AGRICULTURAL CORE CURRICULUM - - (CLF1000) Advanced Core Cluster: AGRICULTURAL BUSINESS MANAGEMENT (CLF1200) Unit Title: Economic Principles ____________________________________________________________________________ (CLF1204) Topic: FIXED AND VARIABLE COSTS, Time Year(s) MARGINAL COSTS AND MARGINAL 4 Hours 3 / 4 REVENUE, PROFIT MAXIMIZING LEVEL OF OUTPUT ____________________________________________________________________________ Topic Objectives: Upon completion of this lesson, the student will be able to: Learning Outcome #: (E- 7) - Use economic decision-making tools to increase the profitability of agricultural enterprises. (E- 9) - Distinguish between fixed and variable costs. (E-10) - Distinguish between marginal cost and marginal revenue. (E-11) - Calculate the estimated fixed cost and variable costs for an agricultural commodity. Supplemental Materials: SUPPLEMENTAL HANDOUT 1 TOTAL COST CURVES SUPPLEMENTAL WORKSHEET 1 COMPUTING TOTAL COST, TOTAL VARIABLE COST, AND TOTAL FIXED COST SUPPLEMENTAL WORKSHEET 1 INSTRUCTOR KEY SUPPLEMENTAL WORKSHEET 2 CLASSIFYING COSTS SUPPLEMENTAL WORKSHEET 2 INSTRUCTOR KEY SUPPLEMENTAL WORKSHEET 3 FIXED AND VARIABLE COSTS SUPPLEMENTAL WORKSHEET 3 INSTRUCTOR KEY SUPPLEMENTAL WORKSHEET 4 CALCULATING FIXED AND VARIABLE COSTS SUPPLEMENTAL WORKSHEET 4 INSTRUCTOR KEY SUPPLEMENTAL HANDOUT 2 CROP BUDGET SUPPLEMENTAL WORKSHEET 5 BREAK-EVEN POINT CALCULATIONS SUPPLEMENTAL WORKSHEET 5 INSTRUCTOR KEY SUPPLEMENTAL WORKSHEET 6 CALCULATING AVERAGE AND MARGINAL COST CURVES SUPPLEMENTAL WORKSHEET 6 INSTRUCTOR KEY References: Casavant, K., & Infanger, C. (1984). ECONOMICS & AGRICULTURAL MANAGEMENT: AN INTRODUCTION. Reston, VA: Reston Publishing. Castle, E. N., Becker, M. H., & Nelson, A.G. (1987). FARM BUSINESS MANAGEMENT: THE DECISION-MAKING PROCESS (3rd ed.). New York: Macmillan. Cramer, Gail L., & Jensen, Clarence W. (1991). AGRICULTURAL ECONOMICS AND AGRIBUSINESS (4th ed.). New York: John Wiley & Sons. Leftwich, R. H. (1976). THE PRICE SYSTEM AND RESOURCE ALLOCATION (6th ed.). Hinsdale, IL: Dryden Press. Luening, R. A., Klemme, R. M., & Mortenson, W. P. (1991). THE FARM MANAGEMENT HANDBOOK (7th ed.). Danville, IL: Interstate Publishers. Resources: Baker, Richard L. (Ed.). (1970). PROFIT-MAXIMIIZING PRINCIPLES. Available from: Instructional Materials Laboratory, University of Missouri, 22316 Industrial Drive, Columbia, MO 65202 Deere & Company. (1987). FARM AND RANCH BUSINESS MANAGEMENT (2nd ed.). Available from: John Deere Technical Services, Department F, John Deere Rd., Moline, IL 61265. Looney, J. W. (1983). BUSINESS MANAGEMENT FOR FARMERS. Available from: Doane Information Services, 11701 Borman Drive, St. Louis, MO 63146. University of Missouri-Columbia. (1988). AGRICULTURAL MANAGEMENT AND ECONOMICS: Instructor's Guide (Unit I: Economic Principles in Agriculture) Available from: Instructional Materials Laboratory, University of Missouri, 22316 Industrial Drive, Columbia, MO 65202 Evaluation: Unit Exam TOPIC PRESENTATION: FIXED AND VARIABLE COSTS, MARGINAL COSTS AND MARGINAL REVENUES, PROFIT MAXIMIZING LEVEL OF PRODUCTION A. Costs of Production 1. All costs of production can be classified into two categories: a. Fixed costs are costs which are incurred for resources which do not change as output is increased or decreased. These costs must be paid regardless of whether production is undertaken or not. b. Variable costs are those costs which change with the level of production. If no production is undertaken, there are no variable costs. 2. Total cost of production (TC) equals total variable costs plus total fixed costs (TFC). (TC = TVC + TFC) _________________________________________________________ ACTIVITY: 1. Refer to SUPPLEMENTAL HANDOUT 1, TOTAL COST CURVES, to demonstrate the relationships between TC, TVC, and TFC. 2. Have students complete SUPPLEMENTAL WORKSHEET 1, COMPUTING TOTAL COST, TOTAL VARIABLE COST, AND TOTAL FIXED COST. _________________________________________________________ B. Length of Run 1. Fixed and variable costs are defined relative to a specific period of time called a length of run. 2. The short run is a time period where one or more of the factors of production are fixed. a. Decisions made within one production season, after basic enterprise choices have been made, are short run decisions. 