PercyBlakeney
Member
apologies in advance for the long post but I read an interesting case study analysis on hill farm profitability - specifically the bit about variable costs (copied and pasted below) - and that in increasing variable costs to increase output can be a false economy
Full report..
Hill Farm Profitability Report
4.2.1 Investigating variable costs
In seeking to understand the relationship between the volume of output from the farm and its variable costs, the critical discovery is that variable costs have to be separated into two categories and the inflection point between the two identified in order to make sense of what is going on. These two categories have been differentiated as follows: - Productive variable costs: essential /unavoidable costs linked to livestock production (e.g. seeds, home grown concentrates, bedding, contract labour, essential vet & med costs); and - Corrective variable costs: Avoidable / non-essential costs linked to livestock production associated with production above the natural carrying capacity of the grass (e.g. bought in livestock feed, fertilisers, sprays). What the Nethergill approach showed was that the variable costs were non-linear in nature (i.e. that there was an inflexion point in two separate linear costs lines).
However, discussions with farmers in the case studies indicated that farmers were making business decisions based on the assumption that their total variable costs were linear. This meant that increasing production to achieve economies of size was leading to a reduction in profitability rather than an increase. This can be explained as follows: - Many farmers were assuming that their variable costs were linear. By doing do, the assumption was that output (and therefore income per unit of output) would increase in proportion to increases in variable costs – so the more one puts into the system, the more one gets out. If one operates on this logic, once revenue exceeds variable and fixed costs, then breakeven point is reached and the business starts to make a profit. If either variable or fixed costs can be reduced, then the breakeven point can be reached at lower volume of output and therefore profits can be increased.
- In farming however, the reality is that variable costs are not linear. Instead there is a point at which the costs per unit of output start to increase at a faster rate – i.e. it starts to cost more to produce an additional unit of output. This is in keeping with the economic explanation of how costs behave. The Nethergill approach, using a geometric approach (see Annex 1), has calculated that this is the point at which it is no longer possible to generate the volume of output on the basis of ‘free issue inputs’ (naturally available grass, rain etc) and productive variable costs (e.g., home grown feed concentrates, seeds, bedding, machinery costs etc) – see point of inflection on the variable costs line in Figure 5 below. At this point, to generate more volume, one needs to add additional inputs/costs (corrective variable costs (e.g. fertilisers, vet & med, feed concentrates, winter fodder, auction fees, off-wintering costs, haulage etc). However, the additional costs increase at a faster rate than the volume of output it is possible to generate. Therefore, any additional output produced using corrective variable costs becomes more expensive per unit of output than that produced using only productive variable costs. - The result of this is that if one continues to assume variable costs are linear (i.e. apply a volume driven logic to the farm business) past the point where corrective variable costs kick in) then before long the costs exceed the revenue and the farm business moves from making a profit, to making a loss (see Figure 5). This means that beyond a certain point, the business cannot continue to make a profit by volume increases alone.
Put another way, if there isn’t enough natural grass, no amount of corrective economic action can make farming any more profitable. 28 To note that in this approach actual costs are used rather than marginal costs. 13 Figure 5: Principles of non-linear variable costs – an illustrative situation facing a hill farm
Full report..
Hill Farm Profitability Report
4.2.1 Investigating variable costs
In seeking to understand the relationship between the volume of output from the farm and its variable costs, the critical discovery is that variable costs have to be separated into two categories and the inflection point between the two identified in order to make sense of what is going on. These two categories have been differentiated as follows: - Productive variable costs: essential /unavoidable costs linked to livestock production (e.g. seeds, home grown concentrates, bedding, contract labour, essential vet & med costs); and - Corrective variable costs: Avoidable / non-essential costs linked to livestock production associated with production above the natural carrying capacity of the grass (e.g. bought in livestock feed, fertilisers, sprays). What the Nethergill approach showed was that the variable costs were non-linear in nature (i.e. that there was an inflexion point in two separate linear costs lines).
However, discussions with farmers in the case studies indicated that farmers were making business decisions based on the assumption that their total variable costs were linear. This meant that increasing production to achieve economies of size was leading to a reduction in profitability rather than an increase. This can be explained as follows: - Many farmers were assuming that their variable costs were linear. By doing do, the assumption was that output (and therefore income per unit of output) would increase in proportion to increases in variable costs – so the more one puts into the system, the more one gets out. If one operates on this logic, once revenue exceeds variable and fixed costs, then breakeven point is reached and the business starts to make a profit. If either variable or fixed costs can be reduced, then the breakeven point can be reached at lower volume of output and therefore profits can be increased.
- In farming however, the reality is that variable costs are not linear. Instead there is a point at which the costs per unit of output start to increase at a faster rate – i.e. it starts to cost more to produce an additional unit of output. This is in keeping with the economic explanation of how costs behave. The Nethergill approach, using a geometric approach (see Annex 1), has calculated that this is the point at which it is no longer possible to generate the volume of output on the basis of ‘free issue inputs’ (naturally available grass, rain etc) and productive variable costs (e.g., home grown feed concentrates, seeds, bedding, machinery costs etc) – see point of inflection on the variable costs line in Figure 5 below. At this point, to generate more volume, one needs to add additional inputs/costs (corrective variable costs (e.g. fertilisers, vet & med, feed concentrates, winter fodder, auction fees, off-wintering costs, haulage etc). However, the additional costs increase at a faster rate than the volume of output it is possible to generate. Therefore, any additional output produced using corrective variable costs becomes more expensive per unit of output than that produced using only productive variable costs. - The result of this is that if one continues to assume variable costs are linear (i.e. apply a volume driven logic to the farm business) past the point where corrective variable costs kick in) then before long the costs exceed the revenue and the farm business moves from making a profit, to making a loss (see Figure 5). This means that beyond a certain point, the business cannot continue to make a profit by volume increases alone.
Put another way, if there isn’t enough natural grass, no amount of corrective economic action can make farming any more profitable. 28 To note that in this approach actual costs are used rather than marginal costs. 13 Figure 5: Principles of non-linear variable costs – an illustrative situation facing a hill farm
