JINKA UNIVERSITY

COLLAGE OF AGRICULTURE AND NATURAL RESOURCE

DEPARTMENT OF AGRICULTURAL ECONOMICS

Course Tiltle: Farm Management

Lecturer Note By: Aklok Getnet (M.Sc.)

2015/2022
 CHAPTER 1: Concepts of Farm Management and Decision Making
Definition and Scope
1.1 Preliminary concepts

Farm management comprises two words i.e. Farm and Management.

Farm Define: is the smallest unit of agriculture which may consist of one or more plots
cultivated by one farmer or group of farmers in common for raising crop and livestock
enterprise. It is a producing unit as well as a consuming unit. Management means the act or art of
managing. There are various definitions of farm management by different authors; among these
definitions the following definitions are mentioned.
Farm management is a decision making process whereby limited agricultural resources are
allocated to a number of production alternatives to plan, organize, operate and control the farm
business in such a way to attain predetermined goals and objectives.
Farm management is a science which deals with the proper combination and operation of
production factors including land, labor and capital, and the choice of crop and livestock
enterprises to bring about the maximum of continuous return to the most elementary operation
units of farming.
“Farm Management” as a subject matter is the application of agricultural science, business
and economic principles in farming from the point of view of an individual farmer. The
principles may serve as a guideline for collecting and using requisite information for rational
decision making. They also provide a set of tools for the preparation of farm budgets and
production programs.
Farm management can also be defined as the sub-branch of agricultural economics which deals
with decision making on the organization and operation of a farm for securing maximum
continuous net income consistent with the welfare of farm family.
Thus, in simple words, farm management can be defined as a science which deals with judicious
decisions on the use of scarce farm resources, having alternative uses to obtain the maximum
profit and family satisfaction on a continuous basis from the farm as a whole and under sound
farming programs.
The most common features of farm management definitions are: organisation of resources and
decision-making process.
Some Other Preliminary Concepts
Management of Farm vs. Farm Management: Generally speaking, management of farm aims
at maximizing production in the sphere of Agronomy, whereas, Farm Management is concerned
with maximizing profit in the realm of agricultural economics.
Stock and flow inputs- Stock inputs are resources which are consumed during the production
period, like seeds, fertilizers, pesticides and the like. They can be stored, if not used currently, for
future use. As against this, flow inputs like labor and management, if not used, cannot be stored
for the next season.
Economic unit- It is the sum of resources for which costs, returns and net income can be worked
out. As such, a farm is an economic unit.

1.2 Nature and Characteristics of Farm Management

Farm Management is basically both an applied and pure science. It is a pure science because it
deals with the collection, analysis and explanation of factors and the discovery of principles
(theory). It is an applied science because the ascertainments and solutions of farm management
problems (technology) are within its scope. Farm management science has the following
distinguishing characteristics from other fields of sciences.
i. Practical science: It is a practical science, because while dealing with the factors of other
physical and biological sciences, it aims at testing the applicability of those facts and findings
and showing how to put these results to use on a given farm situations. A farmer has to select a
method which is more practicable and economical to his particular farm situation taking in to
consideration the volume of work and financial implications.
ii. Profitability oriented: Farm management alone is interested in profitability. Biological fields
such as agronomy and plant breeding concern themselves with distaining the maximum yield per
unit irrespective of the profitability of inputs used. But the farm management specialist always
considers the costs involved in producing each unit of output in relation to returns, and decides
optimum level of production. He has to consider all relevant factors such as financial
implications, transportation, storage facilities and costs.
Profitability is the major criterion in the decision making process/adoption of a new technology
of farming practice. Farm management is interested in optimum results/yields which may not
necessarily coincide with the maximum production point. In brief, when other sciences deal with
physical efficiency, farm management concerns with economic efficiency.
iii. Integrating science or interdisciplinary science: The facts and findings of other sciences
are coordinated for the solution of various problems of individual farmers with the view to
achieving desired goals. It involves different disciplines to decision making. It considers the
findings of other sciences in reaching its own conclusions. Principles of farm management
integrate results thrown out by physical sciences under specific set of conditions.
iv. Broader field: It uses more than one discipline to make decisions. It gathers knowledge from
many other sciences for making decision and farm management specialists have to know the
broad principles of all other concerned sciences in addition to specialization in the business
principles of farm management.
Depending on the type of farm, a farm manager must understand a variety of subjects including
soil structure, soil microbiology, livestock genetics, crop and animal nutrition and growth, weed
and insect management, plant and animal sciences, ecology, machinery management, economics,
financial management, international food markets, leadership, human psychology, business
organization, business law, communication, and strategic planning and management.
v. Micro-approach: In farm management, every farm unit is considered as unique in terms of
available resources, problems and potentialities. It recognizes that no two farms are exactly
identical with respect to soil, other production resources, farmers‟ managerial ability, etc. Each
farm unit has to be, therefore, studied, guided or planned individually.
vi. Farm unit as a whole: In farm management analysis, a farm as a whole is considered to be
the unit for making decisions because the objective is to maximize the returns from the whole
farm instead of only improving the returns from a particular enterprise or practice. Farm
management considers all possible aspects of crop and livestock enterprises of a given farm. The
principles of farm management, thus, help to get the optimum enterprise mix that would yield the
highest income to the farmer from the total farm organization.
1. 3 Objective and Scope of Farm Management

Objective of Farm Management

The main objective of farm management is to help in realization of the maximum profit from the
various enterprises on a farm.
Specifically the objectives of farm management are:
To study the input-output relationship in agriculture and determine the relative efficiency
of various factor combination.
To determine the most the profitable crop production and livestock raising methods.
To study the cost per hectare and per quintal or per kg.
To evaluate the farm resource and land use.
To study the comparative economics of different enterprises.
To determine the relation of size of farm to land utilisation, cropping pattern, capital
investment and labour employment.
To study the impact of technical changes on farm business.
To find out ways and means for increasing the efficiency of arm business through better
input -output relationship and proper allocation of resources among different uses.

Scope of farm management

The primary concern of farm management is the farm as a unit. It deals with the allocation of
resources at the level of an individual farm. It covers the whole aspects of individual farm
business which have bearing on the economic efficiency of the farm. Such farm management
activities may be grouped into technical, commercial, financial, and accounting categories.
a) Technical Activities
These are comprised of all physical production activities. That is include responsibility for
all production know how, seeing that productions accomplished on time, and adapting
production processes to changing economic and technical conditions.
b) Commercial Activities
These include all buying and selling activities of the farm/business. This are involves
procurement of inputs in the quantities and combinations necessary for efficient production,
plus orderly storage, handling, marketing of commodities produced. It also includes the task
of market forecasting and contracting for services of others.
c) Financial Activities
These are comprised of all activities related to the procurement of and use of financial or
money capital. That is acquisition and use of capital, presumably in an optimal manner. This
requires forecasting future investment needs and arranging for their financing. Such capital
is normally used for the purchase of physical assets and running the farm/business.
d) Accounting
These activities involve the establishment and maintenance of farm/business records,
including records of buying and selling, etc. Include physical, human, business, and tax
records. This area may involve setting standards for certain enterprises or segments of the
business.
All the above aspects of farm business, which fall within the view of the subject of farm
management, are so interlinked and drawn together that systematic study of all of them is
required to understand the business of farms within the circle of scarcity and choice.
Classification Description/Nature of Activities Examples of Actual Decisions Made and
of Implemented.
Activities
Technical Production of goods and services . What to produce: enterprise choice and
combination
. How much to produce: Amount to produce of
each crop
. How to produce: Amounts of inputs to
use on each crop. How to combine them, how
to co-ordinate their production.
Using land
Capability-fertility
Tillage practices - conservation
Regulations -constraints
Determining level of
mechanization Capital requirements
Availability of services
Labour implications
Commercial Acquiring inputs Purchase of inputs (source, terms, quality,
quantity, financing, etc.)

Marketing products Sale of produce (form of produce; time to sell;

place to sell; type of market - open market,
contract, etc.
Forecasting costs and prices. Inputs and Outputs
Financial Acquiring funds Purpose of funds/ quantity and terms
Source of financing
Using funds Lender position
Equity position and liquidity position
Repayment plan

Depreciation of assets
Forecasting future needs Expansion / contraction
Changing technology
Accounting Keeping production records Records of output of produce
Records of use of resources

Recording commercial and Records of sales and purchases

financial transactions Records of borrowing and repayments
Cash flow forecasting
Tax reporting Income and other taxes, wages and
depreciation
1.4 Farm Management Problems in Developing Countries

Farm management problems in developing countries may vary from place to place depending
largely upon the degree of agricultural development & the availability of resources. The
following are some of the most common problems in the field of farm management.

i. Small size of farm business: The average land size or operational holding in less developed
countries like Ethiopia are small. The holdings are fragmented too. Excessive pressure of
population creates unfavorable man-land ratio in most parts of the country. This combined with
excessive family labor, which depends upon agriculture, has weakened the financial position of
the farmers and limited the scope for business expansion.

ii. Farm as a household: In most parts of the country family farms perpetuate the traditional
combinations of crops and methods of cultivations. Thus the equation between agricultural labor
and household labor becomes an identity. This makes difficult for the farmer to introduce
business content and incorporate new management idea in his farm operations. Home
management thus heavily influences and gets influenced by farm decisions.

iii. Inadequate capital: Capital shortage is atypical feature of farming in developing countries.
Most often, peasant agriculture (which is mostly subsistence) is labor intensive and characterized
by serious deficiency of capital. Generally small size of farms, problems of tenure ship and
unremunerated prices have set the farmer under perpetual poverty. New technologies demand
higher inputs such as more fertilizers, plant protection measures, irrigation and better seeds as
well as investment in power and machinery. Small farmers cannot meet the financial
requirements from their own funds. Hence, low cost, adequate and timely credit is their most
pressing need if they have to put their farms on growth paths.

iv. Under-employment of factors of production: Under-employment of factors of production

in developing countries emanate from:
Small size of the farms,
Large family labor supply,
Seasonal nature of production
Lack of subsidiary or supporting rural industries.
v. Slow adoptions of innovation: Small farmers are usually conservative and sometime
disbelieving of new technologies and methods. The rate of adoption, however, depends; largely
on the farmers‟ willingness and ability to use the new information (once they get it effective they
will become eager to adopt it). However, since established attitudes and values do not change
overnight, the extension take time to get the research results commercially adopted and existed
on the farms. It calls for training and substantial financial requirements.

vi. Inadequacy of input supplies: Farmers may be willing to introduce change yet they may
face the difficulty in obtaining the required inputs of required quality, in sufficient quantity, and
on time to sustain the introduced changes. Shortages of foreign exchange in developing countries
seriously limit importation of needed supplies and materials. Domestic industries generally lack
raw materials, skills, capital or a combination of these to manufacture the needed farm supplies
for inputs. No fertilizer, tractor, insecticides, etc. manufacture is yet introduced in the country.

vii. Managerial skill: The most important and difficult problem for many years has been the
managerial skills of large number of small-scale farmers in the country. This is necessary to
make millions of ultimate users of research results develop progressive attitudes and be
responsive to the technological changes. Education of the farmers on a mass scale is thus most
important. Even illiterate people can be educated through demonstration of the application of
new techniques and better ways of the inputs available.

viii. Communication and markets: These are two important elements of infrastructure
necessary for introducing economic content in the farm organizations. Lack of adequate
communication systems and the regulated market organization stand as a major bottleneck in the
way of improving the management of farms on business lines. Substantial investments therefore
need to be made on roads, marketing systems, and other communication facilities in almost all
parts of the country.

1.5 Characteristics of Farming as a Business

Farming as a business has many distinguishing features from most other industries in its
management methods and practices. The major differences between farming and other industries
are:
  Primary forces of production: Agriculture is primarily biological in nature. A slight
change in the environment may cause serious difficulties. One day cold, for example,
may destroy the whole of standing crop. Unforeseen changes in the environment such as
plant or animal diseases and storm can cause a considerable damage. Most of the other
industries are less likely to be affected by such circumstances.
 Size of the production unit: Farming is a small sized business as it gives little scope for
the division of labor. In this business the farmer id both the laborer and the capitalist.
 Heavy dependency upon climatic factors: Weather changes may involve readjustments.
As a result of dependency on climatic factors, management practices in farming must be
much more flexible than in other industries.
 Frequency and speed if decisions: Farming requires many and speedy decisions on the
part of the farmers and the farm workers.
 Change in price: Agricultural prices and production usually move in opposite directions.
Because of the effects of climatic and biological factors, a relatively large volumes of
production of a given farm commodities is usually followed by a decrease in price, and a
smaller volume results in increased in prices
 Fixed and variable costs: Of the total costs, portion of fixed costs is more in agriculture
than in other industries. This high proportion of fixed costs tends to make the adjustments
in production more difficult.
 Inelastic demand for farm products: Agriculture deals with production of food and raw
materials. As a standard of living improve and income increases, the demand for
agricultural products will increase less rapidly than that of industrial products. On the
other hand, if increased production comes from the decreased marginal returns phase,
costs will go high. Higher production May reduce prices so low that total returns might
not increase or even may decrease.

