Partial Budgeting: Looking at the Small Picture

Managers of today's farms are constantly being assailed by situations requiring them to make decisions. Some decisions are big ones, others not so big, but each has an impact on the success or failure of the farming enterprise. Little decisions may not seem crucial at first, but they may have a way of being repeated time after time. A small mistake repeated many times can add up to a large loss. Or, on the positive side, a small savings repeated often enough may make the difference between red and black on the income statement.

Some of the decisions or changes managers might be considering could have far-reaching impacts on other parts of the business or fora long period of time. Others are relatively small or simple, in the sense that their impacts are confined to a small or single part of the business or will only be felt for a limited time. It makes sense to use an analysis tool that is commensurate with the size or complexity of the decision. Partial budgeting is a relatively simple tool that can help managers better operate the farm business.

When To Use Partial Budgeting

Partial budgeting is used to analyze the costs and returns of business decisions or changes that affect only a small part of the operation. It is a method to formalize those "back of the envelope" calculations and reduce the chances of making a mistake or overlooking an important part of the decision. Examples of situations where a partial budget might be used include:

Substituting one crop for another when only small parts of your acreage or resources are being used;

Adding a few head to a livestock enterprise when there is surplus labor available;

Adopting a new production practice;

Participating in a Government program, or;

Taking advantage of an early payment discount on a fertilizer bill. These examples give an idea of the scope of decisions for which partial budgeting might be appropriate. If the partial budget starts to look too complicated, analyze whether you should be using a total farm budgeting approach instead. (See Part III, Chapter 7 on whole-farm budgeting.)

Why Change?

First ask yourself, "What am I trying to accomplish with this decision?" What are your objectives? Usually, we assume the objective is to increase profit or net income from the farming operation. Keep in mind, however, that other factors may be important in the decision. Reserving a certain amount of free time for family or community activities might be an example. Also, some costs and returns may not be cash transactions. Depreciation and operator labor, for example, are not out-of-pocket expenses. In certain instances, your "bottom line" may be how the decision affects cash flow rather than profit. In this chapter, profit or net income will he the decision criterion.

Components

Any business decision, when it is fully implemented and all necessary adjustments have been made, can affect profitability in only four possible ways. It can add to profit by either 1) increasing returns or 2) reducing costs. The change can subtract from profit by 3) adding to costs or 4) reducing returns. Although this sounds simple, the difficulty lies in separating these four possible effects, not omitting anything, and not counting anything twice. We will set up a simple account for each decision (see table 1).

To train yourself to think about all the possibilities, force every small decision into this framework, even if some of the categories turn out to be unused.

Joe and Curley

Joe Rancher for the past several years has been hiring his neighbor, Curley Farmer, to custom swath his 50 acres of alfalfa hay twice a year. Curley charges Joe $20 per acre each time he swaths the hay, but is willing to rent the machine to Joe for $25 per hour as recorded on the hour meter. Joe would buy the fuel (8 gallons per hour at $.85 per gallon), and Curley would maintain and repair the machine. Joe figures he could do 4 acres per hour, but he would have to take time off from an extra job he has with the farm supply cooperative where he makes $8 per hour. Because of improved timeliness of harvest, Joe feels he will be able to sell higher quality hay if he cuts it himself. He expects to be able to sell his 5-ton-per-acre yield (including both cuttings) for $2.50 per ton more than he did before.

Setting this problem up in a partial budgeting framework will help Joe decide whether he should continue with the custom hire arrangement or rent the machine and do the work himself. Begin with the four categories in table 1 and start to fill in the details. Refer to table 2 as you work.

What Joe Gains

Added returns. The higher return for the better quality hay that Joe feels he will be able to harvest amounts to $625 (50 acres x 5 tons per acre x $2.50 per ton). Notice that we only include the change in returns.

Reduced costs. If he rents the swather, Joe will eliminate the custom fee of $2,000 (50 acres x 2 cuttings x $20 per acre).

What He Loses

Added costs. When he rents the swather, Joe will have to pay the rental fee, as well as purchase fuel. For both of these expenses, calculate how many hours it will take to complete the operation. Since 50 acres need to be cut twice during the year and Joe estimates he can do 4 acres per hour, the operation should take 25 hours altogether (50 acres x 2 cuttings 4 acres per hour).

The rental fee will be $625 (25 hours x $25 per hour). The fuel cost will be $170 (25 hours x 8 gallons per hour x $.85 per gallon).

Reduced returns. If Joe decides to do the swathing himself, he will have to give up wages from his part-time job. This is a classic example of an opportunity cost an economic return you have to give up because you are using resources in a particular way. The opportunity cost, in Joe's case, is the value of wages he could have made if he chose not to rent the swather. In this example the wages amount to $200 (25 hours x $8 per hour). Assume this is a before-tax amount.

Analysis and Precautions

When totaling the additions to income (the left side of the partial budget in table 2), the result is $2,625. The sum of the subtractions from income (the right side of the partial budget) is $995. Calculating the difference between these totals shows that Joe has an increase in profits of $1,630. This is a before-tax increase, however. Assuming that Joe is in the 15 percent marginal tax bracket, he will retain only 85 percent of the increase in income after paying income tax. Thus, the bottom line, after taxes, is an increase of $1,386. While it would appear that this budgeting exercise has proven the swather rental to be a profitable decision, note a few cautions. First, we have looked at only one alternative to the present action of custom hiring. A partial budget, by its very nature, can only compare two options. There might well be other actions worth investigating. Purchase or long-term lease of the swather, for example, might prove advantageous. Obviously, we would need to calculate several more partial budgets to investigate other alternatives.

A second precaution, mentioned earlier, is that it might be worthwhile to look at cash-flow impacts in addition to profitability impacts. In this particular example, the results would be the same; but if some of the economic costs and returns were of a noncash nature, the results could be different.

Third, if you decide on a long-term investment, be aware that initial expenses are more costly than expenses that occur in the future. This is because money saved or received today, instead of being spent, can be put to an alternative, profitable use. Account for the time value of money when income and expense streams are not constant through time.

A final caution is that a partial budget analysis is only as good as the data and estimates that went into the calculations. The garbage-in/garbage-out rule always applies. Use care and be realistic when you predict returns and expenses for new alternatives.

Once you become accustomed to it, you will find yourself using partial budgeting more and more frequently to analyze little decisions that crop up in the day-to-day management of your farm.

Bart Eleveld, Extension Economist, Oregon State University,Corvallis, OR.