CHAPTER 13
MEASURING FARM PROFITABILITY
Nicola Shadbolt, Massey University, Palmerston North
Summary
For the majority of farm businesses, one of the key outcomes that must be
achieved is a profitable financial result. This chapter describes how one
determines profit. The actual income or gross farm revenue (GFR) relevant
to costs in any one year is the sum of cash sales less cash purchases, plus
any changes in inventory. These inventory items, including livestock, should
be valued as close as possible to market value.
Expenses are both cash and non-cash adjustments. They include
operating costs or farm working expenses (FWE) and funding costs
which reflect business ownership and financing.
Profitability is measured by calculating the returns from the farming
business (the operating profit after tax) and adding to it the returns from
the property business (the capital gains and losses).
Various profitability measures exist including:
•
Return on equity and family labour
•
Operating profit or Economic Farm Surplus (EFS). This equals
Earnings before Interest and Tax (EBIT) if there is no unpaid family
labour.
•
Return on (total) capital (RoC)
•
Return on Assets (RoA)
•
Return on Equity (RoE)
•
Economic value added (EVA©)
•
Key performance indicators (KPI’s); profitability items such as the
above which help to benchmark a business against external (to the
business) standards.
Costs of production, costs per unit of output and costs per unit of input are
further useful benchmarking indicators of business efficiency and
profitability.
Always state the assumptions used when calculating performance
measures and, when comparing with others, ensure they are based on the
same assumptions.
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195
Introduction
For the majority of farm businesses, one of the key outcomes that must be
achieved is a profitable financial result.
A long-run profitable farm business will:
•
service borrowings
•
provide the family with an adequate standard of living
•
allow investment on-farm to maintain the farm’s productive assets
•
provide funds for further investment to increase long-term productivity
•
demonstrate ecological and or environmental sustainability.
Determining profit
To determine profit, there first must be an assessment of income and expenses.
Both cash elements and non-cash adjustments are used in calculating income
and expenses. To determine the profitability of any one product produced on
the farm, an allocation of expenses to that product is required. Direct expenses
such as animal health and freight are relatively easy to assess and allocate. But,
overheads (such as consultancy, repairs and maintenance) are more
complicated as a decision has to be made on how much of each overhead
expense should be charged to each product produced by the farm. Overheads
should also include both a value for unpaid family labour and management,
and an annual charge for the cost of capital invested in the farm to provide a
full economic costing for the products.
Income and inventory changes
The actual income relevant to the costs incurred in any one year (Figure 1) is
the sum of cash sales less cash purchases plus any changes in inventory.
Inventory includes both produce in store such as grain and ‘live’ inventory,
such as beef cattle. Because these live inventories may also reproduce, it is
essential to complete inventory reconciliations with every assessment of
income.
When income or Gross Farm Revenue (GFR) is calculated for management
purposes; the same values are used for valuing both opening and closing stock
of the same age or classification. Values selected are as close as possible to
market values. This method is used in the “Sheep and Beef Farm Survey”
produced annually by MWI’s Economic Service (The Economic Service).
Their GFR calculation includes inventory adjustments for changes in cattle
numbers, between the beginning and end of the year. For livestock inventories,
the IRD national average market values at closing are acceptable for the
calculation of GFR, whereas inventory of other stock/produce is valued at fair
market value.
Gross farm revenue can also be expressed per kg DM consumed, per
hectare or per stock unit. This can be compared with similar farms provided
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that the financial year is the same. This is termed benchmarking or comparative
analysis; GFR can also be compared for the same farm for different years – a
time series analysis or within-farm comparison over years.
Figure 1: Dependence of gross farm revenue on cash and non-cash adjustments.
When undertaking comparative or benchmarking analyses comparing data
from a farm against published data, it is absolutely essential that the method
of calculation is identical. The comparison is not valid if methods of
calculation differ.
Expenses
Expenses are both cash as well as non-cash adjustments. This includes both
operational expenses that occur irrespective of how the business is funded or
owned, and funding costs reflecting business ownership and financing.
Operating costs
Operating costs (Figure 2) are a combination of the cash expenses incurred or
Farm Working Expenses (FWE), and non-cash expenses. These latter expenses
include firstly, those that account for changes in the amount of input
inventory (e.g. chemicals, feed supplement) on hand at year-end, secondly, the
annual allocation of capital costs through depreciation charges, and thirdly,
the recognition of inputs that have not been paid for such as family labour and
management.
