Lilongwe University of Agriculture and

Natural Resources

Bachelor of Science in Agricultural Economics

AAE33104
Farm Business Management I

Module Writer
Yanjanani Lifeyo, MSc.

Reviewer

i
 Copy right
All rights are reserved. No part of this module may be reproduced, stored in retrieval
system or transmitted in any form or by any means, electronic or mechanical, including
photocopying, recording or otherwise without copyright clearance from Malawi University
of Science and Technology.

Lilongwe University of Agriculture and Natural Resources (LUANAR)

Open, Distance and e-Learning
P.O. Box 219
Bunda
Lilongwe
Email: [email protected]

ii
 Acknowledgements
Management of the Lilongwe University of Agriculture and Natural Resources
(LUANAR) for its commitment in the establishment of the centre of Open and Distance
Learning (ODL) and also for the continuous support of the activities in the directorate,
including the provision of funding for the development of this module.
All instructional designers for their dedication in development and review of the modules.

iii
 Table of Contents
List of Tables ........................................................................................................................ vii
List of Figures ...................................................................................................................... viii
Module Overview .................................................................................................................. ix
Visual Icons ........................................................................................................................... xi
Assessment ........................................................................................................................... xii
Unit 1: Introduction to Farm Business Management.............................................................. 1
1.1 Nature and scope of farm business management .......................................................... 2
1.2 Farm business management objectives ......................................................................... 3
1.3 Roles of managers of farm businesses .......................................................................... 4
1.4 Commercial and subsistence production. ..................................................................... 6
1.4.1 Common characteristics of subsistence and commercial production systems. ...... 7
Unit 2: Farm Production Resources ....................................................................................... 9
2.1 Productive resources classification ............................................................................... 9
2.2 Land as a Productive Resource ................................................................................... 10
2.1.1 Land tenure system............................................................................................... 11
2.1.2 Controlling land – own or lease?.......................................................................... 12
2.1.3 Things to consider when buying land .................................................................. 15
2.1.4 Land Appraisal ..................................................................................................... 16
2.3 Labour as a productive resource ................................................................................. 18
2.3.1 Characteristics of agricultural labourers .............................................................. 19
2.3.2 Labour measurement ............................................................................................ 19
2.3.3 Planning Farm Labour Resources ........................................................................ 22
2.4 Capital as a productive resource ................................................................................. 23
2.4.1 Types of capital .................................................................................................... 23
2.4.2 Sources of capital ................................................................................................. 23
2.4.3 Credit and loans - classifications .......................................................................... 25
2.4.4 Sources of agricultural loans ................................................................................ 31
Unit 3: Production and Cost Analysis .................................................................................. 35
3.1 The basic farm business questions .............................................................................. 35
3.2 Production, production function and physical relationships ....................................... 37

iv
 3.3 Law of diminishing marginal returns and the neoclassical production function ........ 39
3.4 The Factor-Factor Analysis ........................................................................................ 43
3.5 The Factor-Product Analysis ...................................................................................... 43
3.5.1 Input Substitution Ratio ....................................................................................... 47
3.6 Product-Product Analysis ........................................................................................... 50
3.6.1 Enterprise combination ................................................................................... 50
3.7 Production cost analysis.............................................................................................. 53
3.6.1 Opportunity Cost .................................................................................................. 53
3.6.2 Fixed, Variable and Total Costs ........................................................................... 54
3.8 Returns to Scale .......................................................................................................... 57
3.8.1 Economies and Diseconomies of Size ................................................................. 57
Unit 4: Practical Farm Planning Techniques ........................................................................ 61
4.1 Enterprise Budget ....................................................................................................... 61
4.1.1 Purpose and use of enterprise budgets ................................................................. 62
4.1.2 Terms and constructing an enterprise budget ....................................................... 62
4.1.3 Interpreting and analyzing enterprise budgets ..................................................... 63
4.2 Whole-Farm Budgeting .............................................................................................. 67
4.2.1 Procedures in developing a whole-farm plan ....................................................... 67
4.3. Linear programming .................................................................................................. 73
4.4 Partial Budgeting ........................................................................................................ 77
4.4.1 Partial budgeting procedure ................................................................................. 78
4.4.2 Partial Budget Format .......................................................................................... 78
4.4.3 Partial Budgeting Example................................................................................... 79
4.4.4 Limitations to partial budgets ............................................................................... 81
Unit 5: Planning Under Risks and Uncertainties .................................................................. 85
5.1 Definitions and concepts ............................................................................................. 85
5.2 Sources of risk in agriculture ...................................................................................... 86
5.3 Classification of risks.................................................................................................. 88
5.4 Risk Management ....................................................................................................... 89
5.4.1 Approaches to risk management .......................................................................... 89
5.4.2 Risk Management Process ................................................................................... 91
5.4.3. Risk management strategies ................................................................................ 92

v
 5.5 Decision making in a risky environment .................................................................... 93
5.5.1 Forming expectations ........................................................................................... 93
5.5.2 Variability............................................................................................................. 95
Glossary .............................................................................................................................. 101
References .......................................................................................................................... 103
Module Test ........................................................................................................................ 104

vi
 List of Tables
Table 2. 1:Estimated Annual Income and Expenses for Appraisal (160-acre tract with 150 crop
acres) ................................................................................................................................................. 17
Table 2. 2: Labour Productivity ........................................................................................................ 19
Table 2. 3: Amortization schedule of MWK100,000 Loan over 10 years at 8% interest using Equal
Principal Payment Method. ............................................................................................................... 28
Table 2. 4: Amortization schedule of MWK100,000 Loan over 10 years at 8% interest using Equal
Total Payment Method. ..................................................................................................................... 30

Table 3. 1: Production Function of Maize Yield and Nitrogen Fertilizer. ........................................ 37

Table 3. 2: The Average Physical Product (APP) ............................................................................. 38
Table 3. 3: Marginal Physical Product (MPP) .................................................................................. 39
Table 3. 4: Marginal Value Product, Marginal Input Cost and The Optimum Input Level .............. 45
Table 3. 6: Selecting Least-Cost Feed Ration ................................................................................... 49
Table 3. 7:Profit-Maximizing Combination of Two Competitive Enterprises .................................. 52

Table 4. 1: Enterprise Budget for Maize (1 Acre) ............................................................................. 64

Table 4. 2: Resources Inventory for Example farm .......................................................................... 70
Table 4. 3: Potential Enterprises and Resource Requirements .......................................................... 70
Table 4. 4: Estimating Gross Margin ................................................................................................ 71
Table 4. 5: The whole-farm Budget .................................................................................................. 72
Table 4. 6: Resources and resource requirements. ............................................................................ 73
Table 4. 7: Partial Budget Form ........................................................................................................ 79
Table 4. 8: Partial Budget for Owning Combine Versus Custom Hiring .......................................... 80
Table 4. 9: Partial Budget for adding 50 beef cows and convert 100 acres from grain to forage) .... 81

Table 5. 1: Using Probabilities to Form Expectations....................................................................... 93

Table 5. 2: Simple and weighted average methods ........................................................................... 94
Table 5. 3: Historical data for corn and soybean yields on an individual farm ................................. 96
Table 5. 4: Cumulative Probability Distributions for Corn and Soybean Yields .............................. 97

vii
 List of Figures
Figure 2. 1: Flow chart of the farm labour planning process. ........................................................... 22
Figure 3. 1: The Neoclassical Production Function and the Three Stages of Production. ................ 42
Figure 3. 2: Three Possible Types of Substitution ............................................................................ 47
Figure 3. 3: Production possibility curves for competitive enterprises. ............................................ 51
Figure 3. 4: Supplementary and Complementary physical relationships. ......................................... 52
Figure 3. 5: Economies and diseconomies of scale. .......................................................................... 58

Figure 4. 1: Breakeven Chart ............................................................................................................ 66

Figure 4. 2: Step in whole-farm planning.......................................................................................... 69
Figure 4. 3: Whole-farm budget development in picture .................................................................. 71
Figure 4. 4: Graphical illustration of resource restrictions in a linear programming problem. ......... 74
Figure 4. 5: Graphical solution for finding the profit-maximizing plan using linear programming. 76
Figure 4. 6: Partial budgeting and marginal analysis. ....................................................................... 77

Figure 5. 1: Sources of risk in agriculture ......................................................................................... 87

Figure 5. 2: Risk Management Process ............................................................................................. 92
Figure 5. 3: Cumulative distribution functions for corn and soybean yield. ..................................... 98

viii
 Module Overview
The Farm Business Management course is designed to equip you with the knowledge
and skills necessary to effectively manage the complexities of modern farming operations.
This comprehensive module encompasses key aspects of farm management, including
financial planning, resource allocation, risk management, and sustainability practices. You
will gain a deep understanding of the agricultural industry's economic dynamics, enabling
them to make informed decisions that enhance profitability and long-term viability. Through
a combination of theoretical learning and practical case studies, this module empowers you
to analyze agricultural markets, develop strategic business plans, and implement innovative
management techniques that align with the evolving demands of the agriculture sector.
This module overview provides you with a glimpse into the comprehensive curriculum,
focusing on the following crucial units:
Unit 1: Introduction to farm business management: This unit provides you with a
comprehensive introduction to farm business management, covering its nature, objectives,
roles of managers, and the distinctions between subsistence and commercial production.
Understanding these concepts is essential for effective farm management and sustainable
agricultural practices.
Unit 2: Farm production resources: In this unit, we discuss the essential components
essential for the production of goods and services, collectively referred to as productive
resources. This unit categorizes these resources into four fundamental elements: Land,
Labour, Capital, and Entrepreneurial Ability. The discussion begins with a detailed
examination of land, unravelling its unique characteristics, land tenure systems in Malawi,
and the pivotal decision-making process of whether to own or lease land, taking into account
the advantages and disadvantages associated with each option. The unit then transitions to a
comprehensive discussion on factors to consider when purchasing land and the types of the
land appraisal process. Shifting focus, the Unit explores labour as a productive resource, by
moving into the key features of agricultural laborers and providing insights into measuring
and planning labor resources on the farm. Capital takes centre stage in the subsequent
section, being portrayed as the crucial resource for any agricultural enterprise. The
discussion encompasses various facets of capital, including its types, sources, and the role

ix
of credit and loans in agriculture. In essence, Unit 2 equips learners with a comprehensive
understanding of land, labour, and capital as indispensable resources in the realm of farm
production.
Unit 3: Production and cost analysis: In this Unit, we will discuss the three key
production questions of how much to produce, how to produce, and what to produce.
Comprehensive analysis of these questions will enable you to understand and determine the
optimal combination of inputs and outputs, ultimately maximizing profits or minimizing
farm costs. The analytical breakdown of these questions involves factor-product analysis,
factor-factor analysis, and product-product analysis. Furthermore, our focus will extend to
production costs, namely fixed costs, variable costs, and opportunity costs. The unit will
conclude with an examination of returns to scale.
Unit 4: Planning farm techniques: In this Unit, will explore various facets of farm
planning, gaining an understanding in constructing whole farm budgets, enterprise budgets,
and partial budgets. We will also cover breakeven and gross margin analyses, as well as
program planning and linear programming techniques. In a nutshell, this unit empowers you
with practical farm planning skills, enhancing your ability to optimize profitability and farm
resource utilization.
Unit 5: Planning under risks: In this final Unit of the module, we will discuss about
agricultural risks and its related uncertainties. Specifically, we will define the term risk,
importance of risk management in agricultural production, approaches to risk analysis and
practical risk management strategies.

x
 Visual Icons
Text in this module is formatted to help you find information quickly and easily. The
visual icons in the left margin will help you locate information as described below.
Icon What the Icon Depicts
Introduction: This is an advance organizer that tells what you will learn
from a unit of study.
Learning outcomes: These define the type of knowledge, skills and
attitudes you should be able to display after going through the lessons in
the unit.
Key terms: These are words or phrases which will help you understand
lessons in the unit.
Lessons: This is content you must read and understand to achieve the
stated unit objectives.
Activity: This tells you the tasks you should perform to facilitate your
learning from the unit.
Answers to unit activities: This gives you the suggested answers to the
unit activities. Ensure that you begin by performing the activities on your
own before comparing your answers with the suggested answers.
Further readings: Shows you a suggested list of resources you will need
to study for your deeper understanding of lessons in the unit.

Summary: Reminds you of what you have learnt in a unit.

Unit Test: Examines your understanding of lessons in the unit.

xi
 Assessment
The course will be assessed in two parts. The first part will be the continuous assessment,
and you will be expected to complete two comprehensive assignments and a mid-semester,
which will contribute 40% of the final grade. The second part will be end of semester
examination which will contribute 60% of the final grade.

xii
 Unit 1: Introduction to Farm Business
Management

Introduction
Welcome to unit 1 of Farm Business Management I. In this unit we will introduce the
concept of farm business and management. We will specifically define farm business
management, nature and scope of farm business management, farm business management
objectives, role of managers of farm businesses and the commercial and subsistence
production.

Learning Outcomes
Upon successful completion of this Unit, you should be able to:
a. Define what is farm business management.
b. Explain key objectives of farm business management.
c. Explain the role of managers of farm businesses.
d. Differentiate commercial and subsistence production.

Key Terms
Ensure that you understand the key terms or phrases used in this unit as listed below:
• Farm - It is an organized decision-making unit in which crop and livestock
production is carried out with the purpose of satisfying farmers objectives. Farming
can either be subsistence or commercial.
• Subsistence farming – These are type of farms where most work done by hand, by
families, with animal power but not mechanical equipment.
• Commercial farming systems - characterized by the commercial production of
agricultural commodities for specific markets and capital intensive.
• A business - It concerns the making, buying, selling or supplying of goods or
services for profit making.

1
 • Management - It is a process of making decisions that the use of available human
and material resources is planned and controlled to achieve its specific objectives
more effectively

1.1 Nature and scope of farm business management

Farm Business Management involves organizing and combining people, natural and
material resources for the purpose of crop and livestock production in order to maximize
profit while optimizing input use. We can also safely say that Farm Business Management
concerned with utilization of scare resources in order to meet some farm business objectives,
i.e. profit maximization and cost minimization.
Management of agribusiness or farm business has five major functions:
i. Planning
ii. Organizing
iii. Directing
iv. Coordination and
v. Control
Planning Function: It means choosing a course of action, policy, or procedure. Not much
will happen without a plan. To formulate a plan, managers must first establish goals, or be
sure they clearly understand the business owner’s goals. Second, they must identify the
quantity and quality of resources available to meet the goals. In agriculture, such resources
include land, water, machinery, livestock, buildings, and labor. Third, the resources must be
allocated among several competing uses. The manager must identify all possible
alternatives, analyze them, and select those that will come closest to meeting the goals of the
business. All these steps require the manager to make careful long-run and short-run
decisions.
Organizing Function: It involves arranging human and other resources in most effective
way. It includes: Setting up the structure, Determining the job to be done, Selecting,
allocating and training personnel.
Directing Function: It is the responsibility of the farm manager to direct resources.
Directing of resources has to be done in an effective way to achieve the desired goals. It

2
involves assigning who will do what, establishing the results to be achieved. It is the
manager’s responsibility to address each staff’s needs and interest.
Coordination Function: It involves pulling together of the action of different groups of
people in such a way that the action of one group provides and aid to the working of the
other. A conducive environment has to be available for effective coordination. There must
be free flow of information and development of workers.
Controlling Function: It includes monitoring results, recording information, and
comparing results to a standard. It ensures that the plan is being followed and producing the
desired results, or provides an early warning so adjustments can be made if it is not.
Outcomes and other related data become a source of new information to use for improving
future plans.

Activity 1 a
Explain the key functions of Farm Business Management.

1.2 Farm business management objectives

Farm business management involves a range of activities aimed at ensuring the effective
operation, growth, and sustainability of a farming enterprise. In this unit, we will discuss
four key objectives of farm business management:
i. Profit maximization and cost minimization: Maximizing profitability and cost
minimization are the fundamental objectives of any farm business. This involves
managing costs, optimizing production processes, and setting appropriate prices for
products. A profitable farm (lower costs per unit of output) is better equipped to
invest in modern equipment, technology, and practices that can lead to increased
efficiency and competitiveness.
ii. Sustainability: Sustainability focuses on maintaining the long-term viability of the
farm business while minimizing negative environmental and social impacts. This
includes adopting practices that promote soil health, water conservation,
biodiversity, and responsible resource management. Sustainable farming practices
help ensure that the land remains productive and healthy for future generations.

3
 iii. Risk Management: Farming is inherently exposed to various risks, including
weather-related events, market fluctuations, disease outbreaks, and more. Effective
risk management involves strategies such as diversification of crops, proper
insurance coverage, financial planning, and contingency plans to mitigate potential
losses and disruptions.
iv. Growth and Expansion: Many farm businesses aim to grow and expand over time.
This could involve increasing production capacity, diversifying into new products or
markets, or improving infrastructure and facilities. Strategic planning, investment
decisions, and market analysis play crucial roles in achieving controlled and
sustainable growth.
You will note that these four objectives are interconnected and need to be balanced for
the overall success of the farm business. Effective farm business management requires a
combination of technical expertise, financial acumen, and a deep understanding of the
agricultural sector and its dynamics.

Activity 1 b
Discuss the four key objectives of farm business management.

1.3 Roles of managers of farm businesses

In the modern world, managers of farm businesses play a crucial role in ensuring the
success and sustainability of agricultural operations. Though their roles are not different
from the farm business management functions, farm managers' responsibilities encompass
various aspects, from planning and production to financial management, marketing and risk
management. Presented to you here are some of the key roles and responsibilities of farm
business managers:
a. Strategic Planning: Farm managers are responsible for setting the overall direction
and goals of the farm. They develop long-term strategic plans that consider factors
such as crop selection, livestock management, land use, and expansion or
diversification of the operation, among others.

