BUDGETING FOR FARM MANAGEMENT
Max R. Langham and Joseph Nkwain Sama
IW92-8 June 1992
INTERNATIONAL WORKING PAPER SERIES
FOOD AND RESOURCE ECONOMICS DEPARTMENT
Institute of Food and Agricultural Sciences University of Florida
Gainesville, Florida 32611
BUDGETING FOR FARM MANAGEMENT
Max R. Langham and Joseph Nkwain Sama'
Assessing the implications of alternative courses of action is an important part of the management process and budgeting is an old and well- established tool to assist in this task. Applications range from a como~lete budget of a plan for the productive activities of a farm to a toartial budget which focuses on a marginal change in existing farm operations. Regardless, a budget for one unit of a productive activity is the essential building block of the process. Such a productive activity is termed an enterprise and a budget for one unit of it an enterprise budget. For example, a farm which produces broilers, Arabica coffee, and maize, if each were unique, would have three enterprises; and units of measurement for which budgets would be prepared might be defined as 100 birds, a tree, and a hectare, respectively.
A farm budget consists of the quantities of inputs to be used in the production of an agricultural commodity and estimates of their cost. On the returns side of the ledger are estimates of the expected quantities and prices of the outputs which result from the use of the production inputs. Such estimates are basic to the assessment of the economic profitability of an investment in an agricultural enterprise. The need for such basic information was an important factor which led to the development of the discipline of agricultural economics. And indeed, studies to determine the cost of production of farm enterprises date from the very beginning of the discipline.
Studies at Cornell University on the costs of producing milk and at the University of Florida on citrus date from the 1920's. Studies on the costs of picking, hauling, and packing oranges and other produce were important parts of research programs in both California and Florida. Such studies provided insights on efficient methods and were used widely by individuals who were planning new investments in land or production facilities and by credit officers who were faced with the decision
'Professor of Food and Resource Economics, University of Florida, and Senior Lecturer,
Department of Agricultural Economics, University Center of Dschang (UCD), respectively. The paper was prepared while the first author was serving with the Agricultural Education Project funded by the U.S. Agency for International Development and implemented by the University of Florida and Florida A&M University in a cooperative assistance mode with UCD.
of whether to loan money for such investments. Government officials used these estimates to assess the fairness of prices and to help make decisions on price policy. Studies at a particular location usually followed a standard format and were repeated periodically so that changes could be followed and individual producers could compare their personal performance over time against the standards in the estimates for their area.
The paucity of reliable information on enterprise budgets for various crops and livestock in developing countries like Cameroon handicaps the abilities of agricultural advisers, farmers, and policy makers in making planning decisions. They need a basis for comparing "what is" with what can be more efficient in the use of resources, and hence, should be encouraged in planning decisions. Prices of export crops are often fixed with inadequate reference to reliable information on how they affect the future decisions of farmers and persons in the agribusiness sectors who serve them. Also, policy makers concerned with the welfare of farmers need budget information to get some idea of the effect of price changes on the costs and returns of farm enterprises in the various regions of the country.
When used with consistent price information, budgets are basic inputs for policy analysis. They are much used in research with mathematical programming and other matrix-based models which require information on production activities. Budgets can be useful in exploring such important economic fundamentals as comparative advantage. They are also an essential component of economic feasibility studies and are used widely in assessing and evaluating alternative farm enterprises and programs and policies designed to affect change in the rural sector.
Specifically, well-developed and carefully prepared enterprise budgets with the use of an acceptable methodology and appropriate prices can provide basic information for use by:
1 policy analysts as inputs into their models;
2. farmers in making decisions with respect to choice of enterprises and technologies to
improve efficiency and increase profitability in resource allocation;
3. investors and other economic agents in the identification of potential low cost
production areas and processes ;
4. persons responsible for feasibility studies and project identification, selection, and
5. extension and other agricultural advisers to farmers who are seeking information on
the relative profitability of techniques; and
6. faculty members, especially those in departments of agricultural economics for
teaching, research, and outreach purposes.
Development of a strong and meaningful foundation is important for the adoption of sound and consistent methodologies to serve as a standard for use in budget studies. In countries like Cameroon, considerable effort has already been made on budget studies. However, estimated budgets need to be cataloged, reviewed, and appraised for their conceptual consistency.
The economic concepts which provide the basis for budgeting and the appraisal of existing budgets' come from those which have been developed to explain producer behavior. These concepts are, therefore, essential to the understanding of the strengths and weaknesses of the budgeting tool and provide valuable insights into the uses and limitations of prepared budgets.