3. The long run is a time period long enough that all factors of production can be varied. _________________________________________________________ ACTIVITY: 1. Have students complete SUPPLEMENTAL WORKSHEET 2, CLASSIFYING COSTS. Discuss which costs are fixed, which are variable, and why. _________________________________________________________ C. Fixed Costs 1. Fixed costs are incurred regardless of the level of use or production. 2. Some common fixed costs are identified as the DIRTI-5. These are: a. Depreciation - Decline in value of an asset due to such causes as wear and tear, age, and obsolescence. b. Interest - The cost of using borrowed money. c. Repairs (maintenance) - Repairs which are expected regardless of the amount of use. d. Taxes - Property or reclamation taxes are a fixed cost. (However, income or sales taxes are a variable cost.) e. Insurance - All insurance costs--EXCEPT for crop insurance--are considered fixed costs. C. Variable Costs 1. Variable costs change in direct relationship to the level of production or the amount of use. 2. Examples of variable costs include the following: a. Fuel b. Fertilizer c. Seed d. Chemicals e. Feed f. Veterinary medicines g. Water 3. Some variable costs become fixed once they are put into the business. For instance, after they have been applied to the crop, pesticide costs become fixed costs for that crop. 4. Variable costs are the costs which are relevant to economic decision-making in the short run. _____________________________________________________________ ACTIVITY: 1. Complete SUPPLEMENTAL WORKSHEET 3, FIXED AND VARIABLE COSTS. 2. Divide the class into small teams (3 or 4 students each). Have the students complete a research project in developing a budget for an agricultural commodity. Use the format of the sample crop budget provided (SUPPLEMENTAL HANDOUT 2, CROP BUDGET) or other appropriate format. Cooperative Extension and local growers are excellent sources of information. _____________________________________________________________ D. Cost Relationships - ATC, AVC, AFC, and MC 1. Average Variable Cost (AVC) is the amount spent on variable inputs per unit of output. AVC = TVC Average Variable Cost = Total Variable Cost ___ ___________________ Q Quantity a. Average variable cost falls to its minimum where APP is at a maximum, and rises thereafter. b. In the short run, it makes economic sense to produce at any price product above the average variable cost of production, because total revenues will cover all variable costs and also contribute to fixed costs. This is a loss minimizing strategy because fixed costs have to be paid even if nothing is produced. 2. Average Fixed Cost (AFC) is the amount spent on fixed inputs per unit of output. AFC = TFC Average Fixed Cost = Total Fixed Cost ___ ________________ Q Quantity a. Average fixed cost declines with increasing output because a constant total fixed cost is being spread over an increasingly large output. 3. Average Total Cost (ATC) is the total cost of all resources used per unit of output produced. ATC = TC Average Total Cost = Total Cost ___ __________ Q Quantity a. Average Total Cost also equals AVC + AFC. b. As long as the price of the output is greater than ATC, it pays to produce because total revenues (Price X Output) will be greater than total cost (ATC X Output). 1) The price where ATC equals the product price is the break-even point. 2) The break-even point is not necessarily the profit maximizing level of output. _____________________________________________________________ ACTIVITY: 1. Complete SUPPLEMENTAL WORKSHEET 4, CALCULATING FIXED AND VARIABLE COSTS. 