4
b. Crop and Livestock Management: They oversee the day-to-day activities related
to planting, cultivating, and harvesting crops or managing livestock. This includes
making decisions about planting schedules, pest and disease control, and livestock
health and nutrition.
c. Resource Management: Farm managers manage the allocation and efficient use of
resources such as land, water, labor, and machinery. They ensure that these resources
are used optimally to maximize productivity and minimize waste.
d. Financial Management: They are responsible for budgeting, financial planning, and
managing farm finances. This includes tracking income and expenses, securing
financing when needed, and making decisions to ensure the farm remains financially
viable.
e. Risk Management: Farm managers assess and mitigate risks associated with
farming, such as weather-related risks, market fluctuations, and disease outbreaks.
They may implement insurance policies and diversification strategies to manage
these risks.
f. Marketing and Sales: Managers are involved in marketing farm products, whether
it's selling produce to local markets, wholesalers, or direct-to-consumer through
farmer's markets or online platforms. They also negotiate prices and contracts with
buyers.
g. Compliance and Regulations: Farm managers need to stay up-to-date with local,
state, and federal regulations related to agriculture, environmental conservation, and
food safety. They ensure that their farm operations comply with these regulations.
h. Human Resource Management: They hire, train, and supervise farm workers and
laborers. Managing the workforce efficiently is crucial for farm productivity and
ensuring a safe working environment.
i. Environmental Sustainability: In the modern world, issues of environment and
climate change are of paramount importance and many farm managers are
increasingly concerned with sustainable and environmentally friendly practices.
They implement strategies to minimize the environmental impact of their operations,
such as soil conservation and responsible water usage.

5
 j. Record Keeping and Data Analysis: Maintaining accurate records of farm
activities and production data is essential for making informed decisions. Farm
managers may use data analysis to improve farm operations and profitability.
Overall, farm business managers must be versatile and adaptable, as they are responsible
for overseeing a wide range of tasks to ensure the farm's success and sustainability in an
ever-changing agricultural landscape.

Activity 1 c
Discuss three key roles of managers of farm businesses.

1.4 Commercial and subsistence production.

Farming in any setting can be categorized into subsistence and commercial farming.
There is no common definition of subsistence farming. However, there are two major
perspectives to define subsistence production: Consumption or Production perspective.
From consumption perspective, subsistence production is referred to as crop production,
livestock rearing and other activities mainly for personal consumption. On the other hand,
from the perspective of production, subsistence farming is referred to as the farming in which
less than 50% of production is sold. It is a self-sufficient farming in which farmers grow
only enough food to feed their family and planting decisions are determined by family needs
during the coming year, rather than market prices (e.g. tobacco, cotton, etc).
Commercial production on the other hand, it involves the production of crops and
livestock for sale – crops and livestock products intended for widespread distribution to
wholesalers or retail outlets (e.g. supermarkets), and any non-food crops such as cotton and
tobacco. Commercial production is also divided into:
i. Extensive Commercial Farming.
ii. Intensive Commercial Farming.
Extensive commercial carming - It is a system of agriculture in which relatively small
amounts of capital or labour investment are applied to relatively large areas of land. Some
characteristics of Extensive Commercial Farming includes: large areas of land under
cultivation and hence maximizes the cost of machines, low population density and hence

6
few workers as most work is done by machines, monoculture of cash crops e.g. tea, coffee,
tobacco etc, it is associated with low yield and cheap land.
Intensive Commercial Farming – It is practiced in areas where large amounts of capital
(machinery, fertilizers) and/or labour per unit of land are used. It is frequently used in an
area where the population pressure is reducing the size of landholdings. The advantage is
that yields are very high allowing food to be cheaper. The disadvantage is that it involves
huge usage of various kinds of chemicals such as fertilizers, pesticides and insecticides
which may poison the land.

1.4.1 Common characteristics of subsistence and commercial

production systems.
In this section, we will discuss common characteristics of subsistence production and
commercial production systems.
Common characteristics of subsistence production include:
a. Use of small area of land.
b. Less capital involvement.
c. Farm technology tends to be primitive e.g. use of hand tools such as hoes.
d. More reliance on crop rotation, animal manure, and compost to restore the
nutrients rather than on purchased expensive synthetic fertilizers.
e. Associated with low yield
f. Production is mainly for home consumption with little, if any, surplus for sale.

Common characteristics of subsistence production include:

a. Requires large area of land
b. Uses large capital
c. Requires the use of heavy machineries
d. Requires more power.

Activity 1 d
Discuss the differences between commercial and subsistence farming.

7
Summary
Farm Business Management encompasses the coordination of resources, both natural and
human, to optimize crop and livestock production while maximizing profits and minimizing
costs. In this unit we have discussed five key functions: planning, organizing, directing,
coordinating, and controlling. Planning involves setting goals and resource allocation,
organizing focusing on effective resource arrangement, directing focuses on assigning tasks
and ensuring goal achievement, coordination focuses on harmonizing different actions, and
control monitors results and adjusts plans as needed.
We have also discussed the four main objectives of farm business management, which
are: profit maximization, cost minimization, sustainability, and risk management, all of
which are interconnected. Farm managers play a vital role in strategic planning, resource
management, financial management, risk mitigation, marketing, compliance, and
environmental sustainability.
We later categorized farming into subsistence and commercial production, with
subsistence farming primarily for personal consumption and commercial farming focused
on selling products. Subsistence farming may involve less land, capital, and technology,
while commercial farming often requires more extensive resources, machinery, and
intensive practices.

End of Unit Test

1. Discuss the key objectives of farm business management.
2. Discuss four key areas you can apply farm business management concepts for
smooth operations on the farm.

Further Reading
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.
Johnson, D.T. (1982). The Business of Farming: A Guide to Farm Business Management
in the Tropics. London: Macmillan Publishers Ltd.

8
 Unit 2: Farm Production Resources

Introduction
Welcome to Unit 2 of this module. In this unit, we will discuss the four key farm
productive resources namely: land, labour, capital and management. The discussion will
specifically focus on returns to land, labour, capital and management, and also land tenure
systems and their implications on farm business, sources of capital, the role of labour and
management in farm businesses and decision-making.

Learning Outcomes
Upon successful completion of this Unit, you should be able to:
a. Explain the implications of various land tenure systems, on farm business
b. Describe various sources of capital.
c. Explain of labour in farm business management.
d. Explain the return to management and its role to farm businesses.

Key Terms
Ensure that you understand the key terms or phrases used in this unit as listed below:
Land tenure.
Management.

2.1 Productive resources classification

Productive resources are those resources that are used for production of goods and
services. Productive resources also add value to already existing farm businesses. For a
resource to be productive, it has to be used in the production or value addition system.
Productive resources are classified into four general categories:
a. Land
b. Labour

9
 c. Capital
d. Entrepreneurial Ability

2.2 Land as a Productive Resource

Land means much more to the economist than it does to most people. To the economist,
land includes all natural resources (“gifts of nature”) used in the production process.
Agriculture uses large areas of land, distinguishing it from most other industries and sectors.
Land is the basic resource that supports the production of all agricultural commodities, even
livestock because they depend on land to produce forage and grain they consume.
Land has a number of unique characteristics not found in other resources. These
characteristics greatly influence the economics of land use and management. Key features
of land, that you would also agree, include:
a. Land is a free gift of nature, in such cases, land is not manmade.
b. Land is a primary factor of production. All agricultural production happens on
land hence the starting point of production should always be the acquisition of
land.
c. Land has gradeability - land varies from region to region on the basis of fertility,
some land is more fertile and some is not at all. So, fertility wise, grading of land
is possible.
d. Land is a passive factor - land itself doesn't produce anything alone, it needs the
help of labour, capital, entrepreneurship, etc.
e. Land has a derived demand - demand for agricultural goods is a direct demand,
and to produce such goods, land is indirectly demanded. So, as a factor, land has
a derived demand from the consumer's point of view.
f. Land may have diminishing returns - here, return means quantity of crops. By
using fertility of land with the help of capital and labour continuously, returns
from land get diminished because of the reduction in fertility.
g. Land has no social cost - the supply price of land is zero for a society but not for
individuals

10
2.1.1 Land tenure system
Land tenure refers to the right to occupy, hold or use a piece of land. There are three land
tenure systems in Malawi, namely:
i. Customary
ii. Freehold
iii. Leasehold
Note: Freehold and leasehold are referred to as Private land.
Let us now discuss these three land tenure systems in detail:
Customary Land: This is the dominant form of land ownership in Malawi, covers a
significant portion of the country's land. Under this system, land is owned and controlled by
traditional chiefs or local communities. People have access to land and use it for farming
and other purposes based on customary rules and traditions. Customary land tenure is often
characterized by communal ownership, and individual land rights may not be clearly
defined. However, users of the land usually have certain rights and responsibilities within
their communities. In this case, land belongs to the community, the chief is responsible for
distributing the land to his/her members, and this makes the land be subdivided into small
pieces
Freehold Land: Freehold land tenure allows individuals or entities to own land outright.
This type of land tenure is relatively rare in Malawi and is typically associated with large
estates, commercial farms, or urban areas. This is the land that was given to retired
politicians, and influential people in a country without paying any fees. Mission hospitals,
missionaries are built on freehold land.
Leasehold Land: Leasehold land tenure involves the allocation of land by the
government or local authorities for a specific period, typically 99 years. This system is more
common in urban and peri-urban areas. Land under leasehold tenure can be used for
residential, commercial, or industrial purposes, subject to the terms and conditions outlined
in the lease agreement. Leaseholders have more secure land rights compared to customary
land users.

11
2.1.2 Controlling land – own or lease?
How much land to control and how to acquire it are two of the most important decisions
to be made by any farmer or rancher. Errors made at this point may plague the business for
many years. Too little land may mean your business is too small to fully use other resources.
At the other extreme, too much land may require borrowing a large amount of money, cause
serious cash flow problems, and overextend the operator’s management and machinery
capacity. Either situation can result in financial stress and eventual failure of the business.
Land acquisition should be thought of in terms of control and not just ownership. Control
can be achieved by either ownership or leasing.
Let us now discuss these two decisions in detail.
Land Ownership: Owning land is an important goal for many farmers, regardless of the
economics involved. A certain amount of pride, satisfaction, and prestige is derived from
owning land. It also provides a tangible estate to pass on to one’s heirs. Owning land has the
following advantages:
i. Security of Tenure: Landownership eliminates the uncertainty of losing a lease
and having the size of the business reduced unexpectedly. It also ensures that
the operator will enjoy the benefits of any long-term improvements made to the
land.
ii. Loan Collateral: Accumulated equity in land provides an excellent source of
collateral when borrowing money. Increasing land values over time have provided
substantial equity for landowners, although some of this equity can be lost with a
decline in land values such as occurred during the mid-1980s.
iii. Management Independence and Freedom: Landowners are free to make decisions
about enterprise combinations, conservation measures, fertilizer levels, and other
choices, without consulting with a landlord or professional farm manager.
iv. Hedge Against Inflation: Over the long run, land provides an excellent hedge
against inflation, because increases in land values have tended to equal or exceed
the rate of inflation in many economies. However, land values do not necessarily
increase every year.

12
 v. Pride of Ownership Owning and improving one’s property is a source of pride. It
assures a future benefit from years of labor and investment.

Ownership of land controlled by the business can also have some disadvantages. You will
note that most of the disadvantages are primarily related to the capital position of the
business. Possible disadvantages include:
i. Cash Flow: A large debt load associated with purchasing farmland can create
serious cash flow problems. The cash earnings from the land may not be sufficient
to meet the required principal and interest payments, as well as the other cash
obligations of the business.
ii. Lower Return on Capital: Where capital is limited, there may be alternative uses
for it with a higher return than investing in land. Machinery, livestock, and annual
operating inputs such as fertilizer, seed, and feed, often produce a higher rate of
return on investment than land.
iii. Less Working Capital: A large investment or heavy debt load on land may restrict
the amount of available working capital, severely limiting the volume of
production, choice of enterprises, input levels, and profits.
iv. Size Limits A combination of limited capital and a desire to own all the land to
be operated will limit the size of the business. A small size may prevent the use
of certain technologies and result in higher average costs.
The disadvantages of landownership are more likely to affect the beginning for a farmer
with limited capital. With the accumulation of capital and borrowing capacity over time,
they may become less and less important. Older farmers tend to own more land and have
less debt than younger farmers.
Leasing Land: Beginning farmers are often advised to lease land. With limited capital,
leasing is a means of controlling more acres. Based on the discussions we have had above;
you will notice that advantages of leasing land include:
i. More working capital: When capital is not tied up in land purchases, more is available
to purchase machinery, livestock, and annual operating inputs.

13
 ii. More flexible size: Lease contracts are often for only one year or, at most, several
years. Year-to-year changes in business size or location can be easily accomplished
by giving up old leases or leasing additional land.
iii. More flexible financial obligations: Lease payments are more flexible than mortgage
payments, which may be fixed for a long period. The value of share rent will
automatically vary with crop yields and prices. Cash rents are less flexible but can
be negotiated each time the lease is renewed, taking into account current and
projected economic conditions.
Leasing land also has disadvantages, which take on particular significance when all the
land operated is leased. These disadvantages are:
i. Uncertainty: Given the short term of many leases, the danger always exists that
all or part of the land being farmed can be lost on short notice. This possibility
discourages long-term investments and contributes to a general feeling of
uncertainty about the future of the business.
ii. Poor facilities: Some landlords are reluctant to invest money in buildings and
other improvements. Tenants cannot justify investing in improvements attached
to someone else’s property. Thus, family housing, livestock facilities, grain
storage, fences, and machinery housing may be obsolete, in poor condition, or
non-existent.
iii. Slow equity: Accumulation Without landownership, equity can be accumulated
only in machinery, livestock, or cash savings. In periods of rising land values,
tenants may have to pay higher rents without accumulating any equity.
There is no clear advantage for either owning or leasing. Control is still an important
factor, as income can be obtained from either owned or leased land. In the final analysis, the
proper combination of owned and leased land is the one providing enough land to fully use
the available labour, machinery, management, and working capital without creating
excessive financial risk.

14
2.1.3 Things to consider when buying land
The purchase of a farm is an important decision that often involves large sums of money.
A land purchase will have long-run effects on both the liquidity and solvency of the business.
The first step you should consider in a land purchase decision is to determine the value of
the parcel under consideration. Income potential is the most important determinant of land
value, but many other factors contribute to it:
a. Soil, Topography, and Climate: These factors combine to affect the crop and
livestock production potential and therefore the expected income stream.
b. Buildings and Improvements: The number, size, condition, and usefulness of
buildings, fences, storage structures, and other improvements will affect the value of
a parcel of land. A neat, attractive farmstead with a modern house can add many
dollars to a farm’s value, while rundown, obsolete buildings may detract from it.
Farm buildings and improvements are eligible for depreciation expense, creating a
potential income tax savings.
c. Size: Small and medium-sized farms may sell for a higher price per acre than large
farms. A smaller total purchase price puts a farm within the financial reach of a larger
number of buyers. Several neighboring farmers may consider the purchase of a small
farm a good way to increase the size of their business, and bid up the price.
d. Markets: Proximity to a number of markets will reduce transportation costs, increase
competition for the farm’s products, and possibly raise their net selling prices.
e. Community: A farm located in an area of well-managed, well-kept farms or in a
community where land seldom changes hands will have a higher selling price.
f. Location: Location with respect to schools, churches, towns, recreational facilities,
paved roads, and farm input suppliers will also affect value. A prospective purchaser
who plans to live on the farm will pay particular attention to the community and
services provided in the general area.

15
2.1.4 Land Appraisal
An appraisal is a systematic process for estimating the current market value of a given
piece of land. Two basic methods that you can use to appraise the value of income-producing
property such as farmland are:
a. the income capitalization method and
b. the market data method.
Income Capitalization: This method uses investment analysis tools to estimate the
present value of the future income stream from the land. It requires an estimate of the
expected annual net income, the selection of a discount rate, and the computation of the
present value of an annuity. Using the income capitalization method, the land value, V is

found by:

Where I is the annual net income and R is the discount/capitalization rate.

When estimating land value using the income capitalization rate, you must follow the
following steps:
Step 1: Estimate net income (I) that can be obtained from a property
I = Gross farm income minus all expenses incurred to generate it (expenditure)
Step 2: Estimate capitalization rate
R = Actual rate of interest minus inflation rate
If the actual interest rate in Malawi is 40% and the inflation rate is 20%
R=40%-20% = 20%

16
Numerical Example
Table 2. 1:Estimated Annual Income and Expenses for Appraisal (160-acre tract with
150 crop acres)
Income Acres Yield (Kgs) Price (MWK) per Kgs Total (MWK)
Corn 11 3,000.00 500 16,500,000
Soybeans 4 1,000.00 600 2,400,000
Total Income 18,900,000
Expenses
Fertilizer 800,000
Seed 115,000
Pesticides 12,000
Trucking 20,000
Drying 90,000
Labour Management 200,000
Machinery ownership costs 450,000
Machinery operating costs 4,650
Depreciation of buildings 180,000
Property taxes and upkeep 35,000
Total expenses 1,948,000
Annual net income to land 16,952,000
Capitalization of income
Capitalization rate Total Value (MWK) Value per Acre
10% 169,520,000 1,059,500
8% 211,900,000 1,324,375
6% 282,533,333 1,765,833

Market Data: The second appraisal approach compares the land parcels that have
been sold recently with the tract of land being appraised. Prices of the comparable sales are
adjusted for differences in factors such as soil type, productivity, buildings and
improvements, size, proximity to markets, the community, location, and competing uses.

Activity 2 a
Discuss why is land an important productive resource in farm production.

17
2.3 Labour as a productive resource
The second productive resource that we will discuss in this unit is labour. Labour consists
of the physical and mental talents of individuals used in producing goods and services. The
payment for labour is “wage”. You will note that human labour is one of the few inputs in
agriculture whose use has diminished substantially over time. The introduction of
mechanization and other labor-saving technology has allowed agricultural production to
increase despite the decline in labour use, however. More of the labor input on today’s farm
is spent operating, supervising, and monitoring these mechanical activities, and less is
expended on physical effort. Changes in the tasks performed by agricultural labour have
required employees and managers to increase their education, skills, and training.
Agricultural labour is categorized into two:
a. Skilled labour
b. Unskilled labour.
Skilled labour: These requires some specific training and education. e.g. machine
operators, drivers etc…
Unskilled labour: These operate without any additional/special training. Can be done by
secondary school certificate holders or dropouts who have no form of training.
We can also classify agricultural labourers as:
a. Family labour
b. Hired labour
Family labour: Free/costless labour supplied by farm households. A common type of
labour in most smallholder households in Malawi. This labour does not generally receive a
direct cash wage, so its cost and value can be easily overlooked or ignored. However, as with
all resources, there is an opportunity cost for operator and family labour, which can be a
large part of the farm’s total noncash fixed costs. Compensation for operator and family
labour is received indirectly through expenditures for family living expenses and other cash
withdrawals.

