FARM MANAGEMENT

CHAPTER ONE: FARM MANAGEMENT; DEFINITIONS & CONCEPTS

1. Introduction

1.1. Definition of farm management

Farm-management is a word made up of two words namely Farm and Management.
A) Farm
Farm is defined as:
•A land devoted to agriculture to rare animals and grows plants by the farm owner.
The land where crop and livestock enterprises are taken up under the farmer/ farm family control
•A productive unit specialized in converting resources or inputs in to agricultural products.
•In general farm is a socio-economic unit to earn an income and a productive resource under
farmer's control.
B) Management:
•Is concerned with meeting of goals
•Is making use of available resource or allocating scarce resource in efficient manner.
•Is a process which directs action in to some goals through planning, organizing, leading and
controlling of resources (financial and human resources).
•Is making a decision to increase net return or profit
Therefore, Farm management is:
›A decision making process whereby limited resources are allocated in to a number of production
units alternatively to attain some objectives.
-Both art (applied) and pure science of organizing and operating farm business. It is applied
(art) because it seeks solution to a farm problem like what to produce, how much to produce and
how to produce? and it is pure science in that it involves in collecting of data, organizing,
analyzing, explaining and interpreting of results and coming out with scientific generalization.
-Attainment of farm goals in an effective and efficient way through planning, organizing, leading
and controlling of farm resources.
- Farm management may also be described as the art and science of organizing and operating a
farm business. In this case again, there are two aspects/dimensions involved.
a) The technical aspect, calls for a knowledge of the scientific principles and practical skills,
for example, of crop and livestock production.
b) The business aspect, which is a decision-making and organizational process, calls for
judgment and business acumen/ability.
Farm management is a decision-making science. It helps to decide about the basic course of

action of the farming business. The basic decisions of the farming business
are:????
(a) What to produce or what combination of different enterprises to follow?
(b) How much to produce and what is the most profitable level of production?
(c) What should be the size of an individual enterprise, which, in turn, will determine the best
overall size of the farm business?
(d) What methods of production (production practices or what type of quality of inputs and their
combination) should be used?
(e) What and where to market?
Definition of farm management explained by different authors in different ways:
- Farm management is concerned with how can the individual farmer organize the factors of
production land, labor, and capital on his farm, so adapt practice to his particular environment
and so dispose of his product, as to yield him the target net return while still maintaining the
integrity of the land and equipment (Butter field, 1910).
- Farm management is the subdivision of economics which considers the allocation of limited
resources with the individual farm. It is a science of choice and decision making (heady and
Jensen, 1954).
- Farm management can be thought of as being a decision making process. It is a continuous
process. The decisions are concerned with allocating the limited resources of land, labour and
capital among alternative and competing uses. This allocation process forces the manager to
identify goals to guide and direct the decision making (Kay and Edwards, 1994).
These are clearly have both similarities and marginal differences among these definitions, it is
interesting that the earliest definition of 1910 is little different from the most recent of 1994. The
common thread through most of them is decision making about the allocation of resources.
 1.2 Why study farm management?

What is the main aim of farm management?????

 The main aim of farm management is to help in realization of the maximum net profit
from the various enterprises on a farm. A typical farm is a combination of two or more
enterprises and the chief aim of the farm manager would be to get the whole unit give the
maximum total returns. It is not the return from anyone enterprise that determines the
financial success of a farm, but it is the total return from all enterprises that counts its
success or failure. A proper understanding of farm management principle helps in
selection combination and execution of enterprises, which are consistent to a sound
agricultural policy.

 The management study is undertaken(why management study is undertaken????)

 To study the input-output relationship in agriculture and determine the relative

efficiency of various factor combination.
 To determine the most profitable crop production and livestock raising methods.
 To study the cost per hectare and per quintal or per kg.
 To evaluate the farm resource and land use.
 To study the comparative economics of different enterprises.
 To determine the relation of size of farm to land utilisation, cropping pattern, capital
investment and labour employment.
 To study the impact of technical changes on farm business.
 To find out ways and means for increasing the efficiency of farm business through better
input -output relationship and proper allocation of resources among different uses.
Why do some farm businesses grow and expand, while others struggle to maintain their size?
Why the Difference? Usually this is due to the Management. Observation and analysis often had

the same conclusion. The differences due to management can be shown in

three main areas;
1. Production differences; includes choice of agricultural commodities to be produced and how
they are produced.
2. Marketing differences (includes)
 When, where, and how of inputs are purchased and selling commodities(products) (prices
differences)
3. Financing covers ,not only borrowing money and related questions of when, where and how
much, but also the entire area of how to acquire the resources necessary to produce

agricultural commodities.

The risks have to be considered in all the three areas(pxn,financing,and marketing) – i.e. how a
farm manager adapt to and handle the risks can have a major impact on profit.
Good or bad luck cannot explain all the differences observed in the profitability of farms even
among those, which have about the same amount of land and capital available.
In every association or system, management is the key ingredient. The manager makes or breaks
the business. In agriculture, management takes a different dimension especially with uses of
many technological innovations, and mechanisation.

1.3 Nature and Characteristics of farm management

Some characteristics of farm management are:
a. It s a practical science, because it aims with testing the applicability and practicability
of innovation at farm level
b. It is also studies with the practical problems with the practical solutions

c. It is also profitability oriented; this means agronomists interested in maximum

yield but economists interested in maximum return/profit. Farmers also interested in

maximum return not maximum yield.

d. Farm management concerns with economic efficiency not physical (technical)
efficiency. Physical (technical) efficiency mean quantity, but economic efficiency means
money.
Relation Ship of Farm Management with Other Sciences

Basically farm management is economics in the context of fundamental definition of

economics which involves three elements, viz. the scarcity of resources, their alternative uses &
the objective of profit maximization. It is a science which deals with making rational,
profitable & economic recommendations to the farmers. It also deals with the growth & stability
aspects of economics. why do we call FM is economics ……..

The basic information about the multiple (alternative) uses to which the scarce resources can be
allocated is supplied by other physical & biological sciences. The research in these sciences
should continually generate the relevant data on alternative technologies & practices whose
profitability can be tested under actual farm situations. And these data are required for the farm
organization as a whole & not far for a single hectare, animal or tree.

The challenge to the farm management specialist is to be able to integrate & synthesize the
diverse pieces of information from many disciplines such as agronomy, animal husbandry,
horticulture, soil science, plant breeding, entomology, plant pathology, general economics,
sociology & psychology, into an optimum 'package' which can be used on the farms with profit.

Agricultural scientists mainly put emphasis on the maximization of yield rather than on the use
of the optimum level of resources. But the goal in farming is not to make a profit on some single
enterprise or from a part of the farm land but to use land, labour, & capital resources in such a
way that they make the greatest contribution to the total profits from the entire farm. The
superiority of this discipline, thus, lies in its treating the farm as an operational unit &
tailoring the recommendations of all other disciplines to fit into an individual farmer's pattern
of resources.(what is the superiority of fM discipline???
In the context of the recent technological breakthrough, management today should be viewed as
a process within a rapidly moving frame of reference. "It is now more scientific, less artistic;
more dynamic, less static; more versatile & less rigid". Farm management is forward-looking
in its approach. Its task is not so much the improvement of the present farming practices but of
the establishment of the whole sets of new production methods & farming systems which would

put our agriculture on a continuously rising growth curve. what is the task of
fm////?????
Government policies should change the economic environment to help the interests of the
farmers to converge on the national goals. Studies on farm management to determine the
 responsiveness of the farmers to different levels of prices become extremely relevant in inducing
the farmers to produce the quantities of different agricultural products & services needed by
society. A rational pricing policy is needed. For e.g. Canal water, is charged for without any
direct relation to the quantity supplied. As a result, there is no incentive to the farmer to allocate
water in the most economical manner. Farm management helps to identify such uneconomic
practices & the most limiting factors. Irrigation or power (the bullock versus the tractor) may be
a more important restriction than the limits imposed by land. In areas where water rather than
land is the principal limiting factor & the marginal-value productivity of irrigation water is very
high, it should be most carefully used rather than over irrigating a few hectares of crops needing
high water consumption.
Good farm management can lead to a highly productive use of farm resources & can avail itself
of the technological revolution now going on in our agriculture.

The graphical relationship of farm management with other sciences

Physical and
Economic relation ship
biological
relationship  Basic economic principles
 Agronomy  Agricultural marketing
 Soil science  Price analysis
 Agricultural  Agricultural cooperation etc.
engineering
 Animal
husbandry
 Plant
breeding
 Entomology

FARM MANAGEMENT

Supplementary sciences
 Statistics
Social relation ship
 Maths
 rural sociology
 Political
 psychology ex. Ethics,
relationship( political
religion, habits, culture,
science , laws) ex. tenure
values, customs
systems, ceiling of land
holding, subsidies, food and
These all guides/help to solve economic problems associated with maximization of returns and
minimization of cost.
The farm manager (agricultural economists) combines all the above information's got from
different disciplines and come in to decision. i.e. the point of optimum utilization of resources.
The agricultural engineers, agronomists, livestock scientists cannot determine or decide, what
type of implement to be used and the point of optimum is decided by the farm manager.

1.4 Farm Management Problems under Ethiopian Condition

1. Small size of farm business
In Ethiopia:
 80- 90% of labour force engaged in agricultural sector
 Agriculture has about 50% contribution to GDP
 Agricultural sector also covers 90% of export earning
 Average land holding size 0.75ha and fragmented, difficult to manage or prepare farm
plan
 High family size
 High dependency ratio
 less application of - intensive farming
- Technology
- double cropping
But in developed countries:
 3-4% of labour force engaged in agricultural sector
 industrial sector contributes more to GDP
 main export earning is industrial sector
2. Farm as a house hold:
  Work habits of the farmers are closely related to food intake, sanitation and living
condition as a whole
 Use of similar farming system
 Less application of specialization and diversification principles
 Subsistence farming, not promoting commercial farming
3. Inadequate capital: farmers do not have enough capital. On top of this, lack of availability of
credit at required time, amount and need of collateral also other problem to farmers. Due to this
farmers use less of modern technologies like;
o fertilizer, improved seed
o Different farm implements (water harvesting technologies, motor pumps etc.
o irrigation technologies
4. under employment: it means that farm family seems to be employed but not fully employed
due to:
 Small size of the farm
 Large family labour supply
 Seasonal nature of agricultural production
 Lack of subsidizing or supporting industries
 Lack of off-farm employment activities like petty trade,
This condition creates:
 Economic frustration
 Social tension
 Laziness/idleness
This in turn also reduces efficiency and productivity of rural farm.
5. Slow adoption of innovation: low income farmers are usually conservative and most time
skeptical to adopt the technology easily. This is due to risk aversion. There are farmers who
prefer risk and there are also farmers who prefer averse.
Risk preference: a person who wants to take a risk and maximize profit.
Risk averse: a person who does not want to take risk and wants to get a usual profit.
6. Inadequate supplies of inputs: farmers face problems, in getting improved technologies, at
required time, quantity, place and reasonable price.
7. Lack of managerial skill:
  the problem of solving economic problems
 managers are scarce
 illiteracy of farmers
 farmers wants to produce as usual
8. Lack of infrastructure
 lack of transportation facilities to transport the products
 Lack of price information about input/out put
 Lack of communication facilities etc.

1.5 Type and Systems of Farming

There is confusion in the definition of two terms in mind of students. The two terms do not have
the same meaning.
Types of farming: refers to farm types, the nature and degree of products and combination of
products being produced and practices used for to produce. The type of farming includes;
 The type of product to be produced
 The size and volume of product and practice adopted for production

Systems of farming: refers to/ concerning with the organizational set up (owner ship) under
which the farm is run. It includes the question of;
 The owner of the land
  How resources are pooled
 Who make the managerial decision,

A). Types of farming:

Farms can be classified in to different categories based on;
 size and scale of production
 the type of product to be produced,
 practices adopted for production
 the size & volume of products

I. Based on size and scale o f p r o d u c t i o n : f a r m s c a n b e c l a s s i f i e d a s s m a l l , m e d i u m , a n d l a r g e - s c a l e f a r m s . The problem with

this classification is that there is no clear demarcation among these different sizes like, number of employees, size of land, amount of profit, amount of input used etc.

