Clarifying Cost of Production (CoP)

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By Dwain Duxson

Clarifying Cost of Production (CoP) - We get many replies to our Farm Tender Daily and The Farmers Club stories we write. They go out to a wide range of people involved in Agriculture. I am pretty broad when I write; it's quite short, so I rarely get into much detail. Some people are specialists in their field, and I do enjoy their responses because they are living and breathing this stuff every day. John Francis is a respected Farm performance consultant from Agrista. He sent a reply to our story on the Cost of Production. See the story here and see John's reply below.

Hi Dwain,

I just saw your article on the Cost of Production.

A word for clarity. Cost of production is different to the operating costs of the business. They are two different figures.

The first, cost of production, is just that – it measures operating cost relative to the production in kilograms clean wool, beef or lamb produced by the business.

Cost of production is a ratio. Ratios typically measure efficiency. In this case cost of production measures costs relative to production so it is a cost-efficiency ratio.

In many cases you can drive cost of production down by driving production up. It is counter-intuitive but it makes sense because if the denominator in the ratio increases with no change in the numerator then the value of the ratio declines (a positive in the case of cost of production but not in every ratio). 

Production is calculated as sales less purchases plus inventory change. Inventory change is calculated as closing product inventory less opening product inventory.  

Operating costs are just a figure (not a ratio) and are made up of two broad categories –

• Enterprise expenses (animal health and breeding (NOT cost of rams), selling costs, contract costs, supplementary feed costs, shearing costs, crutching costs etc)
• Overhead costs (admin, labour (including owner labour), R&M, depreciation, rates and rents, insurance etc)

Operating costs do not include interest costs, lease costs, debt repayment, capital expenditure, tax or personal expenses. These costs occur below the operating cost line.

What you talked about in your article was cost, not cost of production. Cost is a figure it is not a ratio.

Without the context of the production, the cost figure is mildly informative. The beauty of cost of production as a measure is it assesses cost relative to production. In the case of the example you gave, if CoP was used by the business in question, they would know whether dropping the second shearing would increase or decrease their cost of production.

Operating cost (with 2 shearings) ¸ kg clean wool (with 2 shearings) vs        

Operating cost (with 1 shearing) ¸ kg clean wool (with 1 shearing)     

The cost of production ratio is important because with one shearing any change in production occurring from reducing shearing frequency is accounted for.

To go one step further a partial budget would deliver a lot of value in this decision.

A partial budget calculates the difference in the outcome of the option to change relative to the existing approach. 

In the case of your example of moving from multiple to single shearings per year the factors that may change include: Price (due to differences in staple length, discount structures etc), production – due to changes in shearing frequency, labour costs due to less frequency of handling, mustering etc, shearing costs due to change in shearing frequency. There may be others that I haven't considered but require inclusion here.

The partial budget deducts all of the marginal (additional) costs from all of the marginal (additional) benefits to establish the extent of the value of the change to the business. 

The reason I raise this is that some farm business managers know their cost structure well enough but very few in my experience actually know their production or how to calculate it.

Sadly this means that they miss out on calculating one of the most important business efficiency ratios in the business - cost of production.

Regards,

John Francis

Agrista

Wagga Wagga, NSW, 2650

Mob: 0427 259 005

Email: john@agrista.com.au | Web: https://www.agrista.com.au

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