ENTERPRISE BUDGETING
James M. McGrann
Extension Economist-Management
Management is a dynamic process which needs
information to be effective. Budgeting can help a
manager by providing economic information for
decisions concerning a production period, an annual
plan, or a long-run plan. Budgeting can provide
details about individual enterprises as well as
information about the whole farm or ranch. And
budgeting is used, in a variety of ways, in all phases
of management; planning, implementing and
controlling. This publication describes the purpose
of budgeting, budgeting terminology, examples of
cattle budgets, availability of budgeting information
and identifies sources of microcomputer software to
develop budgets.
The Purpose of Enterprise Budgeting
Budgeting provides information which can be
used to support a variety of management tasks:
1. Budgeting helps the manager select the best crop,
forage and livestock enterprise combinations.
2. Budgeting can be used to refine organizational
and operating structures; it also forces a manager
to develop a production and marketing plan.
3. Budgeting forces the manager to uncover cost
items that might otherwise be overlooked.
4. Budgeting allows the possible outcomes of a
change to be studied before resources are actually
committed to the change.
5. Budgeting can be used to test the economic and
financial feasibility of alternative production
technologies and management practices.
Texas Agricultural Extension Service Zerle L. Carpenter, Director
PB-2
May 1995
6. Budgeting can be used to develop and organize
information which will be helpful to lending
agencies when the business needs operating,
intermediate, or long-term loans.
7. When credit is limited, budgeting can help the
manager select investments by estimating both
the profits and the impacts on cash flow of each
investment.
8. Budgets provide information which the manager
can use to compare the projected and actual
results of implementing a plan.
9. Budgets are the basic information for preparation
for the farm or ranch cash flow and projected
income statement.
The end result of the budgeting process is i-
nformation. This information is assembled into
budget reports so that it can be understood and
properly used. There are four basic types of budget
reports:
1. Partial budget
2. Enterprise budget
3. Whole-farm or ranch budget
4. Cash flow budget
The need for changes in the original plan can
occur daily in farming or ranching, and the partial
budget can be useful in determining whether
considered or observed changes will contribute to
profits. Only those items that are subject to change
are considered in partial budget analysis. For
example, a change in the market price of stocker
The Texas A&M University System College Station, Texas
cattle might lead a rancher to do a partial budget
analysis of changes in the marketing strategy of
weaning calves. A price increase for stockers may
signal the opportunity to hold cattle and sell them as
stockers, and a price decrease for stockers may be
large enough to suggest that the sale of the weaned
calves is the best option. This type of budget is a
short-cut to enterprise budgeting and is, thus, a
time-saver.
An enterprise budget is a statement of what is
expected if particular production practices are used
to produce a specified amount of product. It is
based on the economic and technological
relationships between inputs and outputs. It consists
of a statement of expected revenues resulting from
stated expenses incurred in the production of a
particular product.
The whole-ranch budget is set up to help plan the
organization of the entire farm or ranch business.
The enterprise budget is set up to help plan the
organization of an individual enterprise. The partial
budget is used for estimating the effects of changes
in the business.
A cash-flow budget indicates the ability of a
business to generate cash inflows (product sales,
borrowed money, withdrawals from savings, and
sale of capital items) to meet its cash outflow (cash
expenses, principal and interest payments on debt,
capital purchases, salaries, or family living
expenses) during a specified period of time. A
cash-flow budget shows the timing and magnitude
of operating loans required and computes the re-
sulting interest costs; it shows when (or if) operating
loans can be paid back. A cash-flow budget shows
the potential liquidity and repayment capacity of the
business.
Accounting Performance
vs. Economic Performance
A distinction must be made between financial
(accounting based) performance analysis and
economic performance evaluation. Financial
performance reflected in the total farm or ranch
accrual adjusted income statement identifies the
revenue from production and services resulting from
the business operation and the expenses or cost
PB-2-2
incurred to perform the revenue generating activity
during the operating year. Actual data on the reve-
nues and expenses are generated through the busi-
ness accounting activity.
