Financial Analysis of an Agricultural Business - the Enterprise Budget
Farm Business Management Update, April - May2007
By Alex White (email@example.com), Instructor, Agricultural Finance and Small Business, Department of Agricultural and Applied Economics, Virginia Tech
My previous articles have discussed the basics of the three main financial statements that a lender or management consultant would typically require of a business owner; these statements are the balance sheet, the income statement, and the cash flow statement. While these statements can be powerful tools for an owner (especially the cash flow statement), there is another statement that helps an owner take a critical look at the profitability of each specific aspect of the business. This statement is called the enterprise budget.
An enterprise budget lists the revenues and expenses related to one specific aspect of a business. For example, a greenhouse operation would have an enterprise budget for each type of plant produced (mums, poinsettias, etc.). A dairy operation would have an enterprise budget for the milking herd, one for the replacement heifers, one for the pasture enterprise, and one for each crop that is produced. Basically, an enterprise budget is a mini-income statement for each enterprise in your business. It allows you to determine which aspects of your business are profitable and which aspects are not as profitable. In contrast, an income statement considers the profitability of your entire business (all enterprises combined).
Sections of an Enterprise Budget
There are 4 main sections to an enterprise budget – Revenues, Operating Expenses, Ownership Expenses, and the Summary. A sample enterprise budget is attached at the end of this article. Enterprise budgets are usually constructed on a per-unit basis; that is, a per-acre basis for most field crops, a per-head basis for most livestock enterprises, etc.
The Revenues section lists all of the revenues associated with that enterprise. For example, a sheep budget would list the sale of feeder lambs, culls, and wool as revenues. It is typical to list each source of revenue, the amount sold per unit, and the market price per unit. The bottom of this section shows Total Revenues for the enterprise.
The Operating Expense section, also called the Variable Cost section, lists the cost of all of the operating inputs necessary to produce that enterprise. Operating inputs are those inputs that vary directly with the level of production. Operating inputs are inputs that are typically used up completely during the production cycle. Examples would be seed, feed, fertilizer, hired labor, and repairs. The manager has complete control over how much of these inputs he/she will use. One note on your operating expenses – list the cost per unit at the net market cost, regardless of whether you are buying your inputs or growing them. For example, if you are growing your own hay to feed to your dairy herd, you should list the homegrown hay at the net market value, NOT what it cost you to produce. One operating expense that is commonly overlooked is “interest on operating capital”. This reflects the cost of the capital that you have invested in the operating inputs over the production cycle. I am conservative in calculating this expense – I use the subtotal of all of my other operating expenses times the average interest rate on operating loans or lines of credit. For enterprises with an annual production cycle I use the interest cost for the entire year. For enterprises with a shorter production cycle I adjust the interest expense by multiplying by the number of months the funds are tied up in the enterprise divided by 12 months. For example, assume my corn enterprise has funds invested for about 9 months out of the year. If my annual interest on operating capital is $10/acre, I would adjust this by multiplying the $10 by 9/12. Therefore, I would include interest on operating capital of $7.50/acre on my corn enterprise budget.
The bottom of the Operating Expense section includes Total Operating Expenses and Return Above Operating Expenses. Total Operating Expenses is just the sum of all the operating expenses (including interest on operating capital) for the enterprise. Return Above Operating Expenses is Total Revenues minus Total Operating Expenses. In a nutshell, you always want Return Above Operating Expenses to be greater than zero. If this figure is less than zero, you should not produce this enterprise this year – it will cost you more to produce than you will receive in revenues.
The Ownership Expenses section, also called the Fixed Cost section, lists all of the costs associated with capital assets needed to produce the enterprise. Capital assets include your machinery and equipment, breeding livestock, and your real estate and buildings. All of these capital assets are not used up completely in one production cycle. For example, the capital assets of a greenhouse enterprise budget might include the greenhouse itself, the heating system, thewatering system, as well as the land on which the greenhouse is situated. To estimate the ownership costs of these capital assets, I typically use 15-20% of the purchase price of the asset. This will approximate the depreciation, interest forgone, property taxes, and insurance premiums associated with the capital assets. If the asset is used for more than one enterprise (as a tractor or delivery truck, or a greenhouse) you should estimate the percentage of annual use devoted to each enterprise – then, adjust your estimated ownership costs by multiplying the annual cost by the percentage of time devoted to that enterprise. Some people (me included) also include an opportunity cost of the owner labor and management as a fixed cost. To estimate the cost of owner labor, I estimate the number of hours of labor the owner works on that enterprise and multiply by a relevant hourly wage. I also estimate the value of the owner’s management ability by multiplying Total Revenues by 5%. As with the Operating Expense section, the bottom of the Ownership Expense Section shows the Total Operating Expenses.
The Summary section of the enterprise budget commonly lists Total Expenses, Return Above Total Expenses, and some form of breakeven analysis. Total Expenses are simply Total Operating Expenses plus Total Ownership Expenses. Return Above Total Costs is Total Revenues minus Total Expenses. This figure must be greater than zero if you want to continue production of this enterprise for the long run (the next 5-10 years). Otherwise, you will not be covering the total costs of production and you will be losing money in the long run.
