AGRIC6: Cost Concepts in Farm Management

This unit covers Cost Concepts in Farm Management and it also looks at Economic Principles applied to the Organization of Farm Business

AGRIC6: Cost Concepts in Farm Management 1Fixed cost (FC): Fixed costs are those costs which do not change in magnitude as the amount of output produced changes and are incurred even when production is not undertaken. These are also called sunk costs. These could be fixed cash costs such as land taxes, interest, insurance premiums, permanently hired labour, etc. Non-cash fixed costs include depreciation on buildings, machinery interest on capital investment, cost of family labour & management, etc.

Variable costs (VC): The costs that are incurred on variable inputs and hence vary with the level of production are called variable costs. Higher the production more will be VC and vice-versa. Expenses on fertilizer, seed, chemical fuel consumption, etc.

Total costs = FC+VC

Total costs (TC) are required to compute net revenue (NR) NR = TR-TC

Opportunity cost: Farm resources are limited but these can be put to different uses. When these are used in our product, some alternative usage is always forgone. The opportunity cost is the value of best alternative forgone.

Cost Function: Cost function (or TC curves) represents the functional relationship between output and total cost. That is what happens to cost structure when different quantities of a commodity are produced. The cost function can be represented by (i) arithmetically (tabular form), (ii) Geometrically or (iii) Algebraically. Exact nature (curvature) of cost function depends on the corresponding production function provided the prices for inputs do not change with the quality of inputs purchased.

  1. Total fixed cost (TFC): The costs incurred on all fixed inputs used in production are known as TFC. These do not change with the output levels & hence represented by a straight line parallel to X
  2. Total variable cost (TVC): Refers to the costs of variable input used in production & is computed by multiplying the amount of variable input by the price.

TVC = Px·X

Shape of TVC depends on shape of production function.

  1. Total cost (TC): TC are the sum of TVC & TFC and are obtained by adding TVC & TFC for different output When no variable input in used (TVC=0) TC = TFC. Shape of TVC & TC are same & depend upon the production function.

TC = TFC = TVC or TC = TFC + Px (X)

Output

  1. Average fixed cost (AFC): It is the fixed cost per unit of output & is computed by dividing TFC by the amount of output at that particular level of AFC varies for each level of output and as the output increases, AFC decreases. When output is zero, AFC = TFC. AFC always slopes downward regardless of production function. AFC curve declines continuously & never shows upward movement because after maximum product is achieved, input use beyond this becomes irrational.
  1. Average variable cost (AVC): AVC is given by

TVC AVC Px .XPx

Y                       Y        Y / X 

AVC varies with the levels of production & its shape depends on production function. The height of AVC depends upon the unit cost of the variable input. Like AFC, AVC cannot be computed when output is zero. AVC is inversely related to APP. AVC falls first due to economies of large scale production & then rises due to diseconomies of scale in production. AVC (like APP) measures the efficiency of variable input: when AVC is decreasing, efficiency of variable input is increasing; it is at maximum when AVC is at minimum & it is decreasing when AVC is increasing. As the production expands, the AVC declines initially, reaches a  lowest point & then bends upwards.

  1. Average Total Cost (ATC) =

TC or AFC +AVC; shape of ATC depends upon shape of production function. ATC decreases as output increases, attains a minimum and increases thereafter. ATC is often referred to as ‘unit cost’ of production – the cost of producing the unit of output. The initial decrease in ATC is caused by the spreading of FC among an increasing number of units of output and the increasing efficiency with which the variable input is used. As output increases further, ATC attains a minimum & begins to increase, as increase in AVC can no longer be offset by decrease in AFC. ATC curve has the same slope as AVC. Difference is that the lowest point in case of AVC reaches earlier as compared to ATC.

  1. Marginal Cost (MC): May be defined as the change in TC in response to a unit change in output. That is  it  is  the cost of producing an additional unit  of output.

DTC .

DY

Actually a change in TC is always equal to change in VC at a given level of FC. So MC must be worked out by dividing the change in VC by the change in output.

Economic Principles applied to the Organization of Farm Business

 1.   Cost Principle

TC = VC+ FC

Net Revenue = TR –TC

  • In the short run: Gross revenue (GR) must cover the VC. Maximum net revenue is obtained when MC = MR. If GR < TC but > VC, guiding principle should be to keep increasing production as long as MR >

In the short run, MC = MR point may be at a level of input use that may involve a loss instead of profit. Yet at this point loss will be minimized. This situation of operating the farms when MR is > AVC but < ATC is common in agriculture. This explains why farmers keep on doing farming even when they run into losses.