Economic performance evaluation is done to
evaluate resource allocation (choice of enterprises or
production practice) and investment alternatives. In
economic comparative analysis "certain economic
costs" i.e. interest on investment, return to
management and labor, etc. are included to get a fair
comparison of alternatives. For example, in
comparing breeding cows to stocker cattle
enterprise, the capital requirement and cost (interest
on investment) must be considered to make a fair
economic comparison. In an economic analysis, the
capital cost difference is shown. In an accounting
evaluation, interest would only be included if the
capital was actually borrowed and the interest
expense was paid or is accrued.
Enterprise Budget Terminology
In order to use budgets effectively, the manager
must understand the terminology used to describe
and explain them. If these terms are not understood,
information may be used incorrectly, and the end
result may be wrong decisions.
A budget is defined as a projection of income and
expenses (either for a single enterprise or a whole
ranch) which is used for planning the future.
Enterprise is used as a common name for any
alternative which a manager can choose to do.
Common enterprises are cow-calf, stocker cattle,
improved pasture, hay, etc. Enterprises can be
combined to develop the whole-ranch budget.
The two basic components of budgeting are
income and expense. A proper understanding and
use of income and expense concepts is the basis of
effective budget development. At the most basic
level, income is a certain value which should be
received in return for the commodities produced,
and an expense or a cost is a charge which should be
made for an item used in the production of goods or
services. Note that "expenses" and "cost" are used
interchangeably in this paper.
 Several groups of terms or distinctions may be
used to clarify the significance of income and
expense items in specific situations. These
distinctions include:
1. Variable vs. fixed costs
2. Cash vs. non-cash income and expenses
3. Opportunity costs
4. Long-run vs. short-run prices, costs and budgets
5. Economic vs. accounting values
6. Total, average, or marginal income and costs
7. Income measures
These distinctions may be absolute in all
situations, but the ideas embodied by each term help
us understand the use (and misuse) of budgets.
These distinctions are discussed in more detail in the
following sections.
Variable vs. Fixed Costs
The distinction between variable and fixed values
is more applicable to costs than to income. Most
farm or ranch income will vary with production; but
very little income is fixed in the sense that a cost
can be fixed. Thus, the explanations in this section
concern only costs.
Fixed costs are those which occur no matter what
or how much is produced on a farm or ranch.
Examples of fixed costs include: taxes on land and
buildings; interest on the investment in land,
buildings and machinery; and depreciation on
buildings and machinery. Many costs, such as
office expenses or supervisor's wages, are fixed
costs in the sense that they will be incurred no
matter what enterprise is involved. The operator's
labor and family labor also may be considered fixed
costs under certain circumstances: the cost of these
items could be the same no matter how much is
produced. With a given set of fixed expenses,
production increases will lower the fixed costs per
unit of production.
PB-2-3
Variable costs are those costs which are more
directly associated with the volume of business.
The costs of seed, fuel, machine, repairs, fertilizer,
herbicides, hired labor, feed costs, veterinary
expenses, and marketing expenses are examples of
variable expenses for livestock production. Interest
on operating loans is also a variable cost. These
costs vary in total with the size of the farm or ranch
business.
The level of some inputs or operations, such as
may not be changed as easily as the fertilizer level
or supplemental feed fed. However, these costs are
still considered variable costs because they are
specific to a certain enterprise and would not be
incurred if that enterprise were not produced.
Three important planning concepts are related to
the distinction between fixed and variable costs.
First, a farmer or rancher, by increasing production
with the same set of vehicles and machinery on the
same land, can often increase profits because the
fixed costs of vehicles, machinery and land are not
increased. That is, the fixed costs have been spread
over more production, causing the fixed costs per
production unit to decrease.
Second, many farmers or ranchers try to cut their
pre-unit variable costs of production by replacing
labor with machinery. These operators may be
substituting higher fixed costs (depreciation,
interest, and property taxes on machinery) for lower
variable labor costs. Decreasing variable costs
while increasing fixed costs does not guarantee
profits.