II. Based on the type of product to be produced: and the size and volume of

products & practices to be adopted for production, the major types of farming
are as follows:
a. Specialized and diversified farming
b. Mixed farming
c. Dry and irrigated farming
d. Ranching
a). Specialized and Diversified Farming;
Specialized farming means that:
 If > 50% income generates from a single enterprise either crop/livestock
 The major resources are devoted on a single enterprise
 It assumes a nature of commercial farm/ business oriented

Diversified farming means that:

 the opposite of specialized farming
 a number of enterprises are taken up in the farm
 No one of single enterprise is more dominant
 no major resources are devoted in a single enterprise

b) Mixed farming:
  combination of many enterprises of independent in nature resulting in certain aspects of
diversification
 the difference between mixed farming and diversified farming is that in mixed farming
enterprises are of independent in nature
Advantages of mixed farming:
 crop provides fodder for animals
 The live stock also gives manure to the crop. both are to the productivity of the others,
complementary enterprises
 livestock provides drought power for transport
 Improve the utilization of labour i.e. the existence of the two enterprises does not require
additional labour. it increases labour productivity
 Greater chance for intensive cultivation leads to highest yield of crop

c) Dry and irrigated farming

Dry farming: generally refers to farming which should be under taken in an area which receives
an annual rain fall of <500mm. Moreover when rain is 750mm and, coincides with high
temperature and high wind velocity, it is categorized under dry farming. In modern classification
it is defined as successful growing of crops in areas where lower sufficient rains fall.
Irrigated farming: refers to the artificial source of water and crops are growing in areas where
water is not sufficient or water not well distributed all over the farm.
 Using irrigation as a supplementary of rain feed agriculture
 Using irrigation for double cropping/ intensification
d) Ranching: mean that raring of animals, especially sheep and goat in a communal /public land.

Factors determining the types of farming :

These might be i.) Physical factors
ii.) Economical factors
i) Physical factors: the most important physical factors affecting the type of farming are climate,
soil type, and topography.
Climate: including total amount of rainfall, minimum and maximum temperature, storm, strong
wind, sun shine etc…
soil: soil depth, fertility of soil, acidic or alkaline, soil structure and texture, soil type/ red, black,
brown etc./
Topography: refers to the slope of the place where the farm is established. This is because
different crops are produced in different altitude (elevation). Example, use of machine is difficult
in high lands
ii). Economic factors:
Comparative and absolute advantage
Marketing costs

 distance between the farm site and consumers}factors affecting marketing costs

 the nature of the product and value of product}

Example; always vegetable farms and dairy are established around the consumer's site (near
to city).
Location of processing plant
Availability of capital

B). systems of farming

Based on the organizational set up (owner ship) under which the farm operates, systems of
farming classified as follows:
a) Peasant farming / traditional farming
b) State farming
c) Capitalist farming
d) Collective farming
e) Cooperative farming
f) Institutional farming
a) Peasant farming:
Objective- Fulfilling their basic needs
Management- individual cultivars (private), the farmer is the owner, organizer and the manager
of his farm.
- Resources are limited as compared to others
Advantage: - it helps to take any decision as quickly as possible.
b) State farming:
Objectives_ supplying basic commodities to the market or the society
-Improving social welfare
-Price regulation
Management-operation and management made by the state or officials selected by
Government
- Labourers are payable temporary or permanent
- Workers have no full right to decide about the farm (centralized decision)
Disadvantage- no immediate decision, but farms require immediate decision at spot
c) Capitalist farming:
Objective- maximizing profit
Management- private, elected by boarded of directors.
- owned by individuals or group of individuals
-plenty of resources
- Use of modern technologies
- Decision made by board of directors
Advantage- good supervision and strong organizational set up
Disadvantage- it might be create social imbalance, if few peoples are outsmarted others
are as it is.
d). collective farming
Objective: Equality of the people (even distribution of income)
 Common in communist countries
 Resources are pooled for a common managerial decision (land, livestock, machinery
etc.)
 Equal share of incomes/ not depend on your equity share
 Once you are a member , you cannot exit with your share resource
 Mostly done by the initiation of government not by the society

Disadvantage: Members are discouraged

e). Cooperative farming
Objective: improving the living standard of its members
 - To get service, which they cannot get individually
- Price regulation or stabilizing the market price
Management- an autonomous body elected from the members
- Voluntarily membership, resources are pooled voluntarily based on the interest
of the individual.
f). Institutional farming: Like farms owned, organized and operated by universities, Research,
Institutions, schools, church, mosques etc.
Objectives- fulfilling the basic needs of the institutions
Management- institution itself

Chapter two
2 Production Relation Ship
2.1 production resources
What are Productive resources? Resources are inputs which are used for further production.
These are also known as factors of production. These are basically,
 Land
 Labor
 Capital
 Management
 Technology and marketing/ demand

1). Land: refers to all natural resources that can be used as inputs for production such as
minerals, water, air, forests, oil and even such intangibles as rainfall, temperature, and soil
quality(soil texiture ,profile, fertility, acidity…..) The key distinction between lands consists of
natural resources or conditions improved by labour or capital expenditure. In short, land is the
short hand extension for natural resources. The payment to land is called rent.
2) Labour – is the physical and intellectual exertion of human beings in the production process.
It embraces a wide variety of skills in specialized trades and occupations, and abilities of
organization and management that are crucial in the productive process. It is clear that some
labour is valued (paid) more than other labour. This is because labour, like land, can be much
more valuable. This occurs when individuals devote money and time to increasing their labour
skills. We refer to this development of labour skills as investment in human capital- the
accumulation of labour enhancing abilities, including health that increases labor’s productivity.
Wages are the resource payments that entrepreneurs make for the use of labor.

3) Capital- refers to all man-made aids (past human efforts) to production, the tools and
production factors, warehouses, stocks of inventories, etc. The term is, however, used in a
number of ways. Capital in its economic definition is the machinery; the tangible equipment that
used to produce other capital can purchase or rented. The payment to capital is called interest.
What is capital in its economic definition????
4) Management/Entrepreneur:
 it is the major and last component of factor of production
 describes the task of making decision and implement these decisions
 It is mental /soft ware energy of human being used in production to organize, lead, direct
and take risk and bear responsibility. Its reward is profit.
Production
Production: is the process of changing economic resources in to output.
Input production output
Inputs: a wide variety of inputs used in production. Like fixed and variable inputs.
Fixed inputs: is the one whose quantity cannot be varied during the period under consideration.
Ex. plant, Equipment
Variable inputs: are inputs whose quantity can be changed during the period under
consideration. Ex. raw material, labour, power, transportation etc.
Time period of production: the fixity and variability of an input depends on the length of time
period under consideration.
Economists classify time period in two categories:
a). short run: is that period of time in which some of the firms inputs are fixed.
b). long run: is that period of time in which all inputs can be changed. No fixed inputs in the long
run.
 2.2 PRODUCTION FUNCTION:
It is the physical relationship between input and output. The relationship shows the rate of
transformation of input to output.
The production function is generally written in the form of equation:
Y= f (X1, X2, X3, -----------, Xn)
Where; Y= output level
Xi= inputs in the production process
f= function
To be specific the production function can be expressed in terms of:
 Tabular form
 A graph
 An equation/ algebraic
Production function rest on two main assumptions:
1. Technology is invariant (fixed): if the technology changes it would result in an alteration
of the input- output relationship depicted by the production function.
2. It s assumed that firms utilize their inputs at maximum level of efficiency.
There are numerous relationships between the resources and farm products, both simple and
complex. The major production relationships fall under three categories;
1. Factor –product relationships or input-output relationship-production function: this
relationship is concerned with resource allocation to optimum production.
2. Factor-factor or input –input relationship or input combination: this relationship is concerned
with minimizing cost at a given level of output.
3. product-product relationship or output- output relationship or enterprise combinations: this
relationship is concerned with optimum combination of out puts for a given input level.

2.3 Factor-product or input –output relation ship

A basic concept in economics is the production function. It is a systematic way of showing the
relationship between different amounts of resource or input that can be used to produce a product
and the corresponding output or yield of that product. In economics out-put or yield is generally
called total physical product, which will abbreviated TPP. In other agricultural disciplines, the
same relationship may be called response curve, yield curve, or input/output relationship.
Whatever the name is, a production function shows the amount of output that would be produced
by using different amounts of a variable input. It can be presented in the form of:
 A table/tabular presentation or tabulation

 Graph

 Mathematical equation.

a).A table/tabular presentation or tabulation:

i. for short run production function

units of input capital TPP APP MPP

(labour in hour)

1 5 5 5 5

2 5 11 5.5 6

3 5 18 6 7

4 5 25 6.25 7

5 5 30 6 5

6 5 32 5.3 2

7 5 32 4.3 0

8 5 28 4.5 -4

TPP (Total physical product): it is the amount of product produced by different quantities of the variable input used.

APP (Average physical products): It is possible to calculate the average amount of out-put or
TPP-produced by each unit of input at each input level. This value is called average physical
product (APP).APP is calculated by the formula:
TPP
APP = X

MPP (Marginal physical products): The first marginal concept to be introduced is marginal
physical product (MPP). Marginal means additional or extra .MPP is the additional or extra TPP-
produced by using an extra unit of input. It requires measuring changes in both out-put and input.
Marginal physical product is calculated as:
ΔTPP
MPP =ΔΧ
Marginal physical product can be positive or negative. It can be also zero if change in input level
causes no change in TPP.A negative MPP indicates too much variable input is being used
relative to the fixed input/s and this combination depresses TP
out put is depressed when we use too much variable inputs relative to

fixed inputs

b. Mathematical presentation of production function

y=f(x) where y=dependent variable (output resulting from the production process)
x = an aggregate independent variable (input that we change)
f= function
y = f(x1|x2----------- xn) for short run production
where x1 = the variable/ input ,Example; fertilizer
X2-xn=all fixed inputs for short period of time (e.g. land, capital, etc.)
Therefore, the variation of y depends on the variable input x1.
Example by considering a linear production function
y = a+bx or y = 20+4x
Where, a indicates the amount of y to be produced with non use of x
b, indicates the slope of linear curve or marginal product we get from use of one
additional unit of input x
Q.y=a+bx, what is the amount of y that will be produced with out x & what is the value of MP?

c. Graphical Illustration of a production function

Notice that TPP or out-put increases at an increasing rate as the input level is increased from
zero. As the input level is increased further, TPP continues to increase, but now at a decreasing
rate, and eventually begins to decline
absolutely as too much variable input is used
relative to the amount of fixed input/s
available. This is due to the principle of
diminishing returns
Stage -I

 it extends from the origin to the point of APP at maximum(MPP=APP)

 at the end of stage -I, MPP curve crosses APP curve
 more of fixed input, less of variable inputs comparatively(fixed inputs not fully utilized)
 MPPx>APPx
 slope TPPx>APPx
 MPP starts to decline
 Uneconomical region
 EP becomes negative when we use too much variable inputs relative to the fixed inputs.
 TPP stsrts to decrease when we use too much variable inputs relative to the fixed input.
 MPP start to decline when we use too much fixed inputs
relative to variable inputs....& it is negative when too much
variables are used.
Stage-II
 starts from MPP=APP(APP maximum) and ends up where MPP=0i.e. TPP is at
maximum
 TPP increases at deceasing rate(MPP is decreasing but it is between 1&0)
 APP>MPP
 APP starts to decline(MPP is < APP)
 Economical region that Economic optimum is found
 But we cannot pin point the optimum production point by looking at the physical output
only.

