Economics 101 – Part 2 of 3
There are four, basic business-management questions a ranch family should ask itself:
- What did I earn last year from running this ranch?
- What was the net cash flow generated by the ranch business last year?
- Is the current production system the best use of ranch resources?
- How can I make this ranch more profitable?
The first two questions are answered with accounting records; the latter two are answered with economic analyses.
Last month’s column focused on the accounting aspects of a ranch business used to answer the first two questions listed above. This column will focus on question three – whether the current production system is the best use of ranch resources. Next month, I’ll focus on the fourth question – how to make the ranch business more profitable.
An “enterprise budget” is a common economic tool utilized to determine whether the current production system is the best use of ranch resources. However, I prefer to call it a “profit center budget” or, in this particular case, a “beef-cow profit center budget.”
To determine if ranch resources are being employed in their most profitable use, a rancher needs to break his ranch business into profit centers. He then must treat each profit center as a stand-alone business.
A beef-cow profit center budget identifies all resources consumed by the beef-cow profit center. Each resource is then priced into the budget at an “opportunity cost” (see sidebar).
Purchased inputs are easily priced in at the prices paid for the input. Non-purchased inputs have to be priced in at an opportunity cost – what that input is worth in its next best use. For example, ranch-raised hay is priced in at local market price, while ranch-provided grazing is priced in at the local going pasture rental rate.
Figure 1 presents a beef-cow profit center budget based on the 2009 average of 119 North Dakota’s Farm Business Management herds (this is my latest data, which is being released here for the first time). The first column of numbers is based on a per-cow basis, while the second column is based on the per-cwt.-of-steer equivalents produced. (Basically, the second column can be thought of as UCOP, or unit cost of producing a cwt. of calf.)
The average gross income per cow on these North Dakota herds was $628/cow, while the average gross income per cwt. of calf produced was $99/cwt. Average annual feed cost (based on opportunity costs) was $303/head. Total livestock cost was $79/cow, making total direct cost $400/cow. Overhead costs averaged $67/cow. Average replacement cost for females and bulls was $176/cow.
Total economic costs averaged $643 or $101/cwt. of calf produced. This $101 is the average UCOP for these herds in 2009.
Whenever you look at a profit center budget, it’s absolutely critical to clearly understand the bottom line of that budget. So, let’s take a detailed look at the bottom line of the profit center budget in Figure 1.
A ranch family provides three resources – unpaid family and operator labor, management and equity capital. These three resources aren’t priced into the profit center budget in Figure 1; instead, they serve as the bottom-line “residual claimant” of any dollars left over after all other resources are paid their opportunity costs. This residual claimant can be negative as well as positive.
The residual claimant in this profit center budget is being measured by the term “economic net returns” and is on a per-cow basis (ENR\C). The ranch management goal should be to make this ENR\C as high as reasonably possible.
For example, the bottom line ENR\C in Figure 1 is -$15/cow, and is the average residual payment for these families’ resources used to run these beef cowherds in 2009. I don’t have to tell you that running beef cows in 2009 was tough. In fact, my data suggests 2009 was the toughest year of the past decade.
Let’s be sure we understand what a negative average ENR\C implies. This negative ENR\C implies that, on average, these North Dakota beef cowherds didn’t earn the opportunity costs for all resources consumed by the beef cowherd. In fact, these ranch families, on average, didn’t get paid anything for the family’s resources used to run these beef cowherds in 2009.
It’s important to note that 2009 was the only year in the 2000-2009 decade that average ENR\C was negative for these North Dakota herds (Figure 2). The peak year for ENR\C was $217 in 2005.
Therefore, the answer – at least for 2009 – is “no” to question 3: Is the current production system the best use of the ranch resources? However, I don’t recommend we answer that question with just one year’s data. Instead, let’s look at the last five-year average ENR/C (Figure 2), which is $83/cow.
Therefore, I conclude the five-year answer to question 3 is “yes” – the current production system is at least a “good” use of these ranchers’ resources. Is it the “best” use of the ranch resources? We’ll try to determine that next month.
Harlan Hughes is a North Dakota State University professor emeritus. He lives in Laramie, WY. Reach him at 701-238-9607 or email@example.com.
The opportunity cost of a purchased resource is simply the market price paid for that resource. However, determining the opportunity cost of non-purchased resources is a little more difficult.
Opportunity cost on a non-purchased resource is the value of that resource if it were used in its next-best use. In the case of raised forages, for instance, opportunity cost is independent of the ranch’s cost of raising the forage.
Let’s use ranch-raised hay as an example of a non-purchased resource. If the local market price of hay is $80/ton, then the beef cowherd should be charged $80 for each ton of ranch-raised hay those cattle consume – assuming that selling the hay is the next best use.
This same opportunity-cost concept also applies to grazing provided by the ranchers. Grazing costs should be based on the local opportunity cost of renting out the grassland.
Is raising hay the best use of this rancher’s resources? A hay-profit budget center can answer this economic question. It can’t be answered with a beef-cow profit center budget.