Third, it should be recognized that all cost items
become fixed once they have been used or
committed to use. These are sometimes referred to
as "sunk costs". Once seed is planted, fertilizer is
applied, or gasoline is used in the pickup, such an
item becomes fixed even though it was variable
before it was used. This distinction is important
because sunk costs do not affect short-run
production decisions.
In a situation where it becomes obvious after
planting an annual forage that the future income
from an enterprise will not cover total forage costs,
an understanding of "sunk costs" will help the
manager minimize losses. For example, suppose a
drought severely reduces production to a point
where the rancher will lose money on the forage.
The rancher still has some variable costs, such as the
harvesting management expenses, which may or
may not be incurred. The grazing decision will
depend upon whether or not the gross income from
the forage will exceed these variable costs. If the
gross income will not exceed the variable costs, the
rancher will minimize losses by leaving, not grazing
the forage. If the gross income exceeds the variable
costs, the rancher will minimize losses by grazing.
In decisions such as this one, any remaining variable
costs become the key to the decision; variable costs
already committed are now fixed or sunk costs.
Cash vs. Non-Cash Income and Expenses
The definitions of income and expenses
emphasize that they are "a value which should be
received" and "a charge which should be made,"
respectively. However, they may or may not
involve actual cash transactions during the operating
or budgeting period being analyzed. The cash
versus non-cash distinction thus includes
consideration of both the nature and the timing of a
transaction.
Cash Income and Costs
Expenditures for supplemental feed, fuel,
fertilizer, purchased seed, repairs, and similar items
are easily recognized as cash costs of production.
Cash income is also easily recognized as actual
receipts of money.
Non-cash income, such as land value appreciation
or the value of the farm or ranch, production of
replacement heifers, or farm or ranch produced
products consumed at home is real income that does
not involve receipt of cash. Non-cash cost items
such as unpaid family labor, depreciation,
opportunity cost and interest on the equity capital
tied up in the farm or ranch do not involve actual
cash expenditures. Consequently, it is easy to forget
that non-cash items are actually income and costs.
PB-2-4
Farm or ranch accounting systems need to be
organized to actually measure family withdrawals so
inputed values for family labor and management are
not required to evaluate enterprises.
Non-cash items are real values. They must be
received and charged appropriately if a farm or
ranch business is to be analyzed correctly.
Accounting for non-cash items is particularly impor-
tant in analyzing individual farm or ranch enter-
prises.
Most farms or ranches have a number of
enterprises producing different intermediate and
final products. It is not easy to be accurate about
the value and allocation of such non-cash items as
building and machinery depreciation, raised feed
(particularly roughage), and pasture when analyzing
the profitability of an individual enterprise.
Similarly, a machine shop enterprise will have
earlier identified cash expenses; but almost all of its
income will consist of non-cash items which are
subsequently entered as cost for the farm or ranch's
production enterprise.
Opportunity Cost
Opportunity cost is a concept used to specify a
cost for using resources. It is very important in
farm or ranch management but easily
misunderstood. The opportunity cost of a resource
is the income which could be received from the best
alternative use of that resource. While this may
appear to be a vague and useless concept, it has real
applications.
Labor, land and capital resources can be used in
several ways. Each alternative may generate a
different income from those resources. For
example, an acre of land could be used to produce
any of a number of crops. Each of these crops
would produce a certain income, but only one crop
can be grown at a time. Therefore, the income from
other crops is foregone.
When any resource is used in one way, the
income from using it in any other way is lost. The
income from the best alternative is called the
opportunity cost of that resource because the farmer
or rancher has given up the opportunity to earn that
income. So the "cost" of using the resource in the
chosen use is its opportunity cost (that is, the
income that could have been earned in the next best
alternative). For resources which are not purchased
for each production period -- such as equity capital
or owner's labor, the opportunity cost of that
resource can be used to evaluate whether the
chosen use is indeed the best use of that resource.