18
 Hired labour also known as casual/temporary/seasonal labourers. These are mostly
smallholder farmers. They possess very little land and devote most of their time working on
the lands of others as labourers. They are usually engaged only during peak period for work.

2.3.1 Characteristics of agricultural labourers

We will now discuss major characteristics of agricultural labourers in Malawi and of
course in many agricultural settings.
✓ They are very unorganized and scattered all over the country. This makes it difficult
to create trade unions and bargain for better wages
✓ Most of the agricultural labourers are unskilled and lacks training, which results in
low wages and incomes. This also leads to low wages and poverty.

2.3.2 Labour measurement

Labor should be quantified so that the farm manager knows how much labor is available.
A man/person-day of work is defined as the amount of work that can be carried out by an
adult male in an 8-hour work period. A man-hour is one-eighth of this. The use of an 8-hour
day to estimate man-day equivalents is only a guide. Different day lengths could be applied
to different circumstances. The man-day equivalent is based on the use of standard
conversion factors (weights) applied to males and females in different age groups. For
instance, a conversion factor of 1.0 means that an individual can perform a given task in the
same time as a normal adult, while a factor of 0.5 means that the task would take the
individual twice as long to perform: more than if it were done by a normal adult.
Adult males and females are assumed to be different in terms of the amount of effective
work they can do. However, this may not be true. Work productivity differs and depends on
the type of task given. There may be some tasks where adult males and females work output
are equivalent (e.g. in cropping). Laborers work for 25day/month.
Table 2. 2: Labour Productivity

19
Numerical Example

Let us consider this example, suppose we have: Two (2) adult males and female (between
15 and 65 years) for herding cattle
• Two adult females (between 15 and 65 years) for herding small stock and calves, and
• Two children (male and female; between 10 and 14 years) for herding cattle and
small stock.
Assuming that adult males and females contribute an average of 0.5 hours/day to herding,
and children an average of 6 hours/day, Children are as effective as adults in there work
• Four (4) adult males and female (between 18 and 65 years) for herding 600 sheep.
• Two (2) adult females (between 18 and 65 years) for shearing wool of the sheep at
the rate of 5 sheep per hour.
• Two (2) older adult males (from 65 years and more) for stacking of the sheep wool
of 2 stacks per hour. Each sheep produces 0.5 stack of wool.
Assuming that adult males and females contribute an average of 5 hours/day with the
conversion factor of 0.8 to herding and shearing, and older adult males an average of 0.5
hours/day
i. What is the total man hours per year?
ii. What is the total man days required?
iii. How long will it take to shear the sheep and stack the wool?
Solution
To find the total man hours per year, we will use the conversions discussed above.

20
Table 2.3: Total man-hours per year
Labour Labour availability
No. of Conversion Total man- Total man-
Category Total
persons Hours/day Hours/day factor hrs/month hrs/year
days
Adult
2 50 600 5 0.8 200 2,400
males
Adult
4 100 1200 5 0.8 400 4,800
females
Older adult
2 50 600 0.5 1 25 300
males
Total man-hour per year 7,500
Total man-days per year ~937.5

Two (2) adult females (between 18 and 65 years) for shearing wool of the sheep at the rate
of 5 sheep per hour.
600 sheep
Assuming that adult males and females contribute an average of 5 hours/day with the
conversion factor of 0.8 to herding and shearing, and older adult males an average of 0.5
hours/day Two (2) older adult males (65 years and more) for stacking of the sheep wool of
2 stacks per hour. Each sheep produces 0.5 stacks of wool.

How long will it take to shear the sheep?

Table 2.4: Total days for sheep shearing
Labour Labour availability Total sheep Total days
No. of Conversion
Category sheared per for sheep
persons Sheep per hr Hours/day factor day shearing
Adult
2 10 5 0.8 40 600/40=15
females

How long will it take to stack the wool?

Table 2.5: Total days to stack the wool
Labour Labour Sheared Total
No. of Conversion Total days for
Category availability sheep wool
persons factor wool stacking
Stack/hr Hrs/day per day stack/day
Older
adult 2 4 0.5 40 40*0.5 1.0 20/2 = 10
males

21
2.3.3 Planning Farm Labour Resources
When planning for labour resources on the farm, the first step is for you to assess the
farm labor needs, the quantity, quality and the conditions under which workers will
functions. This will describe the nature of skills you require on a farm. A flow chart can be
used for this purpose as shown in Figure 2.1.

Figure 2. 1: Flow chart of the farm labour planning process.

Activity 2 b
Discuss 5 key features of agricultural labourers in Malawi

22
2.4 Capital as a productive resource
The third productive resource we are going to discuss is capital. Capital is defined as cash,
balances in savings and checking accounts, and other liquid funds. Broadly, capital is the
money invested in the physical inputs used in agricultural production. It is needed to
purchase or rent productive assets, pay for labour and other inputs, and finance family living
and other personal expenditures. Economists refer to the purchase of capital goods as
investment. Assets on the farm may include Livestock, Machinery and Buildings. Land can
also be included in a definition of capital although it is often considered separately.
A farm manager is faced with two important decisions regarding capital:
a. How much capital should be used? and
b. How should limited capital be allocated among its many potential uses?

2.4.1 Types of capital

We will discuss two major types of capital, namely:
i. Fixed capital
ii. Working or operating capital
Fixed capital: refers to durable capital goods which are used in production again and
again till they wear out e.g., machinery, tools, factory building, etc. Fixed capital does not
mean fixed in location but because the money invested in such capital goods is fixed for a
long period.
Working capital (Variable): refers to the single-use produced goods like raw materials.
They are used directly and only once in production. They get converted into finished goods.
Money spent on them is fully recovered soon produced goods are sold.

2.4.2 Sources of capital

You will notice that capital consists of cash and assets purchased with cash, as such it is
relatively easy to intermingle capital from different sources. An important part of farm
financial management is the ability to obtain capital from several sources and combine it in

23
the proper proportions in various uses. In this section, we will discuss some of the most
common sources of capital in agriculture.
Owner Equity: The farmer’s own capital is called owner equity or net worth. It is
calculated as the difference between the total assets and the total liabilities of the business.
There are several ways the operator can secure or accumulate equity. Most farmers begin
with a contribution of original capital acquired through savings, gifts, or inheritances. As the
farm generates profits in excess of what is withdrawn to pay personal expenses and taxes,
retained earnings can be reinvested in the business. Some operators may have outside
earnings, such as a nonfarm job or other investment income, which they can invest in their
farming operations.
Outside Equity: Some investors may be willing to contribute capital to a farm without
being the operator. Under some types of share lease agreements, the landowner contributes
operating capital to buy seed and fertilizer, or even provides equipment and breeding
livestock. Larger agricultural operations may include limited or silent partners who
contribute capital but do not participate in management. Incorporated farms may sell stock
to outside investors. These arrangements increase the pool of capital available to the business
but also obligate the business to share earnings with the investors.
Leasing: It is often cheaper to gain the use of capital assets by leasing or renting rather
than owning them. Short-term leases make it easier for the operator to change the amount
and type of assets used from year to year. However, this also creates more uncertainty about
the availability of assets such as land and discourages making long-term improvements.
Contracting: Farmers who have restricted access to capital or credit, or who wish to limit
their financial risk, may contract their services to agricultural investors. Examples include
custom feeding of cattle, finishing pigs on contract, contract broiler or egg production, and
custom crop farming. Typically, the operator provides labour and management and some of
the equipment or buildings, while the investor pays for the other inputs. The operator
receives a fixed payment per unit of production. Any special skills the operator has can be
leveraged over more units of production without increasing financial risk. However,
potential returns per unit for contract operations may be lower than for a well-managed
owner-operated business.

24
 Credit: After owner’s equity, capital obtained through credit is the second largest source
of farm capital. Borrowed money can provide a means to: quickly increase business size,
improve the efficiency of other resources, spread out the purchase cost of capital assets over
time, withstand temporary periods of negative cash flow.

2.4.3 Credit and loans - classifications

We all know credit and loans, and at this level, these words are not new. In most cases,
credit and loan are synonymous as they both refer to acquisition and use of capital. But only
differ in technical as - with credit a borrower takes an amount limit as prescribed by the
lender with a promise to return the capital plus some interest, while loan the client receives
a lump sum from the lender, and agrees to pay one or more payments, with or without
interest.
We can classify agricultural loans by:
▪ Length of repayment (e.g., number of years: Short-term loans)
▪ Use (e.g., capital investment loans, personal loans)
▪ Type of security (e.g., Home-equity loans, Mortgage loans)
▪ Repayment plan (e.g., Installment payment plans)
Length of Repayment: Classifying loans by the length of the repayment period is widely
used when preparing a farm balance sheet. Three-time classifications are commonly used in
agricultural lending.
i. Short-Term Loans - loans generally used to purchase inputs needed to operate
through the current production cycle. Purchases of fertilizer, seed, feeder
livestock, and feed are examples. Wages and rents are also financed with short-
term credit. Repayment is due when the crops are harvested and sold or when the
feeder livestock are sold. Short-term loans are also called production or operating
loans and are listed under current liabilities on the farm balance sheet.
ii. Intermediate-Term Loans - When a loan is repayable over more than one year but
less than 10 years, it is classified as an intermediate loan. One or more payments
are usually due each year. Intermediate loans are often used for the purchase of
machinery, breeding and dairy livestock, and some buildings. These assets will be

25
 used in production for several years and cannot be expected to pay for themselves
in one year or less.
iii. Long-Term Loans - A loan with a term of 10 years or longer is classified as a long-
term loan. Assets with a long or indefinite life, such as land and buildings, are
often purchased with funds from long-term loans. Loans for the purchase of land
may be made for a term as long as 20 to 40 years, for example. Annual or
semiannual payments normally are required throughout the term of the loan.

Use: use or purpose of the funds is another common way to classify loans. Loans are
classified into three categories-based use.
i. Real Estate Loans - this category includes loans for the purchase of real estate
such as land and buildings or where real estate assets serve as security for the
loan. Real estate loans are typically long-term loans.
ii. Non-Real Estate Loans - all business loans other than real estate loans are
included in this category and are usually short-term or intermediate-term loans.
Crops, livestock, machinery, or other non-real estate assets may be pledged as
security.
iii. Personal Loans - These are nonbusiness loans used to purchase personal assets
such as homes, vehicles, and appliances. Even though they are non-business
loans, most lenders like to include them on borrowers' farm balance sheets to get
a complete picture of their financial position/condition.
Security: The security for a loan refers to the assets pledged to the lender to ensure loan
repayment. If the borrower is unable to make the necessary principal and interest payments
on the loan, the lender has the legal right to take possession of the mortgaged assets. These
assets can be sold by the lender and the proceeds used to pay off the loan. Assets pledged or
mortgaged as security are called loan collateral. In term of security, loans are further
categorized into:
i. Secured Loans - With secured loans, some asset is mortgaged to provide collateral
for the loan. Lenders obviously favor secured loans, because they have greater
assurance that the loan will be repaid. Intermediate and long-term loans are
usually secured by a specific asset, such as a tractor or a parcel of land. Some

26
 loans are backed by a blanket security statement, which can even include assets
acquired or produced after the loan is obtained, such as growing crops.
ii. Unsecured Loans - A borrower with good credit and a history of prompt loan
repayment may be able to borrow some money with only “a promise to repay” or
without pledging any specific collateral. This would be an unsecured loan, also
called a signature loan, as the borrower’s signature is the only security provided
the lender. Most lending practices and banking regulations discourage making
unsecured loans.
Repayment Plan - There are many types and variations of repayment plans used for
agricultural credit. Lenders try to fit repayment to the purpose of the loan, the type of
collateral used to secure the loan, and the borrower’s projected cash flow. When a loan is
negotiated, the borrower and the lender should be in agreement about when it is to be repaid.
In each case, the total interest paid will increase if the money is borrowed for a longer time.
The fundamental equation for calculating interest is
I =P . i . T
where I is the amount of interest to pay, P is the principal or amount of money borrowed
or currently owed, i is the interest rate per time period, and T is the number of time periods
over which interest accrues.
i. Single Payment - A single-payment loan has all the principal payable in one
lump sum when the loan is due, plus interest. Short-term or operating loans are
usually of this type. Single-payment loans require good cash flow planning to
ensure that sufficient cash will be available when the loan is due. The interest
paid on a loan with a single payment is called simple interest. For example, if
MWK400,000 is borrowed for exactly two years at 8 percent annual interest, the
single payment would be MWK464,000, including MWK 400,000 principal and
MWK32,000 interest.
MWK 400,000 x 8% x 2 years = MWK 32,000

If the loan is repaid in less than or more than one year, interest would be
computed for only the actual time the money was borrowed

27
 ii. Line of Credit: The use of single-payment loans often means having more
money borrowed than the operator really needs at one time or having to take out
several individual loans. As an alternative, some lenders allow a borrower to
negotiate a line of credit. Loan funds are transferred into the farm account as
needed, up to an approved maximum amount. When farm income is received,
the borrower pays the accumulated interest on the loan first, then applies the rest
of the funds to the principal. There is no fixed repayment schedule or amount.
iii. Amortized: An amortized loan is one that has periodic interest and principal
payments. It may also be called an installment loan. As the principal is repaid,
and the loan balance declines, the interest payments also decline. There are two
types of amortization plans: the equal principal payment and the equal total
payment. We discuss these amortization schedules in detail below.

2.4.3.1 Equal Principal Payment and Equal Total Payment

An amortized loan with equal principal payments has the same amount of principal
due on each payment date, plus interest on the unpaid balance. For example, a 10-year, 8
percent loan of MWK100,000 would have annual principal payments of MWK10,000. The
loan balance decreases with each principal payment, so the interest payments also decrease.
The table below shows the repayment schedule.

Table 2. 3: Amortization schedule of MWK100,000 Loan over 10 years at 8% interest

using Equal Principal Payment Method.

Period Principal Repayment Interest Total Payment Balance

0 - - - 100,000
1 10,000 8,000 18,000 90,000
2 10,000 7,200 17,200 80,000
3 10,000 6,400 16,400 70,000
4 10,000 5,600 15,600 60,000
5 10,000 4,800 14,800 50,000
6 10,000 4,000 14,000 40,000
7 10,000 3,200 13,200 30,000
8 10,000 2,400 12,400 20,000
9 10,000 1,600 11,600 10,000
10 10,000 800 10,800 0
Total 100,000 44,000 144,000

28
 As you can notice in Table 2.3, the first payment is a larger amount of the total
payments, borrowers often find the first few loan payments the most difficult to make,
because a new or expanded business may take some time to generate its maximum potential
cash flow. For this reason, many long-term loans have an amortized repayment schedule
with equal total payments, in which all payments are for the same amount. Figures below
shows the amount of principal and interest paid each year under this plan for a MWK100,000
loan. A large portion of the total loan payment is interest in the early years, but the interest
decreases and the principal increases with each payment, making the last payment mostly
principal.

Figure 2.1: Amortization schedule

29
 To come up with a repayment schedule using the equal total payment, you should follow
the following steps:
i. Calculate the Present Value Factor (PVF)
1 − (1 + r )− n 
PVF =  
r
Where r is the interest rate and n is the number of years or repayment period.
ii. Calculate the Present Value Factor (PVF)
Principal
AR =
PVF
Using the same example above, a 10-year, 8 percent loan of MWK100,000. The PVF

1 − (1 + 0.08 )
−10

is PVF = = 6.7101
0.08
and the annual repayment will be:
100,000
AR = = 14,902.95
6.7101
The repayment schedule under the equal total payment will be:

Table 2. 4: Amortization schedule of MWK100,000 Loan over 10 years at 8% interest

using Equal Total Payment Method.

Year Annual Repayment Interest paid Principal payment Unpaid balance

- - - - 100,000
1 14,902.95 8,000 6,902.95 93,097
2 14,902.95 7,448 7,455.18 85,642
3 14,902.95 6,851 8,051.60 77,590
4 14,902.95 6,207 8,695.73 68,895
5 14,902.95 5,512 9,391.39 59,503
6 14,902.95 4,760 10,142.70 49,360
7 14,902.95 3,949 10,954.11 38,406
8 14,902.95 3,073 11,830.44 26,576
9 14,902.95 2,126 12,776.88 13,799
10 14,902.95 1,104 13,799.03 0
Total 149,029 49,029 100,000

You can note that an equal total payment method has a smaller total loan payment than
the equal principal payment loan in the first 4 years. However, a total of MWK49,030 in

30
interest is paid, compared to only MWK44,000 under the first plan (Table 2.3). The
advantage of the lower initial payments is partially offset by more total interest being paid
over the life of the loan, because the principal is being reduced at a slower rate in the early
years.

2.4.4 Sources of agricultural loans

Farmers borrow money from many different sources. Some lending institutions
specialize in certain types of loans, and some provide other financial services in addition to
lending money. In Malawi, the most common sources of agricultural loans include:
• Commercial banks.
• Agricultural associations and cooperatives.
• Savings and Credit Cooperatives.
• Leasing and Financing companies.
• Individuals (friends and family).
• Non-Governmental Organizations.
• Government agencies and projects.

You will agree that these lending institutions have different conditions which you have
to consider before making an application, e.g.
• Interest rates
• Grace period
• Collateral requirements
• Loan portfolio

For you to borrow from these sources you need to establish and develop a good credit
record. When trying to establish or develop credit, it is useful to look at it from the lender’s
viewpoint. What does a lender consider when making a decision on a loan application? Why
can one business borrow more money than another or receive different interest rates and
repayment terms? A borrower should be aware of the need to demonstrate and communicate

31
credit worthiness to lenders. Some of the more important factors that go into making loan
decisions are the following:
• Personal character
• Management ability
• Financial position and progress over time
• Repayment capacity
• Purpose of the loan
• Collateral

Activity 2 c
Briefly discuss why Equal Total Payment method is preferred over the Equal
Principal Payment method among small and infant agricultural enterprises.

