Chap 12

Whole-Farm Planning (Chapter 12)

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Objectives • • • • •

Explain the difference between whole-farm planning and planning of individual enterprises. Learn how to develop a whole-farm budget. Understand the uses for a whole-farm budget. Compare the assumptions used for short-run and long-run planning. Show how linear programming can be used to choose the most profitable combination of enterprises. 2

What is a Whole-Farm Plan and Budget? • Whole-Farm Plan – An outline or summary of the type and volume of production to be carried out on the entire farm, and the resources needed to do it. • Whole-Farm Budget – When the expected costs and returns for each part of the plan are organized into a detailed financial projection. 3

What is a Whole-Farm Plan? • Enterprise budgets are the building blocks of a whole-farm plan and budget. • Partial budgets are useful for making minor adjustments or fine-tuning a whole-farm plan. • Whole-Farm Plan can be designed specifically for the next year or if may reflect a typical year over a longer time period.

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Purpose of a Whole-Farm Plan • Once a strategic plan has been developed the next step is to develop a tactical plan to carry it out. • Every manager has a plan of some kind: • What to produce? • How to produce? • How much to produce?

• A whole-farm plan will hopefully increase profits or help the farm come closer to attaining other goals. 5

Potential Limitations • Compares two alternatives at a time: – The present plan compared with a change in the present plan.

• Represents a “typical” year: – Outcome different in non-typical years.

• Non-proportional changes in costs and revenue: – Economies and diseconomies of size.

• Opportunity costs: – Included so not same as “accounting” profit. 6

Final Considerations • Additional risk: – Is the additional average profit worth the additional risk or variability of profit? – Sensitivity analysis on revenues and costs help here?

• Additional capital requirements: – Is the capital available or can it be borrowed? – How will borrowing affect the financial structure of the business?

• Risk, cash flow requirements, repayment ability: – Will this additional investment cause a capital shortage in some other part of the business? 7

Six Steps in Developing a Whole-Farm Plan 2. Review goals and specify objectives. 3. Inventory available resources. 4. Identify possible enterprises and technical coefficients. 5. Estimate gross margins. 6. Choose a combination of enterprises. 7. Prepare a whole-farm budget. 8

Step 1 Review Goals and Specify Objectives • Include both business and personal goals: – Profit maximization. – Maintaining long-term productivity of the land. – Maintain health of operator and workers. – Maintain financial independence. – Allowing time for leisure activities. • Specify performance objectives: – Crop yields. – Livestock production rates. – Costs of production. – Net income. 9

Step 2 Inventory Resources • The type, quality, and quantity of resources available determines which enterprises can be considered: – – – – – – –

Land Buildings Labor Machinery Capital (money) Management Other Resources (markets, transportation, consultants, market quotas, etc.) 10

Step 3 Identify Enterprises and Technical Coefficients • The resource inventory will show which enterprises are possible: – Don’t be restricted by custom and tradition.

• Estimate the resource requirements (technical coefficients) per unit of each enterprise: – 1 acre of crops, 1 head of livestock.

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Identify Enterprises and Technical Coefficients

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Step 4 Estimate the Gross Margin per Unit • Estimate the gross income and variable costs per unit for each enterprise under consideration: Gross margin = Total gross income – TVC • Contribution toward fixed costs and profit after variable costs have been paid. • In the short-run, maximizing gross margin is maximizing profit. 13

Estimate the Gross Margin per Unit

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Step 5 Choose the Enterprise Combination • Often determined by: – Personal experience and preferences. – Fixed investments in specialized equipment and facilities. – Regional comparative advantage.

• Can experiment with different enterprise combinations by developing many budgets and comparing them. We will look at LP as a tool to select enterprises for this week’s lab! 15

Step 6 Prepare the Whole-Farm Budget Uses: 1. 2. 3. 4. 5. 6.

To estimate the expected income, expenses, and profit for a given farm plan. To estimate the cash inflows, cash outflows, and liquidity of a given farm plan. To compare the effects of alternative farm plans on profitability, liquidity, and other considerations. To evaluate the effects of expanding or otherwise changing the present farm plan. To estimate the need for, and availability of, resources such as land, capital, labor, feed, or water. To communicate the farm plan to a lender, landowner, partner, or stockholder. 16

Constructing the Whole-Farm Budget Enterprise A

Enterprise B

Enterprise C

No. of units of A

No. of units of B

No. of units of C

X

X

X

Gross revenue per unit

Gross revenue per unit

Gross revenue per unit

Variable costs per unit

Variable costs per unit

Variable costs per unit

Whole Farm Gross revenue

-

Variable costs

=

Gross margin

+

Miscellaneous income

-

Fixed costs

=

Net farm income 17

Sensitivity Analysis • Analyzing how changes in key budgeting assumptions affect income and cost projections. • Reduce the gross farm income by 10%: – Decrease in production or selling prices.

• Construct several budgets using different values for key prices and production rates: – High, average, low approach?

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Analyzing Liquidity • The ability of the business to meet cash flow obligations as they come due. • Include: – – – – – –

Cash farm income. Income from nonfarm work and investments. Cash farm expenses. Cash outlays to replace capital assets. Principal payments on term debts. Nonfarm cash expenses for family living costs and income taxes. 19

Analyzing Liquidity • Profitable plans will not always have a positive cash flow: – Large interest payments in the first few years: • Analyze liquidity for the first few years of the plan. • Analyze liquidity for an average year.

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Example of Liquidity Analysis for a Whole-Farm Budget

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Developing a Typical Year Budget 1. Use average or long-term planning prices for products and inputs. 2. Use average or long-term crop yields and livestock production levels. Be conservative. 3. Ignore carryover inventories of crops or livestock, accounts payable and receivable, or cash balances. Assume sales are equal to production.

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Developing a Typical Year Budget 4. Assume that the borrowing and repayment of operating loans can be ignored, because they will offset each other in a typical year. 5. Assume that enough capital investment is made each year to replace assets that wear out. 6. Assume that the operation is neither increasing nor decreasing in size. 23

Short-Run vs. Long-Run Budgeting Short-Run

Long-Run

• Assume some resources are fixed. • Assume prices, costs, and other factors are expected to hold true over the next production period.

• Very few farms or ranches are profitable every year. • A plan that involves long-term investment and financing decisions should project a positive net income in an typical year. 24

Linear Programming • A mathematical procedure that uses a systematic technique to find the “best” possible combination of enterprises. • Linear programming maximizes an objective function, subject to specified constraints. • Objective: Maximize gross margin. • Constraints: Fixed resources available. 25

Shadow Prices • The amount by which total gross margin would be increased if one more unit of that resource were available.

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Summary • Whole-farm planning and the whole-farm budget analyze the combined profitability of all enterprises in the farming operation. • Planning starts with reviewing goals, setting objectives, and taking an inventory of the resources available. • Feasible enterprises must be identified, and their gross income per unit, variable costs, and gross margin computed. 27

Summary • The combination of enterprises chosen can be used to prepare a whole-farm budget. • Whole-farm budgets can be based on either short-run or long-run planning assumptions. • Linear programming (LP) can be used to select the combination of enterprises that maximizes gross margin without exceeding the supply of resources available.

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