Economic Issues Associated with Raising Dairy Replacements

Dairy July 09, 2012 Print Friendly and PDF

Introduction

Cost of production is a key indicator of competitiveness. This is especially true in the dairy farm industry, where a manager must use input efficiency and resulting cost control to generate profit. There is no single method to calculate cost of production. Farm management consultants, university extension personnel, industry analysts, government economists, and farm managers all may have a unique, preferred method to calculate cost of production. The variation across farms with regard to enterprise mix, production technology, labor use, size, record systems, goals, and managerial ability contribute to the variation in cost of production methods. Tight margins and price uncertainty are among the reasons that cost of production is crucial in determining competitiveness and viability of farms.

Cost of production values are used for most major management decisions on the modern dairy farm. Perhaps the most widely used method to calculate cost of production involves using the farm income tax statement (Schedule F). Another method is enterprise accounting, which breaks out the milking herd and replacement heifer enterprises but allocates costs across all relevant enterprises on the farm. Comparing these methods reveals strengths and weaknesses.

In this paper we use detailed data from Michigan dairy farms to examine the cost of heifer raising. Examining the values generated by comprehensive enterprise accounting methods reveals several potential sources of errors, such as accrual adjustments, tax depreciation rather than economic depreciation, allocation errors, and unpaid factors including labor, management, and capital. Adjustments to modify the income tax method are considered to arrive at values acceptable for management decisions.

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Cost of Heifer Raising

The Schedule F income tax form contains farm cash expenses and income for a calendar year. Because everyone has this information, it is a simple place to begin a cost of production calculation. However, one must use caution when using tax information to make management decisions.

There are two major problems with the Schedule F method to calculate cost of production for an enterprise such as heifers. First, cash accounting is grossly inaccurate in capturing true costs because it records cost only when the money changes hands. This aspect is appropriately exploited by farmers to manage tax bills by shifting income and expenses across tax years. In addition, many costs are noncash (or even unpaid).

The second issue is that this method makes it very difficult to allocate revenue and expenses to the appropriate enterprise. In most instances, the enterprise examined becomes the residual claimant of revenue and expenses. The result is that many adjustments must be made to arrive at a cost of production that is useful for management decisions.

There are a couple of basic fixes to the Schedule F method that can greatly improve its accuracy, depending on the characteristics of the operation in question. For example, accrual adjustments for inventory changes should be made to correct some of the cash basis flaws. Also, the value of unpaid labor and management can be estimated and included. Many operations have a computerized accounting system, and with some extra effort, this system can be tailored to deliver a much more usable cost of production.

At Michigan State University we undertook a detailed enterprise accounting system of a set of dairy operations. By doing so, the intention was to provide an accurate picture of the relative strengths and weaknesses of enterprises on Michigan dairy farms and, also, to assess the appropriateness of simpler procedures to estimate cost of production.

Enterprise accounting involves setting up profit, cost, and service centers on the farm as well as allocation, or holding, accounts. Profit centers are enterprises that have both explicit revenue generation and costs. The milking herd, replacement heifers, and crops such as corn and hay are common profit centers for Michigan dairy farms. Cost and service centers are enterprises that exist to contribute to the profit centers. Often, the revenues or income for the cost centers is not explicitly paid; rather, they are a transfer within the same farm. Machinery, equipment, and buildings are examples of cost centers on dairy farms.

Allocation, or holding, accounts were set up to keep track of costs and revenues that apply across multiple profit or cost centers. If the cost or revenue could be readily assigned to a cost or profit center, then that may be done during the standard accounting. However, there are many costs and revenues that apply across profit and cost centers and whose exact allocation is not known until later. An example of an allocation account is feed that is purchased for use by both the milking herd and replacement heifer enterprises. In the case of feed, the costs are allocated using the ration records. Other costs that require allocation include management, utilities, and fuel.