Summary
In this unit we discussed in detail the three key farm productive resources namely: Land,
Labour and Capital. We understood that land is the most important resource in production
and without it, production is not possible. As a farm manager, how much land to control and
how to acquire it are two of the most important decisions that has to be made on the farm.
Too little land may mean the business is too small to fully use other resources. At the other
extreme, too much land may require borrowing a large amount of money, cause serious cash
flow problems, and overextend the operator’s management and machinery capacity.
Labor consists of the physical and mental talents of individuals used in producing goods
and services. Labour is like fuel that drives the agricultural activities on the farm. However,
most agricultural labourers receive low wages and consist of a larger portion of the world’s
poor. Despite low wages, most agricultural workers are scattered all over which makes it
difficult to bargain for better wages.
Capital is the grease that make sure the farm is operating properly and it is able to reach
its objectives and goals. A farm manager is faced with two important decisions regarding
capital: (i) How much capital should be used? and (ii) How should limited capital be
allocated among its many potential uses? Farmers source capital from various sources and

32
the most important source of capital discussed in this unit is Credit and Loans. Agricultural
loans differ in terms of length of repayment, use, type of security and repayment plan.

End of Unit Test

1. A Farm is producing groundnuts and soya bean on 100 acres of land and 16 goats on 2
hectares of land. Suppose groundnuts occupies 65 percent and soya bean 35 percent of
the total crop area. Yield of groundnuts and soya bean per unit of land is 120 kilograms
and 95 kilograms respectively. The price for a goat is MWK40,000, soya bean is
MWK15/Kg and groundnuts is MWK20/Kg. To produce these enterprises, the farm
incurred the following variable costs:

Input Cost (MWK)

Inoculants 4,000
Labour 10,000
Seeds 50,000
Repairs and maintenance 7,000
Fuel 50,000
Drying management 10,000
Forage management 100,000
Herding 50,000

Using the income capitalization rate of 15.6 percent, estimate total value of land
and the value per unit of crop land.

2. Suppose you have been hired as a Farm Business Specialist at Kaya Processors and
Farms in Balaka, and your first task is to conduct a labour analysis based on the current
workforce at the farm. You have been provided with a sheet of paper containing the
following information:
• 3 adult males (between 18 and 65 years) responsible for slaughtering cattle at a
rate of 5 cattle per hour.
• 6 adult females (between 18 and 65 years) responsible for sorting meat
according to flesh quality.

33
 • 5 older adult males (from 65 years and more) responsible for cutting meat into
portions
• 2 older adult females (from 65 years and more) responsible for packing meat in
Kaya Economy Meat packages.

Suppose that adult males and females contribute an average of 4 hours per day with
a conversion factor of 0.8 to slaughtering and sorting. Older adult males and females
contribute an average of 3 hours per day and a conversion factor of 0.5 to cutting
meat into economy portions and packaging.

Calculate the total man-days required.

Further Reading
Ronald Kay, William Edwards, and Patricia A. Duffy, (2016) Farm Management. 8th
Edition.
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.
Johnson, D.T. (1982). The Business of Farming: A Guide to Farm Business Management
in the Tropics. London: Macmillan Publishers Ltd.

34
 Unit 3: Production and Cost Analysis

Introduction
In this Unit we will start by discussing the basic farm business questions and how each
relate to farm business production and cost analysis. The unit will further discuss production
relationships (input and output relationships), revenue (focusing on total, average, marginal
and relationships), stages of production, return to scale and production implications and
economies of scale and farm business implication. The unit will also discuss the various
costs that farmers incur in production and their implication in farm production.

Learning Outcomes
Upon successful completion of this Unit, you should be able to:
a. Explain factor-product, factor-factor and product-product relationships
b. Explain return and economies of scale
c. Explain and differentiate costs incurred in agricultural production.

Key Terms
Ensure that you understand the key terms or phrases used in this unit as listed below:
Cost
Production
Revenue
Marginal

3.1 The basic farm business questions

There are three key basic farm business questions which will for most part of our
discussion in this Unit:
i. What to produce? Product-Product analysis.
ii. How to produce? Factor-Factor analysis.

35
 iii. How much to produce? Factor-Product analysis

Some other farm business questions that a manager needs to ask include:
i. When to buy and sell?
ii. Where to buy and sell?

Let us now discuss these questions in detail.

What to produce? (Product-Product analysis) – It involves selecting a combination of
crops & livestock enterprises to be produced. Should the business produce only crops, only
livestock or some combination? Which crop or rotations? Which livestock? The farmer must
select a combination of enterprises which will maximize profits.
How to produce? (Factor-Factor analysis) - Many agricultural products can be produced
in a number of ways e.g., crops can be produced with more capital and less labour (capital
intensive technology) or more labour and less capital (labour intensive technology). A
manager must select the appropriate combination of inputs which will minimize the cost of
producing a given quantity of some commodity.
How much to produce? (Factor-Product analysis) - The level of production and profit
will be determined by the input levels selected. A manager has to decide how much inputs
to use to produce a certain quantity of the product. The objective is to select a combination
of inputs and output that will maximize profits.
When to buy and sell? - Seasonality of supply in factor & product market results in price
variations. The manager must consider these things in determining when to sell or buy.
Where to buy and sell? - Farmers generally purchase a number of inputs for production.
Attempt is always to purchase at the least cost. The producer must decide whether to sell in
the village market or in the regulated market or other alternative market.

Activity 3 a
Briefly explain why a farm business manager has to ask him or herself the three
basic farm business questions to be successful?

36
3.2 Production, production function and physical
relationships
Production is defined as a process of combining and coordinating materials and forces
(inputs, resources) in the creation of some goods or services. A systematic way of showing
the relation between the resources or inputs that can be used to produce a product and the
corresponding output of that product is called a production function. A production function,
by definition, is a quantitative or mathematical description of the various technical
production possibilities faced by a farm or firm.
A general way of writing a production function is:
y = f ( x)
where y is an output or the Total Physical Product (TPP) and x is an input. All values of
x greater than or equal to zero constitute the domain of this function. The range of the
function consists of each output level (y) that results from each level of input (x) being used.
Production function can be presented in tabular form, as a graph or as a mathematical
equation.
The Total Physical Product (TPP) is the output realized from each input level. For
instance, having a production function presented as y=f(x), where y is the maize yield and x
is the nitrogen fertilizer. The TPP can presented as Table 3.1 below. The table shows maize
yield response to different levels nitrogen fertilizer.

Table 3. 1: Production Function of Maize Yield and Nitrogen Fertilizer.

Input level Total Physical Product (TPP)

0 0
1 12
2 30
3 44
4 54
5 62
6 68
7 72
8 74
9 72
10 68

37
 It is possible to calculate the average amount of output produced per unit of input at each
input level. This value is called average physical product (APP). APP defined as the average
amount of output produced per unit of input used, and is calculated by the formula
TPP
APP =
Input level
Using the previous example (Table 3.1), the APP can be presented as (last column):

Table 3. 2: The Average Physical Product (APP)

Input level TPP APP

0 0 0
1 12 12
2 30 15
3 44 14.7
4 54 13.5
5 62 12.4
6 68 11.3
7 72 10.3
8 74 9.3
9 72 8
10 68 6.8

Marginal analysis1 and production function data can be used to derive additional
information about the relation between the input and TPP. The first marginal concept to be
introduced is marginal physical product (MPP). Remembering that marginal means
additional or extra, MPP is the additional or extra TPP produced by using an additional unit
of input. It requires measuring changes in both output and input.
Marginal physical product is calculated as:
TPP
MPP =
Input level

d (TPP)
=
d ( x)

1
Much of the economics of agricultural production is related to the concept of marginal analysis. The term marginal
refers to incremental changes, increases or decreases that occur at the edge or the margin. It may be useful to mentally
substitute “extra” or “additional” whenever the word marginal is used, remembering that the “extra” can be a negative
amount or even zero.

38
 The numerator is the change in TPP caused by a change in the variable input, and the
denominator is the actual amount of change in the input. Using the previous example (Table
3.1 and 3.2), the MPP can be calculated as:

Table 3. 3: Marginal Physical Product (MPP)

Input level TPP APP MPP

0 0 0 -
1 12 12.0 12.0
2 30 15.0 18.0
3 44 14.7 14.0
4 54 13.5 10.0
5 62 12.4 8.0
6 68 11.3 6.0
7 72 10.3 4.0
8 74 9.3 2.0
9 72 8.0 -2.0
10 68 6.8 -4.0

Activity 3 b
Discuss the Marginal Analysis concept as used in Economics.

3.3 Law of diminishing marginal returns and the

neoclassical production function
The law of diminishing marginal returns is fundamental to all of production
economics. The law states that as units of a variable input are added to units of one or more
fixed inputs, after a point, each incremental unit of the variable input produces less and less
additional output. In other words, as units of the variable input are added to units of the fixed
inputs, the proportions change between fixed and variable inputs. The law of diminishing
returns has sometimes been referred to as the law of variable proportions.
For example, if incremental units of nitrogen fertilizer were applied to corn, after a
point, each incremental unit of nitrogen fertilizer would produce less and less additional
corn. Were it not for the law of diminishing returns, a single farmer could produce all the

39
corn required in the world, merely by acquiring all of the available nitrogen fertilizer and
applying it to his or her farm.
The key word in the law of diminishing returns is additional. The law of diminishing
returns does not state that as units of a variable input are added, each incremental unit of
input produces less output in total. If it did, a production function would need to have a
negative slope in order for the law of diminishing returns to hold. Rather, the law of
diminishing returns refers to the rate of change in the slope of the production function. This
is sometimes referred to as the curvature of the production function.
The neoclassical production function has long been popular for describing production
relationships in agriculture. With this production function, as the use of input x increases,
the productivity of the input x at first also increases. The function turns upward, or increases,
at first at an increasing rate. Then a point called the inflection point occurs. This is where the
function changes from increasing at an increasing rate to increasing at a decreasing rate.
Another way of saying this is that the function is convex to the horizontal axis prior to the
inflection point, but concave to the horizontal axis after the inflection point. The inflection
point marks the end of increasing marginal returns and the start of diminishing marginal
returns. Finally, the function reaches a maximum and begins to turn downward. Beyond the
maximum, increases in the use of the variable input x result in a decrease in total output
(TPP). This would occur in an instance where a farmer applied so much fertilizer that it was
actually detrimental to crop yields.
The MPP function changes as the use of input x increases. At first, as the productivity
of input x increases, so does its marginal product, and the corresponding MPP function must
be increasing. The inflection point marks the maximum marginal product. It is here that the
productivity of the incremental unit of the input x is at its greatest. After the inflection point,
the marginal product of x declines and the MPP function must also be decreasing. The
marginal product of x is zero at the point of output maximization, and negative at higher
levels. Therefore, the MPP function is zero at the point of output maximization, and negative
thereafter.
Average physical product (APP) also changes as the use of x increases, although APP
is never negative. APP is the ratio of output to input, in this case y/x or TPP/x. Since this is
the case, APP for a selected point on the production function can be illustrated by drawing

40
a line (ray) out of the origin of the graph to the selected point. The slope of this line is y/x
and corresponds to the values of y and x for the production function. If the point selected on
the function is for some value for x called x*, then the APP at x* is y/x*. APP reaches a
maximum at a point after the inflection point but before the point in which output is
maximized. It is here where marginal product must equal average product, APP must equal
MPP, and y/x = dy/dx.
There is a relationship that exist between the APP and the MPP function for the
neoclassical production function. The MPP function first increases as the use of the input is
increased, until the inflection point of the underlying production function is reached (point
A). Here the MPP function reaches its maximum. After this point, MPP declines, reaches
zero when output is maximum, and then turns negative. The APP function increases past the
inflection point of the underlying production function until it reaches the MPP function
(point B). After point B, APP declines, but never becomes negative.
The neoclassical production function described above can be divided into three stages
or regions of production. These are designated by Roman numerals I, II, and III. With a goal
of profit maximization, the manager must select from all possible input levels which will
maximize profit. The three stages in the production function can help in the selection process
of the desired input level that will yield the greatest profit. Any input level in Stage III can
be eliminated from consideration as additional input causes TPP to decrease and MPP to be
negative. For any input level in Stage III, the same output can be obtained with less input in
one of the other stages.
Stage I covers the area where adding additional units of input causes the average
physical product to increase. It is rational/logical for a manager to use an input level which
gives the greatest average physical product per unit of input. This point is at the boundary of
Stage I and stage II and represents the greatest efficiency in the use of the variable input. As
such, the characteristics of stages I and III clearly eliminate the two stages from
consideration in determining the profit-maximizing input level. Stages I and III have
traditionally been described as irrational stages of production. The terminology suggests
that a farm manager would never choose levels of input use within these regions unless the
behavior were irrational. Irrational behavior describes a farmer who chooses a goal

41
inconsistent with the maximization of net returns, or profit. This leaves only Stage II which
is the logical or rational stage of production.

Figure 3. 1: The Neoclassical Production Function and the Three Stages of

Production.

Activity 3 c
Explain why it is irrational for a farmer to produce in stages I and III of
production?

42
3.4 The Factor-Factor Analysis
One basic production decision that a farm or ranch manager has to make is how much of
a product to produce. A second basic decision is what resources to use to produce a given
amount of some product. Most products require two or more inputs in the production
process, but the manager can often choose the input combination or ratio to be used. The
problem is one of determining whether more of one input can be substituted for less of
another and thereby reduce total input cost. This leads to the least-cost combination of inputs
to produce a given amount of output.
Substitution of one input for another occurs frequently in agricultural production. One
type of grain can be substituted for another in a livestock ration. Herbicides substitute for
mechanical cultivation, and computers can replace labor. The manager must select the
combination of inputs that will produce a given amount of output or perform a certain task
for the least cost. In other words, the problem is to find the least-cost combination of inputs,
because this combination will maximize the profit from producing a given amount of output.
The alert manager will always be looking for a different input combination that will do the
same job for less cost.
The least-cost input combination is not always the same. Changes in the price of one or
more inputs may make it profitable to substitute one resource for another or at least change
the proportion in which they are used.

3.5 The Factor-Product Analysis

Despite discovering the stage in which a farmer is likely to produce, it is not sufficient to
identify the input-output combination that could maximize profits. Hence, to determine the
level at which a farm manager should produce and maximize profit, output and input prices
must be considered in the analysis. In that case, if a farm is operating under the purely
competitive conditions, the individual farm firm can sell as little or as much output as desired
at the going market price (p).
We assume that the market price, p, does not vary, therefore, TPP multiplied by the price
gives us the Total Value Product (TVP):

43
 TPP * p = TVP

You will notice that TVP is the same as the revenue generated from the sale of output
produced at the farm. However, this is also not enough to determine the level at which a
farmer can produce. As such it is convenient to compare the added revenue or TVP and
added cost of inputs measured in terms of Kwacha per unit of input instead of output. The
value of the revenue produced by adding one more unit of input is called the Marginal Value
Product (MVP). MVP is the additional or marginal income received from using an
additional unit of input, and it is calculated by using the equation:
TVP
MVP =
Input level
Or the MVP = MPP * Product Selling Price

For us to sufficiently determine the input-output level at which a farmer can maximize
profits, the MVP can be compared to the Marginal Input Cost (MIC) or the Marginal
Factor Cost (MFC) or the Marginal Resource Cost (MRC), the unit price of the input being
added. MIC is similar to marginal cost, but is measured in Kwacha per unit of input instead
of unit of output. To calculate the MIC, we first calculate the Total Input/Factor/Resource
Cost (TIC/TFC/TRC) using the following formula:
TFC = Vx
Where V is the input price and x is the level of inputs. Then the formula for MFC is given
as:
TFC
MFC =
Input level
Using the same example in the tables above, suppose we have an input price of
MWK12/unit and output price of MWK2/unit. We can compute MVP and MFC as
follows:

44
Table 3. 4: Marginal Value Product, Marginal Input Cost and The Optimum Input
Level

Input Level TPP MPP TVP MVP MFC

0 0 - 0 - -
1 12 12.0 24 24 12
2 30 18.0 60 36 12
3 44 14.0 88 28 12
4 54 10.0 108 20 12
5 62 8.0 124 16 12
6 68 6.0 136 12 12
7 72 4.0 144 8 12
8 74 2.0 148 4 12
9 72 -2.0 144 -4 12
10 68 -4.0 136 -8 12

We will maximize profit at the point where MVP = MFC (Input level 6). At this point,
the additional income from an additional cost of another unit of input is just equal. Note that
the profit-maximizing point is not at the input level which maximizes TVP or total income.
Profit is maximized at a lower input level. We can also find the profit-maximizing input
level by:
✓ Calculating TVP (total income)
✓ Calculating TFC at each input level (total cost)
✓ Subtracting cost from income to find the level where profit is greatest.
An alternative way to find the profit-maximizing point is to find directly the amount of
output that maximizes profit. In this case, we use
▪ Marginal Revenue (MR) and
▪ Marginal Cost (MC)
Marginal revenue (MR) is defined as the change in total revenue or the additional income
received from selling one more unit of output. It is calculated from the equation:
Total Revenue TR
MR = =
Total Physical Product TPP

45
 Total revenue = Total value product.
If the output price is constant and under a perfect competitive market, MR = output
selling price (P)
Marginal cost (MC) on the other hand, is defined as the change in cost, or the additional
cost incurred, from producing another unit of output. It is calculated from the equation
Total Factor Cost TFC
MC = =
Total Physical Product TPP
It has to be noted that there is an inverse relation between MPP and MC. When MPP is
declining (diminishing marginal returns), MC is increasing, because it takes relatively more
input to produce an additional unit of output. Therefore, the additional cost of another unit
of output is increasing.
Decision Rule: MR and MC are compared to find the profit-maximizing input and output
levels. As long as MR is greater than MC, an additional unit of output increases profit,
because the additional income exceeds the additional cost of producing it. Conversely, if
MR is less than MC, producing the additional unit of output will decrease profit. The profit-
maximizing output level is therefore where marginal revenue equals marginal cost.
Using the same example in the tables above, suppose we have an input price of
MWK12/unit and output price of MWK2/unit. We can compute MVP and MFC as follows:

Table 3. 5: Marginal Value Product, Marginal Input Cost and The Optimum Input
Level

Input Level TPP MPP TR TFC MR MC

0 0 - 0 - - -
1 12 12.00 24 12 2.00 1
2 30 18.00 60 24 2.00 0.67
3 44 14.00 88 36 2.00 0.86
4 54 10.00 108 48 2.00 1.20
5 62 8.00 124 60 2.00 1.50
6 68 6.00 136 72 2.00 2.00
7 72 4.00 144 84 2.00 3.00
8 74 2.00 148 96 2.00 6.00
9 72 -2.00 144 108 2.00
10 68 -4.00 136 120 2.00

46
 Activity 3 d
Briefly explain profit maximization in the factor -product analysis.

3.5.1 Input Substitution Ratio

The first step in analyzing a substitution problem is to determine whether it is physically
possible to make a substitution and at what rate. Figure 3.1 illustrates the more common
types of substitution between two inputs. In Figure 3.1a, the line PP' is an isoquant (from
isoquantity, meaning the same quantity) and shows a number of possible combinations of
corn and barley in a livestock feed ration. This line is called an isoquant because any of these
combinations will produce the same quantity of output or weight gain in this example.