Economics of Budgeting
The theory of producer behavior rests on four pieces of information- -a production technology which describes how productive inputs can be transformed into farm commodities, managerial control of a bundle of productive resources, a source (input market) where productive inputs required by the
'The appraisal of existing budgets is analogous to the task of updating budgets to keep them current. We will say more about this matter in a later section.
technology but produced off farm can be obtained, and an outlet (output market) for items produced. On a semi -subsistence farm much of the output would be consumed in the household and any surplus sold in the output market. To better understand how these four pieces of information interact in production decisions consider the following production situation:
The bundle of resources controlled by a farmer includes one hectare of land, adequate family labor to till the land, adequate seed to plant a hectare of maize, and 12,500 FCFA to purchase fertilizer. A source of fertilizer exist in a local village market and a bag can be purchased for 2500 FCFA. The farmer can sell maize in the local market for 75 FCFA per kilogram. The technology available to the farmer is based on the quality of his land, labor, and seed resources and on what is known in the larger community. The technology can be represented by an input-output relationship between fertilizer use and corn yield per hectare as defined in Figure 1. Finally, it is assumed that the farmer is economically rational and wants to use
his or her resources to maximize his or her economic well-being.
The bundle of land, labor, and capital resources the farmer has at his or her disposal are generally fixed in a particular growing season. However the amount of fertilizer the farmer buys can be varied up to the limit of the capital available. The farmer can treat fertilizer as a continuous input and can purchase and apply from one to 5 bags. The output of maize which the farmer can produce is given by the response curve TP which represents the technology the farmer is attempting to follow. If the farmer applies only complete bags, the outputs which the farmer can expect to obtain are given by the points 1, 2, 3, 4, and 5 in Figure 1. The variable costs (in this example, the cost of fertilizer) at these 5 points and the expected returns from the maize produced are given in Table 1. One can see that point 4 maximizes the farmer's gross margin (net returns to the fixed resources he or she controls).
1 2 3 4 5
Bags of 20- 10- 10 Fertilizer Applied per Hectare Figure 1. A Hypothetical Response Curve for a Maize Production Technology in
West Province, Cameroon
The best enterprise budget would be one based on the use of 4 bags of fertilizer and could be represented as shown in Table 2. In this example there are four inputs not measured in a market. These are land, family labor, seed, and management. However, if there is a basis for assigning a value to any of these four items, one can assign an opportunity cost to them. For example, if 80 days of family labor were required for the hectare of maize and labor could be employed off farm for 800 FCFA per day, the opportunity cost for labor would be 64000 FCFA and could be subtracted out as a return to family labor. If such were the case, net returns to land, seed and management would then be FCFA 91250 less 64000 or 27250. If in addition, seed of equal quality were available in the market to plant a hectare of maize for a cost of FCFA 5000 then the seed too could be listed as a third variable input. If so, the net return to land and management would be FCFA 22250.
Table 1. Net Returns from Maize Production for a Hypothetical Example in West Province by
Bags of Fertilizer Used'
1.2. 3. 4. 5.
Fertilizer Yield of Cost of Fertilizer Returns from Net Returns
(Bags) Maize (kgs) (FCFA = 2500 X Bags) Maize Grown [(FCFA = (4.)-(5.)]
_________ ~~(FCFA = 75 X kgs) _______1 1000 2500 75000 72500
2 1200 5000 90000 85000
3 1300 7500 97500 90000
4 1350 10000 101250 91250
5 1375 12500 103125 90625
'In this example it is assumed that all production is sold and that food for home consumption is purchased from the farm at market prices, i.e., the transaction cost between farm and market are zero.
It is important to recognize that the inputs left unaccounted for in an enterprise budget represent a joint cost and share a claim on the net returns. Economic theory provides no basis for partitioning true joint costs and it is an arbitrary exercise to attempt such a partitioning. Without an objective basis, joint inputs should be left as such to share the net returns. With family farms there is often little need to attempt to partition such residuals since they accrue to the family consumption unit.'
'In businesses which are held by a number of independent interests (as for example businesses whose shares are sold in stock markets), the computation of a residual return on capital is necessary for making a distribution to stock holders. However, such a partitioning is generally done on the basis of an accounting convention or management decision. Such partitionings are arbitrary and those who make them would not be able to justify them an the basis of a meaningful economic contribution of value received. However, management is responsible to the shareholders and cannot ignore what the market is reflecting as a fair return on money.