1.6 Farm Decision Making

As indicated before, Farm management is concerned with the allocation of limited resources
among a number of alternative uses which requires a manager to make decisions.
A manager, first, must consider the resources available for attaining goals which have been set.
Limits are placed on goal attainment because most managers are faced with a limited amount of
resources.
In a farm business, goal attainment is confined within some limits set by the amount of land,
labor and capital available. These resources may change overtime, but they are never available in
infinite amounts. The level of management skill available or the expertise of the manager may be
another limiting resource. If the limited resources could only be used one way to produce one
agricultural product, the manager‟s job would be much easier. The usual situation allows the
limited resources to be used in several different ways to produce each of a number of different
products. In this case, the manager may be faced with a number of alternative uses of the limited
resources and must make decisions on how to allocate them among the alternatives to maximize
profit from the total business.

The process of making a decision can be formalized into a logical and orderly series of steps.
Important steps in farm decision making process are:
1. Identifying and defining the problem
2. Collecting relevant data, facts and information
3. Identifying and analyzing alternative solutions
4. Making the decision – selecting the best alternative
5. Implementing the decision
6. Observing the results and bearing responsibility of the outcomes
7. Following these steps will not ensure a perfect decision. It will, however, ensure that the
decision is made in a logical and organized manner.

1. Identify and define the problem: A manager must constantly be on the alert to identify
problems and to identify them as quickly as possible. Most problems will not go away by
themselves and represent an opportunity to increase the profitability of the business through wise
decision making. Once identified, the problem should be concisely confined. Good problem
definition will minimize the time required to complete the remainder of the decision making
steps.
2. Collecting relevant data and information: Once a problem has been identified, the next step
should be to gather data, information and facts, and to make observations which pertain to the
specific problem.

3. Identifying and analyzing alternatives: Once the relevant information is available, the
manager can begin listing alternatives which are potential solutions to the problem. Several may
become apparent during the process of collecting data (unorganized collection of facts and
numbers obtained from various sources) and transforming data into information (final product
obtained from analyzing data in such a way that useful conclusions and results are obtained).
Each alternative should be analyzed in a logical and organized manner to ensure accuracy and to
prevent something from being overlooked.

4. Making decision: Choosing the best solution to a problem is not always easy, nor is the best
solution always obvious. Sometimes the best solution is to do nothing or to go back, redefine the
problem and go through the decision-making steps again. These are legitimate decisions, but
they should not be used as a way to avoid making a decision when a promising alternative is
available. After all the pros and cons of each alternative are weighed, one may not appear to be
definitely better than any other. The one showing the greatest increase in expected profit would
normally be selected. Uncertainty and risks should be considered if several alternatives have
nearly the same potential effect on profit.

5. Implementing decision: Selecting the best alternative will not give the desired results unless
the decision is correctly and promptly implemented. Resources may need to be acquired and
organized. This requires some physical actions to be taken.

Classifying decision: Decision made by farm manager can be classified in a number of ways.
One way of classification system may be to consider decisions as either organizational or
operational in nature.
 Decision

Organizational Operational
(How to organize (How to operate
profitably?) efficiently?)

Organizational decisions are those in the general areas of developing plans for the business,
acquiring the necessary resources and implementing the overall plan. Some of such decisions
include;
 Decisions regarding selection of the best size of the farm
 What scale should be the farm operation
 Decisions regarding
o How much land to purchase or lease
o How much capital to borrow
o The level of mechanization and
o Construction of buildings and irrigation facilities, etc.
Therefore, Organizational decisions are related to planning and organization of the farm that
tend to be long run decisions which gives shape to the overall organization of the farm and are
not modified or reevaluated more than once a year. Compared to operational decisions,
organizational decisions require heavy investment and have long lasting effect.

Operational decisions are made more frequently than the organizational decisions and relate to
the many details made on a daily, weekly or monthly basis and are repeated more often than the
organizational decisions as they follow the routines and cycles of agricultural production.
Operational decisions are frequent which involve relatively lower investment and their effect is
short lived. Some of such decisions include:
 Selecting fertilizer and seeding rates for a given field and year
 Making changes in livestock feed ration
 Selecting planting and harvesting dates
  Marketing decisions and daily work schedules
 What to produce (selection of enterprises)
 How much to produce (enterprise mix and production process)
 How to produce( selection of least cost method)
 When to produce (timing of production)
Farm Management decisions are not only classified as organizational and operational decisions
but there are also other ways. Decisions can have a number of characteristics, which provide
another classification system. These include;
 Importance
 Frequency
 Imminence
 Revocability and
 Number of alternatives available

Importance: Given the many decisions made by a farm manager, some will be more important
than others. Importance can be measured in several ways, but the most common would be in
terms of the amount of birr involved in the decision or the size of the potential gain or loss.
Decisions involving a few birr might be made routinely, with little time spent gathering data and
processing through the steps in the decision-making process. Decisions involving a large amount
of capital and potential profit or loss need to be analyzed carefully. They can easily justify more
time spent on gathering data and analyzing possible alternatives. E.g. leasing additional land,
establishing an irrigation system and constructing a new-confinement cattle building.

Frequency: Some decisions may be made only once in a life time, for example, the decision to
choose farming as a vocation. Other decisions must be made almost daily, for example, livestock
feeding times, milking times and the amount of feed to be fed each day.

Imminence: A manager is often faced with making some decisions before a certain deadline or
very quickly to avoid a potential loss. But sometimes decisions to be made may have no
deadline, and there may be little or no penalty for delaying the decision until more information is
obtained and more time spent analyzing the alternatives.
 Revocability: Some decisions can be easily reversed or changed if observation indicates the first
decision was not correct. An example would be a livestock feed ration, which could be changed
rather quickly and easily as long as the change was not so abrupt as to upset the livestock. Other
decisions may not be reversible or can be changed only at a very high cost. Examples would be
decision to dig a new irrigation well or to construct a new building. Once the decision is made to
go ahead with these projects, the choice is either to use them or abandon them. It may be very
difficult or impossible to recover the money invested.

Availability of alternatives: Some decisions have only two possible alternatives. They are of the
yes or no and buy or not buy type. The manager may find these decisions easier and less time
consuming than the others which have a large number of alternative solutions or courses of
action. Where a large number of alternatives exist, the manager may be forced to spend
considerable time identifying the alternatives and analyzing each one.
Farm business decisions: These include the following:
Production and organization problem decisions (Strategic decisions)
These decisions involve heavy investment and have long lasting effect. These include decisions
on,
 Size of the farm
 Machinery and livestock program
 Construction of buildings
 Reclamation programs
Administrative problem decisions
These decisions involve financing the farm business. These are,
 optimum utilization of funds, acquisition of funds- proper agency and time ,
 supervision of work &accounting and bookkeeping
Marketing problem decisions
These include decisions on:
 Buying decision: such as what, when, from whom and how to buy,
 Selling decision: such as what, when, where, and how to sell.
CHAPTER 2: Production Resource and Management

2.1 Farm Resource

“Farm resources” refers all the primary means of production, including the land, soil, water, air,
plant communities, watersheds, human resources, natural and physical attributes, and man-made
developments, which together comprise the agricultural community.

 The supply of resources in a whole-farm system can be examined from either an

accounting or, more fruitfully, an operational perspective.

2.1.1 Farm resources from an accounting view

From an accounting viewpoint with its ex post or backward-looking emphasis, farm resources
fall into two broad categories:
Fixed resources: it provide services over a number of years or at least over a period
longer than the production cycle of short-term (seasonal, annual) crop or livestock
enterprises. Common examples are land, machinery, an irrigation system. These services
may be used either by individual enterprises or to maintain the farm as a whole. In the
very long run, of course, few resources are truly fixed in supply.
Short-term resources: are those that are usually entirely used up in the annual
production cycle, e.g., a supply of seed or fertilizer.

The essential difference between fixed and short-term resources is that the former provide a
stream or flow of services over time while the latter consist primarily of quickly exhaustible
material things or time-bound institutional sanctions.

2.1.2 Farm resources from an operational view

From an operational viewpoint farm resources are somewhat different. Here emphasis is on
the ex ante potential or planned use of resources rather than the results of their past use. From a
planning and operational viewpoint, farm resources fall into five categories. Discussion from an
operational viewpoint is focused on how specific resources might constrain or limit farm
production. The five resource categories are:
(1) Material long-term: This category consists of material things which yield their services
over relatively long time periods.
(2) Material short-term: This category, exemplified by such items as seed and other
seasonal inputs, was also discussed above. In a commercial environment where these
items are purchased, the production constraint is generally set by the amount of money
available to buy them, not by the supply of these items in themselves.
(3) Financial: This category consists of cash, debts receivable, and access to credit from
formal (banks, cooperatives) and informal (shops, traders, relatives) sources.
(4) Institutional: This category consists essentially of rights of access to materials, markets
and services. In its financial dimension, this category takes the form of land and road
taxes, water-use license fees, payments for production-quota rights (as sometimes prevail
for sugarcane, milk, tobacco etc.). They are termed „institutional‟ because they consist of
relationships between the farm family on the one hand and institutions/agencies/persons
on the other. Note that where they are transferable and have financial value, these rights
are assets as well as production resources.
(5) Labour: This consists of family labour available for general farm work or which might be
available only for specific tasks. For example, specific-purpose labour might consist of
the very old and young family members who can do only light work such as tending
livestock; or a family member who prefers and is especially skilled in tapping toddy
palms etc. (Management ability is an important attribute of family labour, sufficiently so
as to sometimes warrant attempts at separate evaluation of its productivity, but it is
usually not possible to measure management as an ex ante input, only in terms of what it
actually achieves

2.2 Farm resources and their rewards

Farm resources are the resources which are a means for farm productions and it cannot be
deviate from the sense of factor of productions. If so, the farm resources and their reward are
mentioned below in a clear manner.
Table 2.1 farm resources and their reward

Type Definition Reward

Land All natural resources Rent
Labour The physical and mental works of people Salary/Wage
Capital All man made tools and machines Interest
Enterprise All managers and organizers Profit/Loss

2.3 Farm Resources Valuation

Using market data, economists can estimate the benefits consumers and producers obtain from
marketed goods and services. But many of the benefits we obtain from nature are not necessarily
derived from market transactions. The standard metric normally used by economists is some monetary unit, such
as dollars. Thus the central challenge for nonmarket valuation becomes expressing various benefits
and costs in dollar terms.

2.3.1 Marketable farm resource (farm assets) Valuation

Marketable farm resource valuation entails obtaining a realistic measure of the current value of
the assets of the farm business. The first thing to do in assets valuation is the listing of all the
resources available in physical terms then, place value on the assets. The various methods of
valuation include valuation at cost, market price, net selling price, reproductive value etc.
1. Valuation at cost: - This entails entering in the inventory, the actual amount invested on the
asset when it was originally acquired. A major disadvantage of this method is that after the
business has been in operation for sometimes, the original cost is no more of much value since
the conditions might have changed.
2. Valuation at Market Price- The market price of an asset at the time under consideration can
be taken as its value.
3. Valuation at Net Selling price: - some costs such as cost of advertisement and transportation
might be incurred when selling an asset. Whatever price can be obtained in the market for the
assets (i.e market price (Pm) less the cost of selling (Cs) is the net selling price (Pns),
Rotationally, Pns = Pm – Cs
4. Valuation by Reproductive Value:-An asset can be valued at what it would cost to produce it
at present prices and under present methods of production. This method is more useful for long-
term assets and has little or no application for short – lived assets.

