FACT SHEET: Part 2—Cost concepts

The first and most important step toward effective pricing

By Michelle Frain, Marketing Coordinator for the Rodale Institute and Christine Ziegler, Editor

Posted June 27, 2005

Photo courtesy of T. Gettings, Wildlands Conservancy (PA)

In order to develop a successful pricing strategy, and to keep your operation afloat, you need to calculate your production costs. Most farmers KNOW this, but many will tell you that cost calculations are easy to recommend, but hard to do.

Actually, cost calculations are easier than you might think; they’re just hard to start. Once you define the individual components of your production costs and plug those numbers into a simple record-keeping system, you’ll find that cost calculations get a lot easier. What’s more, these calculations will give you confidence about the current state of your operation and help you find ways to make it more solid, efficient, and profitable.

Basic cost calculations will provide the foundation you need to:

• set sound prices,
• make real money (instead of just breaking even),
• grow your operation, and
• live the life you want.

When you face the challenge of calculating costs, you create an opportunity to increase your income and take control of your operation.

Let’s begin by defining four basic (and often misunderstood) terms that affect cash flow in every business:

• Cost: Money you pay, directly or indirectly, to produce a product or service. Costs include labor (your own labor and any hired help), rent, taxes, utilities, production inputs, equipment depreciation, etc.
• Price: Money you receive from a customer for a product or service. Your price should include all your costs, plus some extra money to keep (profit, or “return to management”).
• Revenue: Money you receive from all sales of your products and/or services (also known as gross income). Government payments also qualify as revenue. Revenue should cover all your business costs and give you some extra money to keep (profit, or “return to management
• Profit: Money you get to keep from all sales of your product or services, after all your costs are paid (also known as net income or “return to management”). Profits allow you to buy your daily necessities, invest back into the business, save for retirement, and take that family vacation you have been planning.

Figure 1: Cycle of money-flow through a business

These definitions may seem unnecessary because we all use these terms every day. But do we use them correctly? Many farmers get into trouble by thinking of revenues and profits as the same thing. In reality, profits are only a part of revenues, the part that’s left after production costs are subtracted. If you confuse the two, you may regularly have to choose between covering your costs or paying yourself (an unpleasant choice).

1. KNOW YOUR COSTS. 2. SET YOUR PRICE.
3. MAKE A PROFIT.

Your profit is determined by three factors: 1) yield, 2) production costs, and 3) market price (which add up to become your gross revenue). The following graph shows how yield, costs, and revenue work together to generate a profit or loss, depending on where your numbers land:

Figure 2: Yield, cost, and revenue values that generate a profit or loss (also called a “break even analysis”). Click to enlarge.

You probably already know that you can calculate your profit or loss on any given product by subtracting your product costs from your price. (Profit [or Loss] = Price – Cost) But look at this equation again. The take-home point (one that most farmers miss) is that your costs and your prices have equal power to influence your revenue and profits, either negatively or positively.

To prove this point, look at figure 2 again. Notice that the “break even point” is NOT a fixed point. It can move left and right or up and down, depending on adjustments you make to your prices (revenue) and/or costs, as illustrated below:

Figure 3: The influence of cost and price adjustments on profit and loss. Click to enlarge.

In Figure 3-A, prices remain the same, but costs increase, which work together to reduce profit. Similarly, in Figure 3-B, costs remain the same, but prices are too low, which also reduces profits. On the other hand, in Figure 3-C, costs remain the same, but price premiums increase revenue, which combine to increase profits. You can achieve similar profit increases by keeping your prices the same, but finding ways to lower your costs.

This is simple stuff, and most farmers already know these basic facts. However, few make the effort to use this knowledge to their advantage. A lot of farmers think they don’t have the time to take a close look at their costs, and many also believe that they can’t control the prices they get for their products. These mind-sets are a major obstacle to the development of a good cost calculation system. Too many farmers throw in the towel before they begin, thinking, “If I can’t control my price, then what good does it do me to know my costs?”