Table 2. A Simplified Hypothetical Example of an Enterprise Budget for the Production of
Maize in West Province
Item Unit Quantity Price/Unit FCFA
Sale of Maize kg 1350 78 101250
Total Variable Cost:
Fertilizer bags 4 2500 10000
Gross Margin (or net
returns to land, family 91250
labor, seed and management)
The representation of the technology in Figure I is given by the curve TP. In an open and competitive input market, the only restriction on a farmer's use of fertilizer is his or her ability to buy. Certainly there is no requirement that a farmer use all of a bag. Therefore any point on the fertilizer axis can be chosen for an application rate. And, any point on the curve TP is potentially the most profitable one depending on the price of fertilizer relative to that for maize. One of the first lessons from the theory of producer behavior is that the most profitable application rate depends on relative prices and occurs where the slope of the function representing the technology is equal to the price of the fertilizer input relative to the price of maize.
The technology depicted by the relationship TP in Figure I represents the maximum amount of output which can be attained at each level of the variable input for the given bundle of fixed resources. This curve also represents the least amount of the variable resource required to produce a given output. It is a frontier or envelope function which by definition represents the solution of a technical optimization problem as a function of variable inputs. As will be seen later, points along this curve are said to be technically efficient. Technical efficiency is attained if and only if the decision maker combines his or her fixed and variable resources to maximize output. The curve itself, therefore, implies best management in the use of resources in a technical sense.
It should also be recognized that every farmer has constraints on his or her resources which limit his or her production behavior. For example, if a farmer had adequate resources to purchase a maximum of two bags of fertilizer, there is no way he or she could produce along TP beyond that amount of the variable input.
Profit maximizing behavior, if attained by the farmer, implies that the farmer is acting in a way that is technically and allocatively efficient." In this example, a farmer would be technically efficient if his or her output of maize was the maximum that could be obtained at each level of input. Since the curve TP in Figure I represents, by the definition of a technology, the maximum attainable output of maize at each level of the variable input, a farmer is technically efficient if and only if his or her output is given by the height of TP at each level of the variable input. A technically efficient farmer is allocatively efficient if he or she is using the profit maximizing amount of fertilizer.
For purposes of demonstrating these concepts of efficiency with the fertilizer-maize example, assume that point a on the frontier production funtion, curve TP, in Figure 1 is the most profitable given the technology and the fertilizer and maize market situations. At this point the farmer is producing where the slope of the curve TP is equal to the ratio of the price of fertilizer to the price of maize. At a, the farmer is both technically and allocatively efficient. A farmer whose output was represented by point b in Figure 1 would be technically inefficient but allocatively efficient with respect to TP. At point c, the farmer would be technically efficient but allocatively inefficient, and at point d, the farmer would be both technically and allocatively inefficient.
Continuing to use the above example, a particular budget can represent any point on or below the curve TP. And, without definitive information about the technology and the market situations, an analyst would not know the locus of his or her budget in relation to the point a. As a consequence, a budget in and of itself has little meaning since it could be one of an infinity of possibilities. And, when one moves away from a simple example into a real world situation, the puzzle gets more
4For a more complete discussion of the concepts of technical and allocative efficiency see the reference by Farrell.
complicated and uncertain. The complicating factors are that there can now be multiple technologies for producing a given product, multiple products that can be produced, and multiple markets for both inputs and outputs. Nevertheless, a particular budget Still represents the situation at one point, but now the point is in a multidimensional space rather than in two-space as in our simple example.
Of course the budget is applicable for different levels of inputs and outputs as long as their proportions are fixed. Therefore, a budget can be geometrically represented as a straight line drawn through the origin and the point budgeted. By varying all inputs (fixed and variable) proportionately, a producer can produce any output along the line in the non-negative orthant where inputs and outputs take on non-negative values. Thus, a budget is identical to an activity in linear programming. Proportions can be varied by constructing additional budgets.
The choice problem from among the productive situations for which particular budgets are to be prepared should not be taken lightly. Choice from an infinite set of points in multi- dimensional space seems a bit overwhelming. It is expensive in both professional time and supporting resources to prepare budgets, and there is always the legitimate economic question, "Are the potential benefits worth the cost?" An essential rule-of -thumb of operational necessity is that the production situations to be budgeted is much like the old adage which states "Good friends should be few and well chosen." It is essential that the user of budgets have enough information to appraise the applicability of the budget in the situation for which it is being used.
On Selecting Specific Enterprises to Budget
It is important to understand that nearly every decision in constructing budgets represents a multiple-choice from among admissible hypotheses. Because of this fact, there is always the temptation to take the many choice problems lightly, and it is a temptation the analyst must avoid if the budgeting estimates are to be consistently constructed.