Farm and opportunity costs are a factor in
virtually all ranch management decisions. The
ranch manager must not only ask, "Will this use of
capital, labor, or land be profitable?" but he must
also ask, "Would this capital, labor, or land produce
a higher income if it were used in some other way?"
Long-run vs. Short-run Budgets
A manager's planning horizon has a large effect
on how prices and quantities are chosen. The
planning horizon relates to the length of time
affected by the current decision. The farmer or
rancher who is deciding whether to sell steers today,
tomorrow, or next week has a very short planning
horizon for that decision. The same rancher would
have a longer-run horizon for a decision concerning
the purchase of a neighbor's feedlot. Because of the
different planning horizons, this rancher might use
two quite different beef prices in developing the
budgets involved with these analyses.
The length of the planning horizon affects not
only values but also the process of choosing which
prices and quantities to use in budgeting. For
situations with longer horizons, the manager needs
information which reflects a longer time period, a
broader geographical base, and a larger, more
political economy.
A very short horizon dictates the use of current
prices and quantities. That is, today's or next week's
values many be used even if they are much higher or
lower than what is normally expected. The very
short-run decision is concerned with profitability in
the short-run horizon.
The planning horizon for a farmer deciding
which crops to grow next year is too long for him to
PB-2-5
rely on projections based only on today's prices.
This manager needs to evaluate economic and
environmental factors which may affect profitability
next year. For such an intermediate term,
projections which emphasize local information from
the recent past may be sufficient.
Managers who are making investment decisions
have the longest planning horizons. Obviously,
brush control or establishing perennial pastures
decisions involve a longer commitment of capital
than annual crop decisions. Thus the former
decisions require a longer horizon. The longer the
horizon is, the more information is needed to project
prices and quantities into the future. For sizable,
longterm investments, a manager may need to
evaluate historical data, long-run population trends,
world climatic conditions, political conditions on
both a regional and an international view, as well as
other information.
In summary, the planning horizon affects the size
and complexity of the information base that should
be used by managers. As the planning horizon
lengthens, the sources of information need to come
from farther away in time, space, and markets.
Economic vs. Accounting Values
The distinction between economic and
accounting values is made by considering three
basic questions. First, how is the value determined?
Second, how is the value allocated between
enterprises? Third, is the value cash or non-cash?
The method for determining value can vary with
the purpose of the budget. For accounting purposes,
the actual interest rate on land loans is used to
determine interest costs. The economic interest cost
of landholding is the opportunity cost of the money
tied up in the land. In recent years, the interest rates
that could be earned in land investments is much
lower than the interest rates that could be earned in
alternative investments. Thus, the difference
between economic and accounting values related to
land can be large. The choice of interest rates to be
used depends on whether one wants to estimate the
impact of existing loans on cash-flow or to compare
the return from farming or ranching with the return
alternative investments.
The method of allocation can also cause a
difference between economic and accounting values.
In an economic sense, the crop may be allocated
only part of the interest costs on land; the rest is
allocated to a land investment enterprise. This
method recognized that the value of land comes
from two sources: farming or ranching and
speculation. The accounting process may place the
full cost of holding land on the crop because until
the land is sold, the crop is the only source of
revenue. However, accounting systems may be set
up to allocate land costs between farming or
ranching and speculation.
The third distinction relates to the difference
between cash and non-cash values discussed earlier.
If the owner works on the farm or ranch, but does
not explicitly pay himself, his "pay" is a non-cash
cost. An economic enterprise budget would include
the owner's implicit pay because it is a cost of
production. An accounting budget may not include
the owner's pay as a cost. It might instead label the
"bottom line" as the return to owner's labor, man-
agement, and risk. Including the owner's pay can
make the analysis of the financial status of the farm
or ranch more accurate, since the owner's labors
would be a cash cost if they were performed by
someone else.
Income Measures
There are many ways to evaluate the profitability
of a business. Different methods are used to answer
different questions and to help identify and solve
different management problems. The income
measures used are:
1. Gross Margin
Gross margin is gross income minus variable
costs. It is usually calculated for individual
enterprises and not for the whole farm or ranch.