Figure 3. 2: Three Possible Types of Substitution

The input substitution ratio, or the rate at which one input will substitute for another, is
determined from the equation
Amount of input replaced
Input substitution ratio=
Amount of input added
where both the numerator and denominator are the differences or changes in the amount
of inputs being used between two different points on the isoquant PP', measured in physical
units.

47
 Constant Substitution Ratio: In Figure 3.2a, moving from point A to point B means
4Kgs of corn are being replaced by 5 additional Kgs of barley to produce the same weight
gain or output. The input substitution ratio is 4/5=0.8, which means 1 kilogram of barley
will replace 0.8 kilograms of corn. PP' is a straight line, so the input substitution ratio will
always be 0.8 between any two points on this isoquant. This is an example of a constant rate
of substitution between two inputs. Whenever the input substitution ratio is equal to the same
numerical value over the full range of possible input combinations, the inputs exhibit a
constant rate of substitution. This occurs most often when the two inputs contribute the same
or nearly the same factor to the production process. Corn and barley, for example, both
contribute energy to a feed ration.
Decreasing Substitution Ratio: Another, and perhaps more common, example of
physical substitution is shown in Figure 3.2b. Here the isoquant PP' shows the different
combinations of corn and forage that might produce the same weight gain on a steer or the
same milk production from a dairy cow. The amount of corn that can replace a given quantity
of forage changes, depending on whether more corn or more forage is being used. The input
substitution ratio is 4/1=4 when moving from point A to point B on isoquant PP', but it is
1/3 = 0.33 when moving from point C to point D. In this example, the input substitution ratio
depends on the location on the isoquant and will decline with any movement down and to
the right on the curve. This is an illustration of a decreasing rate of substitution.
Many agricultural substitution problems have a decreasing input substitution ratio, which
occurs when the two inputs are dissimilar or contribute different factors to the production
process. As more of one input is substituted for another, it becomes increasingly difficult to
make any further substitutions and still maintain the same level of output.
No Substitution Possible: One other possible substitution situation is where no
substitution is possible. Figure 3.2c illustrates one example with tractors and chisel plows.
It takes one of each to make a working combination as shown by point A.
Decision Rule with Factor-Factor Analysis: Identifying the type of physical
substitution that exists and calculating the input substitution ratio are necessary steps, but
they alone do not permit a determination of the least-cost input combination. Input prices
are also needed, and the ratio of the input prices must be compared to the input substitution
ratio. The input price ratio is computed from the equation:

48
 Price of input being added
Price Ratio =
Price of input being replaced
With this ratio, the least-cost combination of inputs can be found. The decision rule for
finding this combination is where the:
Input substitution ratio = input price ratio
Let us have an example: Suppose a farmer wants to select a combination of grain and hay
that will put the same pounds of gain on a feeder steer - ration that produces this gain for the
least cost. Assuming the price of grain is K4.40/kg and the price of hay is K3/kg. The farmer
wants to replace hay for grain.
Table 3. 6: Selecting Least-Cost Feed Ration
Input
Feed Grain Change Change Input Price
Hay (lb) Substitution
Ration (lb) grain (a) Hay (a) Ratio (a/b)
(b/a)
A 825 1,350 - - - -
B 900 1,130 75 -220 2.93 > 1.47
C 975 935 75 -195 2.60 > 1.47
D 1,050 770 75 -165 2.20 > 1.47
E 1,125 625 75 -145 1.93 > 1.47
F 1,200 525 75 -100 1.33 < 1.47
G 1,275 445 75 -80 1.07 < 1.47

The decision rule states that the least-cost combination is where the input substitution
ratio just equals the input price ratio. However, in Table 3.6 and many other problems where
the choices involve a discrete rather than an infinite number of combinations, there is no
combination where the two ratios are exactly equal, get as close as possible without letting
the price ratio drop below the substitution ratio. In other words, select the combination
where the input substitution ratio changes from being greater than the input price ratio to
being less than the input price ratio. Ration E is therefore the least-cost combination for this
problem.

Activity 3 e
For two similar inputs, such as soybean oil meal and cottonseed oil meal in a
livestock feed ration, would you expect the substitution ratio to be nearly
constant or to decline sharply as one input is substituted for another? Why?

49
3.6 Product-Product Analysis
The third basic decision to be made by a farm manager is what to produce, or what
combination of products will maximize profit. A choice must be made among all possible
enterprises, which may include maize, wheat, soybeans, cotton, beef cattle, pigs, poultry,
etc… The manager may have a large number of possible enterprises from which to select
the profit-maximizing combination. In all cases, it is assumed that one or more inputs are
limited, which places an upper limit on how much can be produced of a single product or
any combination of products.

3.6.1 Enterprise combination

The first step in determining a profit-maximizing enterprise combination is to determine
the physical relationship among the enterprises being considered. There are several forms of
physical relations with respect to enterprise combinations and the common ones include:
i. Competitive enterprises
ii. Supplementary enterprises
iii. Complementary enterprises
Competitive Enterprises: Given a limited amount of land, capital, or some other input,
the production from one enterprise can generally be increased only by decreasing the
production from another enterprise. Some of the limited input must be switched from use in
one enterprise to use in another, causing changes in production levels. There is a tradeoff, or
substitution, to be considered when changing the enterprise combination. These are called
competitive enterprises because they compete for the use of the same limited input at the
same time.
Figure 3.3 illustrates two types of competitive enterprises – Constant and increasing
substitution. In the graphs, corn and soybeans are competing for the use of the same 100
acres of land. The first graph exhibits a constant substitution and the second one exhibits an
increasing substitution. The substitution ratio is 120 ÷ 80 = 1.5 near the top of the curve, and
increases to 240 ÷ 40 = 6.0 near the bottom of the curve.

50
Figure 3. 3: Production possibility curves for competitive enterprises.

The most profitable combination of two competitive enterprises can also be determined
by comparing the output substitution ratio and the output profit ratio. The output substitution
ratio is calculated from the equation
Quantity of output lost
Output Substitution Ratio=
Quantity of output gained
where the quantities gained and lost are the changes in production between two points
on the PPC. The output price ratio is found from the equation
Unit Price of the output being gained
Output Price Ratio=
Unit Price of the output being lost
Profit is maximized by producing that enterprise combination where the sub-stitution
ratio is equal to the price ratio.
You will note that rule assumes total production costs are the same for any combination
of the two enterprises. If this is not true, the ratio of the profit per unit of each enterprise
should be used instead of the price ratio. The procedure for determining the profit-
maximizing enterprise combination is basically the same as the least-cost input combination.
Let us look at an example. suppose a farmer wants to find an enterprise combination
(corn and wheat) that maximizes profits. Assuming corn sold at $2.80/bu, and wheat at
$4.00/bu.

51
Table 3. 7:Profit-Maximizing Combination of Two Competitive Enterprises
Input
Corn Wheat Change Change Input Price
Enterprise Substitution
(bu) (bu) corn (a) wheat (a) Ratio (a/b)
(b/a)
1 0 6,000 - - - -
2 2,000 5,600 2000 -400 0.20 < 0.70
3 4,000 5,000 2000 -600 0.30 < 0.70
4 6,000 4,100 2000 -900 0.45 < 0.70
5 8,000 3,000 2000 -1,100 0.55 < 0.70
6 10,000 1,700 2000 -1,300 0.65 < 0.70
7 12,000 0 2000 -1,700 0.85 > 0.70

As we noted in section 3.5.1, If no available combination makes these exactly equal, get
as close as possible without letting the price ratio drop below the substitution ratio.
Therefore, the combination is at enterprise 6.
Supplementary Enterprises: While competitive enterprises are the most common,
other types of enterprise relationships do exist. One of these is supplementary, and an
example is shown in the left diagram of Figure 3.4. Two enterprises are supplementary if the
production from one can be increased without affecting the production level of the other. A
manager should take advantage of supplementary relationships by increasing production
from the supplementary enterprise. This should continue at least up to the point where the
enterprises become competitive.

Figure 3. 4: Supplementary and Complementary physical relationships.

52
 Complementary Enterprises: Another possible type of enterprise relationship is
complementary. This type of relationship exists whenever increasing the production from
one enterprise causes the production from the other to increase at the same time. The
righthand graph in Figure 3.4 illustrates a possible complementary relationship between
wheat production and land left fallow.

Activity 3 f
Where climate and rainfall permit, most farms produce two or more crops.
Explain the reason for this production practice regarding the enterprise
combinations and the output price ratio.

3.7 Production cost analysis

A good understanding of the costs of production is important in economics and very
useful for making management decisions. Costs can be classified in different ways,
depending on whether they are fixed or variable and cash or noncash. Opportunity cost is
another type of cost not included in the accounting expenses for a business but an important
economic cost nevertheless.

3.6.1 Opportunity Cost

Opportunity cost is an economic concept, not a cost that can be found in an accountant’s
ledger or on an income tax return. However, it is an important and basic concept that needs
to be considered when making managerial decisions. We can define opportunity cost in one
of two ways:
i. the income that could have been earned by selling or renting the input to someone
else, or
ii. the additional income that would have been received if the input had been used in
its most profitable alternative use.
Let look at an example: A farm manager has MWK 2 million with which he can either
buy a tractor or 3-ton lorry. If he buys the tractor, the opportunity cost is the lorry and if he
buys the lorry the opportunity cost is the tractor.

53
 Opportunity costs are used widely in economic analysis. For example, the opportunity
costs of a farm operator’s labor, management and capital are used in several types of budgets
used for analyzing farm profitability. The opportunity cost of a farm operator’s labor (and
perhaps that of other unpaid family labor) would be what that labor would earn in its next
best alternative use. That alternative use could be nonfarm employment, but depending on
skills, training, and experience, it might also be employment in another farm or ranch
enterprise.

3.6.2 Fixed, Variable and Total Costs

Some of the most useful cost concepts that we are going to discuss in this module include:
i. Total fixed cost (TFC)
ii. Average fixed cost (AFC)
iii. Total variable cost (TVC)
iv. Average variable cost (AVC)
v. Total cost (TC)
vi. Average total cost (ATC)
vii. Marginal cost (MC)
These costs are output-related. They show the cost per unit for producing a given amount
of output.

3.6.2.1 Short-run and Long-Run

Before the costs above are discussed in some detail, it is necessary to distinguish between
what economists call the short run and the long run. These are time concepts, but they are
not defined as fixed periods. The short run is the period of time during which costs and input
amounts are fixed and cannot be changed. On the other hand, the long run is the period long
enough in which all costs and input amounts vary. For example, at the beginning of the
planting season, it may be too late to increase or decrease the amount of cropland owned or
rented. The current crop production cycle would be a short-run period, as the amount of
available land is fixed. Over a longer period, land may be purchased, sold, or leased, or
leases may expire causing the amount of land available to increase or decrease

54
3.6.2.2 Fixed Costs
The costs associated with owning a fixed input are called fixed costs. These are the costs
that are incurred even if the input is not used. Depreciation, insurance, taxes (property taxes,
not income taxes), and interest are the usual costs considered to be fixed. Repairs and
maintenance may also be included as a fixed cost. Fixed costs do not change as the level of
production changes in the short run but can change in the long run as the quantity of the
fixed input changes. By definition there need not be any fixed resources owned in the long
run, so fixed costs exist only in the short run.
Another characteristic of fixed costs that you should note is that they are not under the
control of the manager in the short run. They exist and stay at the same level regardless of
how much or how little the resource is used. The only way they can be avoided is to sell the
item, which can be done in the long run.
You also know that most assets lose value over time, whether they are in use or not. This
loss in value is called depreciation and is considered an annual fixed cost. To be depreciable,
an asset must have the following characteristics:
• A useful life of more than one year.
• A determinable useful life but not an unlimited life.
• A use in a business for the depreciation to be a business expense (loss in value on
a personal automobile or personal residence is not a business expense).
Several methods or equations can be used to compute annual depreciation. There is no
single correct choice for every business or every asset. The most common method used is
the straight-line method. Using this method, depreciation is calculated as
Original Value - Salvage Value
Depreciation =
Useful Life
where original value is the initial cost of the asset, useful life is the number of years the
item is expected to be owned, and salvage value is its expected value at the end of that useful
life.
Fixed cost can be expressed as an average cost per unit of output. Average fixed cost
(AFC) is found using the equation
TFC
AFC =
Output

55
3.6.2.3 Variable Costs
Variable costs are those over which the manager has control at a given time. They can be
increased or decreased at the manager’s discretion and will increase as production is
increased. Items such as feed, fertilizer, seed, pesticides, fuel, and livestock health expenses
are examples of variable costs. A manager has control over these expenses in the short run,
and they will not be incurred unless production takes place.
Average variable cost (AVC) is calculated from the equation
VC
AVC=
Output
Variable costs exist in both the short run and the long run. All costs can be considered to
be variable costs in the long-run, because there are no fixed inputs. The distinction between
fixed and variable costs also depends on the exact time when the next decision is to be made.

3.6.2.4 Total Costs

Total cost (TC) is the sum of total fixed cost and total variable cost (TC = TFC + TVC).
In the short run, it will increase only as TVC increases, because TFC is a constant value.
Average total cost (ATC) can be found by one of two methods. For a given output level, it
is equal to AFC AVC. It can also be calculated from the equation
TC
ATC =
Output
which will give the same result.

3.6.2.5 Marginal Costs

Marginal cost (MC) is defined as the change in total cost divided by the change in output:
ΔTC ΔTVC
MC= or MC=
ΔOutput ΔOutput
It is also equal to the change in total variable cost divided by the change in output. TC =
TFC + TVC, and TFC is constant, so the only way TC can change is from a change in TVC.
Therefore, MC can be calculated either way with the same result.

56
3.8 Returns to Scale
3.8.1 Economies and Diseconomies of Size
The term economies of size is used to describe a situation in which as the farm expands
output, the cost per unit of output decreases. There are a number of reasons why costs per
unit of output might decrease as output levels increase.
The farm may be able to spread its fixed costs over a larger amount of output as the size
of the operation increases. It may be possible to do more field work with the same set of
machinery and equipment. A building designed for housing cattle might be used to house
more animals than before, lowering the depreciation costs per unit of livestock produced.
An expansion in output may reduce some variable costs. A farmer who previously relied
on bagged fertilizer may be able to justify the additional equipment needed to handle
anhydrous ammonia or nitrogen solutions if the size of the operation is expanded. While
fixed costs for machinery may increase slightly, these increases may be more than offset by
a reduction in the cost per unit of fertilizer.
The larger producer may be able to take advantage of pecuniary economies. As the size
of the operation increases, the farmer might pay less per unit of variable input because inputs
can be bought in larger quantities. Such pecuniary economies might be possible for inputs
such as seed, feeds, fertilizers, herbicides, and insecticides.
The term diseconomies of size, on the other hand, is used to refer to an increase in the per
unit cost of production arising from an increase in output. There exist two major reasons
why diseconomies of size might occur as the farm is expanded.
First, as output increases, the manager's skills must be spread over the larger farm. A
farmer who is successful in managing a 500-acre farm in which most of the labor is supplied
by the farm family may not be equally adept at managing a 2000-acre farm that includes five
salaried employees. The skills of the salaried employees will not necessarily be equivalent
to the skills of the farm manager. A firm with many employees may not necessarily be as
efficient as a firm with only one or two employees.
The farm may become so large that the assumptions of the purely competitive model are
no longer met. This could result in the large firm to a degree determining the price paid for

57
certain inputs or factors of production. The farm may no longer be able to sell all its output
at the going market price. Although this may seem unlikely for a commodity such as wheat,
it is quite possible for a commodity such as broilers.
The long run average cost curve represents a planning curve for the farmer as he or she
increases or decreases the size of the operation by expanding or contracting output over a
long period of time. Each of the short-run average cost curves represent possible changes in
output that could occur within a much shorter period of time. The possible changes in output
associated with each short-run average cost curve are a result of varying some, but not all,
of the inputs. Thus the respective short-run average cost curves each represent possible levels
of output during a period long enough so that some inputs can be varied, but short enough
so that all inputs cannot be varied.

Figure 3. 5: Economies and diseconomies of scale.

Activity 3 g
Why is interest included as a fixed cost?

58
Summary
We have discussed that economic principles that use the concept of marginal analysis to
provide useful guidelines for managerial decision-making. These concepts have direct
application to the basic decisions of how much to produce, how to produce, and what to
produce. In addressing the question of how much to produce, marginal revenue and marginal
cost are equated to find the profit-maximizing input/output level. When a limited amount of
input is available and there are several alternative uses for it, the equal marginal principle
provides the rule for allocating the input and maximizing profit under these conditions. The
question of what to produce is also one of finding the profit-maximizing combination of
enterprises when the quantity of one or more inputs is limited. That combination will depend
first on the type of enterprise relationship that exists—competitive, supplementary, or
complementary. The profit-maximizing combination for competitive enterprises is found by
computing output substitution ratios and the output profit ratio. Finding the point where they
are equal determines the correct combination.
Our discussion also dwelled on cost analysis. We noted that the analysis is important for
understanding and improving the profitability of a business. The distinction between fixed
and variable costs is important and useful when making short-run production decisions. In
the short run, production should take place only if the expected income will exceed the
variable costs. Otherwise, losses will be minimized by not producing. Production should
take place in the long run only if income is high enough to pay all costs. If all costs are not
covered in the long run, the business will eventually fail or will be receiving less than the
opportunity cost on one or more inputs. An understanding of costs is also necessary for
analyzing economies of size. The relation between cost per unit of output and size of the
business determines whether there are increasing, decreasing, or constant returns to size. If
unit costs decrease as size increases, there are increasing returns to size, and the business
would have an incentive to grow, and vice versa.