Stage -III
 starts ,where MPP=0 or TPP at its maximum
 TPP starts to decline
 MPP negative
 negative returns(loss)
 APPx>MPPx
 more of variable inputs
 Uneconomical region
 When MPP is negative return will be loos.

Relationship between TPP, APP and MPP

TPP Vs MPP MPP Vs APP
  When MPP increases TPP increases at  When MPP greater than APP,
increasing rate APP is increasing
 When MPP decreases but greater than  When MPP is equal to APP,
zero, TPP increases at decreasing rate APP is at maximum
 When MPP=zero, TPP is at its maximum  When MPP is Less than APP,
 When MPP< zero, TPP declines APP is decreasing
The Law of diminishing returns: The law stated that, if increasing amounts of one input are
added to a production process, while all others inputs are held constant the amount of output
added per unit of the variable input will eventually decrease. The law is a generalization based on
experience that the use of increased inputs leads to less than proportionate increase in output.

In order to determine at what point in stage II one should operate, one needs to know the price of
outputs and costs of inputs. Multiplying the quantities of inputs and products with the respective
prices we can convert the physical production function in to cost and revenue functions. The

optimum level of input use will be where additional cost of an input is equal to the
additional revenue which the input yields (MC = MR) or it is where the value of the marginal
product equals the price of the factor in the market (MVPx=Px). or when Px*MPPx=Px

Marginal revenue (MR): is defined as the change in income or the additional income received
from selling one more unit of output. It is calculated from the equation
MR = ∆ total revenue
∆total physical product
Marginal Cost (MC): is defined as the change in cost or the additional cost incurred from
producing another unit of output. It is calculated from the equation:
MC = ∆ total input cost
∆ Total physical product
Summary: Rule of profit maximization

Stage-I ΔΥ
>
p x
The quantities of the variable inputs used are so small
relative to the fixed input that much of the fixed input wasted.
ΔΧ
p y
hence, produce more by using more units of input for profit
MR>MC maximization(Expand output)

Stage-II ΔΥ
=
p x
Optimum level of input use for profit maximization. Both the
variable input and fixed input are being used in efficient
ΔΧ
p y
amounts relative to each other
MR=MC

Stge –III ΔΥ
<
p x
There is over use of input relative to fixed input. Since, the
MP of the input is negative; more of the input actually makes
ΔΧ
p y
the output decline.(reduce input used)
MR<MC
At stage 3 mp of input is negative
Table 1 Factor - product relationships and economic decisions Analysis

Physical relationships Economic relationships

Input TP MI MP MC MR TR TC NR

0 2 - - - - 6 0 6

1 5 1 3 4 9 15 4 11

2 9 1 4 4 12 27 8 19

3 14 1 5 4 15 42 12 30

4 21 1 7 4 21 63 16 47

5 26 1 5 4 15 78 20 58

6 30 1 4 4 12 90 24 66

7 33 1 3 4 9 99 28 71

8 35 1 2 4 6 105 32 73

9 36 1 1 4 3 108 36 72

10 36 1 0 4 0 108 40 68

11 35 1 -1 4 -3 105 44 61
12 33 1 -2 4 -6 99 48 51

Price per unit of input to be = birr 4

Price per unit of product = birr 3

We can see from the table that profit is maximized where:

 MR=MC
 ΔY/ΔX= Px/Py
 MVPx= Px-----or-----MPPx*Py=Px
Profit it maximized at Birr 73 by using 8 units of inputs.
We use net revenue method if MR=MC is not existed.
From production function equation
2 x −0 .1 x
2 3
y=3 x +
Find MPPx, APPx and Value of X when profit is maximized.
Let PX=100Br. per unit and Py=20Br.per unit
Solution:
2

MPPx= ∂ Χ
∂Υ
=3+ 4 X−0 . 3 x
--- (first derivative)
2

APPx= X
Y
=3+2 X −0 .1 X
Value of X when profit is maximized:
Profit is maximized at a point where:
Py (MPPx) =Px
x
2

20(3+ 4 X −0 .3 ) =100

√b
2
−b± −4 ac
x= 2a

2. 4 Factor-Factor Relationship (the question of Input substitution)

The particular concern of this section is with the possibilities of substituting one factor (X 1) for
another factor (X2) as product level (Y) is held constant. Thus, the objectives of this analysis of
factor-factor relationships are twofold:

 Minimization of cost at a given level of output, and

 Optimization of output to the fixed factors through alternative combinations of
resource use that produce a unique amount of output.
2.3.1. Iso-quants
An iso-quant is the locus of all technically efficient methods (all combinations of factors of
production) for producing a given level of output; i.e. it shows the different combinations of two
inputs that can be used to produce a given level of output.

Table 2 combination of two inputs X2 and X1 to produce a given level of output

X2 X1 ΔX1 ΔX2 MRS

23 0 -
16 1 1 7 7
10 2 1 6 6
5 3 1 5 5
1 4 1 4 4
0 5 1 1 1

2.3.2. Iso-Cost Lines and Least Cost Combination

Iso-Cost Lines

We have seen the iso-quant curves in the previous section. In this section, with related concept,
we will discuss about the iso-cost lines.

Just as an iso-quant can be constructed to indicate all possible combinations of inputs which will
produce a given quantity of output, an iso-cost line can be drawn to indicate all possible
combinations of two inputs which can be purchased with a given outlay of funds. Each
combination of two inputs has some total cost which includes the costs of two inputs (X 1 and X2)
combined. Since total outlay is a function of the amount of X 1 and X2 used, it can be graphed in a
manner similar with the production surface. Just as a production surfaces are characterized by
iso-quant, similarly total outlay surfaces can be described by iso-cost lines.

Suppose for example, a farmer has Birr 36 to spend on two variable inputs X 1 and X2. The cost
per unit of X2 is 4 birr and that of X1 is 3 birr.

He may either purchase 12 units of X1 or 9 units of X2.

These two points can be located on the graph as shown below

When the two lines are connected by a straight line, the result is iso-cost line for total outlay. On
this line, he can trace any number of combinations of the two inputs which will cost the same.

Figure 1 Iso-cost line

Mathematical equation of the iso-cost line can be obtained by

T =P X 1 X 1 +P X 2 X 2

For X1 as an explicit function of X2,

X 1=
T
−
[ ]
PX 2
PX1 PX 1 2
X

Least– cost combination

The different concepts discussed above can be used to determine the combination of inputs
which will produce a given output at a minimum cost. A given level of output can be produced
using many different combinations of inputs. Here the problem is to find out a combination of
inputs which should cost the least; a cost minimizing problem. There are three methods to find
the solution to cost minimization problems.

Simple arithmetic calculations

One possible way to determine the least-cost combination is to compute the cost of all possible
combinations and then select the one with the minimum cost. This method is suitable only where
a few combinations of inputs that produce a given output and calculations involved are few and
simple.
Suppose there are five combinations of inputs which can produce 85 units of output as it has
been given in the Table below. The price per unit of X 1 is 3 Br and that of X2 is 4 Br. Compute
the least cost combination of the two inputs.

Table 3. Combinations of inputs that produce the same level of output

Units of X1 Units of X2 Cost of X1 Cost of X2 Total cost

8 2 24 8 32

6 3 18 12 30

5 4 15 16 31

4.5 5 13.5 20 33.5

3.5 6 10.5 24 34.5

Out of the five combinations calculated, 3 units of X 2 and 6 units of X1 is the least cost
combination of inputs i.e. 30 Birr.

Algebraic method

Procedures for finding the least cost combination is

Find the MRS (ΔX2/ΔX1)

Compute the price ratio (PX1/PX2)

Equate the above two

ΔX 2 P1
=
ΔX 1 P 2

Therefore, the least cost criterion is that MRS of X2 for X1 should be equal toPx1/Px2

Px1. ΔX1 = Px2. ΔX2

Graphic method

Since the slope of the iso-cost line indicates the ratio of factor prices and slope of the iso-product
curve represents the marginal rate of substitution, minimum costs for a given output will be
indicated by the tangency of the two curves.
Slope of iso-quant = slope of iso-cost line

Given the iso-quant is convex; the least-cost combination of inputs will be at the point where the
iso-cost line is tangent to the iso-quant.

SUMMARY OF RULE OF DECISION

Rule Marginal rate of Price Ratio Under principle of Substitution
substitution
ΔΧ 2 P x1
Increase the units of X1 or
1 ΔΧ 1 decrease units of X2
(ΔX2*Px2) > P x2

(ΔX1*Px1)
ΔΧ 2 P x1
Increase the units of X2 or
2 ΔΧ 1 < decrease units of X1
(ΔX2*Px2)
P x2

(ΔX1*Px1)
ΔΧ 2 P x1
Least cost combination of
3 ΔΧ 1 = inputs. Any combination for
(ΔX2*Px2)
P x2 minimum cost.
(ΔX1*Px1)

2.5 Product- Product Relationship (Output-Output Relationship)

The economic principle of choosing what to produce is the principle of comparative advantage
which states simply that each unit of resource should be used where it will earn the greatest
return.

Some resources are limited in supply. So, enterprises will compete with each other for some of
these fixed resources. Therefore, expansion of one enterprise will be accompanied by a reduction
in the other.

2.4.1. Production Possibility Curves (PPC) and Iso-revenue curve

Production possibility curve(PPC/f) represents a locus of all possible combinations of two
products which can be produced from a given amount of input. For example, the level of outputs
of two enterprises Y1 and Y2 for a given level of input of 100 of capital are given in Table 2.7. If
we plot the data on a graph, we will get a curve known as production possibility curve (Fig 2.11).

Table 4. Product-product relationship

Input Uni of outputy1 Unitofoutput y2

100 30 0
y1 (Y2)
100 25 25
100 15 45
100 0 52.5

Figure 2. Production Possibility Curve.

Iso-revenue line

Indicates the different combinations of two products, which can give the same amount of
revenue or income. The slope of iso-revenue line is represented by the ratio of prices of two
competitive products.
Example: A farmer can get a revenue of birr 100 from the sale of two products (Y 1 and Y2). If the
price of the first output (Y1) is birr 10 and the second output (Y2) is birr 20, the farmer need to
sell different combinations of the two outputs as indicated in the table.

Y1 10 8 6 4 2 0

Y2 0 1 2 3 4 5

If we plot these data on a graph, we will get the line is known as iso-revenue line.

Figure 3 Iso-revenue line

Characteristics of an iso-revenue line

1. The position of the iso revenue line shows the magnitude of the total revenue. If the total
revenue increases, the line will move further away from the origin

2. A change in price one of or both product is accompanied by a change in the slop of the iso
revenue line.

2.4.2. Determination of optimum product combination

Arithmetic calculation

Example: assume there are only 10 units of inputs given. The price of maize is birr 7 per quintal
and that of wheat is birr 10 per quintal. What is the profit maximizing combination? (Price of
input is 40 Birr per unit).

Table 5. Product-Product relationship

Yield of Yield of wheat Return Return from Total Total Profit

Maize from
(Y1) (Y2) maize maiz wheat return cost

0 78 0 780 780 400 380

10 76 70 760 830 400 430

20 72 140 720 860 400 460

30 67 210 670 880 400 480

40 60 280 600 880 400 480

50 48 350 480 830 400 430

60 28 420 280 700 400 300

70 0 490 0 490 400 90

Table 5 above shows that profit maximizing combination is 40 units of maize and 60 units of
wheat with a maximum profit of 480 birr..

Graphically

Since the slope of the iso-revenue line indicates the ratio of product prices and slope of the
production possibility curve represents the marginal rate of product substitution, maximum profit
for a given level of input will be indicated by the tangency of the two curves.