The concept of a typical or representative farm' has received considerable emphasis in farm management work which focuses on budgeting and on estimating costs and returns. The term benchmark has also been used partly in recognition of the shortcoming of the term typical or representative. However, in use, this latter construct tends too to imply some average farm. An average is attractive from a heuristic sense but is not very useful from a decision-making perspective. The major role of budgets is in planning and decision making and in looking at what can or should be. Budgets are less useful for describing "what is." An objective of description is better left to agricultural censuses and general surveys. We will return to this matter in the next section on the use of budgets.
We do not imply that what is going on in the countryside is not of major importance in budgeting. Enterprises which dominate in an ecological zone must also dominate in the selection of budgets. Choice is less problematic in ecological zones where monocropping, is followed. In zones where intercropping is prominent there is the more difficult choice of, "What mixture(s)?" In most such zones, however, there is a dominant crop in each mixture. A useful guideline to follow is to choose one mixture for each dominant food crop and one for each dominant commercial crop. For examples, in Menoua Division of West Province of Cameroon, one would want to choose at least one maize -based -mixed -cropping enterprise and an Arabica coffee -based -mixed- cropping enterprise.
Subsequent choices involve the technologies, market situations (both for inputs and outputs), and the level of management to assume. Again, what dominates in a particular zone can play an important role- -particularly with the choice of technology and market situations. However, we would argue that it does not serve one as well in the choice of management level.
The choice of "average" or "typical" management makes little sense in constructing budgets- the major uses of which are for planning decisions. The agricultural sector in a developing economy
'See for example Schaefer Kehnert, p. 67, where budgets are presented which supposedly
represent 50 percent of all farms in North West Province. It is a rather heroic inference to present a model result based on 5 enterprise budgets and claim that it represents so many farms. "In what way does it represent 50 percent of the farmers?", is a very legitimate question.
and the farm population both fall relatively to the non-farm sector and population early in the development process and absolutely as the process continues. When one takes into consideration the dynamics of the process, it makes no sense to base planning on the average situation at a point in time. When viewing the situation from a dynamic and developmental perspective, the average farmer at any point in time is in a very precarious position and will survive in agriculture only by moving vigorously to graduate upward in his or her decision-making role of management. If a farmer plans on the budgeted norm based on an average, his or her family will be essentially gone from the agricultural business in a generation.
Returning to Figure I for reference, a focus on farms that are very well managed should put one closer to point a for a given set of market conditions. Technical and allocative efficiency are important whether a farmer is using a traditional or a modern technology, and the farmers doing the best job in allocating his or her resources should be closer to a well defined optimal for his or her situation in production. The average farmer is likely to be at some point like A at considerable distance from the most profitable allocation.
One often encounters budgets based on technologies which are termed recommended as defined by experts. We would argue that budgets should be based on both traditional and modern technologies, but that in both cases, the technologies be presented as embedded in farm practices on farms with superior management.'
In summary, we argue that the choice of enterprises and markets should be those which dominate in the farming community defined within an ecological zone. However, the management
'There are some interesting accounts of scientists criticizing farmers for not following their recommendations, but who, when placed in demonstrative competition with the farmers, were soundly outperformed by the best farmers. Scientists have a tendency to claim too much for their knowledge and farmers have a way of adopting that which is useful and essentially ignoring the rest. Scientists are after all human and they tend to remember and recommend on the basis of their best outcomes which are too often not replicable.
level implicit in budget should be that of the best farmers! The choice of technologies to be budgeted should be at least two for each enterprise --traditional and modern and based on farm experiences."
Evaluating and Updating Budgets
The only sound way to evaluate an existing budget is against a conceptual framework that is embedded in reliable knowledge. For a given ecological zone and assuming common units of measurement of inputs and outputs, the preferred budget is the one which is most efficient in the use of resources. Returning to the reference of Figure I and our earlier discussion of efficiency and assuming that the information contained in the budget is from a real-world production source, one can derive the following logical guidelines:
I An enterprise budget for an unknown technology and production environment
(including knowledge of such key factors as soil type, elevation, moisture situation, and slope of land) is of little value to a potential user, or stated positively the technology and decision environment should be explicitly specified for the potential
2. For a given technology, a budget which gives a higher output for a given level of
inputs is more efficient and hence preferred over one showing a lower output.
3. For a given technology, if two budgets show the same output at two levels of input,
the one which uses the smallest amount of input is more efficient.