Changes in input inventory are seldom recognised in New Zealand financial
statements although, it is recognised as good practice in other businesses and is
common overseas.
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Figure 2: Categories of expenses.
Without making adjustments where changes in input inventory such as feed
supplements on hand at year-end are significant, cost estimates are incorrect
and misleading. These adjustments require collecting physical information on
year-end inventory, and then reconciling this with sales and purchases through
the year to determine the cost of inputs utilised that year.
Similar inventory reconciliation may be carried out for changes in soil
fertility by undertaking a nutrient balance. This is necessary where fertiliser
application is much greater in some years than others. Without this adjustment,
the cost of fertilizer can be under or over estimated.
In financial accounts, depreciation is based on the historic purchase price.
An alternative to this would be to use replacement values, but this is seldom
done. The capital investments on a farm (e.g. plant, machinery, buildings and
other land improvements), impact on both the fixed and variable operating
costs for that farm. Comparisons between farms, particularly with respect to
income generated and operating costs, provide a useful indication of the
benefits of such investments and whether they are strengths or weaknesses of
the business. The funding of these investments and indeed the whole farm is, of
course, not included in operational costs but is picked up in the funding costs
that are the result of business ownership and financing decisions.
Funding costs
Sources of capital
The capital employed by the business can be owned or leased. The capital that
is owned and the assets of the business can be funded by the bank (or by family
loans) as debt, or by the owner as equity (Figure 3).
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Figure 3: Components of capital.
In a set of financial statements, the assets shown are those owned by the
business. These assets appear at their historical cost less depreciation at IRD
rates, as this is standard accounting policy. While some accountants will revalue
assets where these have lifted appreciably, this is not the norm. The Net Worth
in the Statement of Financial Position can, therefore, greatly understate the
owner’s equity.
Accurate valuation of assets is essential in determining equity growth and
other wealth indicators. As land values can be more volatile than farm profit,
wealth indicators can fluctuate widely from year to year making trends difficult
to determine. A common practice is to use a 3-5 year rolling average for land
values.
Cost of capital
The cost of capital is the cost to the business from meeting the requirements of
the providers of capital. The cost of leased capital is the rent paid. The cost of
debt is the interest paid (Figure 3).
The cost of equity, or required return on equity, is owner specific and
reflects such things as: the opportunity cost of their money, attitude to risk,
lifestyle expectations, and the stage in the lifecycle of the business and the
family and their desire to invest in a farm. In addition to this are the nonfinancial reasons (e.g. being self employed, security, quality of life, fulfilling a
dream…). The cost of equity is therefore less easy to determine, and the same
rate is not common to all farmers.
Profitability
To assist in the explanation of profit it is helpful to split the farm into two
businesses that are often, but not necessarily, linked. The two separate entities
are; the property business, where success is measured by changes in asset
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199
values over time and is driven by smart purchase and sale decisions, and the
farming business, where success reflects effective and efficient sustainable
operation of the resource base.
Too frequently, rural professionals use the terms profitability and cashflow
(liquidity) interchangeably. As identified above, the profitability of a farm
investment is the sum of its farming and its property businesses. One is
delivering primarily a cash result and the other is not. ‘Asset rich, cash poor’ is
a commonly used term for some farmers; the problem inherent in a land
investment is therefore that of liquidity not profitability.
Profitability is measured by determining the returns from the
farming business, the operating profit after tax, and adding to it the
returns from the property business, capital gains or losses.
Using data from MWI’s example Sheep and Beef Farm Survey by the
Economic Service, the returns for that example year are shown in Figure 4.
Capital gain more than triples the return for this business; a 9.5% return was
generated from total assets valued at $1,453,840.
Figure 4: Components of profitability.
In practice, only the operating profit of the business is used to calculate a
range of measures such as Return on Capital, Return on Assets and Return on
Equity. These measures outlined below, are in common use, but ignore the
profit from the property business so should be interpreted with caution. The
EVA© (Economic Value Added) measure also outlined below more completely
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brings the two sources of profit together and is used in a number of businesses
as an indicator of successful performance.