Data Recording and Collecting

The records needed to participate in this project were, for the most part, similar to what the farm cooperators were keeping with a few notable additions. Required information included:

  1. Financial Transactions: The participants of the project utilized a computerized accounting program such as Microtel from MSU, Quicken, or QuickBooks. Entering financial transactions into the accounting system included assigning each transaction an enterprise code. This allowed tracking expenditures and income by profit centers or service centers.
  2. Beginning and Ending Inventories: Balance sheets and the depreciation record had the market values used in valuing equipment, facilities, livestock, crops in storage, and other similar inventory items.
  3. Supplemental Physical Data Record: This record was new. Its main purpose was to show how the inputs supplied by the service centers of the business are employed in the profit centers. For example, the cooperators recorded hours of labor as it was used by the corn or heifer enterprises. Information was recorded for the utilization of major machinery items in a similar way. This information was subsequently used to allocate the costs related to these service centers to the profit centers.
  4. Feed Utilization Sheet: This record tracked the rations and the length of time they were fed to the various livestock groups. Often, the only extra effort involved was making a copy of rations being fed, noting the number of animals being fed the ration and the time period the rations were fed. From this information we allocated costs of both purchased and grown feeds to the livestock profit centers.
  5. Crop Production Record: Most producers kept a log of crops harvested. This information was transferred to a summary sheet.
  6. Monthly Animal Inventories: If the participant was on Dairy Herd Improvement Association (DHIA), this information was already recorded. If not, a barn sheet was supplied to record animal numbers by group (e.g., cow in milk, dry cows, heifers less than a year in age) on a monthly basis.

These records were checked for accuracy and later verified in summary form by the farm cooperators. Additional information such as the relevant market places for replacements, land rental, and opportunity cost of unpaid management and family labor was collected as needed.

Data Analysis

Costs were allocated from the holding accounts, such as feed to the appropriate enterprise. The crops that were harvested by a given farm were sold from that crop enterprise into a storage and marketing account. The milking herd and replacement heifer enterprises then purchased the feed from the storage and marketing account throughout the year at the going market rate. In this way, the storage and marketing account would gain any increase in market price since harvest, but would also be responsible for any loss and the cost of maintaining the storage facilities.

Labor and management-supplied labor were allocated across enterprises based on the supplemental physical data forms. The value of labor was the going market rate for that quality of labor. A management fee was charged to each of the profit centers at 4 percent of the value added by the profit center.

Owner capital was valued based on industry risk premium values estimated using MSU dairy farm industry data (Wolf, Hanson, Wittenberg, and Harsh). The individual farm charge for capital was estimated using the leverage position for the farm. The lowest cost of capital charge was 8.16 percent, while the highest cost of capital charge was 10.37 percent. An appropriate average value was 9 percent.

The total cost, which might also be referred to as the total economic cost of production for the enterprise in question, includes all factors of production, such as unpaid labor, management, and a competitive return to capital. This value did not represent a cash flow notion of costs that many producers are aware of; rather, it represented a complete accounting of all costs without any “free” use of unpaid resources, such as operator labor and capital.

Enterprise Accounting Results

To protect farm anonymity, all values are presented only in summary form, including average, minimum, and maximum. For each table, the minimum and maximum represent the extreme value for that production, revenue, or cost component across the farms. Note that neither the high nor low total costs are the sum of the individual costs by category.

The replacement heifer enterprise was present in some form on all farms. The milk cow enterprise sold each heifer calf to the heifer enterprise as a newborn. The heifer enterprise raised the heifers and sold late pregnant (springing) heifers back into the milking herd. Each transaction was at current market price and validated by the producers.

Because the heifers were of all different ages and the farms were followed for a single year, an inventory adjustment was made, and all expenses are expressed as average cost per heifer month. That is, the costs and revenues were adjusted for the fact that older heifers were worth more than younger heifers at the end of the year. To put the comparisons on equal footing, we chose 24 months as the age to first calving to standardize the values.

The range of heifer prices was $1,200 to $1,850 at first calving. This price reflected what the farm operators determined heifers were worth as they entered the milking herd. The standardized, 24-month-old, average heifer was valued at $1,300 (the last couple of years have witnessed heifer prices substantially higher than this).

The costs of production are divided into variable and fixed costs. The largest costs of raising heifers are the same as for the milking herd — feed and labor (Table 1). The feed costs averaged $25.81 per heifer month (remember, these are across all ages of heifers), while labor averaged $11.06 per heifer month. Calf purchases includes purchasing the heifer calves from that farm’s milk cow herd, while outside heifer purchases are heifers purchased from other operations. The “other” category includes various expenses such as repairs and utilities. The remaining expense categories are straightforward with total average variable cost equal to $54.37 per heifer month.

Fixed costs include depreciation on facilities, equipment, interest, insurance, taxes, and a charge for management. The fixed expenses averaged $13.289/heifer month for a total average cost of $67.65 per heifer month. Assuming a 24-month age to first calving, the average total cost to raise a heifer (with all factors, including unpaid expenses, included) for these farms was about $1,620. Note that this age assumption is perhaps a bold one because the age varied both within and across farms but was necessary for comparison across farms.