59
End of Unit Test
1. Using the aid of illustrations, briefly describe the following physical relationships with
respect to the product-product analysis:
a) Competitive enterprises.
b) Supplementary enterprises.
c) Complementary enterprises

2. The Table shows input and output levels in a farm business.

Input level (Kg) Output (Kg)

0 0
2 30
4 44
6 54
8 62
10 68

Given that Input price = K100/Kg, Output price = K50/Kg,

a. Compute Marginal Value Product
b. Compute Marginal Input Cost
c. Determine the Optimum Input level
d. Explain the optimum Input level in 2c

Further Reading
Ronald Kay, William Edwards, and Patricia A. Duffy, (2016) Farm Management. 8th
Edition.
Debertin, D. L., (1986) Agricultural Production Economics, Second Edition, University of
Kentucky
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.

60
 Unit 4: Practical Farm Planning
Techniques
Introduction
Welcome to Unit 4 which is practical farm planning techniques. In this unit, you will
learn about how to prepare a whole budget, an enterprise budget, a partial budget and conduct
a breakeven and gross margin analysis. You will further learn about program planning and
linear programming.

Learning Outcomes
Upon successful completion of this Unit, you should be able to:
a. Define a whole farm budget, an enterprise budget, partial budget and discuss their
purpose and use
b. Construct a whole farm budget, an enterprise budget and a partial budget.
c. Conduct a breakeven and gross margin analysis.
d. Conduct program planning and linear programming.

Key Terms
Ensure that you understand the key terms or phrases used in this unit as listed below:
Whole farm budget
Enterprise budget
Partial budget

4.1 Enterprise Budget

An enterprise budget provides an estimate of potential revenue, expenses, and profit for
a single enterprise Each type of crop or livestock is an enterprise. There can be enterprise
budget for cotton/beef cows. Different enterprises use different measures, however, using a
common measure permits an easy and fair comparison across different enterprises.

61
4.1.1 Purpose and use of enterprise budgets
You will note that, the primary purpose of an enterprise budget is to estimate costs,
revenues and profit per unit for the enterprises. Once this is done the budgets have many
uses;
i. They help identify the more profitable enterprises to be included in a whole farm plan
ii. It is a source of data for other types of budgets – a manager refers to the enterprise
budget for various information before making any decision.
You may also be interested to note that most enterprise budgets are economic budgets.
This means that in addition to cash expenses and depreciation, some opportunity costs are
added. Some of the opportunity costs added include, opportunity cost for, Operator labor,
Capital used for variable costs and Capital invested in machinery. Therefore, the profit return
shown in an enterprise budget is economic profit. This profit is different from accounting
profit, where opportunity costs are not recognized. When working with enterprise budgets
developed by others, managers should be careful to check whether opportunity costs have
been included in the cost figures.

4.1.2 Terms and constructing an enterprise budget

When constructing or using an enterprise budget that was constructed by another person,
you should note of the following terms:
Operating or direct costs: these arise from actual operations of the enterprise. These costs
would not exist except for the production from this enterprise
Ownership or indirect costs: Fixed costs that arise from owning machinery, buildings or
land. They result from owning assets and would exist even if they were not used for the
enterprise.
Revenue: All cash and noncash revenue from the enterprise. Some crops have two
sources of revenue e.g. cotton lint and cottonseed. Non cash sources of income should be
valued using the opportunity cost concept e.g. crop residue used by livestock.
Operating or variable expenses: Seed, fertilizer, lime and pesticides – prices can be
gotten by contacting input suppliers Machinery variable costs – cost of fuel, repairs –

62
determine fuel consumption per acre for each machine operation the sum up the fuel usage
for all scheduled activities
Labor – costs of hired labor and opportunity cost of labor.
Interest – capital tied up in operating expenses
Transportation and Crop insurance – hauling produce to markets
Ownership or fixed expenses: costs that must be paid even if no crop is produced:
• Machinery depreciation
• Machinery interest
• Machinery taxes and insurance
• Land charge
• Miscellaneous overhead.
Profit: this represents a return to all resources that were not charged in the budget (usually
management).

4.1.3 Interpreting and analyzing enterprise budgets

Always note that any economic enterprise budget must be interpreted correctly. An
economic budget includes opportunity costs on labor, capital, land, and perhaps management
as expenses. The resulting profit (or loss) is the revenue remaining after covering all
expenses, including opportunity costs. This figure can be thought of as an economic profit,
which will not be the same as accounting profit. A projected economic profit of zero is not
as bad as it might seem. This result means all labor, capital, and land are just earning their
opportunity costs—no more, no less. A positive projected profit means one or more of these
factors are earning more than their opportunity cost.
You will notice that the data in an enterprise budget (Table 4.1 below) can be used to
perform several types of analyses. These analyses include calculating cost of production and
computing break-even prices and yields.
Cost of Production: Cost of production is a term used to describe the average cost of
producing one unit of the commodity.
Total Cost
Cost of Production =
Yield

63
 Using information in Table 4.1, cost of production is MKW 812,800 divided by 380Kgs
= MWK 2,138.95 per Kgs. Cost of production will change if either costs or yields change.
Cost of production is a useful concept, particularly when marketing the product. Any time
the product can be sold for more than its cost of production, a profit is being made.

Table 4. 1: Enterprise Budget for Maize (1 Acre)

Item Unit Quantity Price (MWK) Amount (MWK)

Revenue
Maize yield Kgs 380 1,500.00 570,000.00
Total revenue 570,000.00
Operating expenses
Seed Kgs 10 6,000.00 60,000.00
Fertilizer: NPK bag 2 25,000.00 50,000.00
UREA bag 2 30,000.00 60,000.00
Chemicals acre 1 8,000.00 8,000.00
Fuel, oil, lubrication acre 1 110,000.00 110,000.00
Machinery repair acre 1 70,000.00 70,000.00
Labour hrs. 2 70,000.00 140,000.00
Interest (operating costs for 6 months) MWK 248,000 10% 24,800.00
Total operating cost 522,800.00
Income above variable costs 47,200.00
Ownership expenses 1 100,000.00 100,000.00
Machinery depreciation 1 80,000.00 80,000.00
Machinery taxes & insurance 1 40,000.00 40,000.00
Land charge 1 50,000.00 50,000.00
Misc. overhead 1 20,000.00 20,000.00
Total ownership expenses 290,000.00
Total expense 812,800.00
Profit (return to management) (242,800.00)

64
 Break-Even Analysis: You can also data contained in an enterprise budget to do a break-
even analysis for prices and yields. Break-even analysis is a technique widely used by
production managers and management accountants. Break-even refers to the number of units
that must be sold in order to produce a profit of zero (but will recover all associated costs).
The break-even point for a product is the point where the total revenue received equals the
total costs associated with the sale of the product (TR=TC).
The formula for break-even yield is given as:
Total Cost
Break-even yield =
Output Price
At this yield, all the cost related will be recovered. Using previous enterprise example: it
would be MWK 812,800 divided by MWK1,500 = 541.87Kgs per acre. This is the yield
necessary to cover all costs at a given output price.
The break-even price is the output price needed to just cover all costs at a given output
level, and it can be found from the equation:
Total Cost
Break-even price =
Expected yield
At this price, all the cost related will be recovered. Using previous enterprise example: it
would be MKW 812,800 divided by 380Kgs = MWK 2,138.95 per Kgs.

65
Figure 4. 1: Breakeven Chart

The chart above (Figure 4.1) shows the breakeven point. The graph for costs does not
start at zero depicting the presence of fixed cost. Hence, any point from zero to the point
where to where the cost line or graph starts are the fixed costs. The upward increase in the
costs graph represents variable costs. The income graph starts at zero and increases with
each unit of output. At point P, the business will break even because the graph of income or
revenue intersects with the graph of total costs. At any point before the breakeven, the
business is making a loss since the graph of total costs is above the graph of revenue or
income. And any point after point P a business will realize profits.

Activity 4 a
Discuss why profit (return to management) in enterprise budgets is known as an
economic profit.

66
4.2 Whole-Farm Budgeting
Let us now shift our attention to whole-farm budgeting. A whole-farm plan is an outline
or summary of the production to be carried out on the entire farm and the resources needed
to do it. It may include sufficient details such as fertilizer, seeds, etc or it may simply list the
enterprises to be carried out and their level of production. When the expected costs and
returns for each part of the whole-farm plain are organized into a detailed projection, the
result is a whole-farm budget
Budget is a plan or a statement of expected results or projections expressed in numerical
terms. The financial operating budget is called as a financial plan and may be expressed in
terms of labour-hours, units of products, machine-hours, etc.,

4.2.1 Procedures in developing a whole-farm plan

When you are developing a whole-farm plan, you should follow the following six, as
shown in Figure 4.2 below.
1. Determine Objectives and Specify Goals: Most farms primarily seek profit
maximization but other objectives may also be pursued by farms; Maintaining long-
term productivity of land, Protecting the environment, Guarding health of operators
and workers, Allowing time for leisure activities. After identifying objectives, a
manager should be able to specify a set of performance goals. This can be defined in
terms of crop yields, livestock production rate, cost of production, net income, etc.,
2. Determine resources: Determine accurate inventory of available resources in terms of
type, quality, and quantity of resources. land - total number of acres, types of land,
fertility levels, climate, potential pests, tenure arrangements and leases, etc., buildings
- number, type, condition, capacity. labor - quantity and quality, machinery - number,
size, and capacity, capital - short-run and long-run availability, management: age,
experience, and past performance, other resources: availability of local markets,
marketing quotas, specialized inputs
3. Identify enterprises and technical coefficients: The technical coefficients for an
enterprise indicate how much of a resource is required to produce one unit of an

67
 enterprise. Technical coefficients are important in determining the maximum possible
size of enterprises and the final enterprise combination. For instance, Technical
coefficient for 1 beef cow might be 2 acres of pasture and 6 hours of labour, and MWK
332,000 of operating capital. Accurate figures for technical coefficient can often be
obtained from detailed farm records. For new enterprises, technical coefficient can be
obtained from extension service, or commodity organizations
4. Estimating per unit gross margin: Enterprise budgets provide a basis for gross
margins estimation in whole-farm budgets. An accurate enterprise budget mean an
accurate whole-farm budget. Using of inaccurate enterprise budget leads to misleading
farm-budget
5. Choosing enterprise combination: Managers want to find the combination of
enterprises that will provide the highest amount of profit through the best use of the
farm’s limited resources. Managers use Linear Programming to determine the optimal
combination of enterprises.
6. Prepare the whole-farm budget: In the last stage, the whole-farm budget is prepared.
The whole-farm budget can be used to:
i. Estimate the expected income, expenses, and profit for a given farm plan
ii. Estimate the cash inflows, cash outflows, and liquidity of a given farm plan
iii. Compare effects of farm plans on profitability, liquidity etc.,
iv. Evaluate the effects of expanding or changing present farm plan
v. Estimate the need for, or the availability of resources such as land, capital, etc
vi. Communicate the farm plan to lenders, land owners, etc.

68
Figure 4. 2: Step in whole-farm planning

Example of whole-farm planning. Suppose you or a farmer wishes to choose a

combination of crop and livestock activities that will maximize total gross margin for the
farm for the coming year. For agronomic reasons, the operator wishes to carry out a crop
mix that does not include more than 50 percent of the Class A cropland acres planted to
cotton in any year (objective).
Resource Inventory: Table 4.2 contains the resource inventory for the example farm. The
land resource has been divided into three types: 520 acres of Class A cropland, 200 acres of
Class B cropland, and 380 acres of land in permanent pasture. Labor is the only other limited
resource, with 3,500 hours available per year. Capital and machinery are available in
adequate amounts, and the few buildings available are sufficient for the livestock enterprises
to be considered.

69
 Table 4. 2: Resources Inventory for Example farm

Resource Amount and comments

Class A cropland 400 acres (not over 50% in cotton production)
Class B cropland 200 acres
Pasture 600 acres
Buildings Only hay shed and cattle shed are available
Labor 2,400 hours available annually
Capital Adequate for any potential crop plan, but all harvesting will be custom
Machinery hired Adequate for any farm plan
Management Manager appears capable and has experience with crops and beef cattle
Other limitations Any hay produced must be fed on farm, not sold

Enterprises and Technical Coefficients: Potential crop and livestock enterprises are
identified and listed in Table 4.3.

Table 4. 3: Potential Enterprises and Resource Requirements

Class A cropland Class B cropland Livestock (per head)

Quantity Beef Stocker
Cotton Milo Wheat Milo Wheat
Resources available Cows steers
Class A cropland (acres) 520 1 1 1 ___ ___ ___ ___

Class B cropland (acres) 200 ___ ___ ___ 1 1 0.2 ___

Pasture (acres) 380 ___ ___ ___ ___ ___ 2 2

Labour (hours) 3,500 4 1.7 1.6 1.7 1.6 6 4

Operating capital 340 273 382 253 340 332 688

Table 4.4 contains the estimated income, variable costs, and gross margins for the seven
potential enterprises to be considered in the whole-farm plan. Detailed breakdowns of the
variable costs have been omitted to save space but would be included in the enterprise
budgets, which are done first.

70
Table 4. 4: Estimating Gross Margin

Class A cropland Class B cropland Livestock (per head)

Beef Stocker
Cotton Milo Wheat Milo Wheat
Resources Cows (head) steers (head)
Yield 550 lb 80 cwt 52 bu 66 cwt 36 bu ___ ___

Price ($) 0.80 2.50 3.75 2.50 3.75 ___ ___

Gross Income ($) 400 200 195 165 135 675 620

Total variable costs ($) 250 100 80 80 65 470 550

Gross margin ($) 150 100 115 85 70 205 70

Figure 4. 3: Whole-farm budget development in picture

71
Table 4. 5: The whole-farm Budget

Sensitivity Analysis: Analyses how changes in key budget assumptions affect income
and cost projections. In the previous example, a 10% reduction in gross income was part of
the sensitivity analysis.

72
 Analyzing Liquidity: It analyses the ability of the business to meet cash flow obligations
as they come due. Besides farm cash inflows, you can add some nonfarm cash inflows in the
whole farm budget.

Activity 4 c
What is a whole-farm plan?

4.3. Linear programming

After we discussed enterprise budgets and whole farm budgets, another important farm
planning techniques is the linear programming. Linear Programming (LP) is a mathematical
procedure that uses a systematic technique to find the most profitable combination of
enterprises. Linear programming models have linear objective functions that are maximized
(or minimized) subject to the resource restrictions.
The basic logic for solving a linear programming problem can be illustrated in graphical
form for a small problem involving two enterprises, corn and soybeans, and three limited
resources. The necessary information is shown in Table 4.6, with land, labor, and operating
capital as the limiting resources. Gross margins and the technical coefficients are also shown
in the table. Resource limits and the technical coefficients are used to graph the possible
enterprise combinations shown in Figure 4.4.

Table 4. 6: Resources and resource requirements.

Resouce Requirements
(per acre)
Resources Resource limit Corn Soybeans

Land (acres) 120 1 1

Labor (hours) 500 5 3
Operating capital ($) 30,000 200 160
Gross margin ($) 120 96

73
 The supply of land limits corn and soybeans to a maximum of 120 acres each. These
points, A and A’, are found on the axes and connected with a straight line. Any point on line
AA` is a possible combination of corn and soybeans, given only the land restriction. Labor,
however, restricts corn to a maximum of 100 acres (500 hours divided by 5 hours per acre)
and soybeans to 166.7 acres (500 hours divided by 3 hours per acre). These points on the
axes are connected by line BB`. Any point on line BB` is a possible combination of corn and
soybeans permitted by the labor restriction. In a similar manner, line CC` connects the
maximum corn acres permitted by the operating capital restriction ($30,000 $200 per acre
150 acres) with the maximum soybean acres ($30,000 $160 per acre 187.5 acres). Line CC`
identifies all the possible combinations based only on the operating capital restriction.

Figure 4. 4: Graphical illustration of resource restrictions in a linear programming

problem.
The sections of lines AA`, BB`, and CC` closest to the origin of the graph, or line BDA`,
represent the maximum possible combinations of corn and soybeans when all limited
resources are considered together. Line BDA’ is a segmented production possibility curve
similar to those for competitive enterprises discussed in earlier units. The graph reveals that
operating capital is not a limiting resource. It is fixed in amount, but $30,000 is more than

74
sufficient for any combination of corn and soybeans permitted by the land and labor
resources.
The next step is for us to find which of the possible combinations of corn and soybeans
will maximize total gross margin. Total gross margin from planting 100 acres of corn, the
maximum possible amount if no soybeans are grown (represented by point B), is $12,000.
Adding one acre of soybeans increases the gross margin by $96, but requires 3 hours of
labor, which in turn causes 0.67 less acre of corn to be grown
(remember, no extra labor is available). This subtracts (0.67 $120 $80) from total gross
margin, for a net increase of $16.
This substitution can be continued until no more unused land is available (point D in
Figure 4.4). At this point, increasing soybeans by one more acre requires one less acre of
corn to be grown, resulting in a net decrease in gross margin of ($120 $96) $24. Thus, point
D represents the combination of the two crops that maximizes gross margin. This
combination is 70 acres of corn and 50 acres of soybeans, with a total gross margin of
$13,200. Producing either more acres of corn or more acres of soybeans would only reduce
the total gross margin.
Figure 4.5 shows the graphical solution to this example. Only the relevant production
possibility curve, or line segment BDA`, is shown. The graphical solution to a profit-
maximizing linear programming problem is the point where a line containing points of equal
total gross margin just touches or is tangent to the production possibility curve on its upper
side. This is point D in Figure 11-4, just tangent to a line representing all possible
combinations of corn and soybeans producing a total gross margin of $13,200. Higher gross
margins are not possible, because they require combinations of enterprises or enterprise
levels not permitted by the limited resources. Combinations other than 70 acres of corn and
50 acres of soybeans are possible, but they would have a total gross margin of less than
$13,200.