Profitability measures
The measure sought will determine the appropriate expenses as outlined in the
following section.
Return on equity & family labour
This measure is the residual, after paying rent for non-owned capital such as
leased land and interest on debt, to reward the family for their invested funds
(their equity) and unpaid labour and management. The only non-cash
adjustments are for changes in inventories and depreciation of buildings, plant
and machinery. If these adjustments are removed the resultant measure is the
Farm Cash Surplus.
While it is a useful measure for a business to monitor, it is not
recommended for comparison as differences occur in paying for family labour
and management (e.g. a company ownership structure allows full
compensation for family labour as a tax-deductible cost, while a partnership
does not). Differing debt levels will also hinder comparisons and a true return
on equity cannot be determined, as this measure is a combination of a return
on equity and a return for unpaid labour.
Operating profit or economic farm surplus
Operating Profit is also, in New Zealand, called Economic Farm Surplus (EFS)
as it contains an imputed or standardised cost for unpaid items such as family
labour and management. The internationally accepted definition of operating
profit also includes such a non-cash adjustment for family labour.
Earnings before Interest and Tax (EBIT), a term commonly used in
business and usually taken from the financial statements, is identical to
operating profit if there is no unpaid family labour.
Operating profit is calculated from the GFR and Operating Costs as
follows:
Gross Farm Revenue – Operating Costs = Operating Profit
Due to the non-cash adjustments made when calculating GFR and Operating
Costs outlined above, it can be seen that it is possible to have a negative
operating profit while simultaneously achieving a farm cash operating surplus.
Sometimes the reason for this is the selling down of inventory, but usually it is
due to insufficient profit to pay family labour and management at market rates.
This is not sustainable; while the current owners may not see this as an issue;
future generations may have different views.
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Not all consultants and accountants make the same non-cash adjustments.
In fact, there is considerable variation in calculating even the most basic
operating profit. Care is required therefore, to check the method used and
make the necessary adjustments, to be certain that like is being compared with
like.
Return on capital (RoC)
This measure requires two indicators, Operating Profit and Opening Total
Capital. It pays no heed to the way in which a business is owned (tenure) and
financed, excluding associated costs (i.e. rent and interest). This is because the
operating profit does not include non-farm and investment income. The Total
Capital should be adjusted to exclude non-farm assets and the value of the
homestead and car in calculating business capital. Figure 5 shows an example
breakdown of capital and the cost of leased and debt capital given in the Sheep
and Beef Farm Survey.
Figure 5: Example breakdown of capital in the Sheep and Beef Farm Survey.
Using this example the value of business capital was ($1,537,179 $171,067) or $1,366,112. The pre-tax operating profit in that year was $41,043
so based on the equation below the Return on Capital was 3.0%.
Operating Profit / Business Capital Employed = RoC
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Return on assets (RoA)
This measure is also based on operating profit, but takes into account any
leased capital by deducting the value of such capital from total capital and the
annual cost of that lease from the operating profit.
Using the example Sheep and Beef Farm Survey data, the value of business
assets was ($1,366,112 - $83,339) or $1,282,773. The pre-tax operating profit
less lease costs was ($41,043-3,730) or $37,313 so, based on the equation
below, the Return on Assets was 2.9%.
(Operating profit – rent) ÷ (Business Capital – Non-owned capital) = RoA
Net Profit
Assets
Too frequently, practitioners calculate RoA by dividing the operating profit
by the value of total assets and make no adjustment for operating profit
generated from capital not owned. If capital is used which is not owned, it has
a cost (rent or lease) and this must be deducted from the operating profit in
calculating RoA.
Return on equity (RoE)
This measure is also based on operating profit and considers not only business
ownership, but also its financing. To account for the former, the value of leased
capital is deducted from total capital and the associated annual cost (rent) is
deducted from the operating profit. To account for business financing, total
liabilities are deducted from total assets and the annual cost of servicing those
liabilities (interest) is deducted from the operating profit.
Using the example Sheep and Beef Farm Survey data in Table 5, the value
of business equity was ($1,282,773 - $279,703) or $1,003,070. The pre-tax
operating profit less lease and interest costs was ($41,043-$3,730-$21,808) or
$15,505 so, based on the equation below, the Return on Equity was 1.5%.