The minimum and maximum columns in Table 1 are across farms for that cost category. That is, the lowest average total cost to raise a heifer was $61.15 per heifer month, while the maximum cost was $67.65 per heifer month (these totals are not equal to the sum of each cost category, which are themselves minimums or maximums). Those farms that had lower costs in some categories (e.g., labor) often were higher in other cost categories (e.g., equipment).

Even with the range in farm size and location, the farms examined were remarkably consistent in almost every cost category. The net average loss per heifer across these farms was $21.23 per heifer month, or about $480 per heifer. This reflects the difference between what the producers thought the heifer was worth as a springing heifer and what it cost to raise the heifer to 24 months. This value applies only to these farms and is not necessarily representative. It is possible that the producers did not assign a large enough value to the springing heifers. The numbers do, however, reflect all the costs involved for all factors of production, and the key point is the methodology.

Implications for Cost of Production Estimates

Cost of production is a key performance indicator in the dairy industry. Heifer raising enterprises can use a cost of production estimate to make decisions. The most accurate cost of production method is accrual enterprise accounting, which allocates all costs. It is probably impractical to expect all producers to track all the required information. However, there are several key actions that can make cost of raising heifer estimates more accurate.

First, be certain to use accrual accounting because cash methods ignore inventory changes, which are very important in agriculture (consider how many expenses you prepay in December of a good income year).

Second, unpaid labor, management, and capital should be included in the cost estimate. Labor and management should be valued at their opportunity cost. That is, if you were to hire labor, what would it cost (including any relevant benefits)? Similarly, what would replacing the unpaid management functions cost? The capital investment should also earn a return — it could be in stocks or bonds, for example. We found that 9 percent was a good estimate for the risk level on Michigan dairy farms.

Finally, allocating overhead, feed, fuel, and other expenses that are spread across multiple enterprises is very important if the farm has more than one major enterprise. We had farm managers track labor and machinery uses in notepads. We found that if they kept careful track for a week or so during each season, the allocation was fairly stable. This means that you need not track your efforts for months at a time. But take the time to track a week and use that as a basic rule of thumb to allocate unpaid labor and management. The same implication applies to allocating machinery and equipment that is used for multiple enterprises.

Author Information

Christopher Wolf
Michigan State University

References

Harsh, S., C. Wolf, and E. Wittenberg. “Profitability and Production Efficiency of Livestock and Crop Enterprises on Michigan Dairy Operations.” MSU Ag. Econ. Staff Paper 01-04. January 2001.

Wolf, C., S. Hanson, Wittenberg, E., and S. Harsh. “Discount Rates for Dairy Farms.” MSU Ag. Econ. Staff Paper 02-08. May 2002.

Table 1. Replacement heifer enterprise costs.
  Average Minimum Maximum  
  ($ per heifer per month)  
Income       % Total Rev.

Heifer Sales

45.69 34.72 53.94 98.42

Manure

0.73 0.26 0.91 1.58
TOTAL INCOME 46.42 35.30 54.20 100.00
Variable Costs       % of Total Cost

Labor

11.06 6.41 15.97 16.35

Feed

25.81 21.47 32.37 38.15

Calf Cost

7.34 3.55 10.80 10.84

Supplies & Bedding

2.02 1.03 2.72 2.99

Misc. Dairy

0.22 0.00 0.74 0.32

Breeding

0.86 0.43 2.21 1.27

Vet and Med

1.15 0.54 1.98 1.70

Equipment

2.30 1.27 3.33 3.40

Building & Improvements

1.72 0.18 4.08 2.54

Utilities

1.74 0.84 3.18 2.57

Other

0.15 0.00 0.33 0.22

TOTAL VARIABLE COST

54.37 44.57 60.11 80.37

Net Over Variable Costs

-7.94 -24.81 9.59 -11.75
Fixed Costs        

Equipment

2.34 0.76 4.40 3.46

Interest & Insurance

4.96 3.38 5.86 7.33

Building & Improvements

3.50 0.30 8.18 5.17

Management Fee

0.94 0.70 1.15 1.39

General Overhead

1.55 0.64 2.55 2.30

TOTAL FIXED COST

13.28 8.08 17.40 19.63

TOTAL COST

67.65 61.15 77.18 100.00

NET RETURN

-21.23 -41.89 -7.81  

 

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This work is supported by the USDA National Institute of Food and Agriculture, New Technologies for Ag Extension project.