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Enterprise Analysis

Enterprise Budget and Analysis

(Appendix to Step 1 of Business Planning)

Most businesses are a collection of individual activities (enterprises) that generally complement one another. But the owner must assess each activity separately to know which ones are earning a profit and which activities should be changed (expanded or contracted).  This page introduces enterprise analysis; a procedure for analyzing the various activities of a business. 

  • The purpose of conducting an enterprise analysis is to determine the profitability of a particular portion of the overall business; preparing an income statement (exit this web site) is the procedure to assess the profitability of the overall business.
  • The revenue, cost, and profit of an enterprise are measured or quantified in monetary terms, that is, dollars; but an enterprise analysis also requires an understanding of the physical units of inputs and output.
  • Sample format to prepare an enterprise analysis.

    Example of completed enterprise analysis.

A farm business will be used as an example to demonstrate enterprise analysis but the concept is equally applicable to non-farm businesses.  The first question in analyzing enterprises is to define the enterprises. 

Defining Enterprises

One way to define an enterprise is according to the commodity being produced; that is, raising wheat is a separate enterprise from raising soybeans or producing beef calves.

Another distinguishing factor may be the method of production.  For example, growing corn using conventional tillage practices is separate from the enterprise of raising corn using reduced-tillage practices. These are distinct enterprises because the yields and inputs will likely be different.

Likewise, an enterprise can be defined to recognize the activity being performed.  Raising wheat is a separate enterprise from storing wheat. Raising wheat encompasses preparing the field in fall, planting in spring, and harvesting at the end of summer. However, what occurs after harvest is another enterprise; thus on-farm wheat storage is an enterprise distinct from producing the wheat.

  • The reason for this distinction is that the farmer could sell the wheat directly from the field, or it could be stored on the farm or at an elevator. The decisions of whether to store, where to store, and when to sell are distinct from planting and harvesting.  Thus the wheat production enterprise is separate from the wheat storage enterprise, and the revenue for the wheat production enterprise is the market value of the grain at harvest.  Any increases in revenue due to storing the wheat would be attributed to the second enterprise and used to offset storage costs, shrinkage, and interest expenses.

In addition, enterprises could be defined to recognize different production response.  For example in a cow-calf operation, one enterprise may be maintaining the breeding herd and the calves until they are weaned. A second enterprise perhaps would be to background the calves until they gain 200 pounds after weaning. A third enterprise may be to keep the calves until they gain yet another 200 pounds. By separating the feeding enterprises, the farmer recognizes the various feed/gain ratios and is better able to consider the potential returns and costs of each step.

  • An alternative to an enterprise analysis is a partial budget analysis which calculates the change in profit resulting from a change in the business.  Although the two methods of analysis and the information they provide differ, they rely on much of the same information; that is, to complete a partial budget analysis, a manager relies on much of same information needed to complete an enterprise analysis.

The type of commodity, production practices, activity being performed and production response are not the only categories of farm enterprises. Equipment ownership, land ownership, and financing also can be defined as enterprises within a farm. For example, enterprise analysis can help determine whether it is more profitable to:

  1. own land, pay property taxes and interest on borrowed capital, not earn interest on the equity in the land, but enjoy the appreciation in land values, or
  2. pay rent and invest the owners' equity in other farm or nonfarm alternatives.

Regardless of how they are categorized, carefully defined enterprises allow farmers to better understand the components of their business, and to identify profitable activities as well as those that are being subsidized by other enterprises.

Enterprise Account compared to Enterprise Budget

An enterprise analysis can be

  • an historical account that reports past activities and profit, or
  • a budget that projects future profits based on estimated or expected quantities and prices.

One strategy would be to prepare an enterprise budget at the start of the year as part of cash flow planning and developing marketing strategies. An enterprise account could then be prepared at the end of the year to record and assess actual experiences and outcomes.