For most enterprises, I like to include a simple form of breakeven analysis. I typically calculate the Minimum Price Necessary to Cover Operating Expenses and Minimum Price Necessary to Cover Total Expenses. These are very simple to calculate – simply divide the Total Operating Expenses (or Total Costs) by the expected quantity of production. For example, assume I can expect to get 100 bushels/acre from my corn enterprise and the Total Operating Expenses are $250/acre. To calculate my short-run breakeven price (covering Total Operating Expenses), I divide my operating expenses of $250/acre by my yield of 100 bushels/acre. In this example, I need to get at least $2.50/bu for my corn so that I can cover my operating expenses. This is a powerful tool for your marketing program.
Uses of an Enterprise Budget
Enterprise budgets are great tools for critically analyzing each specific aspect of your operation. The main uses of an enterprise budget are:
• clearly identifying all of the inputs needed to produce that enterprise
• easily identifying your top 5 expenses for cost control management
• which helps to determine potential changes in the operation
• estimating the minimum operating loan that you should request from your lender
• determining how much revenue you can generate from the enterprise
• breakeven analysis for your price and yield
For example, examine the sample enterprise budget at the end of this article. This budget shows the revenues and costs associated with 1 acre of Halloween Pumpkins. You’ll notice the total revenues are based off an expected yield of 2,000 pumpkins per acre and an average price of $2.00 per pumpkin. We are expecting total revenues of $4,000 per acre.
The Variable Costs section shows all of the operating inputs needed to produce pumpkins, as well as the amounts and costs of each. Total Variable Costs (or Operating Expenses) are $2,083 per acre. To help you control your production costs, identify the top 5 expenses. In this case, you should focus your cost control efforts on Marketing, Supplies, Irrigation, Fungicides, and Fertilizer.
The Fixed Costs (or Ownership Expenses) list the expenses for Owner Labor, Management, Machinery, Buildings, and Land. For this enterprise, you will have $2,365 of costs whether you produce 2,000 pumpkins per acre or 20 pumpkins per acre. Fixed costs are critical factors for long-run profitability!
The Summary section shows the Return Above Variable Costs to be $1,917/acre. This means that you are generating just over $1,900 more in revenue than in your operating expenses. This means that it is a wise idea to produce pumpkins this year. However, the Return Above Total Costs shows a loss of $448/acre. This indicates that you should not produce pumpkins for the next 5-10 years unless you make significant changes to your cost structure or pricing policy. In the long run, you need to be able to cover your fixed costs as well as your operating costs. If you can’t, then you won’t be able to replace your equipment as it depreciates, or maintain the productive condition of your facilities.
Finally, the Summary section shows you some basic breakeven analysis. The Breakeven Yield shows that if your costs remain constant, you need to get a yield of at least 1,042 pumpkins per acre to cover your variable costs. Further, if you do get a yield of 2,000 pumpkins per acre, you must sell your pumpkins for at least $1.04/pumpkin to cover your variable costs. Is this great stuff or what?!
Enterprise budgets are powerful tools in managing each particular aspect of your business. They help you identify all of the inputs (amounts and costs) needed to produce that crop, as well as the revenues you can expect to receive. It allows you to identify potential methods of controlling your costs. It helps you determine how much of an operating loan you might need for an individual enterprise. And it helps you determine the profitability and the breakevens for your enterprise. It’s a powerful tool for managers!
If you would like to receive an Excel spreadsheet with a basic enterprise budget, please contact Alex White at firstname.lastname@example.org, or call Jill at 540-231-7727 and leave your contact information. You can also go to my new (and still under construction) website at http://faculty.agecon.vt.edu/alexwhite/ to download an enterprise budget spreadsheet. Also, Virginia Cooperative Extension provides sample enterprise budgets for the main crop and livestock enterprises for the state of Virginia. These can be found by going to http://www.ext.vt.edu/resources/ and clicking on the “Farm Business Management & Marketing” link.
|Insecticides:||Thiodan 50 WP||Lbs.||1.5||$8.50/Lb.||$12.75|
|Crop Supplies - Bins||Each||60||$9.50/Bin||$570.00|
|Marketing:||Hauling & Grading||Loads||6||
|Total Variable Costs||$2,083.33|
Out-Of-Picket Cost Per Pumkin
|Machinery Fixed Costs||$/acre||$385.00||$1.00/Acre||$385.00|
|Building Fixed Costs||$/acre||$0.00||0.00%/Acre||$0.00|
|Total Fixed Costs||$2,365.00|
Total Cost Per Pumpkin
|Return Above Variable Costs||$1,916.67|
|Return Above Total Costs||($448.33)|
|To Cover:||Breakeven Yield||Breakeven Price|
|Variable Costs||1,042 pmpkn/A||$1.04/pumpkin|
|Total Costs||2,224 pmpkn/A||$2.22/pumpkin|
Visit Virginia Cooperative Extension