Slope of production possibility curve = slope of iso-revenue line

Given the production possibility curve is concave; the optimum combination of outputs will be at
the point where the iso-revenue line is tangent to the production possibility curve. The graph
illustrated as shown below.

Figure 4. Optimum output combination

Activity 8:

1. What are the different types of production possibility curves?= constant,decreasing and
decreasing MRPS

2. There are six types of relationships among different enterprises. Explain all of them.

Chapter 3
3 Economic principles applied in farm management
3.1 The principle of Cost

The term cost of production refers to the total amount of fund used for purchase of
different fixed and /or variable inputs employed in the production process.

Cost of production exists because the supplies of productive resources are scarce and has market
value. The costs of production usually calculated in relation to a particular amount of product
(per unit of output) in a particular time period because the cost of production in any particular
period include the value of the resource/services transformed into a product in that single period
rather than the value of the resource itself. The resources used in the production may be:

Poly - period resources: refers to resources for which only a part of their services is transformed
in to product in each distinct production period (example tractor services).

Mono - period resources: represent a stock of services (seed, fertilizer), where the entire stock
of their services is transformed into production in a single period.

For example, in the production of one quintal of wheat, there are different costs involved.

Fertilizer, seeds, etc. which are transformed into product during the production period and other
cost items such as tractor services, and land, etc. of which only a part of their total service goes
to the production process. Costs should, thus, be considered with relation to a specific time
period in order to make rational decision. Without specifying the amount cost and the time
period, any reference to cost will be meaningless.

Before moving to the details of the principle of cost of production, let us briefly discuss about
explicit and implicit costs

Explicit and Implicit costs

Explicit Cost: The term explicit cost refers to those expenses that are actually paid by the
producers for purchase of different inputs in the production process. In other words, any expense
or payments made to those outsiders who are supplier of labour services, raw materials, fuel,
transportation services, power etc. to the firm are called explicit cost. It is also called cash cost.
The value of purchased inputs (explicit costs) is usually determined by market price (accounting
price) of that particular input. Such costs usually appear in the accounting records of the firm.

Implicit Cost: The term implicit cost refers to the earning of those employed resources, which
belong to the owner him/herself in the production process. The value of self owned inputs
(implicit costs) should be inputted or estimated from what they could earn in their alternative use
which is called opportunity cost of that input.

Examples of these costs are:

The salary of owner manager,

 Depreciation cost of a building that belongs to the owner of the farm,

 Depreciation cost of a tractor or other fixed farm equipments, which belongs to the owner
of the farm,
 Interest forgone when the owner uses his capital in his farm, etc.
 The total cost of production is the sum of explicit cost and implicit cost.
Economic (opportunity) cost

Opportunity cost is the economist’s concept of costs of production that are based on the fact that
recourses are scarce and have alternative value. That means, when resources are used for certain
production activity other alternative products must be forgone. Therefore, production of one
product entails giving up so much of the opportunity to produce something else because
recourses are used for production of the first product.

Opportunity cost, therefore, means the value forgone because the resource was used for another
purpose. In other words, it is the return which must be given up in the next best alternative use.

Suppose, for example, by using 3 quintal of fertilizer , a farmer can add birr 300 to the total
revenue from wheat production and birr 250 total revenue from maize production. If that farmer
fertilizes his maize, his opportunity cost is birr 300, which he has forgone by not fertilizing his
wheat. On the contrary, if that farmer fertilizes his wheat, his opportunity cost will be birr 250,
which he forgone by not fertilizing his maize.

Accounting periods

On the bases of length of period for different inputs to get transformed into outputs, planning
period can be divided into two categories: short run and long run. These periods are time
concepts, but are not defined as fixed time periods.

Short-run is that a period of time which is long enough to permit desired changes in output
without altering or changing the size of the farm. In other words, it is a period of time during
which one or more of the production resources are fixed in amount and can’t be changed.

That means in the short run, we have two major categories of inputs: fixed inputs and variable
inputs. Usually capital equipment and entrepreneurship are considered as fixed inputs and labor
and raw materials can be taken as variable inputs in the short-run. Consequently, costs are of two
types: fixed costs and variable costs. During this period the firm can expand or contract its output
only by varying the amounts of variable inputs.

Suppose there is a farm, which produces milk with 12 cows. Further suppose that with the rise in
demand for milk, prices rise and intern the margin of profit increase. In such cases, the farmer
will be encouraged to increase his production either through purchasing and maintaining more
cows, which may not be possible immediately, or bring about change in feed-mix and level of
feeding, which do not require change in the size or scale of the business (number of cows) but
increase production. That means, with in that short period, the number of cows remain to be
fixed and any change in the level of output will be achieved through change in the level of
variable inputs.

Long-run is that period of time over which all factors of production can be varied. That means,
in the long-run, all inputs are variable and hence all costs are also variable.

Suppose the farmer may expect that wheat production is going to be more remunerative in the
future years. In this case, the farmer may try to increase land by purchasing or leasing in and he
may improve his productive capacity by installing new tractor, hiring more labour, using more
fertilizer, seed etc. In this case, the farmer can get sufficient time period that is needed to change
the size/scale of the holding (business).
2.5.1. Production cost in the short-run
As it has been briefly indicated, we have two major categories of costs in the short-run: fixed
costs and variable costs.

Total Fixed Cost (TFC)

Fixed costs are costs associated with owing fixed inputs. These are costs, which are not changed
in magnitude as the amount of output of production changes and incurred even when production
is not undertaken.

Fixed costs are costs of the investment goods used by the firm on the idea that these reflect a
long-term commitment that can be recovered only by wearing them out in the production of
goods and services for sale. They consist of both cash and non cash fixed costs. Fixed cash cost
includes: land tax, interest on borrowed capital, insurance premium, annually hired labour wage,
rent for building or machinery etc. Fixed non cash cost includes: depreciation cost of buildings,
machineries and other fixed equipments, interest on own capital investments etc.

Total Variable Cost (TVC)

Variable costs are costs that are incurred in using variable inputs. Therefore, these costs increase
with the increase in the level of output of the firm. This means, the variable costs of production
are incurred by a firm only when there is an output. Cost items such as wages paid to laborers,
payments made to the raw material suppliers (like feed, fertilizer, seed, chemicals etc.) payments
made to the fuel suppliers and transportation agencies etc. are examples of variable costs. TVC S
are computed by multiplying the amount of variable inputs used by the price per unit of input.

TVC = Px * X

Where: Px is the price of input

X is the level of input

Total cost (TC)

The total cost of production is a sum of total fixed cost and total variable cost. In the short run, it
will increase only as TVC increases, as TFC is a constant value.
 Figure 5. Total, fixed and variable cost curves

Figure 5 shows the shapes of TFC, TVC and TC curves. The fixed cost curve starts at some
point above the origin and it is horizontal. The TVC curve starts from the origin and it slopes
positively upwards. It indicates that the variable cost is zero when the level of output of a firm is
zero and these costs increase with the increase in the level of output. Since it is the sum of TFC
and TVC, the TC curve has the same shape as the TVC curve. However, it is always higher by a
vertical distance to TFC.

Average (Per unit) Cost

Costs may be more meaningful if they are expressed on a per-unit basis, as averages cost per unit
of output (Q). The average costs are:

 Average fixed cost (AFC),

 Average variable cost (AVC), and
 Average total cost (ATC).
Average fixed costs (AFCs): are costs obtained by dividing the total fixed costs (TFC s) by the
level of output.

TFC
AFC=
Q
Table 6 shows the AFC column is computed by dividing the AFC column by the different
quantities of output (Q). As the rate of output (Q) increases, TFC remain the same, and the AFC
becomes smaller and smaller. The corresponding AFC curve, as shown in fig.6 is also down
ward slopping to the right throughout its entire length.
As the quantity of output increases, the AFC curve approaches but never touches the output axis.
This indicates, a farm can reduce substantially its cost per unit by producing larger quantities of
output (Q). Therefore, for every small level of output, AFC is high and for larger output it is low.

Average Variable Costs (AVCs): are obtained by dividing the total variable cost by the
respective level of output (Q).

TVC
AVC=
Q
In the Table 6 the AVC column is computed by dividing the TVC column by the different
quantities of output (Q) using the above formula.

The AVC may be either increasing or decreasing depending upon the underlying production
function or average productivity of inputs. For a given production function, AVC will initially
decrease as output is increased and then will increase beginning at the point where average
physical product (AP) start to decline.

As shown in fig. 8, the AVC cost curve is inversely related to average physical product (AP),
i.e., when AP is increasing, AVC is decreasing. When AP is at its maximum, AVC attains its
minimum. And when AP is decreasing, AVC is increasing.

Table 6. Cost relationships

Output
TFC TVC TC AFC AVC ATC MC TR MR Profit
(Q)

0 20 0 20 - - - - 0 - -20

2 20 5 25 10.00 2.50 12.50 2.50 6 3 -19

5 20 10 30 4.00 2.00 6.00 1.67 15 3 -15

9 20 15 35 2.22 1.67 3.89 1.25 27 3 -8

14 20 20 40 1.43 1.43 2.86 1.00 42 3 2

19 20 25 45 1.05 1.32 2.37 1.00 57 3 12

23 20 30 50 0.87 1.30 2.17 1.25 69 3 19

26 20 35 55 0.77 1.35 2.12 1.67 78 3 23

28 20 40 60 0.71 1.43 2.14 2.50 84 3 24

29 20 45 65 0.69 1.55 2.24 5.00 87 3 22

29 20 50 70 0.69 1.72 2.41 0.00 87 3 17

28 20 55 75 0.71 1.96 2.68 0.00 84 3 9

Where Px is birr 3

TVC P x∗X P
AVC=
Q
=
Q
=P x
X
Q
=P
1
AP ( ) ( )
= x
AP , because average product of variable

Q Px
( AP x )= ⇒ AVC =
input X AP x

As AP measures the efficiency of the variable inputs, AVC provides the same measure for cost
function. Therefore, when AVC is decreasing, the efficiency of the variable inputs is increasing.
It is at its maximum when AVC is at its minimum; and it is decreasing when AVC is increasing.

Figure 6. Average cost curves

Average cost (AC) or (ATC): It is simply total cost (TC) divided by quantities of output (Y) or
it is the sum of AVC and AFC.

TC TFC + TVC TFC TVC

ATC= = = +
Q Q Q Q ⇒ ATC= AVC + AFC
The shape of AC curve is usually thought to be a U shape curve. This U shape depends upon the
efficiency of both fixed and variable input used. At the initial stage (fig.7), the ATC decreases
because AFC is decreasing rapidly and AVC is also decreasing. However, at larger output level,
AFC will be decreasing less rapidly and AVC will eventually increase and be increasing at faster
rate than the rate of decrease in AFC. The combined effect of this leads ATC curve to increase
and have U shape.

The minimum point of the ATC curve must be to the right of the minimum point of the AVC
curve. That means, as shown in Fig. 7, the minimum point of the AVC curve lies at a lower
output level than does the minimum point of the AC curve.

Figure 7 Average and Marginal cost curves

Marginal Cost (MC): is the extra cost of producing an additional unit of output (Q). It can also
be defined as the change in total cost resulting from one unit change in output.

the change in total cost ΔTC dTC

M argnal cost = MC= =
the changein output → ΔQ or dQ

Marginal cost is related to marginal product in the same manner that AVC related to AP.

Δ TVC P x ( ΔX ) Px
MC=
ΔQ
=
ΔQ
=P x ( ) ( )
ΔX
ΔY
=Px
1
=
MP MP , because marginal product of variable
ΔQ
( MP x )=
input ΔX
Figure 8. Relationship between product and cost curves

The above figure indicates that MC and MP are inversely related. At low level of output a farm
benefits from increasing marginal returns to the variable inputs (that is increasing MP), MC will
be declining. MC reaches its minimum at the level of output at which MP is at its maximum.
When the farm encounters diminishing marginal returns, so that MP is falling and MC begins to
rise. Whenever there is a fixed factor, so that the low of diminishing returns comes into
operation, the MC curve eventually starts to rise. If we plot the MC curve on a graph against
output, we can see that it is a U shaped curve (see fig.3.3).