Methods of computing depreciation

Depreciation refers to the financial estimate of the annual loss of value of capital equipment due
to wear and tear over its useful life. The original cost of the asset is a prepaid expense. However,
if the asset is used in more than one accounting period, this cost will be allocated to those
accounting periods that correspond to the productive life of the asset. Depreciation cost of an
asset can be computed using different methods. Some of these are:
1. The straight line method,
2. The reducing balance method,
3. Sum-of-the year digit method.
Straight line method
It is the easiest, simplest and usually very satisfactory for most purposes. This method assumes
that assets are used more or less to the same extent every year. Therefore, equal amount of costs
on account of their use can be charged over its useful life. Based on this method the annual
depreciation of the asset can be computed as:
Original cos t  Salvage value
Annual depreciation 
Useful life of the asset
Where:
Original cost is the purchased price of the asset,
Salvage (scrap/junk) value is the value of the asset at the end of its useful life. It is zero if the
asset is completely worn out at the end of its useful life.
Useful life is the expected number of years that item will be used in the business.
Example: A fixed equipment costs birr 1000 and is expected to last for 5 years. The salvage
value of the asset after 5 year is birr 50. The annual depreciation cost using straight line method
is computed as:
1000 50 950
Annual depreciation    190
5 5
Throughout its useful life the asset depreciate by birr 190.
Reducing balance method:

It is a method that uses a fixed rate of depreciation each year and it applies the rate to the value
of the asset at the beginning of the year (book value). This means, a fixed percentage is deducted
every year from the diminished balance till the asset reaches the salvage value. Here no further
depreciation is possible. Using the previous example of an asset costing birr 1000 and taking an
annual depreciation rate of 45 percent, the depreciation cost of the asset is given by Table 1.

The formula is: Annual depreciation = (Book value)*Fixed rate

Table2.2. Annual depreciation at 45% on reducing balance
Value
Year Book value Depreciation
at the year end
1st 1000.00 450.00 550.00
2nd 550.00 247.50 302.50
3rd 302.50 136.13 166.38
4th 166.38 74.87 91.51
5th 91.51 41.18 50.33
The amount of depreciation is different at different stages and gradually diminishes with the life.
In this particular example the depreciation cost diminishes from 450 to 41 within 5 year of useful
life.
Sum-of-the year digit:

In this method the annual depreciation is found out by multiplying a fraction by the amount to be
depreciated (cost minus salvage value).
The formula is:

RL
Annual Depreciation  * (Originalcost  Salvagevalue)
SOYD
Where:
RL is remaining useful life
SOYD is the sum-of-the year digits‟, which is simply the sum of the numbers 1 through the
estimated useful life.
For example, for 5 year useful life, the SOYD is 15
 SOYD for 5 year = 1+2+3+4+5 = 15
Table 2.2. shows the annual depreciation cost of an asset, costing birr 1000 with an estimated life
of 5 year and a scrap value of birr 50, computed using the sum-of-the year digit method.
Table2.3 Annual depreciation using sum-of-the year digit method

Depreciable Depreciation
Year RL SOYD
Value Cost
1 5 15 950.00 316.67
2 4 15 950.00 253.33
3 3 15 950.00 190.00
4 2 15 950.00 126.67
5 1 15 950.00 63.33

2.3.2 Valuation of non-marketable farm resources:

None marketable farm resources as well as environmental resource can be value through stated
preference or revealed preference method. Revealed preference methods are based on actual
observable choices that allow resource values to be directly inferred from those choices, on the
other hand, stated preference method that can be used when the value is not directly observable,
such as the value of conserving environmental resource. But let us see some preliminary issues
before valuation techniques:

First, it needs to consider the benefits that we receive from natural resources and the
environment. Marketed goods and services provide benefits to consumers as defined by the
difference between their maximum willingness to pay and price, which is consumer surplus. The
same notion can be applied to nonmarket goods and services. The economic value that people
obtain from a specific resource is defined as their maximum willingness to pay (WTP) for it. For
many nonmarket goods, there is not a direct “price” that must be paid to receive benefits. Clean
air, for example, is something for which most people would be willing to pay. While they cannot
necessarily express the valuation of clean air in markets, they can express their support in other
ways, such as by voting or donations. If a specific policy would damage or destroy a certain
environmental resource or decrease environmental quality we can ask how much people would
be willing to accept in compensation for these changes. This is the willingness to accept (WTA)
approach to environmental valuation. Both WTP and WTA are theoretically correct measures of
economic value. They can be applied to any potential policy situation. We will consider various
economic techniques used to estimate WTP or WTA shortly, but first, we turn to the different
types of economic value.

Types of Values that We Place on the Environment

Economists develop classification schemes to describes various types of values that we place on
the environment. These values are classified as use and nonuse values. Use values are tangible
benefits that can be physically observed. They are further classified as direct use value and
indirect use value. Direct use value is obtained when we make a deliberate to use the
environmental resource. These values may derive from the financial benefits that we could
obtain by extracting or harvesting a resource, such as the profits from drilling for oil. They may
also derive from the well-being that we obtain by interacting with a natural environment, such as
fishing or going for a hike or fishing. Indirect-use values are tangible benefits obtained from
nature without any effort on our part. Also referred to as ecosystem services, they include flood
prevention, the mitigation of soil erosion, pollution assimilation, and pollination by bees. While
these benefits may not be as apparent as direct use benefits, they are still real economic benefits
and should be included in economic analysis. Nonuse values are derived from the intangible
well-being benefits that we obtain from the environment. While these benefits are psychological,
they are nonetheless “economic” as long as people are willing to pay for them and they are
further classified into option value, bequest value, and existence value. Option value refers to
the amount that people are willing to pay to preserve a resource because they wish to use it in the
future. On the other hand bequest value is the value that one places on a resource because he or
she wishes it to be available for future generations. Finally, existence value is the benefit that an
individual obtains from knowing that a natural resource exists, assuming that he or she will never
physically use or visit the resource separate from any bequest value
Figure 2.1 Types of environmental values

Table 2.4 definition of environmental values

2.3.2.1 Valuation techniques of non-marketable resources

A. Revealed Preference Method

Revealed preference methods are those that are based on actual observable choices that allow
resource values to be directly inferred from those choices. These methods are observable. They
involve actual behavior and indirect because they infer a value rather than estimate it directly
resource. The revealed preference indirect approach methods infer the value of environmental
goods by studying their actual or revealed behaviors in closely related markets through the
application of some model of relationships between marketable goods and environmental
services Some of the revealed preference methods that are in use about environmental resource
valuation are hedonic pricing method (HPM) and the travel cost method (TCM).

I. Hedonic pricing method

The hedonic pricing method is the most commonly used revealed preference valuation technique.
It is derived from the characteristics theory of value and seeks to explain the value of
commodities as a bundle of valuable characteristics. HPM relies on market evidence related to
property values to determine the value that people assign to improvements in access to public
and quasi-public goods (e.g., police and fire protection, local parks) and environmental quality. It
is assumed that individuals choose the number of public goods and environmental quality they
want by the choices they make concerning residential purchases. People choose to live in areas
that have cleaner air or less crime, they choose to live near airports or along highways, and they
choose to live on quiet or on busy streets. The choice is determined by what they are willing and
able to pay for housing. HPM exploits these choices by estimating implicit prices for house
characteristics that differentiate closely related housing classes.

II. Travel cost method

The travel cost approach is used to estimate the value of recreational benefits generated by
ecosystems or the environment. It takes the costs of travel that are incurred by individuals in
visits (the costs of transport plus the value of time) made to recreational sites as implicit prices to
value of the service provided and changes in its quality. TCM measure only the use-value of sites
and are usually limited to recreational use-values. This approach theoretically takes into account
for time spent in travel, assigning a value to it is somewhat arbitrary

B. Stated preference method

Stated preference methods use survey techniques to elicit willingness to pay for a marginal
improvement or for avoiding a marginal loss. The most direct approach, called contingent
valuation, provides a means of deriving values that cannot be obtained in more traditional ways.
The simplest version of this approach merely asks respondents what value they would place on
an environmental change or on preserving the resource in its current state. Alternative versions
ask a “yes” or “no” question such as whether or not the respondent would pay $X to prevent the
 change or preserve the species. The answers reveal either an upper bound (in the case of a “yes”
answer) or a lower bound (in the case of a “no” answer). This survey approach creates a
hypothetical market and asks respondents to consider a willingness-to-pay question contingent
on the existence of this market. Some of the stated preference methods that are frequently used in
the valuation of an environmental resource are contingent choice modeling and contingent
valuation approach

I. Choice modeling

Indirect hypothetical stated preference methods include several attribute-based methods.

Attribute-based methods, such as choice experiments, are useful when project options have
multiple levels of different attributes. Like contingent valuation, choice experiments are also
survey-based, but instead of asking respondents to state a willingness to pay, they are asked to
choose among alternate bundles of goods. Each bundle has a set of attributes and the levels of
each attribute vary across bundles. Since one of the attributes in each bundle is a price measure,
willingness to pay can be identified.

II. Contingent valuation method

Contingent valuation, the most direct approach, provides a means of deriving values that cannot
be obtained in more traditional ways. CVM is a recognized and widely used non-market
valuation technique. In developing countries, contingent valuation surveys were originally
applied in water supply and other environmental benefits estimation, and are much easier and
very straight forward to conduct because the respondents take it more serious than in the
industrialized countries. CVM is a demand-side approach with hypothetical markets that allow
individuals to state their willingness to pay for changes in the quantity or quality of
environmental goods and services and the objective of CVM is to measure consumer surplus for
the environmental attributes. There are two advantages to this method. First, CVM can assess an
individual‟s WTP in the present conditions and also values their WTP with hypothetical changes.
Second, CVM can value trips with multi destinations by asking hypothetical questions for each
specified destination. Specifically, CVM was seen both as an alternative method of valuation
TCM and HPM and as being able to quantify some types of benefits, such as non-use or passive-
use benefits, which lie outside the scope of TCM and HPM studies. Given this, and the fact that
indirect methods cannot address non- use/existence values, the study employed the CVM in the
context of trying to ascertain non-use/existence values. The steps involved in applying the CVM
can be stated as follows. The first step is the creating of a survey instrument for the elicitation of
individuals‟ WTP/WTA. This can be broken down into designing the hypothetical scenario,
deciding whether to ask about WTP /WTA and creating a scenario about the means of payment
or compensation. The second step is using the survey instrument with a sample of the population
of interest. This step is followed by the analysis of the responses to the survey that can be seen as
using the sample data on WTP/WTA to estimate average WTP/WTA for the population and
assessing the survey results to judge the accuracy of this estimate. Fourthly, computing total
WTP/WTA for the population of interest is followed. The last, but not least step in CVM is
conducting sensitivity analysis

Figure 2.2.Valuation method

CH3. : ANALYSIS OF FARM RECORDS AND ACCOUNT

3.1. Introduction: Records are statements of fact or data concerning a specific subject which
may be specified in physical, monetary, mathematical or statistical terms. Farm records pertain to
information recorded on the day-to-day operation of a particular farm.

Farm records can be defined as systematic documentation of all activities taking place in a farm
enterprise over a given period of time. It is an act of writing down every activity engaged in on
the farm in every production season and at different stages of the production process up to the
final disposal of the goods and services to the ultimate consumer.
Farm record keeping is more than just keeping track of what crop was planted in what field, it is
a concept applicable to the entire farm operation. A complete farm record will include all daily
activities and transactions and with a proper accounting system it should be possible to have a
complete estimate of the profit or loss statement at the end of the year.

3.1.1 Purpose of farm records:

The use of timely and accurate records can provide useful information and indications on the
past, current and future performance of the business. Without a proper understanding of record
keeping and its current and future implications, the farm operator will not make it very far in
today‟s business environment. When used properly, good records can help a farmer to improve
his performance, even though it may already be of a high standard.
Specifically Records should be used to:
Evaluate past performance of the operation,
Provide a financial picture of the present situation, and
Serve as a planning guide for future decisions.

3.1.2 Types of farm records

There are three basic types of farm records: resources inventories, production accounts of
livestock and crop operations, and income and expense records.
1) Resource Inventories:
Farmers use resources such as land, labour, machinery, management and financial capital to
produce a product. As part of your records, you must place a value on these resources and
maintain current inventories so that you know the foundation from which you operate your
business. A resource inventory includes both farm assets and liabilities at a particular point of
time. A direct application of a resource inventory is the development of a balance sheet. A
balance sheet provides information about the long-term stability and viability of a business and
the ability of a business to meet its short-term commitments. It also determines the net worth of
the business at a particular point of time and allows the manager to determine how well the
business is progressing.

