1. Partial Budgeting Kevin Bernhardt June 2016
Center for Dairy Profitability and UW-Extension Farm Management Specialist and UW-Platteville Professor of Agri-Business
Questions:

2. 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

3. 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

4. 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

5. Partial Budgeting Process
Ask Four Questions

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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%

14. 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.)

15. 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.

16. 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.

17. 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!

18. 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.

19. 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!

20. ? Questions ?