ΔTVC
MC=
Dear students, can we say ΔQ ? Why?

Since a change in total cost (∆TC) is caused only by a change in total variable cost (∆TVC),
marginal Cost (MC) depends on no way upon TFC. So that, we can say that MC is depends on
the change in TVC.

TC = TFC + TVC

∆TC = ∆ (TFC + TVC)

0
∆TC = ∆TFC + ∆TVC

∆TC = ∆TVC

ΔTC Δ TVC
⇒ MC= or
ΔQ ΔQ
Nature and Relations among ATC, AVC, AFC and MC:
AFC approaches both axes asymptotically.

All AVC, ATC, and MC curve first decline, reach at minimum point, and then rise up.

The minimum points of these curves are not the same (Usually, output at minimum point of MC
less than output at minimum point of AVC which is less than output at minimum point of ATC).

As AFC approaches asymptotically close to the horizontal axis, AVC approaches ATC
asymptotically.

MC equal to both AVC and ATC when these curves attain their minimum values;

MC lies below both AVC and ATC curves over the range in which these curves decline; and it
lies above these curves when the curves are rising.

Principle of variable proportion

Return to scale
The behavior of output consequent to change in the quantities of all factor inputs in the same
proportion known as return to scale.
When we increase all factors in a given proportion, three types or stages of returns are usually
noticed.
I, Increasing return to scale:- when output increase by a greater proportion than the proportion
of increase in all the inputs.
E.g. if the amount of inputs are doubled, output increase tripled or quartered
II, constant return to scale:-when output increases by the same proportion.
E.g. if a firm double inputs, it doubles output.
III, Decreasing or diminishing return to scale:- when output increase by a smaller proportion
than the proportion of inputs increase.
E.g. if all inputs are increased by 15% and the result of this output increase by less 15%.
What are the reasons for increasing and decreasing return to scale?
For increasing return to scale:-
 Greater division of labor and specialization which increase productivity.
 Use of more productive specialized machinery
 Efficient and effective planning and management system
For decreasing or diminishing returns to scale:
 Difficulty management and coordination when scale of operation became bigger and bigger
 Use of less productive technology
2.5.2. The economic Optimum
If we use Total Cost-Total revenue approach, the economic optimum of production is reached
when the difference between total cost and total revenue (profit) is maximum. This means that
when the extra cost of one more unit of output (MC) is just equal to the extra benefit/revenue
from one more unit of output (MR). Provided that the farmer is not operating on a large scale to
influence market, prices and the price received per unit is constant and equal to MR. In this case,

If the price of a commodity does not vary with quantity sold, total revenue increases with an
increase of output.

Profits are at the maximum for a farm business when output (factor input) is at a level where
marginal cost is equal to the marginal revenue (MR) (MC = MR).

Production of an additional unit of output is always profitable as long as MC is less than MR

because less is added to total costs than is added to total revenue.

Production of an additional unit is always unprofitable if MR is greater than MC, since more is
added to the total cost than is added to the total revenue. Therefore there is a need to decrease
production to the point where MR = MC.

Based on the Table 6, if the output is sold at constant price of birr 3 per unit, for the level of
production up to 7 units, the fixed cost per unit exceeds the value of product (Q). In fact, a
farmer will lose if he produces an output less than about 14 units. The economic optimum occurs
at an output level of about 28 units, where the marginal cost (MC) is equal to the marginal
revenue (MR) or price per unit of output. At this level the total profit became birr 24.

If we use Minimum loss principle, there can be three decision situations, these are:

 When selling prices cover Average total costs,

 When selling prices are less than average total costs but more than average variable costs,
and
 When selling price are less than average variable costs.
In short-run only variable costs are important in decision-making because once commitments for
fixed costs have been made there after, they are in fact unchanged. Fixed costs do establish the
level of total costs but only variable costs that determine the rate at which total costs change.
Based on fig. 3.5, let us discuss about the three rules used for making production decision in the
short run. They are:

 When the expected selling price (MR1) is greater than minimum ATC (or TR is greater than
TC), a profit can be made and is maximized by producing where MR = MC.
 When the expected selling price is equal to MR 2, which is less than minimum ATC but
greater than minimum AVC (or TR is greater than TVC but less than TC), the income will
not be sufficient to cover total cost. However, it covers all variable costs with some left over
to pay part of fixed costs. That means the loss cannot be avoided and will be somewhere
between zero and the TFC. In this situation, the loss is minimized by producing where MR =
MC.
 When the selling price is equal to MR3, which is less than minimum AVC (or TR less than
TVC), the income will not even cover the variable costs. That means the loss cannot be
avoided and will be greater than TFC. In this situation, the loss is minimized not producing.
This would minimize the loss at an amount to TFC.

Figure 9. Illustration of short-run production decision

 CHAPTER 4:
4 FARM PLANNING AND BUDGETING
4.1.1 Farm planning
Planning mean taking decisions in advance. It stimulates thinking, broadens understanding &
challenges the farmer to move forward. It is a forward-looking approach.

Farm planning is a process to allocate the scarce resources of the farm and to organize the farm
production in such a way that to increase the resource use efficiency, the production and the
income of the farmer. In general, it is an approach which introduces desirable changes in farm
organization and operations and makes the farm viable unit by making rational decision
regarding the organization and operation of a farm business. It tells how best to make use of
opportunities to a farmer to channelize his scarce resources.

4.1.2 objectives of farm planning

Without planning, farm business decision would become random, ad hoc choices. The following
concrete reasons explain the paramount importance of farm planning.

i. Income improvement

Farm planning primarily concerned with making choices and decisions: selecting the most
profitable alternative from all possible alternatives, and seek to present an opportunity to
cultivators his level of income. It is this opportunity of income maximization that induces
farmers to adopt desirable changes. Such income maximization could be achieved from a given
bundle of resources by re-organizing present type of production as well as introducing changes in
technology.

ii. Focuses attention on the farm organization’s goals

Farm planning helps the manager to focus attention on the organization’s goals and activities.
This makes it easier to apply and coordinate the resources of the farm more effectively. The
whole organization is forced to embrace identical goals and participate in achieving them. It also
enables the farm manager to outline in advance an orderly sequence of steps for the realization of
organizations goals and to avoid a needless overlapping of activities.

iii. Educational process

Farm planning is an educational tool to bring about a change in the outlook of the cultivators and
the extension workers. Knowledge of the latest technological advances in agriculture is a pre-
requisite for better farm planning; so farmers or farm managers keep their information up-to-date
through this forced action situation of farm planning process. This act is used as a self-educating
tool for the farmers. The farmers or farm managers can closely study their own business and see
more clearly their opportunities and limitations, thus, improving their managerial ability.

iv. Desirable organizational change

Planning helps to introduce desirable change in farm organizations and operations. In its broad
sense, it may mean any contemplated change in the method or practices followed on the farm.
The advantage of farm planning lies in its treating the farm as an operational unit and tailoring
the recommendation to fit into the individual farmers' opportunities, limitations, problems and
resource position.

v. Minimizes risk and uncertainty

By providing a more rational and fact based procedure for making decision; farm planning
allows managers and organizations to minimize risk and uncertainty.

vi. Facilitates control

In planning, the farm manager gets goal and develops plans to accomplish these goals. These
goals and plans then become standards or benchmarks against which performance can be
measured. The function of control is to ensure that the activities confirm to the plans. Thus,
control can be exercised only if there are plans.
4.1.3 Features of good farm plan
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4.1.4 The Steps of Farm planning:

There are six steps in farm planning
1. Define the business opportunity/change
2. Swot analysis
3. Setting up objectives
4. Developing functional plans and budgeting
5. Implementation
6. Monitoring and adjusting.
1/ Define the business opportunity:
This is mainly a process to acquire information relevant to the farm business. Technical and
business information is essential, Such as new technology of cropping and Livestock rearing,
price trends, market demands and potential capital resources.
There has been much conjecture about why one person recognizes an opportunity or problem and
another does not. Basic findings suggest a preparedness or frame of mind able to recognize and
define new conditions or problems.

Several factors have been identified as being associated with competence in opportunity /
problem recognition Included are:
(a) Experience (growing up on a farm or having farming experience) ,
(b) Level of schooling (exposure to a broad range of ideas and approaches to problem solving),
c) Motivation by accomplishing a goal, and (d) willingness to take risk

2/ The Swot Analysis

SWOT analysis is concerned with the identification of specific views, feelings and information
that is directly collected from different sources such as customers, managers, labours,
competitors, etc. Issues to be identified include the strength or achievements, the weakness or
constraints, the opportunities for improvement and the threats which are considered as external
negative forces which increase the risks of failure.

SWOT is therefore the abbreviation formed by the first letters of the words. Strengths ( s) ,
weaknesses (w) , opportunities ( o) and Threats ( T) . The SWOT analysis is to identify the
internal and external factors of a farm.

SWOT is a tool to help a manager /farmer to identify the advantages and disadvantages of a farm
undertaking by analyzing the internal forces (strengths and weaknesses) and the external forces
(opportunities and threats) that affect the development process/ production process (
Figure 4 -1. Internal and external factors analyzed using SWOT

Competitors Customers
-Who are they? -Who are they
- Specific strengths -Specific needs
-Specific weaknesses -Buying process
-Current and projected -Segments-size & Potential
strategy -important anticipated
changes

Farm
Marketing -Price
-Product/service
-Distribution/location
People -Management
- Technical staff
-Labour
Production -Resources to be used
- Implementation
Finance -Cost
-Profitability
-Debt position
-Inventory/receivable
3/ Setting up objectives
In would make little sense to start out on a trip without a pretty of idea where you are going.
The objective answer the question'' what are we trying to accomplish'' It gives purpose and
direction to decisions and actions. For planning purposes it is necessary that a farm's objectives
specifically indicate the direction in which the resources of the organization should be pointed.
They must be defined so as to serve as a measure of success or failure therefore, the importance
of objectives is ( a) set direction, (b) provide performance targets, and (c) constrain decisions.

Objectives should answer a number of fundamental questions about the farm’s future growth and
development. For example:
A/ what is the economic mission of the farm?
B/ what kind of business should be the farm be in?
C/ what goods and services should be sold?
D/ what markets should be served?
E/ what share of the market is desired?
F/ what are the profit objectives?
G/ The rate of growth are required in sales, profits, assets, and values of equity capital
investment.
Objectives, therefore establish a direction in which the management of the farm wishes to be
heading. The attainment of the objectives should be measurable in some way and ideally people
should be motivated by them.
4/ developing functional plans and budgeting
Functional plans include market, production, people and finance plan. To develop the functional
plans we have to follow the following steps:
a/ Resource inventory
b/ Identifying enterprises and resource requirements
c/ Budgeting
d/ Developing plan
5/ implementing the plan: select a plan and put it into operation. Once the planning process is
completed the best alternative must be selected and action taken to place the plan in to operation.
The selected plan should be implemented with all the efforts to meet the expected objective. It is
important to recognize that preparation and completion of the document itself is not the end of
successful planning. This requires the acquisition and organization of the necessary land, labour,
machinery, livestock, and annual operating inputs.
The contents and intent of the plan should be understood and accepted by all employees on the
farm. Clear responsibility and indexes should be assigned to specific person. The objective of the
plan should be closely related with the benefits of each department and individual. An important
part of the implementation function is the financing of the necessary resources. Since
implementation can take time, it must begin early enough that all required resources are available
at the proper time. Information system, including statistics system, technical testing system and
accounting system, should be set up to collect all necessary information for the farm
management.

