```Cost Concepts—Key Questions
Chapter 9, pp. 129-134
What is an opportunity cost?
How do operating and ownership costs differ?
How are ownership costs calculated?
In the short run?
In the long run?
How do cash and noncash costs differ?
Opportunity Cost
The amount a certain resource could have earned in another use.
Amount given by using a resource in farming.
Examples:
Labor
Capital
Home grown feed
Operating Costs (variable)
Cost of goods or services that are used up in one production cycle
Seed, fertilizer, fuel, wages, rent, repairs, feed, veterinary, etc.
Ownership Costs
Costs of goods that last more than one production cycle
Machinery
Equipment
Breeding livestock
Land
Buildings
Ownership Costs (fixed costs)
Depreciation: loss in value due to wearout or obsolescence
Interest on investment: cost of a loan or opportunity cost on your own capital
Insurance: casualty, theft, etc.
Taxes: property (on some items)
Repairs and maintenance: just buildings
They are an operating cost for machinery.
Machinery Example (pages 403-405)
Current Year Costs
Current value of tractor = \$50,000
Depreciation: take 10% of current value
\$50,000 x 10% = \$5,000
Interest: current value x interest rate
\$50,000 x 7% = \$3,500 / year
Insurance and taxes: est. 1% of current value
\$50,000 x 1% = \$500 per year
 Total ownership cost = \$9,000 / year
What Interest Rate to Use?
Use weighted average cost of capital
Example:
\$30,000 is owed on the tractor, at 9 % interest (60% debt capital)
\$20,000 of equity capital that could earn 4% in a savings account (40% equity)
Cost of capital = (.60 x 9%) + (.40 x 4%)
= 5.4%
+ 1.6% = 7.0%
7% x \$50,000 = \$3,500
Interest Cost on Capital Assets
Or:
Loan: \$30,000 x 9% = \$2,700
Equity: \$20,000 x 4% = 800
Total interest =
\$3,500
Ownership Costs for Buildings
Use slower depreciation (5% of current value)
Include repairs and maintenance
Building Ownership Costs
Estimated value of building is \$60,000
Interest (on current value)
7% x \$60,000 = \$4,200 / year
Depreciation
5% x \$60,000 = \$3,000
Taxes and insurance (current)
1% x \$60,000 = \$600
Repairs.& maintenance: 2 - 4% of value
3% x \$60,000 = \$3,000
Total ownership costs = \$10,800 per year
Average Ownership Costs over the Entire Ownership Period
Depreciation =
(purchase cost – salvage value)
years owned
See page 399 for estimated salvage values for machinery.
Tractor: salvage value after 10 years is 32% of original list price
Tractor Example—Average Costs
New value = \$100,000
Salvage value = 32% x 100,000
Total depreciation =(\$100,000 - \$32,000) = \$68,000
Average annual depreciation is:
\$68,000 / 10 years = \$6,800 per year
Interest Expense
Interest is charged against the average value of the machine
=\$32,000
Take average of new value and salvage value
Average value =(100,000 + 32,000) / 2= \$66,000
Interest = 7 % x \$66,000 = \$4,620 per year
Insurance and Taxes
Assume 1% of the average value of the machine.
Insurance & taxes = 1% x \$66,000 = \$660
Total = \$6,800 + 4,620 + 660
= \$12,080 per year
Ownership Costs Over Ownership Life for Tractor
Economic Principle
If gross revenue exceeds variable costs, profit will be increased (or losses decreased)
by producing.
That is, when gross margin > 0 go ahead and produce
Example:
Finishing Feeder Pigs
Variable costs: feeder pig
\$40.00
feed
50.00
operating
10.00
labor
3.00
=total variable costs
\$ 103.00
Fixed costs (bldg, equip)
\$ 13.00
Total costs
\$ 116.00
Profit (250 lb. pig)
Price Revenue
\$.50 \$135
\$.40 \$ 108
\$.30 \$ 81
Produce
\$19
-\$ 8
-\$35
Do not
-\$13
-\$13
-\$13
Variable cost breakeven = \$103 / 270 lb.
= \$.38 per lb.
Higher Cost Facilities, Perm.Labor
Variable costs:
feeder pig
\$40.00
feed
45.00
operating + labor
8.00
total v.c.
\$ 103.00
Fixed costs (bldg, equip)
\$ 23.00
Total costs
\$116.00
V.C. breakeven = \$93 / 270 lb. =\$.34
Economic Principle
If a higher proportion of a farm’s costs are fixed, it will continue to produce even at a
lower price.
In the long run all costs are variable.
Fixed resources could be sold
Cash and Noncash Costs
Cash Costs
Seed, fertilizer, pesticides
Fuel and repairs
Hired labor
Cash rent
Interest on loans
Etc.
Noncash Costs
Depreciation
Opportunity Costs
unpaid labor
net worth capital
feed produced on the farm
Sunk Costs
As the production cycle progresses,more and more costs become sunk.
Sunk costs no longer affect decision making in the short run (within the production
cycle)
Sunk Costs
Should you harvest a poor crop even if you expect to not cover total costs?
Diminishing Returns
Chapter 7 (pages 113-124)
In an agricultural production process, how does adding more units of input
change the units of output?
How is the most profitable level of input use determined?
Corn Yield Response to Nitrogen
Law of Diminishing Marginal Returns
As more units of input are used, output will increase.
The rate of increase in output will eventually decline.
It may even become negative at high levels of input.
This response is due to biological limitations.
Yield Response to Nitrogen
Increase N application from 0 to 40 lbs/ac
Cost of N is \$.20 per lb.
Marginal cost = 40 lb. X \$.20 = \$8
Corn yield increases from 103 to 128 bu/a
Marginal product = 128 – 103 = 25 bu.
Price of corn is \$2.00 per bu.
Marginal Revenue = 25 bu. X \$2.00 = \$50
Definitions
Marginal Product--Amount of added product for each unit of added input. Depends
on biological factors.
Marginal Revenue--Value of the marginal product. Depends on product selling price.
Marginal Cost--Cost of additional input. Depends on purchase price of input.
Profit Maximization Rules
As long as MR > MC, use more input.
If MR < MC, do not use more input.
Where MR = MC, profit is maximized.
Optimum N Rates at Increasing N Prices
Corn after Soybeans
Nitrogen Rate Calculator
http://extension.agron.iastate.edu/soilfertility/nrate.aspx
Diminishing Marginal Returns: Cattle Feeding
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