(Operating profit-rent-interest) ÷ (Business Assets – liabilities) = RoE
Net Profit
Equity
This business is generating sufficient operating profit to meet rent and
interest expenses so the return on equity is positive.
Both profitability and gearing of a business determine the return on equity.
If the return on capital is greater than both the annual cost of nonowned capital and the interest charge on liabilities, then the return on
equity will be greater than the return on capital. In the example above,
however, the converse has occurred; the return on capital of 3.0% is less than
both the rent at 4.5% ($3,730/$83,339) and the interest at 7.8% so the return
on equity is below the return on capital.
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There is little logic in renting capital or borrowing funds for capital if the
operating profit it generates is less than its annual cost. If, on the other hand,
the property business profit is included in the equation and lifts the return on
assets from 2.9% to 9.5% as it did in that year; there is logic in borrowing
funds at a cost of debt of 7.8%. The challenge instead, will be liquidity and
servicing that debt, as two thirds of the returns are not in cash (capital gain).
The really successful businesses are those that consistently produce a return
above the cost of capital from their farming operation. These businesses not
only achieve outstanding returns on their equity and are able to manage
liquidity well, but as an added bonus, they benefit from the equity growth
created by profits from their property business.
Economic value added (EVA©)
A recently developed and now frequently quoted driver of wealth creation is
EVA© or Economic Value Added (Figure 6). This is the difference between the
profits generated by a business and its cost of capital. If the profit generated
exceeds the cost of capital, then economic value is created for that business.
For a publicly listed company, the inference is that if profit is less than the cost
of capital, economic value will be lost in the company and reflected by an
immediate sell down and drop in share value.
Similarly, in a farm business, if total profit does not meet the cost of capital
one would expect restructuring to be occurring.
Figure 6: Components of EVA©.
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To calculate the EVA© for a total farm (encompassing both the farming and
the property businesses), both capital gain (calculated from an increase in value
rather than purchases of additional assets), and operating profit after tax, are
combined to calculate profit. The cost of capital (the sum of cost of debt and
opportunity cost of equity) is deducted from this profit to determine the
EVA©. A positive EVA© means economic value has been created for the
business and restructuring is not necessary.
Key performance indicators (KPIs)
Key performance indicators are profitability items such as those described
above which help to benchmark a business and provide quick indicators of its
financial robustness and level of risk. The indicators against which the business
is compared are usually derived from data on as many other similar businesses
as are available and provide a judgment commentary on what levels of
performance are strong or weak etc. In some respects, they provide arbitrary
boundaries between one level and another. Nevertheless, they provide useful
guidelines based on the success or otherwise of many other similar businesses
(Table 1) and can highlight the strengths and weaknesses of the farm business.
Table 1: Key (financial) performance indicators for sheep and beef cattle farms in
New Zealand.
Costs of production
The costs of production of a farming business (Figure 7) are a combination of
the operating costs, (some of which are variable or enterprise specific while
others are fixed or farm specific), and the funding costs or cost of capital. A
simple method of determining the cost of capital for the farming business is to
estimate what might be earned if the farm were to be leased out. Another
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205
method is to estimate what cash commitments the business has to both
financiers and family: this is termed the extracted cost of capital.
Farming is a high fixed cost business. Generally, it is excessive fixed
costs that cause problems in a farm business, not high variable operating costs
such as freight and animal health. Cost containment strategies that are aimed
at lowering the fixed costs per unit of output include increasing productivity,
efficiency and scale.
Costs per unit of output
While costs are often expressed on a per enterprise, per hectare or per stock
unit basis, the most relevant measure is cost per unit of output as this can be
readily compared against the returns per unit of output from the marketplace
(see the calculation outputs at the bottom of Figure 7).
Allocating variable operating costs is simple, but there is significant debate
in accounting literature on allocating total fixed costs (fixed operating costs
plus funding costs) to output. Often they are allocated on the basis of volume,
but this has been proven to be inaccurate. Instead, the allocation of fixed costs
on the basis of resource use is adopted; the method is termed Activity Based
Costing (ABC). Recent applications of ABC to pastoral farms have used feed
consumed as the resource for allocating fixed costs. This aims to estimate the
real cost drivers of the production system and thereby helps farmers to improve
farm economic efficiency.