  • In the long Run: GR should be > VC + FC=TC. For taking production decision in such a situation, one should go on using resources as long as added returns remain greater than added total costs. Here, the object is to maximize profits instead of minimizing the
  1. Law of Equi- Marginal Returns (Special case of substitution)

When resources are unlimited, farmer can produce all products under the rule,

But resources are limited, expansion of one enterprise requires contraction of other. The big question is which enterprise combination will give the greatest income? Such an optimum choice of enterprises is made based on the principle of equi-marginal return or the opportunity cost principle. Profit will be the greatest if each unit of labour, capital and land is used where it adds the most to the returns. In other words, this principle lays down: the best combination of enterprises or practices will be where limited resources are allocated in a manner that one cannot change the use of a simple unit without reducing the income. Thus, the resources should be used where they give not the highest average returns but the greatest marginal returns. Thus, the best combination of enterprises is obtained not when we select profitable crops but most profitable crops. The profitability of an enterprise depends on the price of the product, the direct costs attached to it & the amount of product sacrificed as one enterprise gets replaced with other. Budgeting & programming techniques take this principle into account for working out an optimum plan.

Example: A farmer has Rs 5000 to invest on crops, dairy or poultry. What amount of capital he should invest on each enterprise to get highest profit?

Marginal Return to capital on these enterprises are;

Marginal Return (MR) (Rs)
Capital used (Rs)CropsDairyPoultry
1000130014001500
2000130012001250
3000120011001100
400012009001000
50001100800900
Total Return from Rs

5000

610054005750
Net Returns1100400750
Av.              Returns used/rupee

Invested

1.221.081.15

 

The marginal return will however dictate spending as

AmtEnterprisesAdd Return
1st1000Poultry1500
2nd1000Dairy1400
3rd1000Crops1300
4th1000Crops1300
5th10001250
TR from50006750

 

4.   Opportunity Cost Principle:

When resources are limited and there are more than one enterprise where farmer can invest. When recourses are used in one product some alternative is always forgone. The opportunity cost is the value of next best alternative forgone. The value of one enterprises sacrificed is the cost of producing another enterprise. This principle thus refers to the advantages (returns) which might have been obtained from any factor if it had net been used in producing that commodity, but would have been used for other next best purpose. Thus, it is the cost equivalent to the returns from next best alternative forgone.

5.   Time Comparison Principle

There are two types of investments: (1) Investments on operating inputs & (2) Investment on capital assets (land, farm building, machinery, equipment, etc). Analysis of these investments involves not only the comparison of costs and returns associated with it, but also the timings of occurrence of costs & returns. The costs & returns from investments in operating resources occur with a production period of a year or less. The marginal principles are used to determine the optimum level of operating resources & there is no need to bring in time element here. But in case of capital assets where the costs & returns are in different time periods and also capital expenditure involves costs & returns over time (orchards). Some expenditure may be recurring & some non- recurring. To examine the profitability of these investments it requires the recognition of time value of money. Money has time value for the following reasons.

  • Earning power of money: represented by opportunity cost of money (rate of interest )
  • Inflation – purchasing power of money varies inversely with the price A rupee earned a year from now is less valuable than a rupee earned today.
  • Uncertainty: Investment deals with future & future is Investments are made with the expectation of receiving a stream of benefits in the future.

Thus, farm management involves dynamic adjustments in the organization & operation of farm business by taking into account (a) time element in the valuation of present value of future incomes by discounting future returns.

For discounting one needs to know the future & the capital position of the farmer. This implies the exact future income / cost should be known. Capital position of the farmer affects the interest rate to be used for discounting and the (b) risks & uncertainties in farm operations over time (natural calamities, price fluctuations, technical changes). Two aspects of the problem are considered under such situations: (a) Growth of a cash outlay over time i.e. compounding & (b) Discounting of future incomes.

 

For unlimited capital use market rate of interest. And for limited capital use the r that capital may fetch for the farmer. Law of diminishing returns applies to agriculture in general but its operation can be postponed under the following conditions: (i) Improved technology (2) New soils & (3) Scarcity of Capital (as on stage I) – all lead to the produce of increasing returns.

Reasons for law of diminishing returns in agriculture: (1) Excessive dependence on weather, (2) less scope for division of labour, farmer is the labour manager & capitalist (3) Less scope of machinery (4) cultivation of inferior/ marginal lands (5) Continuous cultivation leading to fertility loss.

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