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How To Use Partial Budgets

As you work on final revisions to yield and input cost projections and tweak cropping plans, I hope you also have your total farm operating budget prepared for the year and your operating credit needs identified and secured. These are typically annual and sometimes tedious tasks, but as a farm manager your financial decision making goes on all year. This article is about a simple management process called partial budgeting that can help you organize and analyze many of these smaller, but crucial, decisions on your farm.

A partial budget is a tool for the financial analysis of a change being contemplated (or already made) in your farm business. There are many types of changes on the farm that can be analyzed using this approach. Some examples include:

Trading up or buying new equipment.

Renting or buying additional land.

Purchasing cows or retaining heifers.

Replacing custom work with purchased equipment.

A partial budget only considers the impact on net farm income of revenue and expenses that will be changed. That makes it a great tool to use throughout the year, as it does not require the entire farm budget to be re-worked. It is a quick and relatively easy analysis to complete with a simple spreadsheet or paper and calculator.

I think a lot of farmers use the thought process of partial budgeting when they are thinking about these decisions, but the real power is in committing your thoughts to paper (or screen) to ensure all aspects are considered, organized and documented for future reference.

There are four main points to calculate when preparing a partial budget. These are:

1.Additional income.

2.Decrease or elimination of expenses.

3.Increase in expenses.

4.Reduction in income.

The first step is to write a clear statement of the change you are considering and wishing to analyze. Let’s look at an example. A farmer is considering buying a new larger seeder to replace the current unit because he wants additional capacity to shorten his seeding time and hopes to improve crop emergence with better seed placement. He will also be able to custom seed his brother’s farm with the new unit. In this example, we will assume that his current tractor can handle the slightly larger seeder. Note that the statement includes both the change itself and the reason we think the change may make sense. Next, we need to calculate the likely positive and negative financial impacts of this change.

1. ADDITIONAL INCOME

The additional revenue from custom work is pretty easy to calculate as it is just acres to be custom seeded times the price to be charged per acre. The potential increase in income from more timely seeding and better seed placement is much more difficult to calculate. Our farmer may want to leave this potential impact out initially and come back to it after completing the other sections and calculating the net impact of this change.

If the initial net impact is negative, a calculation of how many extra bushels of production per acre would be required to get to a breakeven would be an insightful reasonability check.

2. DECREASE OR ELIMINATION OF EXPENSES

Anytime an equipment change is analyzed using a partial budget, the factors considered should include a likely reduction in repair expense and the impact, if any, on fuel consumption. As the new unit is wider, the hours on the tractor would be reduced but the fuel consumption per hour may increase. There may also be some reduction in inputs depending on how the new seeder is equipped. It will take some research to come up with some reasonable numbers to use in the calculations but it’s worth the effort if we want to do a thorough analysis.

3. INCREASE IN EXPENSES

We would expect the biggest expense increase will be the interest costs on the loan for the new seeder or the lease costs if it is financed using a lease. As we are trying to determine the impact on net income, the principal payments will not be included but a depreciation expense could be included.

Also, depending on the cash position of the farm, the principal payments could impact cash flow and operating loan interest. If this farmer is in a strong cash position, he still needs to include an opportunity cost for his cash. With current interest rates on deposits that would not be a big factor but still important to include. Insurance will also increase.

4. DECREASE IN INCOME

In this example there would not be a decrease in income. If you were analyzing a change such as substituting one crop for another or retaining heifers the decrease in income would be sales you had planned in your whole farm budget to make but now will not make because of the change being considered.

Purchase decisions such as this can also be difficult because of the emotions that can be involved — the difficulty of separating “need” and “want.” The objective is to help you gain a better understanding of the net impact of the decision on your entire business not just focus on the “deal.”

EarlSmithisvicepresidentandco-founder ofgroPartnersInc,awesternCanadian farmandlandmanagementcompany.A recoveringbanker,Earl’sconsultingworkis focusedonfarmbusinessanalysis,financial management,andsuccession.Contacthimat 403-586-2504or [email protected]

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