75
 Figure 4. 5: Graphical solution for finding the profit-maximizing plan using linear
programming.

The solution at point D was found in a manner similar to that used to find the profit-
maximizing enterprise combination in Unit 3, where the substitution ratio was equated with
the profit ratio. One basic difference is that linear programming generates a production
possibility curve with linear segments, rather than a smooth, continuous curve. The solution
will generally be at one of the corners or points on the production possibility curve, so the
substitution ratio will usually not exactly equal the profit ratio. Only the variable costs
change as the number of acres of each crop changes, so the ratio of the gross margins per
acre for each crop is compared instead of the profit ratio. The gross margin ratio will fall
between the substitution ratios for the two most limiting resources. For example, the
substitution ratio of soybeans for corn is 0.67 along segment BD and 1.0 along segment DA’.
The gross margin ratio is ($96 $120) 0.80, which falls between the two substitution ratios.

Activity 4 c
Discuss the relationship between production analysis, enterprise budget, whole-
far plan and the linear programming.

76
4.4 Partial Budgeting
Enterprise budgets are useful, but they do have limitations because they are restricted to
one enterprise. A partial budget is often the appropriate way to analyze changes involving
interactions between several enterprises.
A partial budget provides a formal and consistent method for calculating the expected
change in profit from a proposed change in the farm business. A partial budget compares
the profitability of one alternative, typically what is being done now, with a proposed change
or new alternative. Designed to analyze relatively small changes in the farm business, partial
budget is a form of marginal analysis.

Figure 4. 6: Partial budgeting and marginal analysis.

Figure 4.6 illustrates this point by showing how typical changes analyzed by partial
budgeting relate to a production function, an isoquant, and a production possibility curve.
Assuming that the current input/output combination is point A, the production function in
the first panel of Figure 4.6 shows possible increases or decreases in that combination.
Examples would be using more or less fertilizer, irrigation water, labor, or capital and
analyzing the effects on output, revenues, expenses, and profit.
The second panel shows possible movements up or down an isoquant or different
combinations of two inputs to produce a given amount of output. Possible changes in input

77
combinations can be analyzed easily with a partial budget. Substituting larger machinery for
less labor would be an example. Another typical use of a partial budget is to analyze the
change in profit from substituting more of one enterprise for another. This adjustment is
shown in the third panel by possible movements up or down the production possibility curve
from the current combination at point A. A fourth general type of alternative adapted to
partial budget analysis is expanding or contracting one or more enterprises. This would be
illustrated by moving to a higher or lower isoquant or a higher or lower production possibility
curve.

4.4.1 Partial budgeting procedure

Important information required in partial budgeting is changes in costs and revenues
These changes can be identified by considering the following questions; (Note: these
questions must be answered on the basis of what would happen if the proposed alternative
was implemented)
i. What new or additional cost will be incurred?
ii. Important information required in partial budgeting is changes in costs and
revenues
iii. These changes can be identified by considering the following questions; (Note:
these questions must be answered on the basis of what would happen if the
proposed alternative was implemented)
iv. What new or additional cost will be incurred?

4.4.2 Partial Budget Format

There are different partial budgeting forms, but all have these four categories arranged
in some manner. For each category, only the changes are included, not all costs or revenues.

i. Additional Costs: costs that do not exist at current time but will be incurred if the
change is made
ii. Reduced Revenue: revenue that is currently received but which will be lost or
reduced if the change is made

78
 iii. Additional Revenue: revenue to be received only if the alternative is adopted
iv. Reduced Costs: costs that are now incurred which would be eliminated if the change
is made.

Table 4. 7: Partial Budget Form

Problem:

Additional Costs: Additional Revenue:

Reduced Revenue: Reduced Costs:

A. Total additional costs B. Total additional revenue

and reduced revenue $ and reduced costs $
$
Net Change in Profit (B-A) $

On the right-hand side of the budget are the two categories that increase profit—
additional revenue and reduced costs. Entries on the two sides of the form are summed and
then compared to find the net change in profit. If the total of additional revenue and reduced
costs is greater than the total of additional costs and reduced revenue, then the net change in
profit will be positive and profit will increase by making the change. In the opposite case,
net change in profit will be negative and profits would fall if the change were made.
Whenever opportunity costs are included on a partial budget, the result is the estimated
change in “economic profit.” This will not be the same as the change in “accounting profit.”

4.4.3 Partial Budgeting Example

Two examples below will illustrate the procedure and possible uses of partial budgeting.
Table 4.8 is a fairly simple budget analyzing the profitability of purchasing a combine to
replace the current practice of hiring a custom combine operator to harvest 1,000 acres of

79
 wheat. Table 4.9 looks at a proposed change of adding 50 beef cows to an existing herd. To
accommodate the additional cows, 100 acres currently in grain production would need to be
converted to forage production.
Table 4. 8: Partial Budget for Owning Combine Versus Custom Hiring

Problem: Purchase combine to replace custom hiring (1,000 acres wheat)

Additional Costs Additional Revenue

Fixed costs None
Depreciation $10,000
Interest 8,000
Taxes 100
Insurance 300
Variable costs
Repairs 2,500
Fuel and oil 1,300
Labour 550

Reduced Revenue Reduced Cost

None Custom combining charge
1,000 acres @$20 per acre $20,000

A. Total additional costs B. Total additional revenue

and reduced revenue $22,750 with reduced costs $20,000
$22,750
Net Change in Profit (B-A) ($2,750)

80
 Table 4. 9: Partial Budget for adding 50 beef cows and convert 100 acres from grain
to forage)

Problem: Add 50 beef cows and convert 100 acres from grain to forage)

Additional Costs Additional Revenue

Fixed costs 5 cull cows $2,500
Interest on cows/bulls $2,500 23 steer calves 500 lbs @ $0.85 9,775
Bull depreciation 200 18 heifer calves 460 lbs @ $0.78 6,458
Taxes 100
Variable costs
Labour 600
Vet and health 500
Feed and hay 2,000
Hauling 300
Miscellaneous 200
Pasture fertilizer 1,500
Interest on variable costs 320

Reduced Revenue Reduced Cost

Grain production 5,000 bu @ $3 $15,000 Fertilizer 2,750
Seed 1,400
Chemicals 1,200
Labour 1,500
Machinery 1,000
Interest on variable costs 470

A. Total additional costs and B. Total additional revenue

reduced revenue $23,220 with reduced costs $27,053
$23,220
Net Change in Profit (B-A) $3,833

4.4.4 Limitations to partial budgets

Despite its usefulness, partial budgets have the following limitations:
a. Partial budgets are easy to use and require minimal data. However, partial budgeting
can only compare the present management plan with one alternative at a time.

81
 b. If there are many alternatives to consider, the manager will need to develop many
partial budgets.
c. Also, partial budgeting uses one set of price and yield expectations. If these are
variable, cash flow may be a problem in coming years

Activity 4 d
Discuss the use of a partial budget

Summary
In this Unit, we discussed three key farm planning techniques namely enterprise budget,
whole-farm budget or plan and the partial budget. Enterprise budgets are an organization of
projected income and expenses for a single enterprise. They are constructed for a single unit
of the enterprise, such as one acre for a crop and one head for a livestock enterprise. Most
enterprise budgets are economic budgets and, as such, include all variable or operating
expenses, all fixed or ownership expenses, and opportunity costs on factors such as operator
labor, capital, and management.
Whole-farm planning and the resulting whole-farm budget analyze the combined
profitability of all enterprises in the farming operation. Planning starts with determining
objectives, setting goals, and taking an inventory of the resources available. Feasible
enterprises must be identified and their gross income per unit, variable costs, and gross
margins computed. Linear programming can be used to select the combination of enterprises
that maximizes gross margin without exceeding the supply of resources available. It can
handle large, complex planning problems quickly and accurately and also provides
information such as the value of obtaining additional resources or the penalties for including
certain enterprises.
A partial budget is an extremely useful type of budget. It can be used to analyze many of
the common, everyday problems and opportunities that confront the farm and ranch
manager. Partial budgets are intended to analyze the profitability of proposed changes in the
operation of the business where the change affects only part of the farm plan or organization.

82
The current situation is compared to the expected situation after implementing a proposed
change.

End of Unit Test

1. The primary purpose of an enterprise budget is to estimate projected costs, revenues
and profit per unit for the enterprises. You have been called for Farm Manager
Interviews at Bunda Farm. As part of the interview process, you have been given the
following table with groundnuts data and estimates.

Expected groundnuts yield 100 bags weighing 50Kgs each

Expected price MWK 500 per Kgs
Hours of labour required 8 hours
Cost of labour per hour MWK 200 per hour
Quantity of seed 2 bags weighing 20Kgs each
Expected seed price MWK 100 per Kgs
Quantity of herbicides 10 bottles
Cost of herbicides MWK 500 per bottle
Quantity of pesticides 10 bottles
Cost of pesticides MWK 250 per bottle
Amount of rented land 10 acres
Land charge MWK 1000 per acre
Other costs of production MWK 3000
Interest on total operating expenses 6.5%
Depreciation and interest MWK 90,000

Using the concepts of enterprise budget learnt in Farm Business Management I Class,
a. Prepare an enterprise budget and comment on return to management
b. Calculate cost of production
c. Calculate the break-even yield (BEY) and break-even price (BEP), and explain
the importance of the BEY and BEP to farmer managers

83
2. Assuming you have been planning your cropping program for next year and
that you can grow either maize or soybeans with the existing resources at the
farm. After doing market research on prices, the market trends show that
soybean prices will be more favourable than maize prices. Consequently, you will
require to reduce 10 acres of maize and plant soybean. Given expected maize yield to be
1000 Kilograms per acre, maize price to be MWK 250 per Kg, and total cost of inputs
such as fertilizer, seed, herbicides and lime to be MWK 3000 per acre. Maize labour
requirement is 3 hours per acre and must be hired at MWK 400 per hour. For soybean,
it is estimated that yield will be 500 Kgs per acre at an estimated price of MWK 700 per
Kg, with total cost of variable inputs such as fertilizer, seed, herbicides and lime at MWK
1000 per acre. The labour requirement for soybeans is 2.5 hours per acre and must be
hired at MWK 400 per hour. Using the information above,
a. Prepare a partial budget for replacing 10 acres of maize with 10 acres
of soybeans
b. Comment your findings in a

Further Reading
Ronald Kay, William Edwards, and Patricia A. Duffy, (2016) Farm Management. 8th
Edition.
Debertin, D. L., (1986) Agricultural Production Economics, Second Edition, University of
Kentucky
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.

84
 Unit 5: Planning Under Risks and
Uncertainties

Introduction
Welcome to the last unit of this module. In this unit, we will discuss about risks and
uncertainties. Specifically, we will define the term risk, importance of risk management in
agricultural production, approaches to risk analysis and practical risk management strategies.
We live in a world of uncertainty. There is an old saying that “Nothing is certain except
death and taxes.” Many agricultural decisions have outcomes that take place months or
years after the initial decision is made. Managers find that their best decisions often turn out
to be less than perfect because of changes that take place between the time the decision is
made and the time the outcome of that decision is finalized.

Learning Outcomes
Upon successful completion of this Unit, you should be able to:
a. Differentiate between risk and uncertainty.
b. Discuss the importance of risk management.
c. Analyze different risks
d. Discuss risk management strategies.

Key Terms
Ensure that you understand the key terms or phrases used in this unit as listed below:
Risk
Uncertainties

5.1 Definitions and concepts

Risk can be defined as imperfect knowledge where the probability of possible outcome
is known or the chance of loss or an unfavorable outcome associated with an action.

85
 Uncertainty is not knowing what will happen in the future or a situation where both the
possible outcomes and their probabilities of occurring are unknown. The greater the
uncertainty, the greater the risk.
The uncertainty is not measurable while risk can be measured through the probability
concepts. Farming is a financially risky occupation, farmers make decisions in a risky, ever-
changing environment. The consequences of their decisions are generally not known when
the decisions are made, and outcomes may be better or worse than expected. Variability of
prices and yield are the biggest sources of risk in agriculture. Technology changes, legal and
social concerns, and the human factor itself also contribute to the risk environment for
agriculture producers.
The two situations that most concern agriculture producers are:
i. is there a high probability of adverse consequences and
ii. would those adverse consequences significantly disrupt the business (Patrick,
1992).

Activity 5 a
Differentiate between risk and uncertainty

5.2 Sources of risk in agriculture

The sources of risk and uncertainty in agriculture are many. In this Unit, we will discuss
six key sources:
i. Production or yield risk occurs because agriculture is affected by many
uncontrollable events that are often related to weather, including excessive or
insufficient rainfall, extreme temperatures, hail, insects, and diseases.
ii. Price or market risk reflects risks associated with changes in the price of output
or of inputs that may occur after the commitment to production has begun.
iii. Institutional risk results from changes in policies and regulations that affect
agriculture. For example, changes in government rules regarding the use of
pesticides (for crops) or drugs (for livestock) may alter the cost of production.

86
 iv. Human or personal risks that is common to all business operators. Disruptive
changes may result from such events as death, or the poor health of a principal in
the firm.
v. Financial risk these include fluctuations in interest rates on borrowed capital, or
face cash flow difficulties if there are insufficient funds to repay creditors.
vi. Asset risk is also common to all businesses and involves theft, fire, or other loss
or damage to equipment, buildings, and livestock.

Figure 5. 1: Sources of risk in agriculture

Activity 5 b
Differentiate between market and price risks and financial risks.

87
5.3 Classification of risks
Risks are classified as follows:
1. External Risk - External sources of risk arise from the natural, economic, social and
political environments. Of most importance is the natural or climatic environment (that
is, nature). Risks of the economic environment relate to the market (demand and supply)
e.g prices of farm inputs and outputs, inflation and interest rates and productivity
through the availability and merit of new technology.
The social environment is not a major source of risk, although over time, it can influence
education and lifestyle, hence impacts on farm labour supply. Political factors
influencing risk include change in government policies. Other more typical political
influences are changes in political ideology,
2. Internal Risk - Sources of internal risk affect the operation of each individual farm and
include the health of the farm household, their interpersonal relations as influenced by
personality, changing values attitudes and aspirations. The farmer’s approach to
conservation of farm resources, use of credit to finance farm development.
3. Business risk - Business risk stems from variable yields of crops, reproduction rates,
disease outbreak, climatic variability, unexpected changes in markets and prices,
changes in government policies and laws, fluctuations in inflation and interest rates and
personal mishaps. Sources of business risk can be condensed to price and production.
Price risk refers to change in prices of inputs and outputs production risk results from
factors such as weather and pests that affect output yields
4. Financial Risk - Financial risk derives from other people’s money that is used in the
business relative to the proportion of the owner-operator’s capital. The higher the ratio
of debt to equity, the higher the financial risk.

Activity 5 c
Discuss four classifications of risk in agriculture

88
5.4 Risk Management
Risk management strategies consist of a variety of responses which may reduce the
probability of an unfavorable event occurring and/or reduce the adverse consequences if the
event occurs. It will help a farmer to anticipate any unfavorable event that may occur and
acts to reduce the probability of its occurrence and it helps in defining actions which will
reduce the adverse consequences should the unfavorable event occur.

5.4.1 Approaches to risk management

In this section, we will discuss the approaches to risk management. Broadly, risk
management approaches are categorized int informal and formal approaches.

Informal or Formal (market based) - Formal Risk responses or methods of dealing with
variability are commonly grouped into production, marketing, and financial responses. On the other
side, informal approaches are mainly considered by farmers at the household level in developing
countries.
Household approaches include savings, buffer stocks like livestock, off-farm income, family
networks, and informal borrowing and community-level approaches, such as mutualization and
mutual help, can be informal or semiformal.
Production responses generally act to reduce risk by reducing the variability in production.
Activities includes:
✓ Choosing Low Risk Activities
✓ Diversifying Enterprises e.g. corn/soybean rotation, Combining livestock with crop
enterprises
✓ Dispersing Production Geographically
✓ Selecting and Diversifying Production Practices e.g. Planting several hybrids with
different pollination dates and applying different herbicides
Market responses entails developing new market skills and awareness about price risks of
commodity prices. Activities include:
✓ Obtaining Market Information: Most farmers indicate they follow the commodity markets
regularly. Many farmers also obtain outlook information, chart or use charting services,
and subscribe to various marketing services

89
 ✓ Participating in Government Programs: Participating in or maintaining eligibility for
government commodity programs is a marketing response to variability used by many
producers. Government programs provide downside price protection for some
commodities. At different times, this protection has taken the form of price supports, loan
programs, target prices, deficiency payments, and payments in kind.
✓ Spreading Sales: The spreading of sales, making several sales of a commodity during a
year, is commonly used by agricultural producers. Dairymen and many other livestock
producers are forced to spread their marketing over the entire year because of the nature
of their production.
✓ Forward Contracting: The practice of forward contracting can be used for both inputs and
outputs. Some farmers contract needed quantities of inputs at specified prices to avoid
the risk of price increases and unavailability of inputs. Similarly, some producers forward
price some of their production.
✓ Hedging: Hedging, the use of futures contracts, is another marketing response which has
the potential for reducing risk. Farmers can sell commodities on the futures market and
assure themselves of a price, except for basis changes.
✓ Options Trading: Agricultural options provide a farmer with the opportunity to secure
price insurance
Financial Responses include:
✓ Insuring Against Losses - The idea of insurance is to buy protection against a loss. Risks
which have a low probability of occurrence and very adverse consequences are the most
logical risks to insure against. Liability, major medical, disability, and fire/extended
coverage on buildings, equipment, and livestock are examples of insurance.
✓ Maintaining Reserves - Having reserves to provide liquidity is another financial strategy
for dealing with variability. Many farmers use inventory reserves as a cushion that can be
drawn upon in times of adversity. Inventory reserves, like a bin of grain, would be a
current asset on the farmer's balance sheet. If an unexpected event occurs, the grain can
be sold and the proceeds used.
✓ Pacing of Investments - Postponing capital expenditures, including replacement of
durable assets, is a response to adversity. Budgeting and cash flow analysis are tools
which are commonly used in helping to decide whether an investment or expenditure
should be made. It is important that budgets reflect the individual producer's situation and
risk costs. Budgeting typically averages out variations in prices, costs, and yields.