2) Production Records of crop and livestock operations

Production records are used to assess the performance of the crop on your farm during a given
season. Production records usually include variety, yield, soil nutrition, pesticide application,
irrigation, crop rotations, machinery operations and labour. This can provide valuable
information for evaluating the farm performance during a particular year.
Farm maps are also a critical part of record keeping and these can be used to describe field
layouts, cropping patterns, building locations, drainage, irrigation infrastructure and soil
conditions. Farm maps are also useful for Workplace Health and Safety reasons as they may be
used to assist with the employee induction process (eg. identify hazards etc).
Other written crop records show crop rotations, yields, fertilizer rates and pesticide applications.
This information can be summarized and will indicate the efficiency of production.
Livestock and poultry records usually include subsections for mortality, breeding, performance
and feed information. Mortality records list the number of livestock and track disease problems.
Breeding records ensure that only superior individuals or groups of individuals are used to parent
offspring with desired characteristics.
Performance records for livestock are divided between birth and productive information. Birth
records indicate date of birth, important dates in the animal‟s life, parental evaluation and
weaning information. Production records refer more directly to herd size, rate of gain,
kilogramme sold and purchased.
Finally, feed records are important in evaluating overall production efficiency.
Feed normally constitutes at least 50percent of the total cost of raising an animal for meat. The
type of feed ration, its formulation and the rate of feeding should be monitored closely.
Another major category of production record keeping is the enterprise labour. By knowing the
amount and timing of labour required per operation of an enterprise, you can better plan what
options are feasible when faced with labor constraints. Labor input into the business is also
required as part of the calculation of farm profitability.

3) Income and Expenses:

It is necessary to keep records of all business income and expenses. Income may include
payments from crop sales and contract work. Expenses may include chemicals, fuel, fertilizer,
interest, etc. Recording this information is used to provide valuable information to the manager.

Principles of Record Keeping

There are some general principles which apply to all record keeping and these are as stated
below:
1. All records, to be of value, must be accurate, neat and full. One way of making sure that
records are accurate is by filling them in as soon as possible after the operation or
transaction and by checking regularly.
2. All the results of record keeping should be compared with some standards which may be
the results for previous years or the results for other farms. By comparing results and
discussing problems together, farmers can help each other to improve their management.
3. The record keeping system should fit into the farm organization or framework.
4. The person responsible for keeping the records should develop a habit of regularly and
accurately posting transactions.

3.2 Measures of Financial Success & Capital Position

3.2.1 The balance sheet/net worth statement

Balance sheet or net worth statement is a financial statement which shows the financial position
of a farm business at a point in time and represents a stock concept. It is a financial snapshot of
the business, which reports financial information in a format that can be easily read and
understood.
The purpose of this report is to describe the assets, liabilities, and equity (capital) of a business at
a particular point in time. The net worth statement is one of the principal reports of any good
accounting system.
An asset is anything of value owned by a business concern. In order to ascertain the condition
of a business with regard to its immediate obligations, its assets are categorized according to
their liquidity. A net worth statement requires an inventory of all properties or assets as well as
records of all liabilities of the business. There are three classes of assets. They are fixed, working
and current assets.
Fixed Assets: Are those assets which cannot be easily converted into cash to meet current
obligations. Examples of fixed assets are land, buildings and other permanent improvement like
fence.
Working Assets: Are those assets which are used up within the production process of the
business. Their values may be regarded as being transferred slowly to the products during the
farm operations. They are liquidated at a faster rate than fixed assets. Examples of working
assets are farm equipment (like hoes and cutlasses), layers and donkeys.
Current Assets: Are also called liquid assets. Examples of current assets are cash in hand, bills
receivable within a short time, crops and feeds in hand

Liabilities are those legitimate claims that can be made against a business. It is useful to have
classification of the liabilities correspond to that of the assets. Liabilities are classified according
to the time they fall due for payment.
Long-Term Liabilities: Are those that will not fall due for payment in a lump sum within a short
period of time. It may fall due to a period, like say, twenty years. Examples of long-term
liabilities are real estate mortgages and long-term land leases. These are not commonly used by
subsistence farmers.
Intermediate Liabilities: Are those obligations that are deferred for the time being but which will
be paid within a few years like five years or less. Examples of intermediate liabilities are
promissory notes, obligations base on crop or livestock in the process of production and ready to
mature within a few years.
Current Liabilities: Are those obligations that are payable with a year. These payments when
due demand the immediate attention of the farm manager.
Net worth/owners’ equity: assets minus debt equals net worth, we are obviously looking for a
positive figure. A negative net worth shows insolvency. So the basic solvency indicator is net
worth. Trends in net worth show trends in solvency. Table5.3 Balance sheet/Net worth statement
Item Value (Birr) Item Value(Birr)
Asset Liabilities
Current asset Current liabilities
Chicken 200 Account payable now 1,500
Eggs 50 Account payable in 6 months 1,000
Crops 160 Account payable in 12 months 1,000
Working assets Intermediate liabilities
Bulls 1,000 Accounts payable in 3 years 2,500
Breeding stock 2,000 Accounts payable in 5 years 2,000
Fixed asset Long-term liabilities
Land 2,000 Accounts payable in 10 years 2,000
Building 5,000 Total liabilities 10,000
Fencing 1,000 Net worth/equity 1,410
Total assets 11,410 Total liabilities +net worth 11,410

Farm managers use performance indicators all the time. Yield per acre is one example, calving
percentage is another. Almost every production performance activity in a farm business can be
expressed by comparing two or more elements. The same can be done on the financial side of the
business.
Analyzing the results contained in a business plan is simply a process of looking at specific
information contained in the financial statements, interpreting the results, and drawing some
meaningful conclusions from this information. The key is to know what to look for, how to make
some sense out of this information, and then use this information in making informed
management decisions.
One way to analyze financial statements is to look at different ratios. Ratios are simply
relationships between two different sets of financial data or values. Properly interpreted ratios
can point to areas requiring further investigation and inquiry. The analysis of a ratio can disclose
relationships as well as form a basis of comparison that reveals conditions and trends that cannot
be detected by an inspection of the individual components making up the ratio. Some ratios may
be described as being desirable, others as being weak. The trend of these ratios over time is
often more important than the numerical value.
Another way to express the relationship between two or more sets of financial data or values is to
state the relationship in terms of a percentage of one to the other(s). Having established this
relationship, it is important to correctly interpret the relationship, so that a meaningful conclusion
can be reached and a sound management decision made based on this information.
Whether you are using a ratio or a percentage analysis, it is important to keep in mind that the
results and interpretation can be affected by the values placed on the assets, the type of business,
and the size of the farm business.
With a little knowledge, some experience, and a measure of common sense, analyzing financial
statements can become a valued management skill. Let's look now at some of these ratios and
relationships as reported on a typical net worth statement.

Liquidity: is a short-term concept and shows a firm's ability to meet debts when they become
due. Many farms have liquidity problems today, meaning that they cannot pay all the principal
and interest on loans due in the following year. There are three main indicators of liquidity: the
current ratio, working capital, and the debt structure ratio.

i. Current Ratio: The current ratio generally shows the ability of the business to meet financial
obligations in a very short time. A current ratio of greater than 1 implies that the current assets
can be more than pay for the current liabilities. A narrow current ratio shows that problems exist
especially if bills fall due for payment at the wrong time.
The current ratio is often called the acid test because it is a test that can be performed quickly.
current assets
Current ratio 
current liabilities
If, for example, a business has a current ratio of 2:1, it means that there is $2 of current assets
covering every $1 of current liabilities. Agricultural lenders generally like a current ratio of at
least 2:1. If the ratio is 1:1, then the firm is barely liquid, and if the ratio is less than this, the firm
has liquidity problems. It is always hard to generalize in farming because of the variation
between different enterprises and different areas and practices.
Generally, any current ratio trends below 1.3:1 indicate danger. Conversely, a ratio above 5:1
strongly suggests that the firm is overly liquid and should be investing some of its current assets.

ii. Working capital: A second liquidity guide is working capital, that is, current assets minus
current liabilities. Working capital shows what is available after meeting debts due. Obviously,
we need a positive figure; otherwise the firm is illiquid. But the amount of working capital
considered reasonable depends on the size and type of the individual firm. We would expect it to
grow for an expanding business.

iii. Debt Structure Ratio: A third liquidity guide, debt structure ratio, illustrates the debt
structure of the firm. This ratio is calculated by dividing current liabilities by total liabilities, i.e.
current liabilities
debt structure ratio 
total liabilities
A ratio of 0.6:1 (often written as 0.6) means that 60 percent of the total farm debt is due the
following year. If total debt is small, there is nothing to worry about. But most farms have
considerable debt loads, and a debt structure ratio of 0.6 shows that too much of the farm debt is
current.
In general, a ratio of 0.2 or less is safe and 0.5 or more is dangerous. Trends going in either
direction may require some decisions. For example, we could increase borrowing in the former
case and perhaps, by transferring some of the current debt into long-term liabilities, arrange for
debt restructuring in the latter situation.

Solvency: is a long-range concept which shows the firm's ability to meet all debts when assets
are sold. Solvency indicators are found in the balance sheet. The main indicators are net worth,
the leverage ratio, and the solvency ratio.

i. Net Worth: As assets minus liabilities equal net worth, we are obviously looking for a positive
figure. A negative net worth shows insolvency. So the basic solvency indicator is net worth.
Trends in net worth show trends in solvency.

ii. Leverage Ratio: The leverage ratio is another solvency indicator. This ratio is calculated by
dividing total debt by net worth. Most lenders do not want to see leverage ratios over 1.5:1. This
means there is $1.50 of debt for every $1 of net worth. The higher the ratio, the more risk the
firm faces, and, conversely, the lower the ratio, the lower the risk. However, many young
farmers need ratios over 4:1 if they are to obtain sufficient capital to farm. Trends are again
important. Ratios above 2:1 must be watched carefully. Those below 1:1 may suggest acquiring
additional debt to exploit current opportunities.

iii. Debt to asset ratio/Solvency Ratio: It shows the percentage of the assets that are financed by
outside creditors. The ratio is calculated by dividing the total liabilities by the total assets and is
expressed as a percentage.
total liabilities
Debt equity ratio   100
total assets
As a general rule, a farm business having under 25% of its assets financed is in a fairly strong
position, while between 25% to 40% is moderate, and between 40% and 60% is in an
increasingly weaker position. The higher the debt ratio, expressed as a percentage, the greater the
financial risk as a result of the higher borrowing costs.
Solvency, therefore, covers the long-range aspects of the business. We now need to see how the
business is performing throughout the year. This performance is indicated by profitability
indicators taken from the income statement.

5.2.1. Income statement

Other names used for this important accounting statement include: a profit and loss statement, an
operating statement and an income and expense statement. The income statement lists the
income and expenses of a business over a period of time called the accounting period.
Year – to year profits are calculated on the income statement also known as the profit/loss
statement. The income statement is used to calculate net cash income, adjusted by changes in
inventories and capital items.

The Net farm income refers to the „bottom line‟ profit that is earned (or projected to earn) by the
business during the accounting period. The Net Farm Income provides the answer to the question
of how much profit the farm has made or is projected to make, in the business plan.
Table Income Statement
Outputs Value (Birr) Costs Value (Birr)
Sales and receipts Variable costs
Livestock 44 Seeds 50
Chicken 150 Fertilizer 150
Eggs 200 Labour 200
Cotton 600 Feeds 120
Groundnut 300 Fixed costs
Sorghum 400 Taxes 10
Home consumed product Permanent staff 300
Sorghum 600 Repairs on buildings 50
Vegetables 50 Interest on debt 60
Maize 420 Total cost of 940
production
Total farm receipts 2764
Opening inventory Closing inventory
Sheep 144 Sheep 100
Chickens 150 Chickens 350
Ducks 50 Ducks 60
Grains 240 Grains 260
Fertilizer 100 Fertilizer 80
Goats 120 Goats 160
Total 804 Total 1010
Change in inventory = 1010 – 804 = 206

Net farm income = Total Farm Receipts – total Cost of Production+ Change in inventory = 2764
– 940 + 206 = 2030.
Analyzing Net Farm Income

Whether you analyze the Net Farm Income from previous years or a projected Net Farm Income
for the coming year, you need to ask yourself a number of questions: "Am I satisfied with the
current Net Farm Income?"; "Can the value of the farm production be increased or the costs
reduced to improve the income?"; "What went well and what can be done better to improve the
overall profitability?"; "How do my results stack up against the plan prepared last year, other
similar farms in the area, and bench-mark costs of production for similar enterprises?"
An in-depth analysis will involve looking at each enterprise and each source of revenue and
expense to see what could be done to improve the overall income. Analyzing this information on
an enterprise basis and on a per unit basis can provide a great deal of insight as to how much it
costs to produce an acre of grain, a litre of milk, or a tonne of forage. Knowing your costs is the
first step to improving the bottom line. Focusing on production issues, marketing, cost control,
and risk reduction, is the next logical step to improve Net Farm Income. This critical analysis
takes time and effort but can also be very rewarding and absolutely essential for not only
learning from the past, but also for planning for the future. This information and analysis is also
critical to your lender in helping gain insight into your business and providing credit support.
Analyzing the Net Farm Income as a return on the farm assets and equity (net worth) can also be
informative. Since the Net Farm Income represents the return the farm earns on investment.
The measures of profitability are as discussed below.