Gross margins are used to choose between
enterprises in the short run that have similar fixed
costs. It is incorrect to evaluate enterprises that
PB-2-6
have large differences in fixed cost using only the
gross margin; i.e., comparing a cow-calf
enterprise to a stocker cattle or wheat enterprise.
Gross margin should not be used for long-term
planning or investment analysis or estimating
costs of production since fixed costs are not
considered.
2. Net Cash Income
Net cash income is the difference between cash
income and cash expense. Net cash income is the
amount of cash available to pay income taxes,
cover family living withdrawals, meet loan
principle pay-ments, replace machinery, herd
bulls and equipment, save, or reinvest in the busi-
ness. Net cash income should not be confused
with the Internal Revenue Service taxable income
which is calculated under different "rules" than
net cash income from an accounting standpoint
and is seldom close to an adjusted accrual in-
come.
3. Net Farm Income
Net ranch income can be either an economic
measure or an accounting measure. If it is to be
used for economic analysis of investments and
returns to resources, net ranch income needs to be
estimated as an economic measure. If it is to be
used for tax management and reporting, net ranch
income needs to be estimated as an accounting
measure. Net ranch income is calculated as an
economic measure in the printed reports. It is
cash income minus cash expense, depreciation,
interest on capital, and non-cash adjustments
such as owner's labor, owner's management, and
inventory changes, etc. Neither economic nor
accounting net income should be confused with
the Internal Revenue Service (IRS) taxable
income especially when it is calculated on a cash
basis, which is most common in agriculture.
Because of the rules followed in cash income tax
accounting it is an extremely poor measure of the
farm or ranch business accrual income.
4. Residual Return to Land, Labor, Capital,
Machinery Ownership, Risk, and Management
 The return to land, labor, capital, machinery
ownership, risk and management is the return to
all fixed factors of production. It is the amount
of money available to pay all fixed costs. It is
cash income minus cash operating expenses
(except interest on operating capital). It is the
residual return available to pay interest. It is
depreciation, insurance, owner's labor, land costs,
management, and a return for risk.
5. Residual Return to Land, Labor, Machinery
Ownership, Risk and Management
The return to land, labor, machinery ownership,
risk and management is the same as the previous
income measure except that interest costs (both
cash and opportunity) have been subtracted. It is
used to show the residual return after capital has
received its share.
6. Residual Return to Land, Labor, Risk and
Management
The return to land, labor, risk and management is
the same as the previous income measure except
that depreciation, taxes, and insurance costs for
machinery and irrigation equipment have been
subtracted. It is used to show the residual return
after capital and machinery expenses have
received their shares.
7. Residual Return to Land, Risk and Management
The return to land, risk and management is the
same as the previous income measure except that
the opportunity costs of the owner's labor have
been subtracted. It is used to show the residual
return after owner's labor, capital, and machinery
have received their shares.
8. Residual Return to Risk and Management
The return to risk and management is the same as
the previous income measure except that the
actual or opportunity costs of land have been
subtracted. It is used to show the residual return
to the manager's skill and gambling after land,
owner's labor, capital, and machinery have re-
ceived their shares.
PB-2-7
Residual return budget formats are useful for
enterprise budgeting because they allow the user to
consider different resource ownership situations
(borrowed vs. equity capital). The format also helps
overcome the problem of not knowing exactly what
to change for inputs like land and owner labor and
management. The economic and cash flow analyses
help analyze economic versus cash flow
implications for the enterprise. This structure also
facilitates short run (where returns above variable
cost is used for decision making) versus long-term
analysis.
Enterprise Budget Development
In general, the process of developing enterprise
budgets involves:
1. Describing the resources enterprise alternatives,
inputs, and potential products for the farm or
ranch enterprises. Preparing the beginning and
ending balance sheets and accrual adjusted
income statement for the last operating year.
2. Fitting enterprise budget information into a
budgeting format.