90
 ✓ Acquiring Assets - Leasing rather than purchasing assets may be another way to maintain
greater liquidity in the farm business. Very commonly, farmers cash rent or share lease
land, allowing greater investment in short and intermediate term assets. Debt
commitments are avoided, and liquidity of the firm is preserved.
✓ Limiting Credit and Leverage - Credit or loan limits influence the degree of leverage in a
farm operation. Credit limits may be internal, imposed by the farmer (''Never buy land
unless you can put 50 percent down''). Alternatively, credit limits may be external,
imposed by the lender (''The most we can go on operating expenses is $50,000 this year
'').

5.4.2 Risk Management Process

Now let us divert our attention to risk management processes. There are four main steps that you
have to follow in risk management:
1. Risk identification: You have to ask yourself questions like which risks are relevant for a
specific farm? For instance, livestock, crops, etc.,
2. Risk assessment: In this step, you ask yourself a question like, how much attention do the
risks identified in the first step deserve?
a. Incident rate: What is the probability that a specific risk will occur?
b. Potential loss: What will be the financial loss if a risk, such as an animal disease or
a hail storm, occurs?
3. Risk management: After relevant risks have been identified and assessed, you or farmers
have to decide how to cope with these risks. In general, farmers have four options for
managing a risk:
a. Risk avoidance – Avoid taking a risky action
b. Transfer of risks to third parties, such as insurance companies or financial investors
in futures markets;
c. Mitigation or risk reduction through such means as concluding longer-term contracts
or diversifying farm activities; and
d. Coping or risk acceptance, a strategy used mainly where incident rates and loss
potentials are low
4. Mitigation or risk reduction through such means as concluding longer-term contracts or
diversifying farm activities; and coping or risk acceptance, a strategy used mainly where
incident rates and loss potentials are low

91
Figure 5. 2: Risk Management Process

5.4.3. Risk management strategies

Risks (and their impacts) are assessed by quantifying three main variables: Hazard, Vulnerability
and exposure
i. Hazard: This is the categorization of the type of risk being considered
▪ Frequency: How often or likely is the risk to occur?
▪ Severity: What are the likely fiscal impacts of such a risk if it occurs?
▪ Spatial extent: How widespread would the impact of the risk be—one person? one
village? One country?
ii. Vulnerability is an estimation of what the impact of the risk would be, given the assets
affected by the event and taking into account, the current ability to manage the impact.
iii. Exposure is the identification of the location of crops, livestock, and farm holdings that may
be directly impacted by the hazard.

Activity 5 d
Discuss four step in risk management.

92
5.5 Decision making in a risky environment
The existence of risk adds complexity to many decisions. When managers are uncertain
about the future, they often use some type of average or “expected” values for yields, costs,
or prices. There is no assurance that this value will be the actual outcome each time, but
decisions must be made based on the best information available. To analyze risky decisions,
a manager needs to understand how to form expectations, how to use probabilities, and how
to analyze the whole distribution of potential outcomes.

5.5.1 Forming expectations

You can use several methods to form expectations about future events. Once a “best
estimate” is chosen, it can be used for planning and decision making until more information
allows a better estimate to be made. Below we will discuss the most common techniques
used to make decisions in risk environment.
1. Most Likely
One way to form an expectation is to choose the value most likely to occur. This
procedure requires a knowledge of the probabilities associated with each possible outcome,
either actual or subjective. This can be based on past occurrences or on analysis of current
conditions. The outcome with the highest probability is selected as the most likely to occur.
An example is contained in Table 5.1, where six possible ranges of maize yields are
shown along with the estimated probabilities of the actual yield falling into each one.

Table 5. 1: Using Probabilities to Form Expectations

Possible Number of Years

Yield (bags/acre) yield was in that range Probability (%)
00 – 14 1 5
15 – 21 2 10
22 – 28 5 25
29 – 35 7 35
36 – 42 4 20
43 - 51 1 5
Total 20 100

93
 Using the “most likely” method to form an expectation, a yield of 29 to 35 bags per acre
would be selected. For budgeting purposes, we could use the midpoint of the range, or 32
bags. There is no assurance the actual yield will be between 29 and 35 bags per acre in any
given year, but if the probabilities are correct, it will occur about 35 percent of the time over
the long run. The “most likely” method is especially useful when there is only a small
number of possible outcomes to consider.

2. Averages
Two averages can be used to form expectations
a. Simple average or mean
b. Weighted average
Simple average has problems associated with selecting the length of years to consider.
High yields due to new technologies might also inflate the average. To these reasons,
weighted averages are favored to simple average or mean. In weighted average technique,
recent values are given higher weights than older values. The assigned weights should
always add to 1.00. Each price is multiplied by its assigned weight, and the results are
summed. The expected price is $82.72 using the weighted average method. This method
assumes that recent prices (which have been higher) more accurately reflect current supply
and demand conditions, while the simple average treats each year’s result with equal
importance.

Table 5. 2: Simple and weighted average methods

Weighted average
Year Average Annual Price Weight Price * Weight
5 years ago 73.10 0.10 7.41
4 years ago 66.40 0.15 9.96
3 years ago 82.40 0.20 16.48
2 years ago 87.50 0.25 21.88
Last year 90.30 0.30 27.09
$399.70/5=$79.94 1.00 $82.72

94
5.5.2 Variability
Adding to the expected values, farm manager should also consider variability of possible
outcomes around expected values. E.g., If there are 2 alternatives with the same expected
outcomes, managers should choose the one whose potential outcomes have least variability.
Measures of variability: Range, standard deviation, coefficient of variation and cumulative
distribution function.

1. Range
One simple measure of variability is the difference between the lowest and highest
possible outcomes, or the range. Alternatives with a smaller range are usually preferred over
those with a wider range if their expected values are the same. Range is not the best measure
of variability, however, because it does not consider the probabilities associated with the
highest and lowest values, nor the other outcomes within the range and their probabilities.

2. Standard Deviation
A common statistical measure of variability is the standard deviation.1 It can be estimated
from a sample of past actual outcomes for a particular event, such as historical price data for
a certain week of the year. A larger standard deviation indicates a greater variability of
possible outcomes, and therefore, a greater likelihood that the actual outcome will differ
from the expected value.
Standard deviation is calculated as a square-root of the variance.

( X − X )
2

Variance=
n −1

3. Coefficient of Variation
The standard deviation is difficult to interpret, however, when comparing two types of
occurrences that have different means. The occurrence with the higher mean value often has
a larger standard deviation, but is not necessarily riskier. In this situation, it is more useful
to look at the relative variability. The coefficient of variation measures variability relative to
the mean and is found by dividing the standard deviation by the mean. Smaller coefficients

95
of variation indicate that the distribution has less variability compared to its mean than other
distributions.

Table 5. 3: Historical data for corn and soybean yields on an individual farm

Year Corn (Kgs/Acre) Soybean (Kgs/Acre)

1 165 45
2 185 66
3 181 48
4 128 38
5 145 43
6 169 54
7 158 50
8 115 31
9 172 47
10 167 58
Mean (expected Value) 158.5 46.9
Standard deviation 22.7 8.2
Coefficient of Variation 0.14 0.17

4. Cumulative Distribution Function

Many risky events in agriculture have an almost unlimited number of possible outcomes,
and the probability of any one of them occurring becomes very small. A useful format for
portraying a large number of possible outcomes is a cumulative distribution function, or
CDF. The CDF is a graph of the values for all possible outcomes for an event against the
probability that the actual outcome will be equal to or less than each value. The outcome
with the smallest possible value has a cumulative probability of nearly zero, while the largest
possible value has a cumulative probability of 100 percent.
The steps in creating a CDF are as follows:
i. List a set of possible values for the outcome of an event or strategy, and estimate
their probabilities. For example, the data from Table 5.4 can be used set of possible

96
 values for corn and soybean yields. If it is assumed that each of the 10 historical
observations has an equal chance of occurring again, each one represents 10
percent of the total possible outcomes or distribution.
ii. List the possible values in order from lowest to highest.
iii. Assign a cumulative probability to the lowest value equal to one-half of the range
it represents. Each observation represents one segment or range out of the total
distribution, so it can be assumed that the observation falls in the middle of the
range. For the example, the lowest yield observed represents the first 10 percent of
the distribution, so it can be assigned a cumulative probability of 5 percent.
iv. Calculate the cumulative probabilities (probability of obtaining that value or a
smaller one) for each of the other values by adding the probabilities represented by
all the smaller values to that value’s own probability. In the example, the remaining
observed yields would have cumulative probabilities of 15 percent, 25 percent, and
so on.
v. Graph each pair of values and connect the points.

The cumulative distribution function permits a view of all possible results for a certain
event. The more vertical the graph, the less variability among the possible outcomes.

Table 5. 4: Cumulative Probability Distributions for Corn and Soybean Yields

Con (Kgs/acre) Soybean(kgs/acre) Cumulative Probability

115 31 5
128 38 15
145 43 25
158 45 35
165 47 45
167 48 55
169 50 65
172 54 75
181 55 85
185 58 95

Using the data in Table 5.4 above, you can produce two graphs below.

97
 The upper portions of the graphs in Figure 5.3 are steeper than the lower portions,
indicating that the positive yield responses to good weather are not as significant as the
negative responses to poor growing conditions.

Figure 5. 3: Cumulative distribution functions for corn and soybean yield.

98
 Activity 5 e
List at least five sources of risk and uncertainty for farmers in your area. Classify
them as production, price, financial, legal, or personal risk. Which are the most
important? Why?

Summary
We live in a world of uncertainty. Rarely do we know the exact what, when, where, how,
and how much of any decision and its possible outcomes. Decisions must still be made,
however, using whatever information and techniques are available. No one will make a
correct decision every time, but decision making under uncertainty can be improved by
knowing how to identify possible events and strategies, estimate the value of possible
outcomes, and analyze their variability.
Probabilities, averages, standard deviation, range, coefficient of variation and cumulative
distribution functions can be used to organize the outcomes of different strategies. Several
decision rules can be used to choose among risky alternatives. Some consider only expected
returns, some take into account the variability of outcomes both above and below the mean,
and some look only at adverse results

End of Unit Test

1. The Table 1 below shows 7 years data for soybean productivity value (MWK/ha),
MWK/ha Number of years productivity was in that range
0 - 55,000 5
56,000 – 100,000 8
101,000 – 150,000 4
151,000 – 200,000 7
201,000 – 250,000 12
251,000 – 300,000 9
301,000 – 350,000 2
Total 47

99
 a. Using the most likely technique, choose the productivity range that a farmer can
form his or her expectation and why.

2. Table 2 shows 5 years data on groundnuts and soybean yield,

Year Groundnuts (Kgs/Acre) Soybean (Kgs/Acre)

1 55 15
2 80 34
3 54 23
4 67 45
5 120 67

Using the information provided in table 1 above,

a. Calculate the variability of each enterprise using coefficient of variation and
standard deviation.
b. As a farm manager, which enterprise can you recommend for production?
Explain your answer.

Further Reading
Ronald Kay, William Edwards, and Patricia A. Duffy, (2016) Farm Management. 8th
Edition.
Debertin, D. L., (1986) Agricultural Production Economics, Second Edition, University of
Kentucky
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.
Johnson, D.T. (1982). The Business of Farming: A Guide to Farm Business Management
in the Tropics. London: Macmillan Publishers Ltd.

100
 Glossary
Amortized loan is a loan scheduled to be repaid in a series of periodic payments.
Break-even price - the selling price for which total income will just equal total expenses for
a given level of production.
Break-even yield - the yield level at which total income will just equal total expenses at a
given selling price.
Capitalization method - a procedure for estimating the value of an asset by dividing the
expected annual net returns by an annual discount rate.
Coefficient of variation - a measure of the variability of the outcomes of a particular
event; equal to the standard deviation divided by the mean.
Collateral - assets pledged as security for a loan.
Competitive enterprises - enterprises for which the output level of one can be increased
only by decreasing the output level of the other.
Complementary enterprises - enterprises for which increasing the output level of one
also increases the output level of the other.
Cumulative distribution function (CDF) - a graph of all the possible outcomes for a
certain event and the probability that each outcome, or one with a lower value, will occur.
Depreciation - an annual, noncash expense to recognize the amount by which an asset
loses value due to use, age, and obsolescence. It also spreads the original cost over the
asset’s useful life.
Diminishing returns - a decline in the rate at which total output increases as more inputs
are used; a declining marginal physical product.
Economies of size - a production relation in which average total cost per unit of output
decreases as output increases.
Enterprise - an individual crop or type of livestock, such as wheat, dairy, or lettuce. A
farm’s production plan will often consist of several enterprises.
Farm management - the process of making decisions about the allocation of scarce
resources in agricultural production for the purpose of meeting certain management goals.
Fixed costs - costs that will not change in the short-run even if no production takes place.

101
Gross income - the total income, cash and noncash, received from an enterprise or
business, before any expenses are paid.
Gross margin - the difference between gross income and variable costs; also called
income above variable costs.
Gross revenue - the total of all the revenue received by a business over a period; same as
gross income.
Income - economic gain resulting from the production of goods and services, including
receipts from the sale of commodities, other cash payments, increases in inventories, and
accounts receivable.
Law of diminishing returns - a relation observed in many physical and biological
production processes, in which the marginal physical product declines as more units of a
variable input are used in combination with one or more fixed inputs.
Marginal cost (MC) The additional cost incurred
from producing an additional unit of output.
Marginal input cost (MIC) The additional cost incurred by using an additional unit of
input.
Marginal physical product (MPP) The additional physical product resulting from the use
of an additional unit of input.
Marginal revenue (MR) The additional income received from selling one additional unit
of output.
Marginal value product (MVP) The additional income received from using an additional
unit of input.
Production function A physical or biological relation showing how much output results
from using certain quantities of inputs.
Production possibility curve (PPC) A line on a graph that connects points representing
all the possible combinations of outputs that can be produced from a fixed set of resources.
Profit, accounting Gross revenue minus total expenses where both values are computed
using standard accounting principles and practices.
Profit, economic Accounting profit less opportunity costs on all unpaid resources
(generally labor, management, and equity capital) used to produce that profit.

102
 References
Ronald Kay, William Edwards, and Patricia A. Duffy, (2016) Farm Management. 8th
Edition.
Debertin, D. L., (1986) Agricultural Production Economics, Second Edition, University of
Kentucky
Cramer, G.L. and Jensen C.W. (2001). Agricultural Economics and Agribusiness: An
introduction. 8th ed. John Wiley and Sons.
Johnson, D.T. (1982). The Business of Farming: A Guide to Farm Business Management in
the Tropics. London: Macmillan Publishers Ltd.

103
 Module Test
1. Farming has always been a risky business due to the handling of living organisms and
its exposure to weather conditions and other natural phenomena.
a. Define the term “risk” (1 mark)
b. Explain how the following can be used in decision making under risky
environment
i. Standard deviation (2 marks)
ii. Coefficient of variation (2 marks)
iii. Range (2 marks)

2. Briefly explain how you can use market data to appraise land (8 marks)

3. A farmer wants to produce maize on his 1-acre farm. After undertaking market and
yield trend analysis, he projected a MWK180/Kg market maize price for 2020/2021
season. Suppose he is planning to use fertilizer under the Affordable Input
Programme, sold at MWK 4, 495/50Kgs bag. Using the information in table below,
find the Input-Output profit maximizing level. (10 marks)
Fertilizer (50Kgs bag) Maize Yield (Kg)
0 0
2 500
6 750
9 800
11 850
15 900

4. A group of students from Farm Business Management class have formed a Micro-
farm enterprise aiming at providing vegetables to staff houses at Bunda. They have
obtained a loan amounting to MWK200, 000.00 at National Bank of Malawi, with a
repayment period of 7 years and an interest rate of 10.5 percent annually. Using Equal

104
 Total Payments amortization plan, prepare a repayment schedule for the enterprise.
(15 marks)
5. A Farm is producing groundnuts and soya bean on 100 acres of land. Suppose
groundnuts occupies 60 percent and soya bean 40 percent of the total area. Yield of
groundnuts and soya bean per acre is 100 kilograms and 75 kilograms respectively.
The price for soya bean is MWK15/Kg and groundnuts is MWK20/Kgs. To produce
these two crops, the farm incurred the following total variable costs:

Input Cost (MWK)

Inoculants 4,000
Labour 10,000
Seeds 50,000
Repairs and maintenance 7,000
Fuel 50,000
Drying management 10,000

Using the income capitalization rate of 14 percent, estimate the value of land.
(10 marks)
6. For 10 years, a farmer has been producing corn on his 10 hectares of land, valued at
MWK50 million. Due to high variability in rainfall patterns and other risks associated
with corn production, he decided to put 50 percent of the total corn area under
groundnuts production. After an in-depth crop estimation on the new and old
enterprises, he expects a constant corn yield of 1000 kilograms per hectare and an
estimate of 500 kilograms per hectare for groundnuts. Corn production on a 10 hectares
of land costed the farmer a total of MWK 300, 000 on fertilizer, MWK 50, 000 on seeds,
MWK 100, 000 on labour and MWK 20, 000 on herbicides. Dividing the farm in two
halves for corn and groundnuts production will see the total cost for corn production
cut by 50 percent on fertilizers, seeds, labour and herbicides. It is estimated that
groundnuts production on the 5 hectares will cost the farmer MWK 100, 000 on seeds,
MWK 50, 000 on labour and MWK 10, 000 on inoculants. It is expected that corn and
groundnuts will fetch an average price of MWK 190 per Kg and MWK 520 per Kg

105
respectively. Factoring in uncertainties in the prices of inputs, the farmer added 10
percent and 5 percent on total variable costs for groundnuts and corn respectively.
a. Prepare a partial budget using the information above. Clearly state the
problem on the top of your partial budget (15 marks)
b. Comment on the net profit margin (5 marks)

106