6/ Monitoring and adjusting

The operation plan is dynamic. It means the implementation of farm plan can be affected by the
changes in natural, social and economic conditions, which may not have envisaged in your
original plan. The plan should be monitored and adjusted constantly. It is important to recognize
that preparation and completion of the document itself and then implementing of the plan is not
the end of successful business planning. You now have the initial task of undertaking follow-up
exercise and making adjustment if there is any deviation from the original plan.

4.2 Farm budgeting

4.2.1 What is farm budgeting
A farm budget is a statement giving an estimate of all the farm receipts and expenses to be
incurred for the agricultural year. In other words, it is the expression of a farm plan in monetary
terms by estimation of receipts, expenses and net income of a farm or a particular enterprise is
called budgeting.
Budgeting is a very simple and straight forward exercise, which can be used to select the most
profitable plan among a number of alternatives and used to test the profitability of any proposed
change in a plan. It is a way ‘try it out paper’ before a plan or a proposed change in a plan is
implemented. Therefore, farm planning and budgeting go side by side.

4.2.2 types of budgeting

There are different types of budgeting, each of which is adapted to a particular size, purpose and
type of planning problems. Basically the following types of budgets are known to exist:

1. Partial budget,
2. Enterprise budget,
3. Whole farm (complete) budget.

3.2.1. Enterprise Budget

An enterprises budget is a listing of all estimated income and expenses associated with a specific
enterprise to provide an estimate of its profitability. Therefore, one can develop an enterprise’s
budget for each actual and potential enterprise in a farm plan such as cotton, wheat, maize, beef
cows, dairy cows, and so forth.

The primary purpose of an enterprise budgeting is to aid in selection of inputs and enterprises
consistent with the resources available. In addition, it also aid to select combination (s) of
enterprises that will increase income from the farm business so that it can be included in the
whole farm plan because a whole farm plan often consists of several enterprises.

Although construction of an enterprise budget requires a large amount of data, once completed, it
could be used as a source of data for other types of budgeting. Several kinds of data are
necessary for budgeting, which includes:

 Physical input data (variable and fixed inputs) involved for production of a particular
enterprise,
 Field output data (yield per hectare at different level of input use),
 Price data for all inputs and outputs of that enterprise.
Table7. An example of enterprise budgets estimate for wheat production (1 hectare).

No. Item Unit Quantity Unit pice Value/ha

1 Revenue
Main product (wheat output) Qt. 50 250.00 12500
By product (straw) “ 30 60.00 1800
Total Revenue Birr 14300
2 Variable Cost
Seed Qt. 5 260.00 1300
Manure & fertilizer
Manure Qt. 50 20.00 1000
Inorganic fertilizer “ 4 260.00 1040
Chemical
Pesticide Kg 10 80.00 800
Fungicide “ 10 70.00 700
Machinery expense
Fuel Lt 50 4.00 200
Oil Kg 5 35.00 175
Lubricant “ 1 50.00 50
Machinery repair Birr 500.00 500
Labour
Normal Hr. 57 2.00 114
Peak season ” - - -
Contractual “ 30 3.00 90
Operating interest (@ 10% for 6 months) Birr 596.9
Total Variable Cost “ 6565.9
3 Gross Margin (1-2) 7734.10
4 Fixed Cost
Depreciation Birr 200.00 200
Interest on investment (10%) “ 20.00 20
Tax and insurance “ 100.00 100
 Land charge “ 300.00 300
Total Fixed Cost “ 620
5 Total Cost (2+4) “ 7185.9
6 Estimated Profit (1-5) “ 7114.1

3.2.2. Complete Budgeting

The whole farm plan discussed earlier does not provide full and details information on sources
and amounts of income, types and amount of expenses, and the total expected profit for the farm
business using the plan. A whole farm budget is needed to provide additional details and the final
estimate of farm profit. Therefore, a whole farm budget is a summary of the expected income,
expenses, and profit for a given farm plan. It considers the cost and returns of all the crop and
livestock enterprises in order to drive the net return of the whole farm.

Table8. Example of whole farm budget showing projected income, expenses, and profit
No. Description
1 Income
Cotton 54000
Milo 43000
Wheat 13500
Stocker steers 40000
Total income 150000
2 Variable expenses
Fertilizer 11900
Seed 3600
Chemical 7900
Fuel, oil, Greases 4050
Machinery repair 2650
Feed purchase 1600
Feeder livestock purchase 29000
Custom machine hire 10250
Operating interest 7340
Miscellaneous 2450
Total variable expenses 80740
Gross margin (1-2) 69760
3 Fixed expenses
Property taxes 2600
Interest on debt 22000
Insurances 1250
Machinery depreciation 7200
Building depreciation 3200
Other fixed costs 3000
Total fixed expenses 39250
 4 Total expense (2+3) 119990
5 Net farm income (1-4) 30510

3.3.3. Partial budgeting

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

Partial budgeting is the method of making a comparative study of costs and returns analysis
resulting from a small change or possible adjustment in the part of farm business plan.
Partial budgets do not calculate the total income and expenses for each of the two plans. Rather it
considers only those income and expenses which are affected by the proposed adjustment in the
plan.

A partial budget usually prepared to ascertain the effect on the net benefit of the farm due to a
small change in the farm plan such as:

 Substituting one enterprise for another without any change in the entire farmland area, for
example, substituting 1 ha of soybean for 1 ha of maize.
 Changing to different levels of a single technology, for example, estimating the effect of
changing one level of N-fertilizer application to another in maize production on net
benefit
 Changing to different technologies, for example, changing from hand weeding to
herbicide use for weed control
The format used for computing a partial budget is:

Gain Cost
 a) Additional income d) Reduced income

Expected additional returns that would Returns that will no longer be received after the
accrue from the change under consideration. change has been made.

b) Reduced expenses e) Additional expenses

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

c) Total gain f) Total cost

Additional income (a) plus reduced cost (b). Reduced income (d) plus additional expenses
(e).

Net change (change in net income)

The difference between total gain (c) and total cost (f) is net farm income. A positive
difference indicates that the proposed change plan has higher expected net income than the
base plan and vice versa.

The example below illustrates how a partial budget can be used to analyze the decision to
substitute wheat for maize production. The farmer has observed that the expected wheat price for
the coming year appears to be somewhat more favorable than the projected maize price. Based
on this information, that farmer is considering decreasing his maize production by 40 hectare and
increases his wheat production by the same amount. The available additional information used to
determine the profitability of the two alternative plans are:

 The farmer can produce 14 quintal of wheat and 18 quintal of maize per hectare.
 The farmer needs to use 3 quintal of wheat and 5 quintal of maize seed per hectare.
 The farmer needs to hire 41 and 47 hour of labour per hectare for wheat and maize
production, respectively.
 The farmer can earn an income of birr 170 and 140 per quintal from the sell of wheat and
maize products, respectively.
  The farmer costs birr 182.2 and 146.8 to purchase a quintal of wheat and maize seed,
respectively. In addition, the farmer requires to pay birr 4.25 for an hour of labour used
for wheat or maize production.
The question is to determine the profitability of the proposed plan.

Solution

Gain Cost

a) Additional income d) Reduced income

Increased wheat income Loss of maize income

14 qt. wheat output per ha.* birr 170 per qt.* 18 qt of maize output per ha.* birr 140 per qt.
40 ha = 95200 * 40 ha = 100800

b) Reduced expense e) Increased expense

Reduced maize cost Additional wheat cost

5 qt. maize seed per ha.* birr 146.8 per qt.* 5 qt. wheat seed per ha.* birr 182.2 per qt.* 40
40 ha. = 29360 ha. = 21864

47 hr of labour per ha* birr 4.25 per hr * 40 41 hr of labour per ha* birr 4.25 per hr * 40 ha
ha = 7990 = 6970

Total Reduced Expense = 37350 Total Additional Expense = 27834

c) Total Gain (a + b) = 132550 f) Total Cost (d + e) = 129634

Net Gain = 132550 - 129634 = 2916

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

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

Chapter five
5 Farm resource management
5.1 farm land management
Land is the most valuable resource and most important resource in agriculture as compared to
other industries. Owning and using the land for agricultural production requires attention to
resource conservation and environmental sustainability as well as profits. Land has a unique
characteristics not found in other agricultural or non- agricultural resources. These characteristics
greatly influence the economies of land use and management.

5.1.1. Unique Characteristics of Land

a). land is permanent resource, that does not depreciate or wear out, provided soil fertility
is maintained and appropriate conservation measures are used. Proper management of land not
only maintains the inherent productivity of land but also can even improve it.
b). land is immobile and cannot moved to combined with other resources, but others
resources like machinery, seed, fertilizer must be transported to the land and combined with it to
produce crops and livestock( pasture, grazing land-----).
c). the supply of land suitable for agricultural production is essentially fixed. Even though,
small amounts may be bought in to production be clearing and draining or may be lost to non-
farm uses. This makes the price of land very sensitive to changes in demand of it; because land
cannot be manufactured when the demand increases.
Therefore, changes in the profitability of agricultural production are eventually factored in to
land prices, rent and the land owner receives the economic benefits of losses.

5.1.2. Planning Land Use

A land use plan which is developed based on a completed land inventory (soil fertility, slope,
depth, soil types, and drainage) is the most profitable farm plan.
Land use plan is affected by:
 regional differences in productivity( comparative advantage-----------) however, the most
profitable use for land depends on :
 relative commodity prices and
 production technology
Both can change over time brings change in land use.
Main sources of land:
1. owning land ( through land distribution)
2. leasing
3. renting( share cropping)
4. buying( for some years)
Each has its own advantage and disadvantage from development point of view.
Determinants of cropping system (land use system);
1. Density of the population
 if we have more land ----- extensive farming
 if we have less land ----- intensive farming
2. Technology;
 The production system is affected by the availability of technology and skill we have.
3. Soil fertility, topography (slope), soil type; these alas determines the type of crop grown and
enterprise that would be selected
4. Location: location of land to infrastructure also determines the type of crop to be produced.
Like, to produce vegetable, the land must be near to market or roads etc, unless they loss their
intensity.
Ex. perishable products
5. Land tenure institution (lease, renting, individual users right, communal), therefore, depending
on the type of owner ship you decide what type of crop produced (annual, perennial)
Generally, land use decision need to consider long run environmental effects, interactions among
enterprises and consequences that occur beyond the borders of the farm in order to conserve
resources and sustain agricultural in to the future.

5.2 farm labor management

5.2. Farm labor management
Labour is one of the production resources which mobilize other resources. Labour requirement
for the work determined by the amount of work to be done. Amount of work to be done also
determined by:
 number of persons
 amount hours worked
 amount of works
Amount of Hours Worked also Determined By:
i. the amount of work needed to obtain subsistence needs
ii. potential gain from extra unit of force( from leisure preference)
iii. health and diet
iv. climate( hot places, rainy season)
v. market day ( it make some other business to purchase something)
vi. job opportunity
vii. social customs( festivals, holydays etc------)
Labour standardization mainly made in terms of adult man; this helps to calculate labour
requirement of the farm.
Standard conversion rate in adult man equivalent:
Age Male female
<10 0 0
10-13 0.2 0.2
14-16 0.5 0.4
17-50 1 0.8
>50 0.7 0.5

** Base on these we can determine the available labour for work.

Substitution of labour by other technologies like mechanization and other labour saving
technologies has increased agricultural production as well as decrease in labour use. But, these
charges in the tasks performed by agricultural labour have required both employees and
managers to increase their education, skills, and trainings.
Why we adopt labour saving technologies? Most labour saving technologies have been
adopted for one or more of the following reasons:
a. if it is less expensive than labour, it replaced
b. if it allows farmers to increase volume of production
c. if it makes work easier and more pleasant
d. if it allowed to complete certain operations on time( planting, harvesting, if rain-------)
e. if it does a better job than could be accomplished manually
Therefore, input substitution occurs because of a change in the marginal physical rate of
substitution.