3. Calculating receipts and costs and preparing the
enterprise budget reports.
Good data is needed to develop good budgets.
Without good data, the information in budgets will
be incomplete or inaccurate. Income tax records
and historical records for individual farmers or
ranchers provide the best source of basic
information for ongoing activities.
Other data (such as yields, input rates, prices)
may be more effective if it is farm or ranch specific,
but more general sources can be used. In this
section, several sources of ranch data are discussed.
Statistical data generated by the state and national
level, especially price data, can be useful. Most
input use information, however, has insufficient
localization to be of much use in enterprise
budgeting.
 Labor requirements, wage rates, and benefits can
be determined from several sources. The "ongoing
rate" (that is, the most common wage) in the local
area is often the most-used source. Often, labor
contractors will provide workers on a job basis for
one total fee. Union contracts may set wage rates,
benefits, hours and other conditions for some
workers. The best estimates of labor productivity
are from individual farm or ranch records.
Machinery information can be obtained from
manufacturers, dealers, government and university
sources and individual farm or ranch records. An
estimate of the fair market value of machinery,
equipment, and trucks can be obtained from the
Official Guide: Tractor and Ranch Equipment which
is published annually by the National Ranch and
Power Equipment Dealer Association (1984 is refer-
enced as an example). Repair and maintenance
expenses can be estimated from equations based on
experience, but more accurate, localized information
can be obtained from individual farm or ranch
records. Fuel use estimates are available from
manufacturers, but records could provide
information that is more specific to local conditions,
treatment, and age of the machine. Farm or ranch
records are also the best sources for estimates of
operating speed, field efficiency, and other measures
of time requirements for various tasks. Custom
rates can be obtained directly from custom opera-
tors.
Livestock birth rates, weaning rates, growth rates,
etc., vary with local conditions, so individual
records are the best information sources. In the
absence of farm or ranch records, government,
university, and private sources can supply livestock
information.
Local lenders can supply current information on
interest rates for various lengths of loans. Data
about historical and projected interest rate trends is
available from various government agencies and
financial institutions, as well as in many business
publications. Realtors are one source for estimates
of land values and depreciation rates.
The intended use of budgets will indicate the best
source to use. If a budget is developed to help the
PB-2-8
manager decide which annual forage to plant next
year, price expectations should be formulated from
recent market information extended to the next
marketing year. If a budget is intended to clarify a
decision about whether or not to make a major
investment to change enterprises, price expectations
should be formulated from long-term demographic
and economic indicators and projections; recent
market data should not have an undue impact on
these price expectations.
The need to evaluate the impact of price and
yield variation on costs and income will require the
manager to collect this information also. Several
budgets may need to be estimated to cover the
possible outcomes of varying prices and yields.
In summary, it is hard to beat good farm or ranch
records for accurate budgeting data. Understanding
and using budgets will help identify what data
should be kept. Data collection is costly, so it
should only be done if it is going to be used.
Allocation of Costs
When enterprise budgets are developed for the
first time, most managers will start with records for
the whole farm or ranch. By following the steps
outlined below, you can allocate costs from
whole-farm or ranch records to individual enter-
prises.
1. Determine the costs of separate items for the
whole farm or ranch, based on the latest
operating year accrual adjusted income statement.
If the income statement is in good order, it
should indicate expense figures by individual
item (i.e., supplemental feed, fertilizer for
bermuda hay, etc.). If these records are not up to
date individual items will have to be organized
before costs can be allocated to specific enter-
prises.
2. Identify the enterprises on the ranch.
Most ranches grow more than one forage and/or
raise more than one category of livestock. If
only one forage is grown, allocation is very easy. If
the business involves more than one forage or
livestock enterprise, these enterprises have to be
identified and listed.
3. Classify the costs as direct or indirect.
The costs on the farm or ranch can be classified
as either direct or indirect. Direct costs are those
costs that can be attributed to a specific
enterprise. Examples of direct costs are fertilizer
applied to wheat and feed fed to beef cows.