Time Period

Enterprise analysis (especially a production enterprise such as raising sunflowers) often encompasses one production cycle. In the case of grain, that generally is one year. However, an enterprise analysis that addresses an investment (such as buying a tract of land or a piece of equipment) would encompass the expected duration of ownership. If an analysis encompasses an extended time period, the time value of money needs to be considered.  Similarly, an enterprise analysis can be conducted for less than a year; for example, the production period of a feedlot may be several months to reflect the length of time an animal is kept at the facility.

Profit v. Cash flow

Some transactions involve cash (e.g., purchase of input or sale of output) while others do not (e.g., feeding commodities you raised to your livestock). Thus, the impact an enterprise has on the farm's overall cash flow can differ from its impact on the farm's profitability (see Cost v. Cash Outflow).  Both measures of business performance are important, but most enterprise analyses are prepared to determine profitability.  However, an enterprise analysis can be used to determine its impact on the business' cash flow.  Alternatively, farmers may wish to prepare two analysis to determine the enterprise's profitability as well as its impact on the farm's overall cash flow. The last two columns of the worksheet for enterprise analysis provide space to record both profitability and cash flow.

Allocation Among Enterprises

A challenge in developing enterprise budgets is to measure the portion of an input that should be attributed to each enterprise when the input is used in several enterprises. A tractor is one example. It may be used for wheat, corn, barley, and livestock enterprises. The question becomes what portion of its fuel, depreciation, repairs, and similar costs should be allocated to each enterprise. Different approaches can be used. Perhaps allocating on the basis of acres or hours of use is reasonable.  See Depreciation Based on Use.

Some activities are difficult to allocate to an enterprise; such as recordkeeping. These unallocated costs can be accounted for when the enterprise are combined to understand the whole farm. At that point in the process, activities that cannot be allocated can be added into the whole-farm analysis as unallocated income or expenses.

Estimating Revenue

Enterprise analysis requires detailed information. Another challenge in conducting enterprise analysis is gathering the necessary data, such as quantity of inputs and outputs.

By placing a dollar value on the inputs and outputs, the analysis also reveals the profitability of operating the enterprise. Revenue is calculated by multiplying the units of output by its price.

Some enterprises offer more than one source of revenue. For example, revenue sources from wheat production may include the grain, government program benefits, crop insurance payment, straw, and fall grazing. Even though each of these products may not directly generate cash income (fall grazing, for example), they are products with a value and deserve to be recognized.

Estimating Costs

Cost is generally defined as the amount that must be paid to acquire something, such as the purchase price of fuel or the rental rate of land. However, there are different types of costs and by categorizing costs, an owner may better understand the business.

To determine costs, the business owner needs to identify all the inputs that will be used to produce the commodity; this could be thought of as specifying the "recipe" the will be used. For example, in a crop enterprise, the recipe's ingredients would include the type and quantity of land, seed, fertilizer, fuel, interest, depreciation, labor, and repairs used in the production process. But inputs also include the farmer's time, management skills, capital, and other investments. The inputs the farmer owns and uses in the enterprise need to be recognized even though they do not need to be purchased at this time because they are already owned by the farmer.

Categories of Costs

One way to categorize costs is as variable or fixed. A variable cost is one that can be changed. For example, fertilizer is a variable cost at the start of the planting season because it has not yet been applied and the manager still can alter how much will be used that year, and thus how much will be spent on for that input. A fixed cost is an expense that cannot be changed. The interest that will accrue on a long-term land debt cannot be varied, nor can the depreciation that will occur to equipment. Property tax is another example of a fixed cost.

A second way to categorize costs is whether the expense is cash or non-cash, as described in a previous section. A cash cost requires a cash payment such as paying the supplier for this year's seed or feed. Depreciation, however, is a non-cash cost; it does not require a cash payment at this time. Also see Cost v. Cash Outflow and Depreciation.