2. Complete SUPPLEMENTAL WORKSHEET 5, BREAK-EVEN POINT CALCULATIONS _____________________________________________________________ 4. Marginal Cost (MC) is the change in total cost when output is changed by one unit. Marginal Cost = Change in Total Cost ____________________ Change in Output a. Marginal cost is the incremental cost of producing another unit of output. b. In computing MC, either total cost or total variable cost can be used because the amount of change in either is the same (because total fixed cost is constant.) E. Marginal Revenue 1. Marginal Revenue (MR) is the amount added to total revenue when one additional unit of output is produced and sold. Marginal Revenue = Change in Total Revenue _______________________ Change in Output a. Assuming that the market price of the output stays the same regardless of the amount an individual produces, marginal revenue equals the market price of the output (MR = Price of Output). F. Profit Maximizing Level of Production 1. Profit (net returns) will be maximized at the level of production where MC = MR. a. At the level of production which equates marginal cost with marginal revenue, an additional unit of output adds to revenues just what it adds to the costs of production. _____________________________________________________________ ACTIVITY: 1. Complete SUPPLEMENTAL WORKSHEET 6, CALCULATING AVERAGE AND MAGINAL COST CURVES. Use results to verify statements made about these relationships. _____________________________________________________________ G. Summary 1. A manager should consider all types of costs. Costs have direct effects on business decisions. In the short run, these costs can be classified as either fixed or variable. Variable costs are very important, because as long as these costs are met, short run operation can continue. In the long run, however, all costs plus a reasonable profit have to be met for a business to succeed. SUPPLEMENTAL HANDOUT 1 - TOTAL COST CURVES Total Cost, Total Variable Cost, and Total Fixed Cost Curves | | | | | | 50|__________|__________|__________|__________|__________|__ C | | | | | TC | | | | | | O | | | | | | | | | | TC | S 40|__________|__________|__________|__________|__________|__ | | | TC | | T | | TC | | | | | | | | TVC | TC | | | | 30|__________|__________|__________|__________|__________|__ D | | | | | | | | | | TVC | O | | | TVC | | | | TVC | | | L 20|__________|__________|__________|__________|__________|__ | TVC | | | | L | | | | | | TFC======================================================| A | | | | | | 10 |__________|__________|__________|__________|__________|__ R | | | | | | | | | | | | S | | | | | | | | | | | | V__________|__________|__________|__________|__________|___ 1 2 3 4 5 Q U A N T I T Y - Output at varying levels of production ===== Total Fixed Costs Curve Connect TVC's for Total Variable Costs Curve Connect TC's for Total Costs Curve SUPPLEMENTAL WORKSHEET 1 - COMPUTING TOTAL COST, TOTAL VARIABLE COST, AND TOTAL FIXED COST 1. The fixed costs are $100. The cost of hiring each additional employee is $120. Complete the following table. No. of Workers TFC TVC TC ================================================================= 1 2 3 4 5 6 7 8 TFC = Total Fixed Costs TVC = Total Variable Costs TC = Total Costs SUPPLEMENTAL WORKSHEET 1 - COMPUTING TOTAL COST, TOTAL VARIABLE COST, AND TOTAL FIXED COST - INSTRUCTOR KEY 1. The fixed costs are $100. The cost of hiring each additional employee is $120. Complete the following table. No. of Workers TFC TVC TC ================================================================= 1 100 120 220 2 100 240 340 3 100 360 460 4 100 480 580 5 100 600 700 6 100 720 820 7 100 840 940 8 100 960 1060 TFC = Total Fixed Costs TVC = Total Variable Costs TC = Total Costs SUPPLEMENTAL WORKSHEET 2 - CLASSIFYING COSTS CLASSIFY THE FOLLOWING COSTS AS EITHER FIXED OR VARIABLE COSTS: COST FIXED COST VARIABLE COST _______________________________________________________________________ Inventory ___________ ___________ Salaries ___________ ___________ Water ___________ ___________ Depreciation ___________ ___________ Interest on Land Loan ___________ ___________ Property Taxes ___________ ___________ Seed ___________ ___________ Fertilizer ___________ ___________ Insurance ___________ ___________ Sales Tax ___________ ___________ Repairs ___________ ___________ Gas and Oil ___________ ___________ Crop Insurance ___________ ___________ SUPPLEMENTAL WORKSHEET 2 - CLASSIFYING COSTS - INSTRUCTOR KEY CLASSIFY THE FOLLOWING COSTS AS EITHER FIXED OR VARIABLE COSTS: COST FIXED COST VARIABLE COST _______________________________________________________________________ Inventory _____x_____ ___________ Salaries _____x_____ ___________ Water ___________ ______x____ Depreciation _____x_____ ___________ Interest on Land Loan _____x_____ ___________ Property Taxes _____x_____ ___________ Seed ___________ _____x_____ Fertilizer ___________ _____x_____ Insurance _____x_____ ___________ Sales Tax ___________ _____x_____ Repairs _____x_____ ___________ Gas and Oil ___________ _____x_____ Crop Insurance ___________ _____x_____ SUPPLEMENTAL WORKSHEET 3 - FIXED AND VARIABLE COSTS 1. List the fixed and variable costs associated with a nursery operation raising potted plants in a greenhouse. 