Main Sources of Labour Are;

i. family labour
ii. hired labour( full time or part time)
iii. exchange labour
Unique Characteristics of Agricultural Labour (that affects its use & management)
1. labour is a continuous flow input:
 mean that the service it provides is available hour by hour and day to day
 it cannot be stored
 it must be used as it become available or it is lost
2. full time labour is also a “ lumpy” input
  mean that it is available only in whole , indivisible inputs
 it becomes difficult to avoid a shortage or excess of the resources for lumpy inputs,
machinery, land
3. the human factor
 it is another characteristic that distinguishes labour from other resources
 Ex. if an individual is treated an” inanimate object, productivity & efficiency suffer
 The hopes, fears. Ambitions. Likes, dislikes, worries & the personal problems of both
the operator and employees must be considered in any labour management plan.
Improving labour efficiency:
i. Labour efficiency can be improved by more capital investment per labour. Like the use of large
machinery and other forms of mechanization. However, the objective is to maximize profit and
not just to increase labour efficiency the proper combination is determined by MRTS & price
ratio
 Increase the capital investment per worker will increase profit if and only if;
 total cost is reduced while revenue increases remain constant or at least decreases less
than cost
 the labour that is saved can be used to increase output value elsewhere by more than the
cost of the investment
ii. labour efficiency can be improved by training and education
iii. Labour efficiency can be also improved by making sure workers have safe and comfortable
working conditions whenever possible. Workers should provide with suitable clothing and other
safety equipment when working with agricultural chemicals or performing other hazardous jobs.

5.3 farm machinery management

5.3. Farm machinery management

Mechanization of selected farm operations is a key factor in the successful implementation of an

intensive farming system based on intensive use of yield increasing technology and multiple
cropping. Due to the seasonal nature of agricultural operations, the farmers are facing difficulty
in the timely and successful performance of agricultural operations, especially during the peak
labour-load periods; at the time of sowing, harvesting and threshing. To smoothen these peaks,
labour saving devices can be introduced by mechanizing some selected agricultural operations.
This would make it possible to introduce multiple cropping on some farm organizations. Thus,
switch-over to mechanical power will not only help perform the various operations in time but
will also help the farmer adopt more profitable crop rotations.

In changing over from manual to machine-power, a suitable set of machinery and implements for
use under local conditions and relative cost-benefit relationship on various alternative types of
equipment and power have to be worked out. Mechanization increases the farmer’s total
investments. He has to decide how much capital he should invest in machinery and which
machines he should buy, when it pays to hire rather than buy a machine.

Selection of Size of Machine to Buy

Most farm machines are now made in a range of different sizes and capacities. Farmers can
adjust the quantity of service they buy through the size of the machine. More of the capital and
less of labour will be required for a given job when a farmer chooses a large machine over a
small one. Buying a large instead of small machine, thus, substitutes capital for labour. The key
points to consider while deciding upon the size of a machine are:
(1) the difference in the initial cost of the large and small machines,
(2) the annual use to be made of the machine,
(3) the amount of additional labour saved by the large machine, and
(4) the relative opportunity costs of capital and labour on the farm.

5.4 livestock management

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5.5 farm building management
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 CHAPTER 6
6 FARM BUSINESS RECORDS AND ANALYSIS
6.1 Farm records
Records are statements of fact or data concerning a specific subject which may be specified in
physical, monetary, mathematical or statistical terms. Farm records pertain to information
recorded on the day-to-day operation of a particular farm.
Farm records can be defined as systematic documentation of all activities taking place in a farm
enterprise over a given period of time. It is an act of writing down every activity engaged in on
the farm in every production season and at different stages of the production process up to the
final disposal of the goods and services to the ultimate consumer.
Farm record keeping is more than just keeping track of what crop was planted in what field, it is
a concept applicable to the entire farm operation. A complete farm record will include all daily
activities and transactions and with a proper accounting system it should be possible to have a
complete estimate of the profit or loss statement at the end of the year.

6.1.1 Purpose of farm records

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

6.1.2 Kinds of farm records

Farm records system consists of three (3) parts.
1. Physical Farm Records: - Non-monetary
- Essential to implement the financial records and financial decisions
a) Farm map
b) Land utilization records
c) Production and disposal record for crops livestock, poultry and others.
d) Labour records
Paid labour- hired - full- time
- Part-time
* Market wage rate is taken
Unpaid labour- operator (family) labour
* Opportunity cost is calculated
NB labour days used on crops and livestock enterprises can be recorded separately on
monthly basis.
e) Machinery use records
f) Feed records
g) Stock (goods ready to sale) and store register

Formats for maintain field records:

a) For crop production
Year __________ crop______________ Soil Type_____________,Slope__________
Field number___________ area/ha______________ irrigated or not ______________
Date Seed Fertilizer chemical Machinery
variety amount type amount type amount type Amount

b) For live stock: like inventory record, feed record, breeding record
i.In case of inventory record, we should know the type and number of animals
Year_____________ Animal Type_________________
Month/ Beginning transfer purchase produced sale Death
Date inventory
NO value In(+) Out(-) NO.(+) value NO.(+) value NO.(-) value NO.(-) value
.

** Out- transfer refers to culling, which is negative to the live stock

In- positive
ii). feed record
It is a daily activity and we should record on a separate sheet.
Year__________ kind of animals_____________
Month/ No. of grain commercial Forage pasture
Date animals corn wheat Fagulo silage hay

iii. Breeding records like calving interval, calving date, are some parts of important parameters from
breeding records
c). machinery records
 used for different purposes like
 to schedule regular repairs and maintenance
 to collect a day to day function of machinery
 helps to calculate depreciation per working hour

item___________________ identity________________
Year_____________________ date of purchase_______________
Month/date Hours Fuel Oil& lubricant repairs
used amount value amount value Cost description

d). labour record

Year___________________
Month/date Crop enterprise Livestock enterprise machinery Farm over head

 farm over head : the labour which cannot attribute to either of crop or livestock

2. Financial Farm Records- expressed in monetary terms

 -Important to provide information regarding the profitability of the whole farm business over a
given period.
 All the cash incomes from the operation and expenditures to the operation are recorded
 Year day and mouth should be included
 Include the following

a. Farm inventory
- All kinds of goods purchased and consumed during the operation are recorded
- The es (increases) and es (decreases) in inventory also recorded
b. Farm cash or farm financial record
c. Classified farm cash accounts and annual business analysis (credit and debt accounts)
d. Capital asset and sale register
e. Cash sale register
f. Credit sale register
g. Wage register
h. Funds borrowed and repayment registers
 i. Purchase register
j. Farm expenses paid in kind register
k. Non-farm income record.
3. Supplementary records
- Supplement the two records
- Include
a. Sanction register
b. Auction register
c. Hire register
d. Climate weather condition soil type agro - ecological condition etc

6.2Valuation of farm assets

The data for values of assets may get from:
 records
 inventory( list of the assets of the items of the farm and their value at a particular time
 Research( if there is records & inventory the only method is research by using, survey, census,
statistical, experimental)
i. Valuation at cost or market price: it is a good method if we have currently bought assts and non-
duarable assets. Any normal marketing charges, such as transportation, selling commission, and other fees
are subtracted.
ii. Valuation by reproductive value: this means items produced on the farm can be valued at their farm
production cost. i.e. by counting what we incurred to get it up. Example, growing crops should be counted
by costs incurred to get it up.
iii. Valuation by capitalization:
 cost less accumulated depreciation
 estimated value equal to book value
iv. Inventory method:
 Valuing at cost, mean items that have been purchased can be valued at their original cost.
 it considers the value of the asset at that particular time
 This method works well for items that have been purchased recently and for which cost recodes
are still available.
 6.3. Methods of computing depreciation
Depreciation refers to the financial estimate of the annual loss of value of capital equipment due
to wear and tear over its useful life. The original cost of the asset is a prepaid expense. However,
if the asset is used in more than one accounting period, this cost will be allocated to those
accounting periods that correspond to the productive life of the asset. Depreciation cost of an
asset can be computed using different methods. Some of these are:

1. The straight line method,

2. The reducing balance method,
3. Sum-of-the year digit method.
Straight line method

It is the easiest, simplest and usually very satisfactory for most purposes. This method assumes
that assets are used more or less to the same extent every year. Therefore, equal amount of costs
on account of their use can be charged over its useful life. Based on this method the annual
depreciation of the asset can be computed as:

Original cost − Salvage value

Annual depreciation=
Useful life of the asset
Where:

Original cost is the purchased price of the asset,

Salvage (scrap/junk) value is the value of the asset at the end of its useful life. It is zero if the
asset is completely worn out at the end of its useful life.

Useful life is the expected number of years that item will be used in the business.

Example: A fixed equipment costs birr 1000 and is expected to last for 5 years. The salvage
value of the asset after 5 year is birr 50. The annual depreciation cost using straight line method
is computed as:

1000 − 50 950
Annual depreciation= = =190
5 5

Throughout its useful life the asset depreciate by birr 190.

Reducing balance method:

It is a method that uses a fixed rate of depreciation each year and it applies the rate to the value
of the asset at the beginning of the year (book value). This means, a fixed percentage is deducted
every year from the diminished balance till the asset reaches the salvage value. Here no further
depreciation is possible. Using the previous example of an asset costing birr 1000 and taking an
annual depreciation rate of 45 percent, the depreciation cost of the asset is given by Table 10.

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

Table10 Annual depreciation at 45% on reducing balance
Year Book value Depreciation Value
st
1 1000.00 450.00 550.00
2nd 550.00 247.50 302.50
3rd 302.50 136.13 166.38
4th 166.38 74.87 91.51
5th 91.51 41.18 50.33
The amount of depreciation is different at different stages and gradually diminishes with the life.
In this particular example the depreciation cost diminishes from 450 to 41 within 5 year of useful
life.
Sum-of-the year digit: In this method the annual depreciation is found out by multiplying a
fraction by the amount to be depreciated (cost minus salvage value). The formula is:
RL
Annual Depreciation= ∗(Original cost−Salvage value )
SOYD
Where:
RL is remaining useful life
SOYD is the sum-of-the year digits’, which is simply the sum of the numbers 1 through the
estimated useful life. For example, for 5 year useful life, the SOYD is 15
SOYD for 5 year = 1+2+3+4+5 = 15

Table 11 shows the annual depreciation cost of an asset, costing birr 1000 with an estimated life
of 5 year and a scrap value of birr 50, computed using the sum-of-the year digit method.

Table11Annual depreciation using sum-of-the year digit method

Year RL SOYD Depreciable Depreciation

1 5 15 950.00 316.67
 2 4 15 950.00 253.33
3 3 15 950.00 190.00
4 2 15 950.00 126.67
5 1 15 950.00 63.33

The income and net worth statement

Balance sheet
Balance sheet is a snapshot of the financial position of enterprise at a particular point of time. It
consists of assets, liabilities and equity.

