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Do You Need To Know Your Cost of Production?
"Farmers should definitely know what it costs them to grow their crops!" I'm sure you have sat through a grain marketing meeting or two with the trade expert using that as a main talking point.
"Knowing your cost of production is not necessary!" Less heard of, but depending upon whom you talk to, this is a strong belief. So, which one is it?
Let's start with Roy Smith (SoyRoy), a longtime market analyst contributor to Agriculture.com and recently retired Nebraska farmer. He says that it looks so easy, setting price goals for marketing crops, calculating cost of production, adding a percentage of that cost to profits, place an order to sell for either a cash bid or a futures price.
When that level is hit, the price for your production is set. All you have to do is grow and harvest the crop. Or, if you are marketing last year’s crop, deliver the grain and enjoy your profit.
“Unfortunately, implementing this operation in my early years of farming proved to be a frustrating experience,” says Smith.
“I calculated my estimated cost of production. I set price goals. The market then did one of two things. The price went up. It rallied enough to hit the first target. The sale was made. The market continued to rally until the cash price at the local elevator was much higher than where my price target had been. The year was 1982. I got the price I wanted early in the season. However, I missed the opportunity to cash in on a huge rally in the soybean market,” Smith says.
It could have just as easily done the exact opposite, he says.
“The price could have missed my target by a few pennies, then turned and gone back to a level lower than where it started. In that case, the sale would have been missed completely.”
Point being, setting the price target, using cost of production calculations, risks missing the price entirely. In the worst case scenario the risk is failure to make the sale. In that situation the seller ends up with a price that is comparable to the harvest time price with the storage and interest costs subtracted, Smith says.
Knowing Cost of Production Not Needed
“The way grain is priced makes price goals impossible to use for setting sales targets for at least two reasons. First, if the desired outcome is to price grain that is still growing in the field, the level of production will not be known until harvest. This means that it is impossible to know how many bushels are available to set the price until after harvest is over. In many years, the best pricing opportunities are over by the time harvest begins,” explains Smith.
A second reason estimates are notoriously inaccurate is that machinery and land costs vary considerably, Smith adds. Land and machinery costs depend on the factors used in making the calculations.
“My own situation illustrates this principle. Now that I am retired, the main power source on my farm is a 4440 John Deere. It was purchased in 1982 for $20,000 plus boot. As late as last winter, the resale value on that tractor was approximately $30,000. I do not think that realistically I should count the appreciation in values in the 20 plus years I owned that machine as a profit center in my operation,” SoyRoy says.
Using the appreciated value on machinery or land, to be realistic an individual should set a base price on the item and use that price every year regardless of what the item is really worth, SoyRoy says.
“In the case of land, the farm that is the center of my operation was purchased in 1976 for $700 per acre. That was the going price of land at that time. Today it would probably bring $8,000 per acre, if I wanted to sell out. To calculate a land cost for marketing purposes, good judgment needs to be used to set a realistic floor price you can live with when true values are somewhere outside of a realistic range,” Smith says.
Setting Price Targets
Setting price targets is a tough job. Making them meaningful is difficult, Smith says.
“I prefer to divide my production into segments and sell in increments throughout the year. The number of increments and the times to make sales can be adjusted to fit any farming operation. Some farmers prefer to forward price before the crop is raised. Others, like holding through the winter for a potential spring rally. Regardless of your preference, set your targets at a realistic level and base them on good technical or seasonal factors,” Smith says.
Benefits of Knowing Cost of Production
Michael Rusch, Sales Director- Ag/Commercial Division for Stewart-Peterson, says producers should take into consideration what part of their business needs a running tally of cost of production.
Knowing your cost of production cannot change what marketing decisions you need to make. You still need to make incremental sales and build the best average price for your production over time, Rusch says.
“There are really two answers to whether you need to know your cost of production,” Rusch says. "The first is business advice. As the person tasked with running a business, knowing your cost of operation and operating margin is important to guide long term strategic business decisions you will face. Do I expand, do I invest in a capital improvement, do I pay down debt, where do I address business inefficiencies, etc.”
With regard to grain marketing, producers often fall into a common phenomenon in the markets known as anchoring, Rusch says.
"Anchoring is the concept by which you use data that is immaterial to the decision you are trying to make and let it guide your decision,” Rusch says. There is often an emotional component.
For example, the person trying to sell their house for $20,000 above what the real estate market value is creates an emotional anchor on the value of their home.
“‘Buy one get one free deals are an example of anchoring bias in the other direction. You didn’t pay $40 for one pair of jeans and get a second one for free, you really paid $20 per pair of jeans,” Rusch says.
Knowing vs. Not Knowing
So, knowing cost of production can help producers make business decisions, yet hurt them in their ability to execute on marketing decisions, the grain analyst says.
“Your cost of production is a reflection of decisions you have made on the operational side of your business, and the dirty truth is that the market doesn’t care what that cost of production number is,” Rusch says.
Rusch adds, “There are years where selling when you are above your break even can severely impact your opportunity. 2014 dairy is a great example of this. There are also years where you have to make defensive marketing sales to limit a potential loss or to manage cash flow needs.”
Costs Vary In Spring
Springtime marketing is another good example that can throw producers for a loop, when considering whether cost of production fits into a short-term grain marketing plan, Rusch says.
“Spring is an expensive time for grain producers. Land rents are due, cost of production goes up (e.g., seed and fertilizer expenditures), and producers need cash to pay these types of operational expenses. After three tough years, many farmers needed cash and sales had to be made to create cash flow, and not surprisingly we saw a lot of sales in February and early March. We also saw sales to protect against downward risk,” Rusch says.
Therefore, many producers who had planned to break-even were forced to sell at a point below break-even. Unless they had call protection in place, their remaining 2016 sales will have a higher bogey to make up for the sales under their break-even price, Rusch says. “This means the trigger to sell is higher to make their overall break-even price,” he adds.
In contrast, producers with a long-term marketing plan independent of their break-even are typically in a better position to take on the realities of cash-flow needs and the price in the market, whether good or bad, Rusch says.
“We advised our clients to buy cheap calls in the fall in the event prices rose, and puts in early spring to help protect against any further declines in price. By following a long-term, incremental plan – and being prepared for whatever the market might bring – our clients are less subject to the swings of the market and better positioned for price increases,” Rusch says.