LECTURE V

PRODUCTION PRINCIPLES

Production Costs

Not all costs in farming business are of the same type Kshs 1,000 spent on clothing has no effect on

farm profit, but Kshs 1,000 spent on fertilizer has.

Kinds of costs in a farm business include: Variable costs Overhead (Fixed) costs Finance costs Capital costs Personal Costs

Variable costs

Also known as direct costs.They vary as the size and/or level of

output of an activity varies. Directly associated with the level of

intensity of each activity, but may also determine the yield or level of output of the activity.

E.g. if the area under maize is increased by 50%, then seed, fertilizer and labour inputs will also increase, though not necessarily increasing costs by 50%.

Variable costs

Amounts and kinds of fertilizer, seed, spray and cultivation largely control the crop yield.

Level and type of feed and the type of drugs used have a major effect on the productivity of any given type of animal.

Very little output would occur on commercial farms unless money is spent on variable costs items.

Variable costs Identification of variable costs gives an idea

of the size of the change in costs in one or more activities are expanded or contracted. E.g. if he a farmer decides to decrease the area of

cotton and increase the area of maize, the variable costs will change, but the overhead costs are likely to remain about the same.

Knowledge of likely variable costs helps the farmer make a quick assessment of the merit of making a change in activities.

Variable costs Include:

Fertilizer Seed Purchased animal feed Sprays Animal replacements Seasonal labour Fuel and oil Repairs to machinery and plant Irrigation running costs

Overhead costs Also known as fixed costs These are unavoidable costs that must be

met each year. Within limits they do not change when the

level of the activity changes. An increase of 20% in the area of a crop, or in the

number of animals, is not likely to lead to a rise in overhead costs.

An increase as great as 100%, would, however, increase overheads.

On most farms, overhead costs do not change very much as the level or mixture of activities changes, except for increases due to rising costs.

Overhead (Fixed) costsEven though a large amount of money

is spent on overhead costs, most of this has little effect on the level of crop yield or animal production, because overhead costs are not related to a specific activity.

Include: Total Overheads Operating Overheads Activity Overheads

Total overheads Include:

Essential living expenses of the farmer. Wages and food for permanent workers. Loan interest and repayment. Replacement of capital items such as plant

machinery, buildings, etc. All taxes. Repairs to water supply, roads and structures. Insurance on employees, fixed structures and

plant. Travel and other business expenses.

Sometimes the wages of permanent workers are allocated among the different activities and treated as activity variable costs.

Total overheads

These are the unavoidable costs of the farming business and must be met each year.

They give an indication of the minimum total gross margin must be achieved for all farm activities that are planned for.

If the total gross margin from the present type and intensity of activities is not enough to cover overhead costs the farmer should modify his/her plans to produce a programme that will cover them.

Otherwise his/her debts will increase to a dangerous level.

Operating overheads Are the overheads associated with the annual

business operations of the farm. Are used in calculating the true profits in an

accounting sense. For accounting purposes they exclude

repayments of loans, interest, living expenses, or income tax in operating overheads.

They however include an “operator’s allowance” for the work done by the operator and the decline in value or depreciation of all capital items such as tractors, rather than the actual cost of replacement.

Operating overheads

Main components Include: “Operator’s allowance” Depreciation of capital items such as

buildings, machines and equipment Wages of permanent workers. Taxes but not income tax. Repairs to water supply, roads, buildings,

machines and equipment. Insurance on employees, fixed structures,

plant, buildings and equipment. Telephone and business expenses.

Activity overheadsAre costs that would not be incurred if

the activity were terminated. E.g. Depreciation on equipment used for a

particular crop, assuming it could be sold. In most analyses activity overheads are

included in operating overheads.

Variable/Overhead costs overlaps Some costs that are partly overheads and

partly variable costs. E.g. Machinery depreciation has both

an age component the machine loses value as it ages (overhead cost) and

use component the more the machine is used, the greater the loss in

value (variable cost). Strictly speaking, the cost will be an overhead

if it is not directly associated with just one particular activity but affects the general running of the business.

Finance CostsCover the annual interest paid on

borrowed money, and the repayments made on loan.

When hire purchase is used, the payments include interest, loan repayment and often some insurance cost lumped together in one sum.

Capital costs

Funds spent on capital items such as: New buildings Machinery Land purchase Land clearing Water supply Extra livestock and Planting of palm oil, rubber, cocoa, or fruit trees.

Though not always, increase the productive potential and asset value of the property.

Capital costs Most capital items lose value, or depreciate

over time Thus a depreciation allowance should be

deducted from gross income each year so that the item can be replaced at the end of its useful life.

Where there is a resale market the salvage value of the piece of equipment, etc can be taken into account in calculating depreciation.

Personal Costs Include funds spent on:

Food Clothing Medical expenses School fees and Family traveling costs

Some are directly related to the level of output of the farm. E.g. money spent on food or medicines is likely to have a

direct effect on the total farm output as healthy and well nourished farm workers are likely to have a high work output

For others like school fees and clothing , such an effect is hard to measure.

Personal CostsThe minimum total living or personal

costs of the farmer are normally included in the total overheads when budgeting for family farms, as they are one of the most important and unavoidable items in total farm costs.

Farm ReceiptsMain sources of income

Sale of crops and animals products. Non-cash income resulting from an

inventory change e.g. extra stocks of animals on hand at the end of the trading year, or from farm products consumed in the home.

Annual dividends and rebates on purchases from a cooperative society .

All these are accounted for under annual farm income.

Farm Receipts Other farm receipts include:

Sale of a capital item such as land or machinery. Not part of the annual farm operating income but is

treated as part of the total receipts for the year.