1. Returns on Assets (ROA)

It is a measure of profitability measuring the rate of return that the farm business earns on its
average asset base over the period. The higher the return, the more profitable the farm business
Net farm income  interest exp ense  unpaid labour
ROA   100
total farm assets
An appropriate unpaid labor/management cost must be subtracted from the Net Farm Income, in
order to get a net return to only the capital invested in the business. Income before interest is
used because interest is considered part of the return on your investment and was claimed as an
expense in determining the Net Farm Income. Typical ROA‟s for many farms are in the 2% to
5% range.

2. Return on Equity (ROE)

It is a measure of the return to the net worth (equity) in the business. The farm equity is the
capital that could be invested elsewhere (if you were not farming) and so this analysis provides
an interesting perspective to see just how good a return a farmer is receiving on his investment in
farming as compared to other alternatives. It is calculated by dividing the Net Farm Income less
the unpaid labour/management costs, by the average value of the farm equity (net worth) for the
period and is expressed as a percentage.
Net farm income  unpaid labour
ROE   100
Farm equity (average)
3. Expense/Revenue Ratio:

Shows the percentage of the farm income that is required to cover the operating expenses,
excluding the principal and interest payments. The ratio is calculated by dividing the operating
expenses by the value of the farm production and is expressed as a percentage.
Operating exp enses
Expenses/ Re venue Ratio   100
Value of farm production
This ratio will vary depending on the specific farm enterprise. For example, a dairy farm expense
ratio will generally be between 53% to 60%, and for a typical grain farm this ratio will be
between 65% and 80%.
CHAPTER FOUR: FARM PLANNING AND BUDGETING
Introduction
Planning is the base for all other activities of a business organization. The objective of this
chapter is to demonstrate of some common techniques or tools used in farm planning process, to
maximize the farm income under various sets of farm situation. Therefore this chapter
incorporates different concepts in farm planning and farm budgeting. The farm budget part in
turn comprises whole farm, enterprise and partial budgeting.

4.1. Farm Planning

Planning means taking decisions in advance. It stimulates thinking, broadens understanding &
challenges the farmer to move forward. It is a forward-looking approach.

4.1.1. What is farm planning?

Farm planning can be defined in different ways. Some of these are:
It is a basic but complex management function combining financial, physical and technical
aspects of the farm for selecting and developing the best of the alternative way of achieving the
stated objectives.

Farm planning is an integrated coordinated and advanced program of actions, which seek to
present an opportunity to cultivators to improve their level of income. Farm planning is a basic
management function that involves selecting a particular strategy or course of action among
alternative courses of action with the objective of obtaining the greatest satisfaction of the firm‟s
goals.

Farm planning is a process to allocate the scarce resources of the farm and to organize the farm
production in such a way that to increase the resource use efficiency, the production and the
income of the farmer. In general, it is an approach which introduces desirable changes in farm
organization and operations and makes the farm viable unit by making rational decision
regarding the organization and operation of a farm business. It tells how best to make use of
opportunities to a farmer to channelize his scarce resources.
Planning has to be done in a continuous fashion. Those who cannot make rational decisions and
needed adjustments will find the farming not a profitable proposition for them. Planning is also
organizing, as a plan represents a particular way of combining or organizing resources to
produce some combination and quantity of agricultural products. Land, labour and capital do not
automatically produce wheat, maize, beef cattle or any other products. These resources must be
organized in to the proper combinations, the proper amounts, and at the proper time for the
desirable production to occur.

In the sense of a farm plan, it is to the farmer what the architect's designs and specifications are
to a building contractor. Thus, a farm plan contains the usual adage of "what, how much, when,
where, who, and how " of a situation. The „what‟ involves selection of the combination of
enterprises to be produced. Since the means and resources are scarce, the manager has to plan
about the mix of good to produce and what quantities of these goods and services to produce
over time. This is a question of deciding to produce wheat, maize or livestock or both. Whatever
the decision will be then how much of each commodity should be produced. The question of
„when‟ is about timing of each activities that must be done to achieve the farm goal. The „where‟
issue concerns the place where the plans will reach its conclusion. The question of „who‟ asks
which specific people will perform specific tasks essential to the plans.

Almost all agricultural products can be produced using different combination of inputs and
different techniques of production. Beef can be produced with a high grain ration or a high
roughage ration. Crop can be produced with large machinery and little labour, or small
machinery and more labour. A plan must show the appropriate combination of inputs which will
minimize the cost of producing a given quantity of enterprises. Therefore, the issue of „how‟
involves with what resources and in what technological manner is the mix of enterprises are
produced to accomplish the task of achieving a particular objective.

4.1.2. Objectives of farm planning

The meaning of farm planning discussed earlier very much related to its objectives. On the
majority of our farms, there is underutilization as well as over utilization of the existing farm
resources. Due to this, usually farm organizations fail to get maximum net gain. This indicates
the need for reorganize the farm structure for proper allocation of resources to obtain optimum
production and net income. This calls for proper planning activity Farmers may have some
personal preferences and motivations that must be taken care of in practical planning, which may
includes maximizing security, minimizing risk, minimizing investment, etc. However, the main
objective of farm planning is the improvement in the standard of living of the farmer and its
immediate goal is to get the greatest return interims of cash and food, for his effort both in the
short and long run. 4.1.3. Advantage of farm planning
With out planning, farm business decision would become random, ad hoc choices. The following
concrete reasons explain the paramount importance of farm planning.
i. Income improvement
Farm planning primarily concerned with making choices and decisions: selecting the most
profitable alternative from all possible alternatives, and seek to present an opportunity to
cultivators his level of income. It is this opportunity of income maximization that induces
farmers to adopt desirable changes. Such income maximization could be achieved from a given
bundle of resources by re-organizing present type of production as well as introducing changes in
technology.
ii. Focuses attention on the farm organization’s goals
Farm planning helps the manager to focus attention on the organization‟s goals and activities.
This makes it easier to apply and coordinate the resources of the farm more effectively. The
whole organization is forced to embrace identical goals and participate in achieving them. It also
enables the farm manager to outline in advance an orderly sequence of steps for the realization of
organizations goals and to avoid a needless overlapping of activities.
iii. Educational process
Farm planning is an educational tool to bring about a change in the out look of the cultivators
and the extension workers. Knowledge of the latest technological advances in agriculture is a
pre- requisite for better farm planning; so farmers or farm managers keep their information up-
to-date through this forced action situation of farm planning process. This act is used as a self-
educating tool for the farmers. The farmers or farm managers can closely study their own
business and see more clearly their opportunities and limitations, thus, improving their
managerial ability.
iv. Desirable organizational change
Planning helps to introduce desirable changes in farm organizations and operations. In its broad
sense, it may mean any contemplated change in the method or practices followed on the farm.
The advantage of farm planning lies in its treating the farm as an operational unit and tailoring
the recommendation to fit into the individual farmers' opportunities, limitations, problems and
resource position.
v. Minimizes risk and uncertainty
By providing a more rational and fact based procedure for making decision; farm planning
allows managers and organizations to minimize risk and uncertainty.
vi. Facilitates control
In planning, the farm manager gets goal and develops plans to accomplish these goals. These
goals and plans then become standards or benchmarks against which performance can be
measured. The function of control is to ensure that the activities confirm to the plans. Thus,
control can be exercised only if there are plans.

Defines responsibility:- planning defines the responsibility of each worker in the farm business.
It defines who does what;
Effective communications: Farm planning enables each worker in the farm business to
communicate effectively within the new farm work new ideas and opportunities and his own
resource position,

4.1.4. Who is to make farm plan

Planning technique can be applied to large commercial and small individual farms. On large
commercial farms usually highly trained manager will be employed and he/she may have the
assistance of technical and economic advisors in drawing up plans. However, in small individual
farms, it is the farmer who is expected to keep records and account to prepare his own plan; at
least to the extent of making some rough estimates on paper, otherwise they need to get
assistance from individual specialist for the purpose.

Individual farmers have many objectives. They want low risks, low investment, a certain amount
of leisure time, security, high net income this year and in future years etc. It is usually not
possible to maximize all these objectives at once. Maximum net income for 5 to 10 years from
now may be achievable only by sacrificing some net income in current and in the next few years.
High income usually involves greater risk than low one and will usually require heavier
investments. More leisure will usually be at the cost of lower earnings, etc. Different farmers put
different values on each of these. Therefore, if the plan is prepared by an outsider, he/she cannot
develop a suitable plan for a farmer without knowing how he wants to compromise his
objectives. Thus, one has to plan a farm with the farmer.

Hence, the decision making should also rest with the farmer because it is he who will gain or
lose by implementing the decisions. Moreover, the farmer would be more willing in
implementing the decision made by him than when it is made by someone else for him.

4.1.6. Techniques and Steps in Farm Planning

4.1.6.1. Techniques of farm planning

There are many techniques or tools or models and aids available to a farm planner for generating
answer to multifarious farm management problems either separately or simultaneously. The
various tools and aids to farm planning are depicted in the following chart.
 Chart 4.1 Techniques of farm planning
A. Perfect knowledge and certainty situation
Production
and 1. Production function model
organization 2. Farm budgeting technique
planning tools 3. Linear programming
4. Non-linear programming
5. Dynamic programming
6. Integer programming

Farm planning
B. Perfect knowledge and risk situations
techniques
and aids 1. Modified programming Models

2. Diversification models

Administrative 1. Farm technological coefficients

planning tools (Input-output data)
and aids
2. Electronic accounting and data processing
facilities

3. Interdisciplinary research facilities

4. Metrological forecasting services

Marketing
planning tools 1. Demand and supply projection analysis
and aids
2. Future trading analysis

3. Marketing management research

4. Improved credit facilities

4.1.6.2. Basic steps in farm planning

In developing an optimum farm plan with the following steps are generally followed.
1. Inventory of farm resources
Prepare a complete list of the farm resources which limit the size of the different farm
enterprises; such as land, labour, animals, buildings, machinery and liquid capital, etc. This helps
for assessment of actual resource limitations and production capabilities of the farm. To these
resources, possibilities of hiring or borrowing are added. These restrictions lay down a
framework, within which a farm is considered.
2. Analysis of the existing farm plan

Obtain full information on how each resource is being utilized and what are the outputs obtained
from various enterprises adopted on the farm. In other words, examine the present plan followed
by the cultivators, for its costs and returns and resource use pattern.
Workout the variable costs such as hired labour, seed water charge, fertilizers, pesticides, etc. for
each enterprise.
Workout the gross income from various enterprises by multiplying physical yields times price
per unit of commodities.
Workout the return to fixed farm resources in respect of each enterprise. With the help of these
returns to the fixed farm resources from various enterprises, the total returns to the fixed farm
resource from existing plan of the farmers are analyzed.
3. Identification of the weakness of the present plan
A careful analysis of resource use in the existing plan will throw up the imbalances. The various
weakness in the existing plan will act as a guide line for bringing about improvements in the
alternative plan e.g., relatively more area under less profitable crop or low level of use of yield
increasing technology etc.
4. List out the risks of production on that farm
Make a list of all such risks involved in agricultural production on that particular farm and bear
in mind in developing the alternative plan. To the extent possible, provide for effective steps for
eliminating or reducing such risks.
5. Forecasting
In order to decide where one wants to go, it is necessary to have information about what the
future would look like. Planning is deciding what is to be done in the future against established
background of the estimated future facts. Thus although the future is full of uncertainties, the
manager must make certain assumptions about it in order to plan properly. These assumptions
are based on forecast of the future.
6. Establish objectives
The next step in planning is to establish objectives for the farm organization and for each
enterprise. Objectives specify the expected results and indicate the end points of what is to be
done, where the primary emphasis is to be placed, and what is to be accomplished by the
management.
7. Prepare the alternative plans
There may be a number of alternative plans suiting the situation of a given farm organization.
Within the framework of resource restrictions and keeping in view the weakness of the existing
plan and the possibilities of incorporating modern technology, a few alternative farm plans may
be developed. Alternative plans can be worked out which may vary in the amount of risk
involved, labour requirements and other features as well as probable net income.
8. Analysis and selection of the final plans
Ideally we should evaluate alternative plans on various points such as probable income, amount
of risk involved, labour and capital requirements, etc. The farm manager should select the final
plan for his farm which he feels will give him and his family the highest level of satisfaction in
respect of these and other variables.