Indirect costs are those costs that cannot be
associated with a specific enterprise. These
would include, for example, costs for a truck
which is used for several crops (or general ranch
duties), and fencing which is used for several
types of livestock.
4. Allocate the direct costs.
Direct costs are easily allocated to enterprises
because they are defined as used by that
enterprise directly. Bermuda harvesting costs are
allocated to hay. Weed control for wheat is
allocated to wheat. Veterinary expenses for cows
are allocated to the cow-calf enterprise.
5. Determine the best way to allocate indirect costs.
Indirect costs can be allocated to enterprises by
determining how they are related to those
enterprises. There are three main ways to
allocate indirect costs:
a. On the basis of resource use, or an example
showing that some enterprises require more man-
agement than others. Grazing days or animal
unit grazing days for cattle is an appropriate
allocation for forage cost to grazing livestock.
b. On the basis of variable cost, reflecting that
high variable cost is often associated with high
inputs of management and other whole farm or
ranch indirect costs like phone, accounting, etc.
c. On share of gross income, kind of an ability to
pay concept. Where there are mixed crops and
livestock, this procedure is not very appropriate.
PB-2-9
The key in allocation of cost is not to distort
relationships so that one would be misguided in
choosing between enterprises in resource allocation
decisions. One must be consistent between
enterprises and operating year being evaluated.
Interpretation of Enterprise Budget Results
While budgets are made to be used, they must be
properly understood and interpreted to be used
correctly. Proper interpretation of budgets requires
that the manager take into account the following
factors:
1. The budget's original purpose.
2. The sources of preliminary data and the methods
of collection.
3. The calculations performed on that basic data.
4. The planning horizon reflected in the budget.
5. The methods used to identify and separate
variable and fixed costs.
6. The methods used to identify cash and non-cash
items.
7. The cost and income components included in the
budget.
These factors will determine what questions the
budget can help answer, and how the budget can be
used most effectively as a management tool.
Economic Principles
Management is essentially the process of solving
the problem of how to allocate available resources
to meet the goals of the business. All problems of
resource use involve one or more of three
fundamental economic principles. They are
discussed more fully in the following sections, but
briefly, these principles are:
1. Increase the use of an input as long as the value
of the added output (that is, income) is greater
than the added cost.
2. Substitute one input for another input as long as
the cost of the substituted input is less than the
cost of the input which is replaced and the level
of production is maintained. This substitution
can be a complete replacement or simply a
change in the mix of products.
3. Substitute one product for another product as
long as the value of the new product is greater
than the value of the product it replaced and the
total cost is constant. This substitution can also
be a complete replacement or a change in the mix
of products.
These principles would be sufficient for all
planning if the manager has unlimited resources and
perfect knowledge. Since this is not the case, three
additional ideas must be introduced as aids to the
decision making process:
1. If resources are limited, use each unit of resource
where it will give the greatest returns and the
value added by the last unit of the resource is the
same for each of its alternative uses.
2. When alternative choices involve different time
periods, compare the alternatives on the basis of
the present value of the resulting cash flows. In
other words, take into account the time value of
money.
3. When risk and uncertainty cloud predictions,
different levels of prices, costs, and yields should
be used to evaluate the potential variation in
expected income and cash flow of alternatives
being considered.
The planning and budgeting process described in
this manual incorporate these economic principles
by searching for basic data and information and
compiling that information into budget reports for
decision making.
The Law of Diminishing Returns
Keeping in mind the physical law of diminishing
return is helpful when thinking of what can be
PB-2-10
expected from the use of additional levels of
production inputs. The physical law states, "as
successive amounts of the variable inputs are
combined with a fixed input in a production process,
the total product will increase, reach a maximum,
and eventually decline." This physical relationship
explaining why, unless an input is free it is not prof-
itable to maximize production as the last unit of
input will not increase output enough to pay the
added cost. This law is easily observed in
agricultural production in examples such as when
more nitrogen is applied to pastures or crops, more
irrigation water is used and cattle are fattened to
heavier weights.
