Cost Concepts—Key Questions
Chapter 9, pp. 129-134
 How
do operating and ownership costs
differ?
 How are ownership costs calculated?
 How do cash and noncash costs differ?
 How do fixed and variable costs differ?
 How do sunk costs affect decisions?
Operating Costs
 Cost
of goods or services that are
used up in one production cycle
 Seed, fertilizer, fuel, wages, rent,
repairs, feed, etc.
Ownership Costs
Costs of goods that last more than
one production cycle
 Machinery
 Equipment
 Breeding
livestock
 Land
“Capital Assets”
Tractor Ownership Costs
(pages 403 – 405)



Current value = $50,000
Expected value in 10 years = $12,000
Depreciation: (current value - salvage value)
years owned

($50,000 - $12,000) / 10 years = $3,800/ yr

Interest: current value x interest rate
$50,000 x 7% = $3,500 / year

Insurance and taxes: 1% of current value
1% x $50,000 = $500 per 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%
Average Ownership Costs over
the Entire Ownership Period

Depreciation is the same
(50,000 – 12,000) / 10 = $3,800 per year

Interest is based on average of
beginning value and ending value
Average value =(50,000+12,000) / 2= $31,000
Interest = 7 % x $31,000 = $2,170 per year
Insurance & taxes = 1% x $31,000 = $310

Use this method for analyzing
long-term investments.
Average Ownership Costs Over
Ownership Period
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000
$500
Depreciation
Interest
Ins & txs
$0
1
2
3
4
5
6
7
8
9 10
Age
Building Ownership Costs

Depreciation (assume zero salvage value)
$100,000 current value, 25 year life
$100,000 / 25 yr. = $4,000 per year

Interest (on current value)
7% x $100,000 = $7,000 / year

Taxes and insurance (current)
1% x $100,000 = $1,000 / year

Repairs.& maintainance.: 2-4% of value
3% x $100,000 = $3,000 / year
Average Interest Cost over Life


Average value of building =
($100,000 + 0) / 2
= $50,000
Interest cost = 7% x $50,000 = $3,500
Fixed and Variable Costs
 Variable
costs occur only if a
certain action is taken. Vary by
acres or head produced.
 Fixed costs occur regardless of
whether an action taken is taken or
not, or how many units are
produced.
Fixed and Variable Costs
 Operating
costs are usually
variable.
 Ownership costs are usually fixed
(at least in the short run)
 In the long run, ownership costs
can be variable, also.
Economic Principle
 If
gross revenue exceeds
variable costs, profit will be
increased (or losses decreased)
by producing.
 That is, when gross margin > 0
Example:
Finishing Feeder Pigs
Variable costs:
feeder pig
feed
operating
labor
total v.c.
Fixed costs (bldg, equip)
Total costs
$37.00
39.00
7.00
4.00
$ 87.00
$ 13.00
$ 100.00
Profit (250 lb. pig)
Price
$.44
$.36
$.28
Revenue
$110
$ 90
$ 70
Produce
$10
-$10
-$30
Do not
-$13
-$13
-$13
Variable cost breakeven = $87 / 250 lb.
= $.35 per lb.
Higher Cost Facilities, Perm.Labor
Variable costs:
feeder pig
$37.00
feed
36.00
operating + labor
5.00
total v.c.
$ 78.00
Fixed costs (bldg, equip) $ 22.00
Total costs
$100.00
V.C. breakeven = $78 / 250 lb. =$.31
Economic Principle
 If
a higher proportion of a farm’s
costs are fixed, it will continue to
produce even at a lower price.
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

Diminishing Returns
Chapter 7 (pages 101-112)


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?
Gary Burrack,
Farmersburg:
 “I
always thought that if you got
too much nitrogen on, the yield
stayed level. What really
fascinates me is that corn yields
peak at moderate nitrogen rates
and come down at very high
nitrogen application rates.”
Corn Yield Response to Nitrogen
Yield, Bu...
Lb.N applied per acre
20
0
16
0
12
0
80
40
0
160
150
140
130
120
110
100
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
Lb.of N
per acre
0
Corn yield Value of
bu/acre
corn @$2
Cost of N
@$.20
Net return
over N cost
103
$206
$0
$206
40
128
$256
$8
$248
80
148
$296
$16
$280
120
154
$308
$24
$284
160
156
$312
$32
$280
200
153
$306
$40
$274
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.
Example: Add N to Corn







Increase N application from 0 to 40 lbs/ac
Cost of N is $.20 per lb.
Marginal cost = 40 lb. X $.20 = $8.00
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 = $50.00
Yield Response to Nitrogen
Lb. N Yield Marginal Marginal Marginal
Per
Corn Product Revenue Cost
acre Bu/a Bu/acre Corn @$2 N @$.20
0
103
40
128
80
148
120
160
200
154
156
153
25 bu
$50 >
$8
20 bu
$40 >
$8
6 bu
$12 >
$8
2 bu
$4 <
$8
-3 bu
-$6 <
$8
Profit Maximization Rules



As long as MR > MC, use more input.
When MR < MC, do not use more
input.
Where MR = MC, profit is maximized.
Other examples of diminishing
marginal returns in
agriculture?
Diminishing Marginal Returns:
Cattle Feeding
$0.80
$0.75
$0.70
Price
Cost of gain
$0.65
$0.60
$0.55
$0.50
1050
1100
1150
1200
1250
1300
weight
Go
Beat the
Hawks!
!
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)