4.2. Farm Budgeting

4.2.1. What is farm budgeting?

Farm budgeting is a method of analyzing plans for the use of agricultural resources at the
command of the decision maker. A farm budget is a statement giving an estimate of all the farm
receipts and expenses to be incurred for the agricultural year. In other words, it is the expression
of a farm plan in monetary terms by estimation of receipts, expenses and net income of a farm or
a particular enterprise is called budgeting.
Budgeting is a very simple and straight forward exercise, which can be used to select the most
profitable plan among a number of alternatives and used to test the profitability of any proposed
change in a plan. It is a way „try it out paper‟ before a plan or a proposed change in a plan is
implemented. Therefore, farm planning and budgeting go side by side.
Basically budgeting involves two steps:
1. Preparation of description and specification of the proposed plans,
2. Estimation of the expected cost and returns.
4.2.2. Types of Budgeting
There are different types of budgeting, each of which is adapted to a particular size, purpose and
type of planning problems. Basically the following types of budgets are known to exist:
1. Partial budget,
2. Enterprise budget,
3. Whole farm (complete) budget.
Whole farm budgeting typically involves plan for the entire farm business while partial and
enterprise budgeting are used to analyze only a part of the whole farm. Each of these budgeting
techniques is discussed in separate classes.

4.2.1. Partial budgeting

Improvement in agricultural production technology is necessary for agricultural development.
Agricultural scientists usually develop new production technologies to improve farmers‟ welfare.
Farm managers adopt new production technology that is economically superior to the existing
one(s). However, before changing from one production method to another, the farm managers
consider many factors, such as agro-ecological requirements, availability of required additional
production resources (labor, credit, skill, farmland, equipment etc.), additional costs, and
additional income resulting from the change. Particularly, farmers want to know the implication
of the proposed change on costs and incomes, or whether the extra incomes earned by changing
to the new technology justify the extra cost, etc. One of the tools in economics used to compare
the economic benefits of such a change is partial budget analysis.

Partial budgeting is the method of making a comparative study of costs and returns analysis
resulting from a small change or possible adjustment in the part of farm business plan. This
change may be made through a careful selection alternative method of production or activities,
the choice of which is based on opportunity cost or relative profitability and does not affect the
total farm organization vitally. Partial budgets do not calculate the total income and expenses for
each of the two plans. Rather it considers only those income and expenses which are affected by
the proposed adjustment in the plan.

A partial budget can be compiled more quickly and easily than a complete budget since it is only
concerned with those costs and returns that are to be changed. However, when a major change is
made, such as a tractor in place of hand labour, which can influence most of the existing input
and output relationship of the farm, the whole pattern of farming will be modified. In this case,
partial budgeting is unsuitable and complete budget is needed.
In general a partial budget used to estimate the effect of change(s) in farm operations. For
example, farmers know that fertilizer application will likely increase maize yield, and thus the
gross income. The use of fertilizer also results in additional costs. To decide whether to use
fertilizer for maize production or not requires a partial budget analysis.
A partial budget usually prepared to ascertain the effect on the net benefit of the farm due to a
small change in the farm plan such as:
 Substituting one enterprise for another without any change in the entire farmland area, for
example, substituting 1 ha of soybean for 1 ha of maize.
 Changing to different levels of a single technology, for example, estimating the effect of
changing one level of N-fertilizer application to another in maize production on net
benefit
 Changing to different technologies, for example, changing from hand weeding to
herbicide use for weed control
The format used for computing a partial budget is:
Gain Cost
a) Additional income d) Reduced income
Expected additional returns that would accrue Returns that will no longer be received after the
from the change under consideration. change has been made.

b) Reduced expenses e) Additional expenses

The savings in cost which will no longer be Additional direct costs that would occur in
incurred if the changes are made. year‟s business as a result of the change.

c) Total gain f) Total cost

Additional income (a) plus reduced cost (b). Reduced income (d) plus additional expenses
(e).
Net change (change in net income)
The difference between total gain (c) and total cost (f) is net farm income. A positive difference
indicates that the proposed change plan has higher expected net income than the base plan and
vice versa.

The example below illustrates how a partial budget can be used to analyze the decision to
substitute wheat for maize production. The farmer has observed that the expected wheat price for
the coming year appears to be somewhat more favorable than the projected maize price. Based
on this information, that farmer is considering decreasing his maize production by 40 hectare and
increases his wheat production by the same amount. The available additional information used to
determine the profitability of the two alternative plans are:
 The farmer can produce 14 quintal of wheat and 18 quintal of maize per hectare.
 The farmer needs to use 3 quintal of wheat and 5 quintal of maize seed per hectare.
 The farmer needs to hire 41 and 47 hour of labour per hectare for wheat and maize
production, respectively.
 The farmer can earn an income of birr 170 and 140 per quintal from the sell of wheat and
maize products, respectively.
 The farmer costs birr 182.2 and 146.8 to purchase a quintal of wheat and maize seed,
respectively. In addition, the farmer requires to pay birr 4.25 for an hour of labour used
for wheat or maize production.
The question is to determine the profitability of the proposed plan.
Solution
Gain Cost
a) Additional income d) Reduced income
Increased wheat income Loss of maize income
14 qt. wheat output per ha.* birr 170 per qt.* 18 qt of maize output per ha.* birr 140 per qt. *
40 ha = 95200 40 ha = 100800
b) Reduced expense e) Increased expense
Reduced maize cost Additional wheat cost
5 qt. maize seed per ha.* birr 146.8 per qt.* 40 5 qt. wheat seed per ha.* birr 182.2 per qt.* 40
ha. = 29360 ha. = 21864
47 hr of labour per ha* birr 4.25 per hr * 40 ha 41 hr of labour per ha* birr 4.25 per hr * 40 ha
= 7990 = 6970
Total Reduced Expense = 37350 Total Additional Expense = 27834
c) Total Gain (a + b) = 132550 f) Total Cost (d + e) = 129634
Net Gain = 132550 - 129634 = 2916

Conclusion: This analysis shows that the farmers could increase their returns from wheat
production by birr 2916 by substituting the available 40 hectare of maize land to wheat
production.

Thus, partial budget deals with such changes in the farm organization which can increase farm
income without changing the total farm organization. These minor changes (improvements) can
be affected in the total farm organization as and when necessary. The farmer would know the
total net benefit from the change, the details of what he should do at what cost and what he is not
to do after the change and come out with higher profits.

Differences of partial budgeting from other techniques

a. A partial budget differs from an enterprise budget in that several enterprises might be
involved in the change to be considered in partial budget. However, enterprise budget is
prepared for a single enterprise.
b. Partial budgeting is used to examine the profitability of possible adjustment in the farm
plan while the whole farm budget estimates the profitability of the entire farm plan
c. Partial budget is not suitable for preparing a plan for the whole farm. Partial budgeting,
therefore, intermediate in scope between enterprise and whole farm budgeting.
d. In partial budgeting, the items of income and expenditure that will not change are
ignored. Only those changes in income and expenses are included but in the case of
enterprise and whole farm (complete) budgeting the total values are included.
e. Partial budgets are relatively simple and more applicable.
4.2.2. Enterprise Budget
An enterprises budget is a listing of all estimated income and expenses associated with a specific
enterprise to provide an estimate of its profitability. Therefore, one can develop an enterprise‟s
budget for each actual and potential enterprise in a farm plan such as cotton, wheat, maize, beef
cows, dairy cows, and so forth.

Each enterprise budget is developed on the bases of a small common unit such as one hectare for
crops or one head of livestock, which permit easier comparison of the profit for alternative and
competing enterprises.
The primary purpose of an enterprise budgeting is to aid in selection of inputs and enterprises
consistent with the resources available. In addition, it also aid to select combination (s) of
enterprises that will increase income from the farm business so that it can be included in the
whole farm plan because a whole farm plan often consists of several enterprises.

Although construction of an enterprise budget requires a large amount of data, once completed, it
could be used as a source of data for other types of budgeting. Several kinds of data are
necessary for budgeting, which includes:
 Physical input data (variable and fixed inputs) involved for production of a particular
enterprise,
 Field output data (yield per hectare at different level of input use),
 Price data for all inputs and outputs of that enterprise.

Table 4.1 below is an example of crop enterprise budget. Although no single organization or
structure is used by everyone, most budgets contain the section or parts included in the table. The
cost section is generally divided into two parts, variable or operating costs and fixed costs.
Income or revenue above variable cost is an intermediate calculation and shows the revenue
remaining to be applied to fixed costs.

The first step in developing an enterprise budgeting is to estimate the total production and the
expected output prices. Both of these values will obviously have a great effect on enterprise
profitability and they should be carefully estimated.
The estimated yield should be the average yield expected under normal weather condition, given
the soil type and input level to be used. Input levels must be considered because seeding rates,
fertilizer levels, chemical use, and tillage practice all affect yield. Since enterprise budgeting is
used for forward planning, the output price should be the manager's best estimate of the average
price expected during the next year or next several years depending on the planning horizon.

Table 4.1. An example of enterprise budgets estimate for wheat production (1 hectare).

No. Item Unit Quantity Unit pice Value/ha

1 Revenue
Main product (wheat output) Qt. 50 250.00 12500
By product (straw) “ 30 60.00 1800
Total Revenue Birr 14300
2 Variable Cost
Seed Qt. 5 260.00 1300
Manure & fertilizer
Manure Qt. 50 20.00 1000
Inorganic fertilizer “ 4 260.00 1040
Chemical
Pesticide Kg 10 80.00 800
Fungicide “ 10 70.00 700
Machinery expense
Fuel Lt 50 4.00 200
Oil Kg 5 35.00 175
Lubricant “ 1 50.00 50
Machinery repair Birr 500.00 500
Labour
Normal Hr. 57 2.00 114
Peak season ” - - -
Contractual “ 30 3.00 90
Operating interest (@ 10% for 6 months) Birr 596.9
Total Variable Cost “ 6565.9
3 Gross Margin (1-2) 734.10
4 Fixed Cost 7734.10
Depreciation Birr 200.00 200
Interest on investment (10%) “ 20.00 20
Tax and insurance “ 100.00 100
Land charge “ 300.00 300
Total Fixed Cost “ 620
5 Total Cost (2+4) “ 7185.9
6 Estimated Profit (1-5) “ 7114.1
Variable costs, such as seed, fertilizer, and chemicals can be relatively easily estimated if the
quantities to be used and the input prices are obtained. However, some variable costs such as
fuel, machinery repairs, and labour are more difficult to estimate particularly on a per hectare
base. These costs are depends on machinery type, size and the number of tillage operations to be
performed. Therefore, records of several years and enterprise analysis are good sources of
information.

The operating interest cost reflects an interest cost for the amount of capital the farmer has
invested in selected variable inputs of the enterprise. This charge varies according to the size of
the expenditures involved, the rate of interest paid, and the amount of time the capital is invested.
As it is indicated in Table 4.1 above, an average time period of 6 months is assumed and a 10
percent opportunity cost (interest of capital) is charged on the total of birr 5969 invested on
variable inputs, which amount to birr 596.90.This operating interest charge when added to the
other cash expenses of the enterprise gives the total expense for variable inputs of the enterprise,
which is birr 6565.90.

The difference between the income and total variable cost gives us gross margin of the
enterprise, which is an indication of how much of the total income is left to cover the total fixed
costs of the enterprise.