The main overhead cost in pastoral farm enterprises is DM (dry matter)
production. In the example below, DM consumed by each enterprise is used to
allocate fixed costs to each product. A further refinement for those with the data
would be to allocate the costs on the energy (MJ ME) consumed; this would
allow for the quality of the DM, a critical factor, to be taken into account.
The costs of production in Figure 7 can be easily compared with the market
prices offered for lamb and weaner cattle. There are factors that impact on
these cost calculations such as stocking rates, calving percentages, death rates,
growth rates, variable and fixed costs and income from by-products.
It is a useful exercise to calculate these costs of production for the farm and
to see which factor has the most effect on the result. This will give some idea of
what to concentrate on to improve the margin between costs and returns. It is
the difference between the cost of production per kg of beef and the price per
kg of beef that provides the farmer with what is called entrepreneur’s profit. It
is useful to vary the production output and the prices received for products.
This provides an estimate of the effects of risk factors such as poor DM
production due to say drought or a change in prices received. Risk
management strategies can be put in place. These could include supplies of
supplementary feed, early selling strategies, supply contracts etc.
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Figure 7: Derivation of costs of production per unit of output.
Sheep and beef cattle farm
The farm is 420ha and runs 3000 ewes and 100 breeding cows and their
replacements. The ‘going concern’ value of the farm is $1.848m or $400/
stock unit ($4400/ha). The current returns are:
$660 /ha
gross farm revenue
$396 /ha
operating expenses
$264 /ha
operating profit
This operating profit yields a return on assets of 6%. If the cost of capital is
set at 5% (a rate at which the farm could be leased out), the EVA© for this
business is 1% or $18,480. The fixed costs of the business are $536/ha,
calculated from $316/ha of operating expenses ($80/ha are variable operating
costs) plus $220/ha of funding costs (5% of $4400/ha). The total costs of
production are $616/ha (396 + 220) or $258,720 for the farm.
The total dry matter consumed on the farm is 7233 kg DM/ha of which
86% is consumed by the sheep enterprise (875 kg DM/ewe wintered) and
14% by the cattle (4129 kg DM/cow wintered).
The two key products of the farm are lamb and weaner cattle; to simplify
this exercise, all other products are deemed to be by-products of the lamb or
weaner cattle production system. As producing lamb and weaner cattle are
the prime purpose of the two systems, this is quite a practical approach to
take and their income is therefore deducted from the total cost of products.
The cost of producing each product is the sum of the variable operating
costs for each plus their share of the fixed costs less any income from
by-products e.g.
Lamb
$33,000
$193,603
($58,300)
($31,800)
$136,503
variable operating costs (shearing, an. health etc)
fixed costs (86% of $536/ha)
wool income
ewe income
Total costs of production
The total weight of lamb sold is 45,215 kg equivalent carcass weight so the
cost of producing lamb meat is $3.02/kg carcass weight ($136,503/45,215). If
these lambs were sold store, using a 45% killing out %, their cost is
$1.36/kg live weight.
Weaners
$600
$31,517
($16,700)
$15,417
variable operating costs (an. health, freight etc)
fixed costs (14% of $536/ha)
cow income
Total costs of production
The total weight of weaners sold is 14,220 kg live weight; so the cost of
producing weaner cattle is $1.08/kg live weight ($15,417/14220).
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207
Costs per unit of input
Another useful area to explore in cost of production is the cost per unit of
input. This is done to determine the cost of the most limiting resource and can
be compared with the returns that can be achieved from that resource.
If the example farm above is used, and taking the kg DM produced on the
farm as the most limiting resource, it is possible to calculate the costs per kg DM
quite simply. Once again it is the fixed costs that are relevant to the costs of
production, as the variable costs will differ between the options available to use
that DM e.g. breeding cows versus finishing bulls. The fixed costs per kg DM are
then compared against the gross margins of each alternative use of that DM.
The total DM produced in the example farm was 7233 kg DM/ha and the
fixed costs were $536/ha so the cost is 7.4c/kg DM. The gross margin
calculated for the sheep was 7.7c/kg DM and the breeding cows 10.3c/kg DM.
Both enterprises are covering their fixed costs of production with the breeding
cows, in this example, being a more profitable use of dry matter.
