Cost of Production in Farming

Farm Business Management Update, August 2002

By Bill Whittle

Knowing your cost of production (COP) is a key component to successful farming. What does it cost you (not your neighbor or your industry average) to produce a widget? Farmers do not produce widgets, but they must know what it costs to produce their product, whether it is a 100 pounds of milk, 100 pounds of lamb, one bushel of corn, one quart of strawberries, or a dozen ears of sweet corn. Farming is a business and for those who say that it is a lifestyle, the reply is, "Yes, it is a lifestyle business." Only hobby farmers need not worry about the cost of production.

The following questions may help clarify the need to know your COP:

1. If your purpose in farming is to earn a living for your family, how do you know if your hard work is paying off? It is easy enough to temporarily mask profitability by living off depreciation, equity, or borrowed money.
2. Without knowing your COP, how do you know if a decision such as hiring, using custom operators, and even maintenance will help or hurt your financial situation?
3. How do you know if an expansion is beneficial to your bottom line or just adding to your problems? If the farm is not profitable now, most expansions will only help you go broke faster.
4. When you have an opportunity to sell your product, how do you know if it is a profitable transaction? Within the trading range provided by the market, many commodities can be forward priced in advance of the actual sale date. However, history proves that if you wait for the marketıs top because you do not know your profitable price requirement, opportunity will pass you by.
5. Will you cease farming before or after you use up the farmıs equity because your COP will never allow you to compete in your industry?

Once you understand the need to know your COP, the question becomes how do you determine it? COP is typically calculated using cash or variable expenses, i.e. those expenses that are paid yearly to produce the crop. Total COP uses both variable expenses and fixed expenses such as land costs. One can stay in business for a while covering only variable COP; however, at some point the farm must be able to make the payments associated with fixed costs.

Records are the lynchpin that allows for calculating COP. Whether from the shoebox or computer, compile all expenses related to a particular enterprise such as the dairy. At this time of year, it is also reasonable to use Schedule F information minus Depreciation. However, most farms in the Valley have multiple enterprises and expenses are often blended. An example is the dairy farmer who is also raising sweet corn. These multiple enterprise farms can only determine the true COP if management is willing to allocate expenses such as labor and fertilizer among the different enterprises. Otherwise, an enterprise may look profitable when it may be a money loser. Once enterprise expenses are identified, calculate COP by dividing your sold (or fed) production, such as pounds of milk, dozens of ears of sweet corn, or bushels of corn, into your total cash expenses for the enterprise. This value is what it cost your farm to produce one unit.

COP information provides management the factual information platform necessary to make sound business decisions. If your COP is high compared to what you can sell the product for, you need to make decisions about how you conduct your business. A high COP may mean that you have allowed inefficiencies or debt to increase beyond normal levels or that your higher costs are related to producing a product that has more value. You may need to reduce expenses, market wisely, or change the product you produce.

Contact the author at wwhittle@vt.edu.

Visit Virginia Cooperative Extension