The fixed costs such as costs for land, building, machinery etc. are also must be prorated to the
specific enterprise on per hectare base. The amount of these fixed costs, except land, will be
depends on the depreciation cost of that input.

4.2.3. Complete Budgeting

The whole farm plan discussed earlier does not provide full and details information on sources
and amounts of income, types and amount of expenses, and the total expected profit for the farm
business using the plan. A whole farm budget is needed to provide additional details and the final
estimate of farm profit. Therefore, a whole farm budget is a summary of the expected income,
expenses, and profit for a given farm plan. It considers the cost and returns of all the crop and
livestock enterprises in order to drive the net return of the whole farm.
Steps for complete budgeting
Basically, it consists of two steps:
Preparing a plan that includes the area of each crop, the number of each class of livestock and the
production methods. The proposed plan is based on subjective judgment, experience and
intuition coupled with technical considerations. For example, an agronomist may have suggested
a new crop rotation or a livestock specialist may have suggested the introduction of a goat
enterprise. Thus, several alternative plans may be prepared. Budgeting the expected costs,
including common costs, and returns to financially evaluate each plan and find which is the best
in terms of expected net farm income.

For a given whole farm budget, Table 4.2, the total farm income is calculated for each of the
enterprises included in the plan. The next step is to estimate the variable costs by type or
category such as seed, feed, fertilizer, and repairs etc. Many of these variable costs are the same
as those used to estimate the enterprise budget needed in the planning procedure. The total cost
for each variable input can be found by calculating the total for each enterprise and then
summing across the enterprises.

Notice that some variable cost items such as building repairs, auto and pickup expenses, utilities,
and other farm overhead expenses are very difficult to allocate to specific enterprises and they
are affected little by the final enterprise combination. If these and similar expenses are not
included in the calculation of gross margins of an enterprise budget, they must be included in the
complete budget. These will make income above total variable expenses of a combination of
enterprises, greater than the total gross margin in the whole farm plan.
Table 4.2. Whole farm budget showing projected income, expenses, and profit
No. Description

1 Income
Cotton 54000
Milo 43000
Wheat 13500
Stocker steers 40000
Total income 150000
2 Variable expenses
Fertilizer 11900
Seed 3600
Chemical 7900
Fuel, oil, Greases 4050
Machinery repair 2650
Feed purchase 1600
Feeder livestock purchase 29000
Custom machine hire 10250
Operating interest 7340
Miscellaneous 2450
Total variable expenses 80740
Gross margin (1-2) 69760
3 Fixed expenses
Property taxes 2600
Interest on debt 22000
Insurances 1250
Machinery depreciation 7200
Building depreciation 3200
Other fixed costs 3000
Total fixed expenses 39250
4 Total expense (2+3) 119990
5 Net farm income (1-4) 30510
The budget in Table 4.2 shows an estimated profit or net farm income of the whole farm if the
price and yield estimates are actually realized. Changes in any of these factors will obviously
affect the actual profit received from operating the farm under this plan. The estimated profit also
needs to be carefully interpreted.

Differences of complete budgeting with other methods

What makes complete budgeting differ from partial budgeting? When the proposed changes in
the farming business are so weeping, they affect the whole-farming system and the technique of
complete budgeting to be used. However, complete budgeting is not to be divorced from partial
budgeting. These two are mutually complementary, i.e. the partial budgeting technique should be
used at various stages of complete budgeting in order to decide the changes to be effected in the
farm organization. In fact complete budgeting is not to be and cannot be disturbed very often, but
some changes or improvements have to be made quite frequently where partial budgeting comes
into operations.

Enterprise budget is used to estimate the profitability of a single enterprise while complete
budgeting is for the entire farm, which may consist of several enterprises. Some cost items that
are too difficult to allocate to specific enterprises usually overlooked in the computation of an
enterprise budget that must be included in the whole farm budget.

Uses of complete budgeting

In addition to providing an estimate of net farm income, a whole farm budget has several
potential uses, such as:
It provides a basis for comparing alternative plans for profitability. This can be particularly
useful when planning for growth and expansion.

The cash expenses in the budget provide an estimate of the operating capital the business will
need during the year. A detailed whole farm budget showing the estimated profit can be used to
help establish credit and borrow the necessary operating capital.
The worksheets used to prepare the budget contain estimates of total input requirements, orders
for inputs such as fertilizer, seed, chemicals, and feed can be placed using this information. It is
often used in situations where it is realized that the proposed adjustments in the business will
have an impact on several aspects of the business operations because of the interrelationships
that exist between different enterprises.

It is useful for someone who is planning to enter into farming business to have an idea of the
profitability of the particular farm enterprise. A farmer who is planning to reorganize his farm or
switch entirely to new forms of farming organization may find complete budgeting useful to
estimate the net return or profit of the business.

Criticisms of Budgeting
It was mentioned that budgeting is one of the most important farm planning tool which can be
used to select the most profitable plan among a number of alternatives plans. However, it is also
subjected to certain criticisms.

Several criticisms can be made on budgeting of these most of them are equally applied to all
budgeting techniques. One of the critiques is that budgeting assumes a linear relationship
between input and output that virtually ignores diminishing returns and complimentary
relationships between enterprises. If the necessary information is given, however, allowance can
be made for these aspects.

There is also the problem of estimating yields, especially in the case of new farmers or those
beginners of new enterprise. In addition, is also difficult to estimating input and output prices.
This is because that uncertainty exists and that even the most skillful and experienced advisor
(planner) will be unable to forecast these exactly, especially in each individual years. Any
sensible person accepts that yield and price fluctuations will cause errors in estimating budgets
for individual years. Nevertheless, making calculation based on best estimates is better than
having no guidelines at all.

Finally, budgeting can be criticized as being an inefficient technique if a profit-maximizing plan

is being thought. Many budgets may be needed before a high profit plan is obtained, and still
there would be no certainty that substantially more profitable plans exist. In addition, it is also
more subjective or personal bias on the part of the planner than other planning techniques.
Land valuation: Enterprise budgets take the land charge as an opportunity cost of land and
represent a return for its use in production activity. Three methods can be used to determine a
land charge:

1) An interest opportunity cost based on the current value of the land.

Example: Let the opportunity cost of capital (bank interest rate) is 10%.
The current value of the land is 1500 per hectare.
Then, the annual land charge would be the opportunity cost of capital times the current land
value.
Land charge = 10% * 1500 = 150 per hectare
2) The share rental method.
In this method, the land charge can be determined by the owner‟s rental income from crop share
lease. This means, the value of owner‟s share of the crop become less if any crop production
expenses are paid by the owner.
3) Cash rent charge method.
In this case the land charge is determined by the current market cash rental value of the land. The
estimated profit per unit is the final and it is found by subtracting total cost from total revenue.
Everyone is interested in this value, and it is important if it can be interpreted correctly. Most
enterprises‟ budgets, such as the one included in Table 4.1, is economic budgets that include, in
addition to cash expenses and depreciation, the opportunity costs of the production activities.
Typically, there would be opportunity costs for owner operator labour, capital used for variable
costs, capital invested in machinery, and possibly for invested in land. Therefore, the profit or
return shown on an enterprise budget is an estimate of economic profit which is a different
concept from accounting profit.

The estimated profit can be compared with the estimated per hectare profit for other crops and
select the more profitable crops and crop combinations to be grown each year. However, the
profit figures must be properly interpreted, as they are the return or profit above all costs
including opportunity costs on owned inputs. In some cases, the return above total costs is
negative. That does not mean that the farmer should quit from cropping (if no better alternative
crop) in the short run since the fixed cost is compensated somehow.
Break-even analysis
An enterprise budget can be used to perform a break-even analysis for either price or yield, or
both. Break-even analysis is needed when, for example, there is a great uncertainty about the
level of yield to be expected from a crop to be produced which has no previously been grown. In
this case, the ordinary partial budgeting cannot be used, rather break-even budgeting can be
employed to estimate the yield required to provide an exact balance of changes in cost and
revenue, so that the farmer is neither better nor worse off.
Break-even yield is the yield which is necessary to just cover all costs at a given output price.
The formula used for calculating the break even yield is given by:
Total Cost
Break  even yield 
Output Pr ice
Based on the Table 4.1, the break even yield can be calculated as:
7185.9
Break  even yield   28.75 qt per ha
250
Since the output price is only an estimate of the expected price, the break even yield can be
calculated for a range of possible prices as shown below:
Price/Qt Break-even Yield/Qt
280.00 25.66
250.00 28.74
230.00 31.24
210.00 34.22
190.00 37.82
The break-even price or the price necessary to cover all coasts at a given yield level, can be
found from the equation:
Total Cost
Break  even price 
Expected yield
Continuing with the same example, Table 4.1, the break-even price would be:
7185.9
Break  even price   143.72 per Qt
50
Break-even price can also be calculated for a range of possible yields as shown below.
Yield/ha Break-even Price/Qt
25.00 287.44
35.00 205.31
50.00 143.72
55.00 130.65
60.00 119.77
Since both the yield and output price in an enterprise budget are estimated rather than actual
values, the calculation of break-even yield and prices can aid managerial decision making. By
studying the various combinations of break-even price and yields, managers can form their own
expectations about the probability of obtaining a price and yield combination which would just
cover total costs.

4.3 Linear Programming

Linear programing is one of the tools for farm management.

 A large whole farm planning problem with many fixed resources and potential enterprises
is very difficult to solve using hand calculation methods.
 It is a mathematical technique which can be used to solve large whole farm planning
problems.
 In mathematical terms, it is a procedure for maximizing or minimizing a linear objective
function subject to linear constraints.
 The objective is maximizing of total gross margin, net farm income, income
above variable costs etc., or minimizing costs
 The constraints are the amounts of the fixed resources
Information required to formulate a LPM are:

Gross margin from each enterprise

Per unit resource requirement of each enterprise (technical
coefficients) and
Resource limits
Example: consider the following example.

Given the maximum available amounts of each resources, the per unit resource requirement of
each enterprise, the question is what units of the two enterprise should the farmer produce to
maximize the gross margin.
This question can be answered using a LPPM.
Solution:
Step 1. Formulate the problem
Let Y1 stands for corn and Y2 for soybeans,

Step 2. Calculate the maximum amounts of each enterprise to be produced constrained with the
given resources.
Land limits corn to 120/1 = 120 hectares and soybeans to 120/1= 120 hectares. Any point on the
line connecting these two points gives only land restrictions.
Labor limits corn to 500/5 = 100 units and soybeans to 500/3 = 166.67 units.
Capital restricts corn 150 units (15000/100) and soybeans to 15000/80 = 187.5 units. These
results are shown using the graph.
So, the profit maximizing combination is 120 units of corn and none of soybeans with a
maximum profit of 14,400 Birr. To see how much of each resource is used and how much is left,
substitute the values into the equations.
For land:
Y1 + Y2 = 120
Used 120 + 0 = 120 maximum available is 120, so nothing left unused or idle.
For labor:
5Y1 + 3Y2 = 500,
Used 5*120 + 3*0 = 600 but maximum available is 500 so there is over utilization of labor.
For capital:
100Y1 + 80 Y2 = 15000
100*120 + 80*0 = 12000, but maximum available is 15000, so 3000 units are left idle.
So as to maximize the gross margin further, the farmer should shift this idle resource to land and
labor.

4.4 Risk and Uncertainty

Introduction: Biological nature of farm enterprise entails some uncertainties in their production
and prices, coupled with uncertainties of availability of inputs. Some of them are measurable in
their parameters of probability, yet others are more or less random phenomena that can not be
estimated with any acceptable degree of accuracy.

4.4.1 What is Risk?

Risk is defined as the situation which exists when the future can be predicted with a specified
degree of probability. With the perfect knowledge situation it is possible to say definitely and
positively that an event will happen. In the situation of risk, however, it can be said that the
chances are, for instance 50 – 50 or 60 – 40 that an event will occur.

Risk refers to variability or outcomes which are measurable in an empirical or quantitative

manner. There are two types of risk according Knight – the a priori and the statistical risk.
A priori probability prevails when sufficient information is known in advance about the general
possibilities that the probability of a particular event occurring can be specified. For example, if
a coin is tossed, it is known that it must fall with either the head or tail facing up. It is also known
that both sides have exactly the same opportunity of turning up. Therefore, on the basis of
general principles, the probability of a particular event occurring can be predicted.
When statistical risk occurs on the other hand, the probability of future event can be stated on the
basis of results of many previous observations. An example is the mortality tables of life
insurance companies. Probabilities are assigned to future events on the basis of recorded
experiences as to what has happened in order similar circumstances.