'For an operational norm, we suggest the use of information from farmers in the upper 10 percent and certainly no lower than the upper quartile of their peers from a management perspective.
'In physically presenting hard copy of the enterprise budgets, we recommend the use of a layout with three columns of data with the first representing traditional technology, the second modern, and the third left blank for the farmer to present his or her calculations for whatever technology he or she uses.
4. If two budgets have been estimated for the same technology but are based on different
relative prices, the one with the highest relative price for the input should show a lower intensity of use of the input and a lower output and vice versa. This guidelines assume of course that the constraints on the farmers represented by the two budgets
5. Technologies become obsolete with the development process and budgets for new
technologies are needed with change.
6. When there is a significant shift in relative prices (say greater than 5 percent), budgets
need to be estimated. When such a shift occurs, the optimal point (I in Figure 1) will shift along the production frontier as farmers respond to the new market situation.
The result of such adjustment make the input and output quantities in the old budget
7. Inflation in the economy may have little effect on relative prices so the input and
output quantities in a budget will remain valid. Nevertheless, the budgets being made available to users should reflect nominal prices. The user will normally know very little of the economics -on which a budget is based and have little confidence in a budget which reflect obsolete nominal prices even though relative prices and the validity of the budget has not changed. Consequently, the price vectors on which budgets are based should be regularly updated to keep up with inflation. A good rule of thumb is to track prices and recompute the budgets at a minimum of every two
years with a new price vector.
8. At the risk of being redundant, we need to emphasize a danger closely related to item
7. It is possible that the analyst will also be biased by prices used in a budget as a indication of its validity. A budget estimated several years ago for a traditional technology may still reflect levels of inputs and outputs which are valid- -especially when one is studying a traditional system. The age of an estimated budget should,
however, raise a caution flag so that the analyst checks what has happened to relative
prices since the budget was estimated.
The above guidelines are not exhaustive and an analyst will be left with many unanswered questions as he or she sets about evaluating existing budgets in the process of constructing a meaningful set of enterprise budgets. Sometimes choices which will have to be made will seem a bit too arbitrary. Such circumstances, however, are never admissible excuses for careless estimation.
The mathematics of budgeting involves little more than counting, and the basics of addition, subtraction, multiplication, and division. However, the processes involved in the day-to-day management of a portfolio of estimated budgets to assure accuracy, up-to datedness, and ready accessibility to individual budgets make it essential that a spreadsheet software and a desk-top computer be readily available to the persons responsible. A computer is also needed to screen existing data sets such as the agricultural censuses and surveys that may be available for such critical information as dominant enterprises in the ecological zones being studied.
Having information on the quantities of inputs used in production and their cost and on the quantities of products forthcoming and the revenues received from them is basic to the decisionmaking process. Ideally, the economic analyst would prefer to have this knowledge in a functional sense in order to more accurately estimate the most profitable point in the space of inputs and outputs. However, the reality of the situation leaves analyst and hence decision-makers far short of this ideal knowledge norm. The next best alternative is to develop budgets on what is believed to be near approximations to the most profitable situation in the infinite space of inputs and outputs. It is a difficult task but one that is needed to provide guidelines to persons planning production decisions and to persons giving advice and making policies on such matters.
Some analysts use budgets in a sensitivity analysis mode by varying prices and technologies to see what happens to net returns in the budget. Too often the result is misleading and not appropriate for its intended use. As we have pointed out earlier, one cannot vary relative prices without error. Therefore, it is a poor practice to vary one price and hold other prices constant unless there is information on the technology in a functional sense so one can make an informed judgement about how producers are likely to respond. Also, it is a rather poor practice to vary the point representing the technology unless there is some legitimacy in assuming an iso-slope change in the technology.
It is our recommendation that one avoid doing a lot of meaningless sensitivity work with budgets, and when it is done, that the changes postulated be as small as possible and never larger than
5 to 10 percent.
We have raised several warning flags with regard to the practice of budgeting. Our purpose has not been to discourage the use of budgets. To the contrary, we believe that the processes of estimating and using budgets should be encouraged as a means providing information in the real world situation where there are few cost-effective alternatives for providing information for decision purposes. However, the analyst has a professional responsibility of clearly specifying the legitimate uses and the shortcomings of his or her work.
Farrell, M. J. "The Measurement of Productive Efficiency." J. Royal Stat. Assn., 120(1957):253-81. Schaefer-Kehnert, Hans-Christoph. Institutions and Technical Change in the Development of
Smallholder Agriculture. Kiel: Wissenschaftsverlag Vauk, 1988.