Money received from non-farm sources such as gifts from relatives, sales of handicrafts or work done elsewhere.

Not part of farm operating income but classed as personal receipts.

Loans But not accounted as as part of the income produced by

the farm.

Profit MaximizationRevenue is

Viewed from the standpoint of either input or output.

Income to the producer isMeasured in terms of either revenue

per unit of input or revenue per unit of output.

Profit is maximized when total revenue exceeds total costs

Profit Maximization Total revenue = Amount of product sold X

product price. If there are too many farmers, no one

producer can influence the product price appreciably.

This means that the only way individual farmers can increase their total revenue without changing quality of product is to increase their total production.

This revenue relationship is referred to as a linear one, i.e. a straight-line relationship.

Profit Maximization Profits are maximized when the total revenue

from the sale of the last unit of output just equals the costs necessary to produce it. At this point, marginal costs equal marginal

revenue (MC=MR).This is the least cost point of production.

Net profit is determined by total revenue (TR) minus total costs (TC). Net profit is greatest when the difference

between TR and TC is greatest.

Selecting and Combining EnterprisesMost farmers grow a variety of crops

and may keep some livestock. Mixtures of crops are grown on the same plot

in the same season, a practice known as mixed-cropping or inter-cropping.

The types of plant and animal enterprises that are profitable for any farmer/manager are determined to a large degree by the law of comparative advantage.

Selecting and Combining Enterprises Farmers must

Determine/develop the cropping system. Develop the livestock programme.

The choice of enterprise(s) depends in part On the farmer’s personal preferences and family

goals Upon the farm manager’s ability to apply technical

expertise and economic reasoning, Upon the resources with which the managers must

work.

Selecting and Combining Enterprises

Choices of products are t made based various considerations including: Production possibilities of the products Constraints and Feasible area Maximization of returns Subjective Preferences Food versus Cash Crops Specialization versus diversification

Production possibilities of the productsWhere two crops are competitive the

expansion of one has a “cost” in terms of the amount of the alternative foregone. This is a measure of opportunity cost.

Resources of land, labour and homemade capital has opportunity costs though they may not have a market price.

Production possibilities of the products

Production possibility boundaries may be drawn for any pair of alternative products, crop or livestock.

The slope of the curve of a possibility curve will measure of the rate at which one product can replace another and is known as the rate of product transformation (RPT).

Constraints and Feasible area Limitations of space, soil moisture and

various plant nutrients are constraints on crop growth, but the crops compete at different rates for them.

Mixed cropping is one of the ways to overcome these constraints as it: Increases the utilization of environmental factors

such as light, water and nutrients as different crops have different water and nutrient requirements and different rooting habits.

Enhances better control of weeds, pests and diseases.

Enhances soil protection

Maximization of returns Assuming that the objective of the

farmer is to maximize returns, he/she endavour to produce at the level where he/she has the least-cost combination.

He/she will produce at the point of economic optimum.

Subjective Preferences It is not always that a farmer produces for

the mere objective of maximizing financial gains.

Three theories have been advanced regarding decision-making for a farmer whose main objective is not maximizing financial gains.

They include: Satisficing Ranking of objectives Utility Maximizing

Satisficing Is the behaviour whereby the farmer is

not too concerned about finding a single, best combination or maximizing anything so long as he/she can meet his/her minimum goals.

Ranking of Objectives Is based on the assumption that farm

families can rank objectives in order of priority.

Thus production of sufficient basic cereal staple for family needs might be the principle objective, while producing other crops for variety of diet may have secondary priority.

Ranking of ObjectivesThe high priority objectives may be

treated as goals that must be met. Once a farming system has been

found which meets all the high priority goals then choices may be based on lower priority objectives such as maximizing profits.

Utility Maximizing

This theory assumes that the farmer’s total welfare or satisfaction can be expressed as a quantity of utility.

His/her total utility is a function of the quantities of goods consumed or other needs satisfied similar to a production function only the latter is a function of quantities of inputs used.

Food versus Cash Crops Assuming that the farmer, though not

committed to mixed cropping, is endowed with limited resources, he/she must choose between competing uses of these resources.

For example he/she must choose whether to grow maize for food or coffee for cash.

Production possibility curves showing alternative feasible combinations of food production and cash earnings can be used to make the choice on which crop to produce.

If the price of cash crops rises, the returns from cash crop production must also rise and the opportunity cost of food production increases.

Food versus Cash Crops

In practice, there are choices to be made not simply between cash production and food production but between a whole range of consumption goods and a large array of production processes.

However, it should be remembered that a decision to produce basic food needs on the farm implies adoption of a range of different crops and storage activities in order to provide a balanced diet throughout the year.

Specialization versus diversification

Depending on whether the farmer is a large scale or small-scale producer, there are advantages in specialization and devoting all available resources to that activity where economies of scale exist.

However, diversification into more than one productive activity has several potential advantages.

Advantages of Diversification Given that some inputs are fixed, marginal

returns are likely to diminish as more and more are devoted to a single product. Higher marginal returns and hence more total

product are obtained by devoting some of the inputs to an alternative crop or livestock activity.

Complementary and supplementary relationships between alternative products means that the combined output of both from a given set of resource is greater that that of either one on its own.

Advantages of Diversification Exploiting available resources up to their

limits can increase total production, which means making the constraints effective. This then will involve a combination of productive

activities.

Where subjective choice is involved, as in choosing what crops to grow for home consumption, a variety of products are likely to be preferred over a single one.

Risk may be reduced by diversification.