4.4.2 What is Uncertainty?

In this case of uncertainty, there is no valid basis for assigning any kind of probability to future
events. Yet the farmer must make plans for the future even though he is unable to determine the
probability of future events from either a priori or a statistical standpoint. In a quantity sense, the
outcome cannot be established. Uncertainty is subjective in nature. It refers to the anticipations
of the future and is peculiar to the mind of each individual producer. Examples are variability in
yield and weather. Risk is insurable but uncertainty is not.

Methods of Overcoming Risks and Uncertainty

i) Risks

There are many situations in agriculture that may be classified as risk. If a possible unfortunate
incidence can be insured against, it can be classified as risk. There are various kinds of insurance
that are available. The farmer must decide whether to pay to have the risk
transferred to some other person, or if he can afford to bear the risk himself. A number of factors
will affect decisions. Not all insurance can be viewed in the same way since different amount of
protection against unforeseen events are provided. The following classification
of insurance are available to the farmer.
Property insurance – valuable property – fire or damage
Liability insurance – against large losses
Yield insurance – against loss of yield due to flood or bad weather.
Life insurance – against accidental death.
Health insurance – against sicknesses requiring hospitalization
Certain risk situations cannot be covered by insurance owing to the difficulty of securing
reasonable data to establish fair premiums. For example, breakage of eggs, loss by rodents, grain
waste. They are regarded as costs of production.

ii) Uncertainty
Uncertainty can be classified as follows:
a. On-Farm Uncertainties
Production – physical or biological
Family welfare – farmers and family.
b. Off-Farm Uncertainties
1 a. Markets and prices
b. Factor or input prices
2. Technology or means of production
a. Obsolescence
b. Total production effects
3. Government and institutions
a. Price subsides
b. Production control
c. Credit policies as they affect interest rates etc.
4. Individuals
a. Bankers, landlords and employees.

Product Price Uncertainty

Price fluctuations directly affect the returns from an enterprise. Unfortunately the producer-seller
normally has no control over the product prices. The price uncertainty (it is especially true in
vegetable cultivation), therefore, is accounted for in his decisions on level and combinations of
farm enterprises. Under the situation, a farm-entrepreneur normally faces the following
enterprise alternatives in respect of their returns vis-à-vis price uncertainty (risk):
i. High return enterprise with low price uncertainty.
 ii. High returns enterprise with high price uncertainty.
iii. Low returns enterprise with low price uncertainty.
iv. Low returns enterprise with high price uncertainty.

Decision on situation i and iv are obvious; to take up the first category enterprise(s) to the
maximum permitted by resource use capabilities and discard the category iv enterprise (s)
completely. It is only in enterprise ii and iii that rational decisions on level and combinations of
enterprise would need to be made. In this case a farm entrepreneur‟s resistance line will be in
climbing up the risk ladder.

He will move up the risk elevation from Rs to Rm (fig. ) permitted by his equity, financial shock
absorption capacity, delimited by his own financial resources and credit worthiness. Mental
attitude on business risks, of course, plays a pivotal role. As the entrepreneur moves up form Rs
to Rm, he will travel on returns line from Pl to Pm. Distance moved on Rs to Rm line depend
Pm  Pl P
upon the complementary ratio: or:
Rm  Rl R

P
If both R and P are measured in money terms, the optimum point will be where ratio gets
R
Pr
equated with ratio, here R will measure the movement on risk line, P the corresponding
Pp
direct change in returns through changes in enterprise combinations; Pp the weight attached to a
 Pr
unit of returns vis-à-vis P, cost involved in a unit of risk. Normally the ratio had to be taken
Pp
as next best risk-returns alternative available for investment on the farm. If for example, price
risk-cost is Br. 100 to Br. 200 between points Rs to Rm and corresponding returns Br. 300 to Br.
P 500  300
500 ratio will be =2. Suppose further this returns-risk ratio keeps on declining
R 200  100
Pr
till it is 1 at Rm. If ratio is 1.5 due to 150% next best returns on alternative risk cost (say on
Pp
another crop or animal enterprise), the entrepreneur will move on to the point (say Ra), where
taking this much price risk will have the same risk return ratio (1.5) as promised by the next best
alternative. Moving on this line in this context will mean shifting from low risk low returns
enterprise to higher risk-higher returns enterprises.

Yield Uncertainty and Profitability

Yield Uncertainty
Yield and production also have a probability distribution, the parameters of which can be
measured with a fair degree of accuracy from time series data. Here again the following
categories of farm enterprises will present alternatives to the farmer:
i. low yield high risk enterprise(s),
ii. low yield low risk enterprise(s),
iii. high yield low risk enterprise(s), and
iv. High yield low risk enterprise(s).
In respect to category i and iv, the decisions are again very obvious. The first category
enterprise(s) should not be taken up at all (this analysis is irrespective of the levels and changes
in prices, which has been discussed in earlier section). The fourth category enterprise(s) would
be taken up to the maximum permitted by the farm resource use capabilities. Decisions in respect
of the combination of acceptable yield and uncertainty elements (A point on low yield low risk to
high yield high risk path) will be made exactly in the same way as in case of decisions on price
Y Pv
risk return ratio line. Ratio will be equated to when Y is the change in yield
V Py
and V the yield variability, Pv is the cost, the farmer will put on the yield variability and Py the
value per unit of Y. Here it is a situation of value balancing between increased yield and its
variability. The situation becomes more explicitly demonstrated in the developing countries
where improvements in production technology are promising higher yields but at the same time
involve higher yield variability too, especially in case of new strains of crops like maize, rice and
wheat. The adoption of new technology, therefore, varies from place to place, region to region
and farmer to farmer depending upon yield uncertainty returns ratios‟ their situations promise
and the values the farmers put on these two variables. The yield variability returns‟ ratio in turn
Pv
is influenced by physical, biological and other environmental factors and the value ratio is
Py
affected by the farmer‟s resource situation (especially capital and equity), technical skill
confidence, managerial ability; family structure, social interaction, economic set-up and mental
outlook.

Profitability- A Catch all factors

Price and yield levels and their variability ultimately result in enterprise profitability and
variability in it. But, it involves an element of cost also. This will open up following alternative
enterprise possibilities for the farmer:
i. Low cost low profitability low variability enterprises.
ii. Low cost low profitability high variability enterprises.
iii. Low cost high profitability low variability enterprises.
iv. Low cost high profitability high variability enterprises.
v. High cost low profitability low variability enterprises.
vi. High cost low profitability high variability enterprises.
vii. High cost high profitability low variability enterprises.
viii. High cost high profitability high variability enterprises

Decision again would be obvious in category 3 and 6. The two points will lie at „X‟ and „Y‟ in
three dimensional figure . Rest of the enterprises will lie on cross diagonal line
XY. At the optimum point, following equations will have to be satisfied:
Y Pc
i. =
C Py

Y Pv
ii. =
C Py
V Pc
These two equations will solve down to the equation = . again, thus, the balance will be
C Pv
V
struck where ratio will equal to the ratio of the values the farmer puts on additional costs
C
and additional variability. As he shifts to high profitability enterprise or the higher level of
enterprise, he might have no incur higher costs and face higher variability in the profitability of
the enterprise(s). as such, there can be three situations: 1) constant variability cost ratio, 2)
increasing ratio, and 3) decreasing ratio (fig. ). In the event of the constant ratio, the
entrepreneur would go to the extent; he can bear variability (risk) within the resources available
to him. If it is an increasing ratio, the tendency will be not to increase the level of enterprise or
shift to new enterprise. This factor often plays a crucial role in holding the rapid adoption of new
technology in the developing countries. In case of decreasing ratio, the farmer will tempted to
incur the additional costs to the maximum permitted by their resources in order to increase the
level of enterprise(s) or adopt new enterprise(s) to operate at high profitability level of
enterprise(s).
Uncertain Availability of Inputs
It is not very uncommon, especially in developing countries, that the supplies of some inputs
(more so in case of unconventional inputs such as fertilizers, insecticides, hybrid seeds etc.) go
uncertain to the farmers. This uncertainty element would get incorporated into the production
programmes of the farmers through:
i. Adjustments in the levels of enterprises at the time of planting,
ii. Adjustments in the planting dates, and
iii. Adjustments in the application rates of inputs, especially on the growing crops.

Level of Enterprises
Optimally, the level of a crop enterprise is a, cateris paribus, function of availability of the
crucial inputs (which are assumed uncertain in this analysis). To take a simple case of one
product- one input relationship, this can be the type Y= f(x1/x2….xn) where „Y‟ is the level of
enterprise, „x‟, the crucial input of which the supply is uncertain and „x2,…xn‟ other inputs, of
which supply is assumed to be sure. If the enterprises are more than one, which have a functional
relationship with the same uncertain availability input (a situation of diversified farming) and
also if there are more than one certain inputs, the farm entrepreneur will have alternative
programmes at different levels of estimates of availabilities of inputs. Depending upon the
estimated input or input mix available at the planting time, his decision to allocate acreage to
different crop enterprises will be based on his objective to maximize production (more
appropriately returns) to the estimated available quantities of these crucial inputs.
The allocation process can be illustrated with the help of diagrams. In fig. functional
relationships of two enterprises „A‟ and „B‟ with the availability levels of one input, separately
for each enterprise, are shown. The number of such functions will depend upon the number of
enterprise alternatives available to the farmer. These functions (in case of two enterprises) can be
converted into production possibility curves as shown in fig . each curve will show a different
level of estimated availability of the input at the planting time. The production possibility curve
will thus shift upwards or downwards depending upon higher or lower estimates of the
availability of the inputs. Point P here will indicate the level of two enterprises with the
availability of the input at zero, indicating, of course, that some minimum production of the two
enterprises is possible even without any use of the crucial input. As the estimated availability of
the input increase, the choice horizon will expand along PL or PK or points on curves located
within PL and PK plane. The actual acreage allocation will, however, further depend upon the
relative profitability of the two enterprises shown by the iso-revenue line „pp‟. The tangent at
Y2 Py1
point „M‟ will be the point of optimum allocation where will be equal to . Here the
Y1 Py 2

combination of enterprises will be Oa and Ob.

Inputs Application on Growing Crops
No doubt the supplies of uncertain availability inputs may restrict the level of enterprise(s) at
planting time and also influence the sowing date; the farmer entrepreneurs sometimes does not,
curtail the acreage and/or does not delay the planting of the crop, if the input can be applied after
planting (top dressing). How far this method can go to mitigate the adverse effects of uncertain
availability, again depends upon how far top dressing or after application of the input(s) on
timely sown crop can give advantage over pre-planting or planting time application of the
input(s) on timely sown crop.

Fig illustrates the point. Curve P1P1 depicts the

production of the crop with the planting time

Application of the input over delayed dates of planting. P2P2 curve indicates production of a
timely sown crop, with the (top-dressing) delayed. R1R1 and R2R2 are the total returns curves and
C1C1 and C2C2 are the corresponding total accompanying costs curves. If the supplies are
uncertain to be available beyond point K, the choice of the farmer for definite will be on P 2P2
curve, with revenue shown by R2R2 and costs C2C2, because here C2C2 and R2R2 curves envelop
the C1C1 and R1R1 curves showing larger comparative profits. Upto the date (point) L the choice
will be in delayed planting of the crop with planting time application of the input, because upto
this point, all curves run parallel and P1 has a definite advantage, because there are no
decrements in production due to delayed planting.

Between date L and K, the choice will be in favor of planting time application and delayed
planting till the gap R1- R2 remains greater than the gap C1-C2 i.e., till the gain in returns remains
to be larger than the disadvantages on cost (point N in the diagram). Beyond N, of course, the
choice will be on top dressing on timely sown crops.

All of these, of course, are normative analysis. In actual practice also the farmers do some mental
exercise knowing or unknowingly, and some make rough written calculations too, on the
alternatives open to them under the conditions of risk and uncertainty. Yet majority of the
farmers, do not have any factual information on the elements of risk and uncertainty, their
coefficient of probability and the alternative courses of action open to them with estimates of
accompanying costs and returns. There is, therefore, a need to gather experimental and field data
on risk and uncertainty elements involved in production and prices of outputs and availability of
inputs, as they actually mold or would modify the production plans of the farmers.