Partial Budgeting As a Management Tool

Farm Business Management Update, August 2002

By Gordon Groover

Drought conditions continue to worsen and rains are spotty in many parts of the state. As the final count of problems begins to come in, farmers need to hone their analysis skills. Making decisions between what makes the best business sense or produces the highest returns will be crucial this year. One of the most important tools that farmers can use of to make short-run decisions is a partial budget. The partial budget is a systematic way to compare the positives and negatives of a decision to arrive at a logical choice. To illustrate the use of a particle budget, the decision to harvest drought corn as grain (base plan) or as silage (alternative plan) will be analyzed.

Basics of partial budgeting - Good and bad effects of a decision are broken into 2 categories each: Good side, 1) added income - list all income for the alternative plan that will not be received in the base plan, and 2) reduced expenses - list all expense items for the base plan that will not occur with the alternate plan. On the bad side, 1) reduced income - include income from the base plan not received in the alterative plan, and 2) added expenses - include expenses from the alternative that are not required for the base plan. If the difference is positive (negative) then the alterative provides greater (lesser) returns than the base plan.

The following assumptions will be used in the example:

• 200 acres of corn
• Estimated yields: grain 25 bushels/acre and silage 3.5 tons/acre
• Grain combining expenses (custom hire or out-of-pocket costs only) $15.00/acre
• Silage harvest costs (custom hire or out-of-pocket costs only) $4.00/ton
• Value of corn is $2.25 per bushel, includes discounts, drying, and hauling charges
• Value of corn silage $18.00/ton
• No additional labor will be hired

Listed below are the basic assumptions used in partial budgeting and are applied to this example:

• Consider only expenses or income that change or another way; ignore all items that are not affected by this decision, for example, all productions costs (fertilize, pesticides...) are sunk cost and even though you have $180/ac invested in the corn crop you can never recover that $180 now. The best decision is to compare the out-of-pocket harvest costs to the current value or worth of the corn crop.
• Do not include routinely include the cost of capital items, for example, tractors, combines, buildings, or breeding livestock. These are fixed costs and whether you harvest the corn crop as grain or silage the farm will still have to pay taxes, insurance, and depreciation on all capital items. In this example, the farmer can ignore the ownership costs of the harvest equipment and consider only the cost of fuel and repairs.

Entering the data and doing the math reveals that the decision to harvest the corn as silage will lead to a net gain of $800 for the 200 acres of corn or about $4.25 per acre (see Table 1). If these assumptions were reflective of your farm, the best alterative would be to harvest the corn as silage to be feed during the winter. The analysis is based on some general assumptions that need to be understood before taking the "net change" as a realistic value.

Using partial budgets to consider alternatives becomes a very powerful tool when it is connected with sensitivity analysis. Sensitivity analysis estimates how sensitive the results are to a change in one of the assumptions. In the grain vs. silage example, if the farmer was uncertain that silage was worth $18.00 per ton but thought its value could drop as low as $15.00 per ton, the farmer would be better off ($1,250) by harvesting the 200 acres for grain instead of silage. This simple example demonstrates the how partial budgets can be used to consider many alternatives and evaluate the sensitivity of each decision to a change in prices, values, or assumptions. Finally, use of a spreadsheet (Excel, Lotus, or Quattro) provides an easy way to add up the results and run sensitivity analysis.

Table 1. Change Being Considered: Harvest Drought Corn as Silage Instead of Grain

"The Good Side"			"The Bad Side"
Additional Income:			Reduced Income:
	Value of drought stressed corn silage is a area of short supply $18/ton * 200 ac * 3.5 tons/ac	$12,600		Corn Grain sales - less drying, hauling, and discounts 200 ac * 25 bu/ac * $2.25/bu	$ 11,250
				Value of corn fodder	$?
A.	Total Added Revenues	$12,600	C.	Total Reduced Revenues	$ 11,250
Reduced Costs:			Additional Costs:
	Grain Harvest costs 200 ac * $15/ac	$ 3,000		Silage harvest costs 200*$5/ton yield 3.5 tons/ ac	$ 3,500
B.	Total Reduced Expenses	$ 3,000	D.	Total Added Expenses	$ 3,500
1.	Subtotal (A+B)	$15,600	2.	Subtotal (C+D)	$ 14,750
Net Change (Line1-Line 2) $850
Per acre $4.25

Contact the author at xgrover@vt.edu.

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