While it might not be practical or sensible to immediately increase the
number of breeding cows on this property, the farmer might want to examine
other ways to increase the returns per kg DM. For example, the farmer might
sell 1000 ewes and their replacements and take on the grazing for 438 young
cattle instead. Over the year these animals would consume the same amount of
feed. If, for example, these were dairy heifers consuming just under 2000 kg
DM with the grazing fee being $5/heifer/week, the returns would be 13c/kg
DM, nearly double that of the ewes.
However, care should be taken to allow for the fact that DM is more valuable at
different times of the year. For example, selling DM as cow grazing to dairy
farmers in the middle of the winter can command an 18-25c/kg DM return, while
grazing those same cows in the summer months might return only 2-5c/kg DM.
Also, as stated by McRae (2000), replacing either the breeding ewes or cows
with other options like grazing heifers or finishing cattle might improve the
returns per kg DM, but it will also change the timing of feed demand. This
could impact badly on the performance of the cows or a high performing sheep
enterprise. It is important to have a clear understanding of how each enterprise
impacts on the others when making changes.
Another approach that helps is to put a relative value on DM month by
month. This technique was developed by Mike Petersen (Hawkes Bay Farmer
of the Year 2001). It should reflect the opportunity cost of the DM through the
year. The relative value (Table 2) is obtained by dividing the average annual
pasture growth rate (23.8 kg/DM/day) by the monthly pasture growth rate
(PGR). This procedure attaches more value to the DM being consumed over
the winter (5.29), as PGR is low. In contrast, the spring surplus in November/
December is when the pasture consumed has a lower value (0.6) in comparison
with the rest of the year.
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Table 2: Calculation of the relative value of DM per month. The relative value equals
annual average daily growth divided by average daily growth in each month.
This difference in value is the equivalent of charging $13/cow/week for
grazing dairy cows in the winter versus charging $1.50/cow/week in the
summer. Therefore, the enterprise, beef or sheep, with greater demand over the
winter period for example will “pay” more for the dry matter consumed so
should be generating higher returns per kg DM.
Conclusions
•
Any assessment of profit or cost of production must clearly distinguish
between operating costs (both variable and fixed) that occur irrespective of
how the business is funded or owned; and funding costs (cost of capital)
reflecting business ownership and financing. Which of these costs are
included depends on the performance measure being calculated.
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209
•
•
•
•
•
•
•
If leased capital is used in a business, the annual rental cost of that lease
must be deducted from operating profit before a return on assets can be
calculated.
Similarly, if there is debt in a business the annual interest cost must be
deducted from operating profit before a return on equity can be
calculated. Without making these deductions RoA and RoE will be
overstated.
The aim is to achieve a return on capital that is greater than both the
cost of lease capital and the cost of debt; this will result in a RoE greater
than the RoC.
EVA© is a useful statistic, as it includes both the farming and the
property business in the assessment of a farm’s profit and ability to add
value. Property business returns are very volatile, so a 3-4 year rolling
average should be used in this calculation.
The opportunity cost of equity should reflect the returns (both in cash
and capital gain) that the owners would expect over time from investing
that money elsewhere.
When calculating cost of production, the focus is on the farming
business only, so it would not be prudent to impose it with the full 15%
cost of capital. Instead, the rental value of the farm is a useful proxy; the
farm can either be leased out, or farmed by the farmer. The cash
commitments the business has to financiers and family, termed the
extracted cost of capital, is also useful as it identifies real costs that must
be met by the returns generated by the farming business.
Always state the assumptions that have been used when calculating
financial performance measures. When comparing these measures with
other performance measures, ensure that they are based on the same
assumptions.
Further reading
AgResearch. 2002. In Pasture quality: Principles and management,
The Q Graze Manual. A reference document to accompany The Meat
New Zealand pasture quality workshops, Published January 2002 Meat
New Zealand, PO Box 121, Wellington, pp 1-26.
McRae. 2000. Beef finishing – Enterprise profitability analyses. Mid-Northern
Beef Council Seminars 25 and 26 July 2000, BC 42. Meat New Zealand,
PO Box 121, Wellington
The Economic Service. 2001. Sheep and beef farm survey 2000/01. Meat and
Wool Innovations, (Economic Service), Meat New Zealand, PO Box
121, Wellington.
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