Table 4.10 Balance sheet

Item
Assets
Current assets
Cash and bank balance-------------x1
Account receivable-------------------x2
Inventories----------------------------- x3
Total current assets------------xt=x1+x2+x3
Fixed assets
Building equipment cost------------y1
Less depreciation---------------------y2
Construction in progress -----------y3
Net fixed assets-----------------yt=y1+y2+y3
Other assets-------------------------------z
Total assets --------------------ta=xt+yt+z--------
Liabilities
Current liabilities---------------m1
Accounts payable------m2
Long-term liabilities-----------m3
Total liability---------tl=m1+m2+m3
Equity
Shared capital -----k1
Retained earnings—k2
Total equity-----------te=k1+k2
Total liability and equity---tl+te------------------
Assets = Liabilities + owners’ equity
There are three principal kinds of assets: current fixed and other.
i. Current assets consist of cash including check accounts in bank; accounts receivable (are
amounts owed to the firm by customers and are expected to be convertible into cash in the
near future usually in less than a year.
ii. Fixed assets include durable goods of relatively long life, e.g. property, plant, equipment and
land.
iii. Other assets include long-term securities; deferred expenses such as start-up expenses for a
new project; intangible assets such as patents and trademarks that have no physical existence,
etc...
Liabilities are claims against the assets of the enterprise that creditors hold. That means these are
outstanding debts of the enterprise. There are two principal kinds of liabilities;
i. Current liabilities include debts that are due within one year and include accounts payable,
short-term loans, current portion of long-term loans, suppliers’ credit, and taxes payable.
ii. Long-term liabilities are debts that become payable after one year from the date of the
balance sheet.
Owner’s equity consists of claims against the enterprise by its owners. It is what is left over after
all liabilities have been deducted. Owner’s equity usually takes the form of share capital paid in
by owners of the enterprise and retained earnings (services).

4.6.2. Income statement

Income statement is a financial report that summarizes the revenues and expenses of an
enterprise during an accounting period.
Income statement consists of various elements.
a) Net income or profit is what is left after expenses are incurred.
b) Revenue is obtained from the sales of goods and services.
c) Cash operating expended list all cash expenditures incurred to produce output.
 d) Selling, general and administrative expenses include a number of overhead items such as general
administration, training, research and management fees.
e) Funds from operation (operating income before depreciation): it is the net benefit or cash flow of
the enterprise that arises from operations. It is sometimes called internally generated funds.
f) Non cash operating expenses: the primary element of such expenses is depreciation. Depreciation
refers to the allocation of a portion of the original cost of a fixed asset to each accounting period
so that the value is gradually used up. Further deduction of non cash operating expenses gives
operating income (operating profit) also called the profit before interest and taxes.
g) Non operating income and expenses are subtracted next. These include interests received and
paid, duties, indirect taxes and subsidies.
h) Thus is reached income (profit) before income tax. When income taxes are deducted the net
income (profit) after taxes obtained.

Table 4.11 Income statement

Item
Revenue
Sales of crop----------------x1
Sales of livestock----------x2
Total revenue-----------tr=x1+x2
Expenses
Cash operating expenses
Selling, general and administrative expenses
Non cash operating expenses
Operating income (profit)
Non operating income and expenses
Income (profit) before income taxes
Income tax
Net income (profit) after taxes

4.6.3. The cash flow analysis

Cash flow (also "cash flow") refers to the movement of cash into or out of a business, a project,
or a financial product. It is usually measured during a specified, finite period of time.
Measurement of cash flow can be used

 to determine a project's rate of return or value. The time of cash flows into and out of
projects are used as inputs in financial models such as internal rate of return, and net
present value.
  to determine problems with a business's liquidity. Being profitable does not necessarily
mean being liquid. A company can fail because of a shortage of cash, even while
profitable.
 as an alternate measure of a business's profits when it is believed that accrual accounting
concepts do not represent economic realities. For example, a company may be notionally
profitable but generating little operational cash (as may be the case for a company that
barters its products rather than selling for cash). In such a case, the company may be
deriving additional operating cash by issuing shares, or raising additional debt finance.
 cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting.
When Net Income is composed of large non-cash items it is considered low quality.
 to evaluate the risks within a financial product. E.g. matching cash requirements,
evaluating default risk, re-investment requirements, etc.

Financial analysis of projects is based on cash flow analysis. This means for every period during
the life of the project, the financial analyst estimates the cash likely to be generated by the
project and subtracts the cash likely needed to sustain the project. The net cash flow result in the
financial profile of the project.

When expenditures and receipts of a project are denominated in cash, the net receipts at any time
period are termed Cash flow. The series of such cash flow over several periods is termed as cash
flow stream.

In a cash flow expenses and receipts are recorder in the year they occurred. Usually these cash
flows occur at known specific date, such as the end of each quarter of a year or end of a year.
Project cash flow, therefore, refers to the amount of income remaining after all outflows are
subtracted from all inflows - This is called Net benefit or cash flow.

In the early years of a project the net benefit or cash flow is usually negative. In project analysis,
the net benefit or the cash flow is the basis for calculating the measures of project worth, the
most important of which are the discounted measure of net present worth, internal rate of return,
and net benefit investment ratio. This makes it useful for determining the viability of a project,
particularly its ability to pay bills.
Because the financial evaluation of a project is based on cash flows, it omits some important
items that appear in profit-and-loss statements. For instance, depreciation is used in income
statements and balance sheet accounting to arrive at an estimate of net profit. These concepts are
important financial costs and do not entail cash outlays and consequently do not appear in either
the financial and economic flows used to calculate net present values and economic rates of
return.

In addition, debt service - the payment of interest and principal entails cash outlays is omitted
from financial analysis because in both cases what matters is assessing the quality of the project
independently of its financial mode. Another reason for excluding debt service from economic
analysis is that debt service does not entail a use of resources, but only transfer of resources from
the payer to the payee.
Basic principles for measuring project cash flows

• Use cash flows rather than earnings in your analysis; the firm is interested in what free
cash can be generated by a project, which differs from accounting earnings
• Use incremental cash flows, meaning cash flows that occur as a consequence of the
decision to proceed with the project not total cash flows for the firm
• Adjust cash flows for the time value of money
Which cash flows are relevant when evaluating a project?
• The relevant cash flows include the change in the firm’s total cash flows that come as a
direct consequence of the decision to take the project
• We call these the incremental cash flows of the project
• Any cash flow to the firm that takes place whether we take the project or not are not
relevant to our analysis
• Incremental cash flow = cash flow with project – cash flow without project
Why can we focus only on incremental cash flows?
• We can assume that each project undertaken by a firm is a standalone project
• Once we identify the project’s incremental cash flows, we can evaluate a project based on
its own merits
• This is known as the stand-alone principle
Determining incremental cash flows
  Forget about sunk costs (A sunk cost is a cost that the firm has already incurred or has
incurred the liability to pay)
 Include opportunity costs (The opportunity cost of the land, the value of the forgone
alternative use for the land, must be included in the costs of the project)
 Include all indirect effects from the project (Specific projects may have side benefits or
costs (or both), meaning that they affect cash flows of other projects)
 Recognize investments in net working capital (Projects require investments in net
working capital, both at the beginning and during the life of the project)
 Beware of allocated overhead costs (If a project generates extra overhead costs, then
these must be included in the analysis)
 Separate investment and financing decisions
Components of the cash flow stream
A project’s cash flows are composed of
o Cash flow from operations
o Cash flow from investments in NWC
o Cash flow from investments in plant and equipment

Cash flow is a generic term used differently depending on the context. It may be defined by users
for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer
to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net
cash flow', operating cash flow and free cash flow.

The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to
the change in cash balance over this period: positive if the cash balance increases (more cash
becomes available), negative if the cash balance decreases. The total net cash flow is the sum of
cash flows that are classified in three areas:

1. Operational cash flows: Cash received or expended as a result of the company's internal
business activities. It includes cash earnings plus changes to working capital. Over the
medium term this must be net positive if the company is to remain solvent.
2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital
expenditure (investments, acquisitions and long-life assets).
 3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as
dividends, share repurchases or debt repayments.

Example
Description Amount ($) Totals ($)
Cash flow from operations +10
Sales (paid in cash) +30
Materials -10
Labor -10
Cash flow from financing +40
Incoming loan +50
Loan repayment -5
Taxes -5
Cash flow from investments -10
Purchased capital -10
Total +40

The net cash flow only provides a limited amount of information. Compare, for example, the
cash flows over three years of two companies:

Company A Company B
Year 1 Year 2 year 3 Year 1 Year 2 year 3
Cash flow from operations +20M +21M +22M +10M +11M +12M
Cash flow from financing +5M +5M +5M +5M +5M +5M
Cash flow from investment -15M -15M -15M 0M 0M 0M
Net cash flow +10M +11M +12M +15M +16M +17M

Company B has a higher yearly cash flow. However, Company A is actually earning more cash
by its core activities and has already spent 45M in long term investments, of which the revenues
will only show up after three years.

4.7. Financial Ratios

From the projected financial statements for an enterprise, the financial analyst is able to calculate
financial ratios that allow him to form a judgment about the efficiency of the enterprise, its return
on key aggregates and its credit worthiness.

4.7.1. Efficiency Ratios

Inventory turnover
This measure the number of times that an enterprise turns over its stock each year and indicates
the amount of inventory required to support a given level of sales. It can be computed as
cost of goods sold
Inventory turnover = the inventory
The inventory turnover can also relate to the average length of time a firm keeps its inventory on
hand.

A low ratio may mean that the company with large stocks on hand may find it difficult to sell its
product, and this may be an indicator that the management is not able to control its inventory
effectively. Thus a low ratio, though good, may indicate cash shortage & the firm might
sometime be forced to sell by forgoing sales opportunities.

Operating ratio

This is obtained by dividing the operating expenses by the revenue.

Operating expenses
Operating ratio = revenue

4.7.2. Income ratios

The long-term financial viability of an enterprise depends on the funds it can generate for
reinvestment and growth and on its ability to provide a satisfactory return on investment.
Return on sales
This shows how large an operating margin the enterprise has on its sales.
Netincome
Return on sales = revenue
Return on equity
It is an amount received by the owner of the equity. It is obtained by dividing the net income
after taxes by the equity. Equity - an ownership right or risk interest in an enterprise. Equity
capital is the residual amount left after deducting total liabilities (excluding stockholder's claim)
from total assets.
Net income
Return on equity = equity
This ratio is frequently used because it is one of the main criteria by which owners are guided in
their investment decisions.
Return on assets
Operating income
Return on assets = Assets
The earning power of the assets of an enterprise is viral to its success. The return on assets is the
financial ratio that comes closest to the rate of return on all resources engaged. A crude rule of
thumb is this value should exceed interest rate.
4.7.3. Creditworthiness Ratios
The purpose of creditworthiness ratios is to enable a judgment about the degree of financial risk
inherent in the enterprise before undertaking a project. It also helps to estimate the amount and
terms finance needed.
Current ratio
This is computed by dividing the current assets by the current liabilities. Though it needs
caution, as a rule of thumb, a current ratio of 2 is acceptable.
Current asset
Current =
Current liability
Debt-equity ratio
This is an important ratio for credit agencies. It is calculated by dividing long-term liabilities by
the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities are
to total debt and equity, and then by dividing equity to obtain the proportion that equity is of the
total debt and equity. These are then compared in the form of a ratio.
Equity
Equity Ratio =
Equity + Longterm liability
Longterm liability
Liability ratio = Equity + Long term liability
LR
Debt - Equity Ratio =
ER
It tells us, of the total capital, how much proportion is equity & how much is debt.

If for example liability ratio is 0.40 and equity ratio is 0.60, it means that of the total capital 40%
is debt and 60% is equity. Then debt equity ratio is 1.5 to 1. For each one birr liability a project
has 1.5 birr equity. In general strong equity base is good for a project to overcome risk &
uncertainty. Especially in some risky projects, low ratio of long-term liability to equity is a
necessary condition.
Debt service coverage ratio
The most comprehensive ratio of creditworthiness is the debt service coverage ratio. This is
calculated by dividing net income plus depreciation plus interest paid by interest paid plus
repayment of long-term loans.
Net income + Depr .+ Interest
Debt service coverage ratio = Interest + repayment of loan ( p )
It tells us how a project can absorb any shocks without impairing the firm's ability of meeting
obligations. In contrary to this it can also tell us how the firm chose an appropriate credit term.
Normally, financial institutions regard a debt service coverage ratio of 2 as satisfactory.