2. List the fixed and variable costs associated with an operation buying feeder pigs and selling them as fat hogs in a barn. SUPPLEMENTAL WORKSHEET 3 - FIXED AND VARIABLE COSTS - INSTRUCTOR KEY 1. List the fixed and variable costs associated with a nursery operation raising potted plants in a greenhouse. Fixed Costs: the DIRTI five What items would be depreciated? Greenhouse, benches, delivery truck, What are the "expected repairs"? They would occur whether or not the greenhouse was used or not. Variable Costs: pots potting soil fertilizer water cuttings advertising transportation sales costs sales tax small handtools that are not depreciated 2. List the fixed and variable costs associated with an operation buying feeder pigs and selling them as fat hogs in a barn. Fixed Costs: the DIRTI five Variable Costs: feeder pigs feed medicine bedding transportation and other sales expenses SUPPLEMENTAL WORKSHEET 4 - CALCULATING FIXED AND VARIABLE COSTS Determine the total of fixed and variable costs associated with owning a pickup. Fill in the table below using the following data: Consider the costs of operating a pickup. The pickup has a cost of $14,000, a life of 7 years, and no salvage value. The cost of insurance is $350 every six months. The interest rate is 12% on an average investment of $7000. Repairs are expected to cost 3% of the purchase price per year. The pickup will get 20 miles per gallon of gas, it will be driven 18,000 miles per year, and the cost of gas will average $1.15 per gallon. Lubrication and maintenance are estimated at $.02 per mile driven. FIXED COSTS 1. Depreciation __________ 2. Interest on average investment __________ 3. Repairs/year __________ 4. Insurance/year __________ Total Fixed Costs __________ VARIABLE COSTS 1. Fuel ___________ 2. Lubrication/ Maintenance ___________ Total Variable Costs ___________ Total All Costs ___________ What is the cost per mile driven (ATC)? ___________ What is the cost per mile, if you drive 12,000 per year (ATC)? ___________ SUPPLEMENTAL WORKSHEET 4 - CALCULATING FIXED AND VARIABLE COSTS INSTRUCTOR KEY Determine the total of fixed and variable costs associated with owning a pickup. Fill in the table below using the following data: Consider the costs of operating a pickup. The pickup has a cost of $14,000, a life of 7 years, and no salvage value. The cost of insurance is $350 every six months. The interest rate is 12% on an average investment of $7000. Repairs are expected to cost 3% of the purchase price per year. The pickup will get 20 miles per gallon of gas, it will be driven 18,000 miles per year, and the cost of gas will average $1.15 per gallon. Lubrication and maintenance are estimated at $.02 per mile driven. FIXED COSTS 1. Depreciation $2000 2. Interest on average investment 840 3. Repairs/year 420 4. Insurance/year 700 Total Fixed Costs $3960 VARIABLE COSTS 1. Fuel (18,000 / 20 * 1.15) $1035 2. Lubrication/ Maintenance 360 Total Variable Costs $1395 Total All Costs $5355 What is the cost per mile driven (ATC)? $2975 What is the cost per mile, if you drive 12,000 per year (ATC)? $4075 {(3960 + 930) / 12,000} SUPPLEMENTAL HANDOUT 2 - CROP BUDGET HARTLEY WALNUTS IN THE SACRAMENTO VALLEY Operation Total Cost Per Acre ___________________________________________________________ Cultural Costs Pruning (1 of 3 years) $ 40 Brush removal (1 of 3 years) 7 Fertilizer 41 Irrigation 71 Irrigation Labor 5 Mow (6x) 20 Weed Sprays 39 Blight spray (2x) 55 Husk fly spray 28 Other insect spray 36 Cost for pickup truck 15 Interest on operating capital 20 ________ Total Cultural Costs $377 