Budget Information for Marketing Decisions
Marketing is not just a matter of waiting or
aiming for the high price. There are several
marketing decisions which require information on
production costs because both revenue and costs
determine the resulting profit. These decisions
include:
1. Setting price goals.
2. Timing of market transactions.
3. Hedging decisions on the futures market.
4. Bargaining with processors, wholesalers, and
other pricing agencies.
Setting price goals can involve specifying a
formula such as cost plus (10% for example). If the
production costs are not known accurately, the price
goal will not be estimated accurately. With an
accurate cost of production, the manager will know
what price is needed to break even and what price is
needed to meet the price goal. Without an accurate
cost of production estimate a manager may be
aiming too low, or too high. Either error may result
in lower profits than could have been realized and
greater financial risk for the business.
Timing of market transactions can be handled
better with better estimates of price goals. The
manager who has an accurate estimate of the price
goal can execute the marketing decision as soon as
the price goal has been reached. The risk of not
making the price goal (when it could have been
attained) is reduced. Without an accurate estimate
of the price goal, a manager may sell too soon or too
late to attain the price goal.
A producer utilizing the futures market needs to
have an accurate gauge on production costs in order
to correctly evaluate the benefits of hedging. Also,
accurate production costs aid the manager in timing
hedging.
Cost of production information can also be used
by bargaining groups in their negotiations with
processors and fresh market wholesalers. Producers
can utilize information concerning production costs
to justify bargaining for higher prices. If the cost
information is inaccurate, negotiations could result
in lower profits for the producers. Estimates which
are too high may result in lower contract levels.
Estimates which are too low may result in lower
profits even though contract levels are higher.
Whole Ranch Analysis and Planning
Before enterprise budgeting is initiated for a
specific farm or ranch operation, a set of financial
statements that calculates the adjusted accrual
income should be prepared. If the accrual income
statement is not complete, seldom will the developer
of enterprise budgets capture all the farm or ranch
overhead costs. For good planning enterprise
budgets, an income statement from the most recent
operating year can serve as the basis for the projec-
tions.
Steps in developing whole farm or ranch
financial plans include the following:
1. Define goals, describe resources, enterprises and
production alternatives.
2. Develop the historical balance sheets and accrual
income statements - three years of accrual adjusted
statements are adequate for most situations.
3. Budget out alternatives.
PB-2-11
4. Combine enterprises in the whole farm or ranch
summary program and evaluate the projected
income statement.
5. Go back and look at other alternatives to see if a
better income producing alternative can be
generated.
6. Develop the projected cash flow to insure
everything is financially feasible. The lender will
appreciate this information as it complements the
balance sheet and income statement information.
All farmers and ranchers need a good set of
performance records and an accounting system that
generates good enterprise costs and returns. These
records are essential for monitoring and control and
serve as a basis for evaluation of actual versus
projected performance.
The first time a whole farm or ranch plan is
developed, it is time consuming, but one has the
satisfaction of knowing where the farm or ranch is
headed. Future plans that build off of a good
existing plan and are supported by accurate
accounting and performance records are enjoyable
to prepare. Planning is a never ending process - the
computer certainly can facilitate this business
management task.
Extension Budget Guides
County Extension Agent offices throughout the
state have example enterprise budgets on file for
their area of the state. Budgets are prepared
annually by the Extension Farm and Ranch
Management specialists located in the district
Extension and Research centers. These budgets are
prepared in the same format as previous examples
and can serve as a guide for producers wishing to
develop their own enterprise budgets.
Software Availability
Software for enterprise budgeting, developing
financial statements and projected cash flows are
available from:
Texas Agricultural Extension Service
Extension Computer Technology Group
Special Services Building, Rm. 119
College Station, TX 77843-2468
409-845-3929
The title of the computer templates are Beef Cattle
Budgeting, Marketing, Financial Management,
Planning and Investment Analysis Templates and for
crops, Enterprise Budget Templates.

PB-2-12