Another category of costs is explicit and implicit. An explicit cost is one that needs to be paid to another person. Again, paying for seed or feed would be explicit costs. An implicit cost is one that does not require that the business pay another person. An example would be the cost landowners incur by using owned land in their own business. The cost is that the landowner cannot earn rent by leasing the land to someone else if the land is being used in the landowner's business. This forgone income is called an opportunity cost.

Example. If your land is paid for, there would be no cash cost for the land other than taxes and insurance, but the opportunity cost includes the income that is not earned on the equity invested in the land.

These cost categorizations are not distinct from one another. The seed a farmer purchases is a explicit variable cash cost whereas the interest on a long-term debt is an explicit fixed cash cost and depreciation is an explicit fixed non-cash cost. By comparison, the rent and wages you will not earn because you are using your own land and labor in your farm operation are implicit non-cash costs.

The purpose of recognizing these cost categorizations is to better understand the farm operation. For example, all costs do not require a cash payment; some costs cannot be varied; and if you give up more income by using your resources in your own business than you could earn if someone else used your resources in their business, you may ask yourself whether your use of the resources is their best use.

Resources with More than One Cost

Some resources pose unique issues in developing enterprise budgets. One such resource is land because its cost varies depending on whether it is rented, owned without debt, or owned with some debt. An example may clarify the issue.

Example. A farmer owns 60% of the land used in the business. It has a market value of $500 per acre, but the land debt averages $220 per acre. The farmer pays 10% of the principal each year plus 9% interest on the remaining balance. The property tax is $7 per acre. The remaining land in the business (40%) is leased for a cash rent of $45 per acre. The farmer could invest cash in a non-farm investment and earn an annual return of 6%. To assure a proper rotation, the farmer uses both rented and owned land in the enterprise being analyzed.

With this information, the land cost can be calculated as follows:

  1. Rental rate times the portion leased is the land cost attributable to leasing (variable cash),
  2. Property tax times portion owned is some of the land cost (fixed cash) attributable to owned land,
  3. Amount of land debt per acreage times the interest rate times the portion that is owned is the interest costs attributable to land ownership (fixed cash),
  4. Principal that must be paid on land debt times the portion that is owned is a fixed cash outflow but not a cost, and
  5. Opportunity cost is the foregone interest income on the equity in the land times the portion that is owned; this is a fixed noncash cost.

Table 1. Calculating Land Cost for Profitability and Cash Flow

.
Profitability
Cash Outflow
Land rental ($45 x .4)
 $18.00
 $18.00
Property tax ($7 x .6)  
  4.20
  4.20
Interest on debt ($220 x .09 x .6)
11.88
11.88
Principal on debt ($220 x .1 x .6)
.
13.20
Opportunity on equity (($500 - $220) x .6 x .06)

10.08

.

Land cost per acre
  $44.16
  $47.28

 

Which Depreciation Method Should be Used?

Another question that arises is what method should be used to calculate depreciation.

  • One idea is to use the income tax depreciation deduction; however, those depreciation method may overstate costs in the early years and understate them in later years.
  • An alternative is to use a longer useful life or a slower method to delay the cost to later years, but the allowance would still be tied to time.
  • A third strategy would be to calculate depreciation to the basis of the asset's use so the depreciation cost would be highest in the years of greatest use.

    Example. Pay $79,000 for a machine with an expected life of 10,000 hours. If the machine is used 800 hours one year, the depreciation would be $6,320 (800/10,000 x $79,000). In a year when the machine is used 1,300 hours, depreciation would amount to $10,270 (1,300/10,000 x $79,000).

Output of One Enterprise as an Input for Another Enterprise

In many farm operations, the product of one enterprise is used as an input in another, such as hay being raised so it can be fed to livestock. A question that arises is what amount should be used as revenue for the first enterprise and what cost should be used for the second enterprise. The recommended practice is to use the market value of the commodity. This practice reveals whether the first enterprise would generate a profit if the commodity was sold rather than used, and whether the second enterprise would be profitable if its inputs were purchased rather than raised.

