Know your cost of production for better decision making

When getting a clear financial picture for your operation, basic record keeping isn’t often enough. That’s why it’s essential to know how to calculate your historical cost of production. Getting there isn’t always straightforward, but you should know your variable and fixed costs with certainty. Your accounting software program and financial statements should give you most of the information you need.

Variable vs. fixed costs

Variable costs can be divided into two types - direct and indirect. On a grain farm, direct variable costs are likely to change for each crop since the cost of seed, fertilizer and crop protection products will be different for each.

Indirect variable costs change depending on the level of production, but it may be difficult to assign different amounts to different crops. Examples include fuel, labour and utility costs. Often the cost of these per acre will be assigned to all crops equally.

Fixed costs are expenses that stay the same, regardless of your level of production. These include interest on land loans, property taxes and machinery depreciation. They include the expenses you pay, regardless of putting in a crop or calving cows. Some are easy to pin down - you know what they are. Others are open to interpretation, like the full cost of machinery ownership or a land investment cost.

For farms with multiple enterprises (like grain and livestock), it’s often necessary to allocate fixed costs between enterprises. You could allocate based on the gross margin percentage that an enterprise contributes or use a percentage of total expenses.

Determining cost of production is even more challenging if you’re projecting for the future. You must estimate production, related expenses and what prices you expect for commodities. However, costs and returns from the previous year can help make this easier.

Even if you can’t always be precise, calculating cost of production is essential because it helps you:

• Know what’s a profitable price for appropriate marketing decisions
• Understand how much cash to withdraw from the business for personal use
• Compare different cropping options for profitability
• Determine your fixed costs and whether they can be reduced
• Make informed decisions about equipment upgrades and repairs
• Evaluate government and private insurance programs, farm expansion, diversification and land rentals
• Set prices for consumer food products sold directly to consumers
• Benchmark with comparable farms

Contribution margin as a tool

A cost of production analysis can also be useful without getting into the intricacies of fixed costs. For instance, when comparing cropping options, you can consider the variable costs for seed, fertilizer and crop protection products. These are the expenses that vary from one crop to another... Read More