $27,219 Total Costs $26,700 Net Benefit $519

Comments on Analysis Needed more complete enterprise budgets for cow-calf and grain operations Needed more complete enterprise budgets for cow-calf and grain operations Fixed cost added for cows and bulls, but no fixed cost change for crop conversion from grain to forage. Why? Fixed cost added for cows and bulls, but no fixed cost change for crop conversion from grain to forage. Why? Labor for cow-calf less than for grain ($600 vs. $1,500), an added benefit— What will you do with the extra time? Labor for cow-calf less than for grain ($600 vs. $1,500), an added benefit— What will you do with the extra time?

Comments on Partial Budgeting Final comments on Partial Budgets Final comments on Partial Budgets Economies of Size Economies of Size Opportunity Costs Opportunity Costs Sensitivity Analysis Sensitivity Analysis Risk Changes Risk Changes

Economies of Size Cause non-proportional changes in cost and revenue when make changes Cause non-proportional changes in cost and revenue when make changes Adding 20 cows to herd of 200 will increase labor demand, but less than 10% Adding 20 cows to herd of 200 will increase labor demand, but less than 10% Dropping 100 acres from 1000 acre grain farm will decrease costs, but less than 10% Dropping 100 acres from 1000 acre grain farm will decrease costs, but less than 10% Main Point: Linear (proportional) approximation is fine for small changes, but not for large—need more complete budgeting if large change Main Point: Linear (proportional) approximation is fine for small changes, but not for large—need more complete budgeting if large change The concept that the average cost of production per unit declines as the size of the operation grows The concept that the average cost of production per unit declines as the size of the operation grows Result from spreading fixed costs over a large number of units of production. Result from spreading fixed costs over a large number of units of production.

Opportunity Costs Should be included in the analysis Should be included in the analysis Capital needs change: include costs (benefits) for borrowing more (less) money or tying up more (less) of your capital in farm assets Capital needs change: include costs (benefits) for borrowing more (less) money or tying up more (less) of your capital in farm assets Labor and Management changes: include the costs/benefits of your and your family's time commitment changes Labor and Management changes: include the costs/benefits of your and your family's time commitment changes Change farm operation due to changes in credit or labor resources or desires Change farm operation due to changes in credit or labor resources or desires

Sensitivity Analysis Definition A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. very useful when attempting to determine the impact the actual outcome of a particular variable will have if it differs from what was previously assumed very useful when attempting to determine the impact the actual outcome of a particular variable will have if it differs from what was previously assumed can determine how changes in one variable(s) will impact the target variable. can determine how changes in one variable(s) will impact the target variable. Once an equation, model, or simulation is chosen to represent a given system, there is the question regarding which parts of that equation are the best predictors Once an equation, model, or simulation is chosen to represent a given system, there is the question regarding which parts of that equation are the best predictors Sensitivity analysis involves testing a model with different data sets to determine how different data and different assumptions affect a model (Porter et. Al., 1980) Sensitivity analysis involves testing a model with different data sets to determine how different data and different assumptions affect a model (Porter et. Al., 1980)

Sensitivity Analysis Assumptions used to construct partial budgets not always known with certainty Assumptions used to construct partial budgets not always known with certainty Yield benefit for more timely planting Yield benefit for more timely planting Crop yields and prices Crop yields and prices Machinery costs Machinery costs Run analysis with a range of assumptions Run analysis with a range of assumptions Low, average, high, worst or best case scenario Low, average, high, worst or best case scenario Find break even price or yield and decide how likely Find break even price or yield and decide how likely Formally model the uncertainty: use probability distributions, decision trees, or pay off matrices and do risk analysis Formally model the uncertainty: use probability distributions, decision trees, or pay off matrices and do risk analysis

Risk and Partial Budgeting Partial Budgeting ignores changes in risk Partial Budgeting ignores changes in risk Converting 100 acres from grain to forage and adding 50 cows to cow-calf operation: What are the risk implications? Converting 100 acres from grain to forage and adding 50 cows to cow-calf operation: What are the risk implications? Without formal “tools” comparisons ignore risk, or bring it in afterwards in ad hoc way Without formal “tools” comparisons ignore risk, or bring it in afterwards in ad hoc way “The financial risk of owning a planter is too great to justify the $1,380 net benefit” “The financial risk of owning a planter is too great to justify the $1,380 net benefit” “The risk of not finding a custom combiner is too great to justify the $6,900 net benefit” “The risk of not finding a custom combiner is too great to justify the $6,900 net benefit”

More Information Partial Budgeting a common tool in ag, use Google Partial Budgeting a common tool in ag, use Google Extension Services in many states have bulletins or fact sheets Extension Services in many states have bulletins or fact sheets U of Maryland (posted) U of Maryland (posted) Penn State (posted) Penn State (posted) Colorado State, Virginia, Vermont, etc. Colorado State, Virginia, Vermont, etc.

Summary Explained and illustrated the purpose of partial budgets Explained and illustrated the purpose of partial budgets Did examples, including Think Break #18 Did examples, including Think Break #18 Explained some issues/weaknesses of partial budgets (size economies, opportunity costs, sensitivity analysis, risk) Explained some issues/weaknesses of partial budgets (size economies, opportunity costs, sensitivity analysis, risk) For problem set and exam: be able to make simple partial budget using given information and interpret findings For problem set and exam: be able to make simple partial budget using given information and interpret findings