Crop Rotation

Another challenge in conducting an enterprise analysis is to properly assess the implications of a crop rotation. For example, a farmer intuitively knows that it is reasonable to continue to include a small grain in the crop rotation even though the enterprise analysis indicates that it is unprofitable. An explanation of this apparent conflict maybe that some cost or revenue has not been correctly considered.

With respect to the small grain example, perhaps the land cost is incorrect. If stubble is preferred for the subsequent production of a specialty crop, the small grain enterprise is producing more than just the grain that is harvested and sold. The stubble also has value that needs to be accounted for in the analysis.

The cash rent market already recognizes this value. Some producers may pay a $30 premium to cash rent stubble for one year so they can raise a specialty crop. This additional rent (whether or not it is actually paid) should be considered an added revenue to the small grain enterprise and an increased cost to the specialty crop enterprise.

The following tables demonstrate this concept using hypothetical data. Table 2 illustrates simple enterprise budgets that impose the same land cost for each enterprise. The small grain enterprise looks like a loser whereas the specialty crop is generating a profit.

Table 2.

 

Enterprise 1 Small grain(Year 1)

 Enterprise 2 Specialty crop (Year 2 )
Revenue
$120
$400
Operating costs (-)
65
210
Cash rent (-)     
70
70
Return
 $-15
$120

 

Table 3 assumes that farmers are willing to pay a $30 premium to have stubble ground that can be used to raise a specialty crop. The additional value is a result of producing the small grain and therefore is added revenue for that enterprise.

Table 3.

.

Enterprise 1 Small grain(Year 1)

 Enterprise 2 Specialty crop (Year 2 )
Revenue
$120
$400
Rent Premium (+)
30
.
Operating costs (-)
65
210
Cash rent (-)     
70
100
Return
 $15
$90

 

This procedure increases the profitability of the small grain and decreases the profit generated by the specialty crop. Now, the enterprise analysis agrees with the farmer's intuition. A similar approach can be used if production of the specialty is expected to reduce the yield the following year (table 4).

Revenue from a small grain crop that follows a specialty crop is $25 less than if the grain was produced on other land (e.g., an expected revenue of $125 rather than a normal revenue of $150). The reduction in revenue in the third year is an impact of raising the specialty crop in the second year. To reflect this impact, an adjustment is included in the analysis for both the specialty crop in the second year and the small grain crop in the third year.

Table 4.

 

Enterprise 2 Specialty crop(Year 2)

 Enterprise 3 Small grain(Year 3)

Normal revenue
$400
$150
Revenue reduction following specialty crop
.
25
Expected revenue
400
125
Operating costs (-)
210
65
Cash rent (-)
100
70
Adjustment for subsequent revenue reduction (-)
25
.
Adjustment for added value to previous crop (+)
.
25
Return (based on normal revenue)
$ 65
$ 15

The cost and return to land is not the only resource that may be subject to error. For example, farmers should be careful to recognize whether a specialty crop enterprise that requires an extensive line of equipment during fall harvest is subsidizing a small grain enterprise that uses the equipment during the late summer for combining.

Enterprise Budget Example

Table 5 is an example of an enterprise analysis for raising drybeans in north central North Dakota. This example reveals an accounting profit of $32.42 and a positive cash flow of $39.22. It includes an opportunity cost of $23.34 for equity in the land and equipment and a return of $9.08 for all other owned assets.  Also see opportunity cost's relationship to enterprise analysis.

An enterprise analysis does not reveal

  • time for completing the activities,
  • time of cash flows,
  • availability of resources,
  • whether family draw is equal to opportunity cost of family labor, nor
  • whether this "recipe" for raising drybeans is the most profitable.

Concluding Thought

Each business is a combination of several activities or enterprises. To fully understand the business and effectively manage it requires that the decision maker assess each part of the business. An enterprise analysis is one component of that assessment process.

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