Harvest Costs Shake 40 Sweep and Pickup 55 Hauling 12 Hull and dry 180 ________ Total Harvest Costs $287 Cash Overhead Office and business costs 60 County Taxes (fixed cost) 44 Equipment insurance (fixed cost) 7 ________ Total Cash Overhead Costs $111 Total Cash Costs $775 Total Cash Cost/Ton: 2 ton yield $387.50 Investment (all fixed costs) Interest on Land 220 Depreciation on equipment/buildings 148 Interest on equipment/buildings 94 Depreciation on Trees (40 yr.) 75 Interest on investment on trees 165 ________ Total Investment Cost $702 Total-All Costs Per Acre $1477 Total Cost/Ton (2 tons/acre) $ 738.50 Total Variable Costs $ 664 Total Fixed Costs $ 813 SUPPLEMENTAL WORKSHEET 5 - BREAK-EVEN POINT CALCULATIONS 1. A rice farmer's fixed costs are $75/acre and the variable costs are $400/acre: a. What are the total costs per acre? _____________ b. At a yield of 80 cwt per acre, what is the break-even price? _____________ c. At a yield of 75 cwt per acre, what is the cost of production/cwt? _____________ d. If the variable costs can be reduced to $350 per acre, what is the break-even point at 80 cwt/acre? _____________ at 75 cwt/acre? _____________ at 90 cwt/acre? _____________ 2. A greenhouse has fixed costs of $1000 per year and variable costs of $2.50 per potted plant: a. If 1000 plants are raised, what are the total costs? ______________ b. What is the cost per plant? ______________ c. What is the cost per plant if 2000 are raised? ______________ d. What is the cost per plant if 5000 are raised? ______________ e. If the greenhouse can raise a maximum of 6000 plants and the sales price is $3.00 per plant, is it economical to raise the plants? ______________ f. What is the break-even number of of plants? ______________ SUPPLEMENTAL WORKSHEET 5 - BREAK-EVEN POINT CALCULATIONS - INSTRUCTOR KEY 1. A rice farmer's fixed costs are $75/acre and the variable costs are $400/acre: a. What are the total costs per acre? $475 b. At a yield of 80 cwt per acre, what is the break-even price? 5.94 c. At a yield of 75 cwt per acre, what is the cost of production/cwt? 6.33 d. If the variable costs can be reduced to $350 per acre, what is the break-even point at 80 cwt/acre? 5.31 at 75 cwt/acre? 5.67 at 90 cwt/acre? 4.72 2. A greenhouse has fixed costs of $1000 per year and variable costs of $2.50 per potted plant: a. If 1000 plants are raised, what are the total costs? $3500 b. What is the cost per plant? 3.50 c. What is the cost per plant if 2000 are raised? 3.00 d. What is the cost per plant if 5000 are raised? 2.70 e. If the greenhouse can raise a maximum of 6000 plants and the sales price is $3.00 per plant, is it economical to raise the plants? Yes Total cost = $16,000 Total income = $18,000 f. What is the break-even number of of plants? 2000 SUPPLEMENTAL WORKSHEET 6 - CALCULATING AVERAGE AND MARGINAL COST CURVES No. of Trees TFC TVC TC AFC AVC ATC MC ================================================================= 10 100 120 220 22 100 240 340 36 100 360 460 49 100 480 580 60 100 600 700 66 100 720 820 70 100 840 940 68 100 960 1060 TFC = Total Fixed Costs TVC = Total Variable Costs TC = Total Costs AFC = Average Fixed Costs AVC = Average Variable Costs ATC = Average Total Costs MC = Marginal Costs Given a price of $15.00 per tree, at what level would you produce? Given a price of $10.00 per tree, at what level would you produce? SUPPLEMENTAL WORKSHEET 6 - COMPUTING AVERAGE AND MARGINAL COST CURVES - INSTRUCTOR KEY No. of Trees TFC TVC TC AFC AVC ATC MC ================================================================== 10 100 120 220 10.00 12.00 22.00 xxxx 22 100 240 340 4.54 10.90 15.45 10.00 36 100 360 460 2.78 10.00 12.78 8.57 49 100 480 580 2.04 9.79 11.84 9.23 60 100 600 700 1.66 10.00 11.66 10.90 66 100 720 820 1.51 10.90 12.42 20.00 70 100 840 940 1.43 12.00 13.43 30.00 68 100 960 1060 1.47 14.12 15.58 240.00 TFC = Total Fixed Costs TVC = Total Variable Costs TC = Total Costs AFC = Average Fixed Costs AVC = Average Variable Costs ATC = Average Total Costs MC = Marginal Costs Given a price of $15.00 per tree, at what level would you produce? 60 trees Given a price of $10.00 per tree, at what level would you produce? 49 trees 12/2/91 LM/GB/sg #%&C