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.
Before an investment is made
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
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
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