The truth is that, while there are some yield, cost, and price factors that you can’t control, there are also many factors that you CAN control - perhaps more than you realize – and cost calculations are the key to that control. Once you make the effort to identify and calculate your costs, you will find ways to control them, set better prices, and adjust your yields accordingly. Cost information can help you:

• Increase Your Market Power—You can negotiate and set prices from a position of knowledge and control. When customers ask about your prices, you can clearly describe the value of your product (its production factors, costs, and intrinsic qualities) in ways that will encourage the customer (even the wholesale buyer) to pay the price you want.
• Build Confidence—You will know exactly how much money you are making or losing on a product and can adjust your prices and sales plans accordingly. The confidence that cost information gives you will improve every aspect of your business.
• Reduce The Hassle of Taxes and Financing—Good cost-tracking records allow you to process taxes and apply for loans, grants, and other funding more easily. Your chance of being approved for loans and grants is greatly improved when you can accurately report current and historic production and cost figures.
• Increase Your Business Security!—Cost tracking helps you plan a more secure future for your farm by providing solid facts and numbers to guide your business development.

WHAT ARE MY COSTS?

Even if only you and your family work on the farm, it's important to calculate your labor costs.

Standard business costs include:

• inputs (seed, amendments, animals, feed, ingredients, etc.),
• equipment and depreciation,
• labor (your own labor and hired help, along with costs for any benefits you may provide),
• packaging,
• fuel and transportation,
• utilities,
• rent and mortgages,
• interest on mortgages and loans,
• repairs, and
• taxes.

Many farmers are stumped by the prospect of identifying and totaling all the items on this list, but remember: Knowledge is power! Even if you calculate only a few of your most basic costs, that information can vastly improve your pricing plan and your profits. Start simple. Identify the costs that are easiest to tabulate (like inputs and transportation), and leave more complex costs (like labor, depreciation, and interest) for later, when you have time to devote to them.

To get you started, the following definitions and the worksheets in Parts 3 and 4 will help you identify some of your own operational costs and compile them into a form that allows you to begin to make easy calculations.

Some essential cost definitions include:

• Operating (or Input) Costs: All money spent on supplies and materials needed to produce your product or service, such as seeds, fuel, inputs and amendments, livestock and feed, purchased ingredients to create value-added products, packaging materials, and similar items. To calculate input costs for a service, you must add up the number and cost of supplies and materials that will be used as part of the service.
  
• Labor Costs: All money spent to pay yourself and your employees (if any), and to provide benefits. Even if only you and your family work on the farm, it’s important that you to calculate your labor costs! To do so, multiply the number of hours required to complete a work task by the hourly wage you pay (or would like to pay) yourself, your family members, or employee(s).
  
  Calculating task-hours may sound “nit-picky” and time consuming, but chances are that you already have good estimates of task-hours in your head! Start with those estimates, and then, if you want to be more exact, keep an occasional start/stop time log for your different tasks. After just a couple entries, you’ll have a very clear record of task-hours, and you may even begin to see a few places where you can improve your efficiency. Later, for more precise labor cost calculation, you can also include the cost of any benefits you provide to yourself, your family, or your employee(s) in the hourly wage figure.
  
• Overhead (or Capital) Costs: All money spent on work-related costs other than materials and labor. Overhead costs can be broken into two categories:

  Indirect Overhead Costs: costs that are not tied to the production of a specific product or service, such as utilities, mortgages and interest, rent, insurance premiums, taxes, depreciation, office supplies, any employee benefits, certification costs, dues and subscriptions, advertising, accounting and attorney fees, and similar expenses.
  
  Direct Overhead Costs: project-specific costs, such as equipment costs, travel costs, and similar expenses.

These are the three primary cost category headings you will find on most crop/livestock enterprise budgets (see the budget worksheet in Part 4). All of the above costs are also defined as either fixed or variable:

• Fixed Costs: Expenses that stay the same each month/year, regardless of the amount you produce or sell. Fixed costs include mortgages, taxes, insurance, loans, and advertising, to name a few. For example, your tractor payments remain the same whether you sell 200 or 20,000 bushels of beans.
  
• Variable Costs: Expenses that change according to the amount you produce or sell. For example, your variable cost for fuel and seed will increase when you increase your bean acreage from 2 to 200.

Operating and labor costs are both variable, but overhead costs can be either fixed (mortgages, equipment loans) or variable (advertising, equipment maintenance).

So, now that we’ve defined these important cost concepts, how can you apply them to set a good product price (including a profit) right now? Part 3 of this fact sheet series offers guidance to help you identify your specific costs, and Part 4 provides a budget worksheet that gives you a place to plug-in those numbers and put them to use right away.